Many important events—such as the establishment of the first modern hedge fund–type structure in 1949, advances in technology, and federal regulation of hedge fund firms and managers—have shaped the hedge fund industry.
The Birth of the Hedge Fund Industry
The hedge fund sector as we know it today began in 1949 when Alfred Winslow Jones, a journalist and sociologist, founded one of the first hedge funds. Jones was researching a story on stock-market forecasting when he became fascinated by the process and started his own hedge fund. According to Hedge Funds and Managed Futures: Performances, Risks, Strategies, and Uses in Investment Portfolios, Jones was “the first to use short selling, leverage, and incentive fees in combination,” and this approach helped him generate better-than-average investment returns. In 1966, the term “hedge fund” was coined by Carol Loomis, a reporter for Fortune who wrote a profile of Jones detailing his financial success. The financial industry was impressed by Jones’s achievements, and others began to create their own hedge funds. Within a few years of the article’s publication, the number of hedge funds grew from a handful to more than 100. Today, there are about 14,500 hedge funds in the world.
Technology Changes the Face of the Hedge Fund Industry
The hedge fund industry has come a long way from its early days in the 1950s, when fund managers created and adjusted mathematical equations on paper, used calculators to add and subtract large sums or determine percentages, and waited for the morning paper or television news broadcast to get the latest info on the stock market and the business world. Over the years, technology has completely transformed the hedge fund industry. Computers, software programs, and the Internet (including cloud computing) have revolutionized the way information is collected, analyzed, and managed, as well as how stocks are traded (more on that later). Order and execution management software such as Eze Software Group’s Eze OMS (which was used by 40 percent of firms in 2014, according to a survey by Eze Castle Integration) and Bloomberg’s Asset and Investment Manager (used by 32 percent of firms) allow for more effective workflows between hedge fund departments. To be successful today, hedge fund firms also need quality market and data analytics, research/document management, risk management, compliance, and fund administration software. “The largest managers are spending the most [on technology],” according to The Hedge Fund Journal. “They are making strategic capital investments in technology to continue to scale their operations. Investments have moved to two key areas: data management and integrated front-office systems that create efficiencies between the front and middle office.”
Ninety-four percent of hedge fund managers surveyed by KPMG/ Alternative Investment Management Association (AIMA)/Managed Funds Association (MFA) in 2016 said that the use of technology will have an impact on competition between firms in the next five years. Thirty-eight percent said that the impact of technology will be significant. “Nine out of 10 respondents cited improved controls and compliance as a primary objective for their technology spend,” according to the survey Achieving efficiency objectives was cited as a top reason for technology investments by 88 percent of respondents; investor expectations, 51 percent; improved competitiveness, 48 percent; cost reduction, 47 percent; and reduced complexity, 42 percent.
The most noteworthy change brought about by technology is the growing popularity of high-frequency trading, in which sophisticated algorithmic models are used to trade stocks rapidly and take advantage of small changes in stock prices to earn healthy returns. In 2016, high-frequency trading firms accounted for a little less than 50 percent of all U.S. equity trading volume, according to Credit Suisse. Hedge funds such as AQR Capital Management, Systematica Investments, and R. G. Niederhoffer Capital Management are using algorithmic trading technology to earn big profits.
Despite the popularity of high-frequency trading regulators such as the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission are concerned that this type of trading can negatively affect the stock market and the U.S. economy. For example, regulators believe that automated, high-speed, algorithmic trading exacerbates the phenomenon known as a “flash crash,” which occurs when stock prices drop or rise precipitously in a matter of minutes before recovering. A “flash crash” that occurred in May 2010 was blamed on computer-driven trading. Flash crashes often cause the overall stock market to temporarily decline and investors to lose confidence in the market, among other adverse effects. High-frequency trading “is here to stay,” says Lawrence Leibowitz, former chief operating officer of the New York Stock Exchange Euronext. “The real question is, how do we regulate it and (monitor) it in a way that gives people confidence that it is fair and that they have a chance?”
