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Journal of Economic Perspectives—Volume 21, Number 2—Spring 2007—Pages 175–194

Hedge Funds: Past, Present, and Future

Rene M. Stulz ´

H

edge funds often make headlines because of spectacular losses or spectacular gains. In September 2006, a large hedge fund, Amaranth, reported losses of more than $6 billion apparently incurred in only one month, representing a negative return over that month of roughly 66 percent. Earlier in the year, newspapers focused on the $1.4 billion compensation in 2005 of hedge fund manager Boone Pickens and the 650 percent return that year of his BP Capital Commodity Fund (Anderson, 2006b). The importance of hedge funds in the daily life of financial markets does not make the same headlines, but hedge funds now account for close to half the trading on the New York and London stock exchanges (Anderson, 2006a). Chances are that you personally cannot invest in a hedge fund. Most U.S. investors cannot. Hedge funds are mostly unregulated. These funds can only issue securities privately. Their investors have to be individuals or institutions who meet requirements set out by the Securities and Exchange Commission, ensuring that the investors are knowledgeable and can bear a significant loss. Most likely, however, you personally can invest in mutual funds, which are heavily regulated in how they can invest their funds, how their managers can be paid, how they are governed, how they can charge investors for their services, and so on. The typical mutual fund cannot make the investments that provide the performance of Amaranth or the BP Capital Commodity Fund. The economic function of a hedge fund is exactly the same as the function of a mutual fund. In both cases, fund managers are entrusted with money from

´ y Rene M. Stulz is the Everett D. Reese Chair of Banking and Monetary Economics, The Ohio State University, Columbus, Ohio. He is also a Research Associate of the National Bureau of Economic Research, Cambridge, Massachusetts, and a Fellow of the European Corporate Governance Institute, Brussels, Belgium. His e-mail address is Stulz@cob.osu.edu .

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Journal of Economic Perspectives

investors who hope that they will receive back their initial investment, plus a healthy return. Mutual funds are divided into two types. Some funds are indexed funds (also known as “passive” funds). With these funds, the managers attempt to produce a return which tracks the return of a benchmark index, like the Standard & Poor’s 500. However, most mutual funds and all hedge funds are active funds. Investors in such funds hope that the manager has skills that will deliver a return substantially better than passive funds. Hedge funds have existed for a long time. It is generally believed that Alfred W. Jones, who was a writer for Forbes and had a Ph.D. in sociology, started the first hedge fund in 1949, which he ran into the early 1970s. He raised $60,000 and invested $40,000 of his own money to pursue a strategy of investing in common stocks and hedging the positions with short sales.1 From these modest beginnings, especially since the turn of the century, the assets under management of hedge funds have exploded. At the end of 1993, assets under management of hedge funds were less than 4 percent of the assets managed by mutual funds; by 2005, this percentage had grown to more than 10 percent. In 1990, less than $50 billion was invested in hedge funds; in 2006, more than $1 trillion was invested in hedge funds.2 Since hedge funds and mutual funds essentially perform the same economic function, why do they coexist? Hedge funds exist because mutual funds do not deliver complex investment strategies. Part of the reason mutual funds do not is that they are regulated. In addition, mutual funds and other institutional investors can gather a lot of funds from investors by promoting simple strategies. Mass selling of hedge fund strategies is much harder because hedge fund strategies are too complex for the...
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