Hedge Fund Investing Chapter 3: Industry Trends and History

Chapter 3 is basically a timeline of the hedge fund industry. How it started small, got huge, almost died in 2008, and came back. If you want to understand where hedge funds are today, you need to know how they got here.

From $30 Billion to $2 Trillion

In 1990, the entire hedge fund industry managed less than $30 billion. Today it’s over $2 trillion. That’s not a typo. The industry grew by roughly 65x in about 20 years.

Between 1990 and 2011, the industry rarely lost money. Net outflows (more money leaving than coming in) happened only three times. Every single year except 2008 ended with more assets than it started with.

Mirabile breaks this growth into five distinct periods. Let’s walk through each one.

Pre-1998: Nobody Cared

Before 1998, hedge funds were basically a secret club. A small number of very wealthy individuals found managers through word of mouth or informal networks. Sure, names like George Soros and Tudor Jones made headlines for profiting during currency crises and market crashes. But most regular investors and institutions had zero idea what a hedge fund even was.

There was no media coverage. No academic research. No institutional interest. Just rich guys handing money to other rich guys.

1998-2002: Everyone Noticed

Then the returns got too good to ignore. Some hedge funds were pulling 30%+ per year. Media started paying attention. Market commentators pointed out something interesting: hedge funds were not only generating high returns, they were doing it with lower volatility than the stock market.

Even better, hedge funds held up well during several rough patches. The 1998 mini-crash, the Y2K scare, the NASDAQ meltdown, the Enron-era corporate scandals. Through all of that, hedge fund returns stayed relatively stable.

Institutions started thinking: “Wait, maybe we should be in on this.”

2002-2007: The Golden Age

This is when things really took off. Academic studies confirmed what investors were seeing. Dynamic trading strategies had real portfolio benefits. Institutional money started flowing in hard.

What happened during the golden age:

• Number of hedge funds tripled
• Assets under management exploded
• Banks and brokers started depending on hedge fund commissions
• The industry started becoming “institutional” with real infrastructure

Leverage also expanded rapidly during this period. Low-cost borrowing in US dollars plus increased use of derivatives meant funds could take bigger positions. By the end of 2007, leverage (excluding derivatives) reached nearly 3x the industry’s assets under management. That’s a lot of borrowed money.

Managers got comfortable. Volatility in stocks and bonds was declining, so even with more leverage, the funds’ overall volatility looked normal. Everything seemed fine.

2008-2009: The Crisis

Then 2008 happened and everything changed.

The industry lost money for the first time in 20 years. Losses exceeded 20%. Yes, the S&P 500 dropped over 40%, so hedge funds did better on a relative basis. But investors didn’t sign up for “lose less than the stock market.” They were promised absolute returns. Capital preservation. Profits in any market.

The Madoff scandal made everything worse. It tarnished the entire industry’s reputation. Media coverage turned hostile. Regulators pointed fingers. Investors started questioning whether putting money in hedge funds was even safe.

Then came the redemption wave. Investors wanted out. But many hit a wall called “gates.” When too many investors try to redeem at once, managers can lock the door. They use fine print in fund documents to restrict withdrawals, sometimes to protect investors from fire sales, sometimes to protect their own business. Many managers got sued over this. Some lawsuits dragged on for years.

The $50-70 billion per year the industry was collecting in fees? That didn’t help public perception either. Top managers were still getting paid hundreds of millions personally in 2008, the worst year in hedge fund history.

2010 and After: The Comeback

Once markets settled in 2009-2010, investors came back with demands. They wanted transparency, independent administrators, risk management committees, and better controls. The message was clear: clean up your act or lose our money.

Funds that listened grew. Funds that didn’t closed down.

Here’s what really drove the comeback: pensions and endowments were desperate. The stock market had produced close to zero net gains for the entire decade. Bond yields were near zero to 4%. But these institutions needed 5-8% returns to meet their obligations. Hedge funds, with their high-single-digit returns and low-single-digit volatility track record, looked like the answer.

The big got bigger. Large hedge funds with proper controls and reporting grew fast. Smaller funds started struggling to attract capital.

Strategy Evolution

The mix of hedge fund strategies changed a lot over 20 years. In 1990, global macro dominated at 40% of the industry. By 2011, the allocation was much more balanced:

The US market remained dominant. More than 50% of all global hedge fund assets were invested in US stocks, bonds, or derivatives. That’s partly about market size, partly about liquidity and exchange efficiency.

Performance: The Numbers

According to HFR data, $1,000 invested in the stock market in 1990 would be worth about $6,000 by end of 2011. The same $1,000 in hedge funds would be worth over $10,000. And the hedge fund ride was smoother. Annualized volatility for a diversified hedge fund portfolio was about 6.5%, compared to almost 16% for stocks.

The Sharpe ratio (risk-adjusted return) for the industry was also significantly better than stocks alone.

But here’s the catch. When you break down gross returns from 1995-2006, roughly one-third went to fees, one-third was alpha (actual manager skill), and one-third was beta (market exposure you could get cheaper elsewhere). That fee bite is real.

The Regulation Side

Three agencies regulate US hedge funds: the SEC, the CFTC, and the NFA.

Key regulations:

Investment Advisers Act of 1940 - Advisors with $110M+ in assets must register with the SEC. Smaller hedge fund-only advisors (under $150M) get reduced reporting.

Securities Act of 1933 - Sets up private placement exemptions that let hedge funds exist. Investors must be “accredited.” Rule 506 of Regulation D is the go-to.

Investment Company Act of 1940 - Section 3(c)(7) is the main exemption. Investors must be “qualified purchasers” with at least $5M in investments (individuals) or $25M (entities).

Dodd-Frank Act - After 2008, this required advisors to file Form PF with the SEC. Large advisors ($1.5B+) file quarterly. Smaller ones file annually.

The CFTC gets involved if a fund trades any futures or commodity options, even minimally. Managers then register as Commodity Pool Operators unless they qualify for a narrow exemption.

The Bottom Line

The hedge fund industry went from a tiny club of rich insiders to a $2 trillion machine that pension funds depend on. It survived its worst crisis in 2008 by cleaning up its act and offering what institutions needed: returns higher than bonds with volatility lower than stocks. The barriers to entry got higher, the big players got bigger, and the regulation got tighter. That’s the story so far.

Previous: Chapter 2 Part 2 | Next: Chapter 4

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.