Abstract

Recently I had a discussion about hedge funds with a friend. We were mainly concerned with the question, why this type of investment was growing in popularity. The guy quoted from one of the latest letters by Warren Buffett, who said, that hedge funds provided little value for money. Since it took place in a pub on a Friday night, none was taking it really seriously. Non the less, the topic is quite interesting to me, since I used to work in a company, which developed software for hedge funds, and in general am quite keen to think about financial issues.

Why are hedge funds gaining popularity?

So, why? I think, that there are a few reasons for it, and some are more known and analyzed, and some are less obvious, but still important.

• Hedge funds are much less regulated, so they can do things mutual and especially funds don't do. This usually includes making riskier investments, using higher leverage and, of course, less control and report to the client. The result is sometimes higher profits for the better ones (and higher losses for others)
• It is very easy to set up a hedge fund. Basically, two-three people can join forces and run it. The only problem is to find the clients, who are ready to invest, therefore a hedge fund will succeed if it has good sales team
• There are a lot of people with "easy money". Successful IPOs in dot.com boom (which is coming back, by the way), all sorts of half-legal activities in emerging markets, revenues from economy globalization all created scores of people with personal wealth measured in millions in cash and little understanding on how investment works. The newborn rockefellers looks for ways to invest their money, and some of it ends up in the hands of hedge funds managers, all thanks to their salesmen with silver tongues.
• Some hedge funds are actually quite good. As mentioned, they have greater freedom on what they can do. Also, some of them deploy innovative and aggressive trading techniques, including automated trading and looking for niche arbitrage opportunities, sometimes ignored or overlooked by bigger sharks
• A strong selling point of hedge funds is the fact that their founders usually invest their own money into it. This gives other investors feeling, that the fund managers will take better care of the whole pot
• Also, due to little regulation, hedge funds have to disclose much less about their customers, than the regular mutual funds. Operating from offshore facilities, they can effectively escape the watching eye of SAC, FSA and other regulating bodies, and their clients can enjoy the earnings (or mourn losses) in privacy
• And then, some quite under-performing funds don't provide proper reporting, once again due to being less regulated, thus giving less information about what is actually going on with clients' money. This is one of the things which made the disaster of LTCM

So, to sum up, there are some rich, but not very experience people with free money on one side, and sharp, eager and aggressive traders and salesmen on the other. The global economy has been growing and so everyone was ready to take risks in order to reap off higher dividends.