The hedge fund industry is also beginning to use blockchain technology, which can be defined as a distributed ledger database that maintains a continuously-growing list of financial records that cannot be altered. The KPMG/AIMA/MFA survey found that hedge fund managers have little interest in using blockchain as a digital currency platform. Instead, “hedge fund managers may be utilizing blockchain-based technologies to provide faster and more secure transactions, streamlining and automating back office operations and reducing costs.”
Economic Crises and Corporate Financial Scandals Increase Regulation...at Least for a Time
Corporate financial scandals, the stock market crash of 2000–2002, and the Great Recession of 2008–2009 led to significant financial distress in the United States and around the world and caused the public to lose trust in the financial system. These and other events prompted the federal government to take a closer look at the alternative asset management industry (including the hedge fund sector) and enact a series of laws and regulations that attempted to “right the ship.”
In 2003, the U.S. Securities and Exchange Commission (SEC) issued an extensive report on the industry, with SEC staff recommending a number of measures to increase oversight of the relatively unregulated—some would say under-regulated—industry.
In 2006, the SEC finally took action, requiring all hedge funds to register as investment advisers under the Securities Act of 1933. Many hedge fund companies, hoping to prove the honesty and operations of their operations to potential investors, had already registered voluntarily and subjected themselves to regulatory scrutiny. Now, however, every hedge fund firm must register as an advisor and thereby open its books to the SEC, sometimes in random inspections. This doesn’t mean, however, that the funds themselves are open to complete scrutiny. That point was very important to hedge funds, whose managers prefer to keep the funds’ holdings and trading strategies close to the vest as they try to outperform their competitors. Exposing the “secret sauce” of a fund’s operations could limit the impact of these trading strategies and take away a firm’s perceived advantage. “Hedge funds take advantage of inconsistencies and minute opportunities throughout the broader markets,” says one chief investment officer of a large fund. “If we had to detail how we were doing that, then everyone would try to exploit those little quirks in the market, and there wouldn’t be as much money to be made.”
The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in 2010, increased the regulation of the hedge fund industry. It requires all hedge fund advisers with more than $150 million in assets under management to register with the SEC, to hire a chief compliance officer to create and monitor a compliance program, and to agree to a variety of other rules.
In recent years, the Republican-led Congress and the Trump Administration have reversed some of the provisions of Dodd-Frank and reduced regulation of the hedge fund industry. A study conducted by Georgetown University found that the dollar amount of penalties ordered and the number of enforcement actions undertaken by the Securities & Exchange Commission fell by roughly 16 percent from 2016 (the last year of the Obama Administration) and 2017. In the short term, the trend is toward deregulation, but administrations and control of Congress change. In the future, the pattern may shift once again toward increased regulation of the alternative investment industry.
Women Seek to Gain Ground in the Hedge Fund Industry
It’s common knowledge that the percentage of women in hedge fund positions is significantly lower than their percentage of the U.S. population. Given the dearth of women in the hedge fund industry, it’s a bit ironic that a woman (Carol Loomis) helped popularize the hedge fund industry via her 1966 article in Fortune. Only 4.3 percent of hedge fund companies were owned by women (minorities owned 8 percent of firms) in 2017, according to the Bella Research Group. These firms control less than 1 percent of total assets in the hedge fund industry. Another irony: a report from the professional services firm Rothstein Kass found that hedge funds that are managed by women have higher rates of return than a broad range of index funds.
In the past two decades, professional associations and some hedge fund firms have made efforts to encourage more women to enter into and prosper in the hedge fund industry. One groundbreaking organization is 100 Women in Hedge Funds, which was founded in 2001 by three female professionals who sought to bring 100 women into the hedge fund industry together in order “teach women to better leverage their collective relationships and improve communication within the alternative investment industry.” The organization has really taken off since then; it now has “more than 13,000 members in 19 locations across three continents. Members represent over 2,800 hedge funds, 1,000 fund of funds and 500 institutional buyers.” The Association of Women in Alternative Investing is another organization that seeks to increase the number of women in the hedge fund and other alternative investment industries by providing mentorship, networking, and education opportunities for women who are currently working in or contemplating entering the industry.