My career in the financial industry started in some of its sleepier corners. First, I was at a credit union. Then, I was a mutual fund specialist at a an index fund company. There was talk of CDOs, AMT, SPVs, etc in the air. But more exotic financial products weren’t part of my world until about six years ago.
Since that time, I’ve been exposed to financial products of increasing complexity. I’ve become friends with lawyers who put those products together for a living. I’ve also met the people whose financial interests are the necessity that drives financial invention. I have been lucky enough to be allowed to look “under the hood”. I’ve been able to probe the details of the deals with both the counsels and the financiers. I’ve seen this work and met these people across the U.S. and Europe. What I’ve learned through these experiences has surprised me.
I think we all know that hedge funds and their managers have a bad reputation in America today. They are attacked by politicians in both parties. They are the butt of jokes. Always, the idea is that they are privileged to the point of excess. They burn diamond watches to fuel their private jets or something like that.
What I’ve learned over the past several years is that this impression is inaccurate. I think that comes from two places. First, we confuse hedge fund managers with their clientele. Which is like confusing the waitress at Babbo for the celebrities who dine there. Second, we have some high-profile examples of people who have made billions managing hedge funds. These are guys like George Soros, Carl Icahn, and Steven A. Cohen who got to the party early. They are the exception, not the rule.
The average hedge fund manager, I’ve found, is actually an entrepreneur. It is someone who is turning an investment philosophy and some well-heeled connections into a small business. This small business, rather than being yet another cupcake shop, is an investment fund.
Like other entrepreneurs, they are sacrificing to do it. Most are giving up high paying jobs as money managers for established firms. Their first 2-3 years managing the fund are often at a loss – revenues just don’t meet expenses with small funds. What’s more, they are tying up an inappropriate percentage of their own wealth in the fund to show would-be investors that they have “skin in the game”. I have to say, I have a deep respect for the guts of these people.
Once these individuals have successfully put together a fund with their own funds, the savings of their family members, and investments from a few 3rd parties, then they have to actually perform. In the hedge fund world performing isn’t just making money. Oh no. It’s beating the market, which is incredibly difficult to do on a consistent basis. Often, new hedge funds fold. I recently spoke to someone about this and he estimated that the failure rate was the same for hedge funds as it is for mom and pop restaurants.
At this point, you might be wondering why anyone starts a hedge fund. What I think the chief reason they people choose to start hedge funds is the Investment Company Act of 1940. Complying with the ’40 Act can be prohibitively costly to comply with for someone starting out in the fund management business. The ’40 Act also restricts what the manager can do with the money by requiring liquidity and encouraging diversification.
I hope this post has improved your understanding of hedge funds and the people that manage them. You can certainly still laugh at the hedge fund manager jokes – most have a good sense of humor about the public perception of the business. Just be a little more thoughtful when you hear them come up in a political stump speech. Without exception, the candidate railing against hedge fund managers actually knows, likes, and takes money from them the types of managers I’ve described above.