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. There were about 17,378 hedge funds in the world in 2020, according to alternatives data provider Preqin.
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 SS&C’s Eze OMS and Bloomberg’s Asset and Investment Manager 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. Fifty three percent of hedge fund industry professionals who were surveyed by the Alternative Investment Management Association, Simmons & Simmons LLP, and Seward & Kissel LLP during Q4 2020 said that their firms were investing in new technologies. Thirty-four percent said they were investing in alternative data technology. Twenty-two percent said they were investing in AI/machine learning as they sought to obtain a “legitimate information edge to meet their client’s investment needs in both efficiently managing risk and generating alpha.” Fifteen percent said they were launching a new digital platform. Overall, large firms with more than $1 billion of assets under management were more likely (66 percent) to invest in new technologies than firms with less than $1 billion in AUM (36 percent). More than 300 industry professionals (82 percent of whom were hedge fund managers), accounting for an estimated $1.3 trillion in assets under management (AUM) were interviewed to complete the survey. The results were published in Global Hedge Fund Benchmark Study: Beyond the Horizon.
The industry is increasingly using artificial intelligence (including machine learning and generative AI) in its investment strategies, data analytics, and other areas. “With mass amounts of data on public equities, bonds, financial statements, currency movements, and even social media all publicly available, artificial intelligence/machine learning can be used by the hedge fund industry in helping managers analyze data and predict market movements,” according to the 2020 Preqin Global Private Equity & Venture Capital Report.
One of 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 late 2020, high-frequency trading firms accounted for about 50 percent of all U.S. equity trading volume, according to the Centre for Economic Policy Research. 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.
Hedge funds are using blockchain to provide faster and more secure transactions, streamline and automate back office operations, increase transparency, and reduce costs. In addition, “blockchain is known by many for its role in cryptocurrency systems such as Bitcoin, and for hedge funds, the two are linked intrinsically,” according to the global online trading company IG Prime. There are more than 300 specialist crypto hedge funds across the world. Traditional hedge funds (THFs) are also investing in cryptocurrencies. In 2022, 38 percent of traditional hedge funds were investing in digital assets, according to PwC’s Global Crypto Hedge Fund Report 2022. This was an increase of 17 percent from 2021. But THFs are being cautious with digital investments. Fifty-seven percent of THFs that were surveyed for the report said that they had less than 1 percent of total assets under management in digital assets. “One of the main causes for uncertainty amongst traditional hedge funds is the lack of regulatory and tax regime clarity associated with digital asset investment,” according to IG Prime. “For digital asset adoption traditional hedge fund managers have also identified a need for infrastructure improvements within the areas of audit and accounting, risk management and compliance, ability to use digital assets as collateral, and fund administration.”
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 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.
The Biden Administration has increased regulation of the alternative investment industry. In 2023, the SEC adopted amendments to Form PF (the confidential reporting form for certain SEC-registered investment advisers to private funds). The amendments will require large hedge funds to file current reports regarding the occurrence of reporting events that could indicate significant stress at a fund or investor harm. The SEC says that the “reporting events for large hedge fund advisers include certain extraordinary investment losses, significant margin and default events, terminations or material restrictions of prime broker relationships, operations events, and events associated with withdrawals and redemptions.” It also says that the “amendments are designed to enhance the ability of the Financial Stability Oversight Council to assess systemic risk and to bolster the commission’s oversight of private fund advisers and its investor protection efforts.” In August 2023, the Securities and Exchange Commission also adopted new rules and rule amendments to the Investment Advisers Act of 1940 as a way to protect private fund investors and enhance the regulation of private fund advisers. The Alternative investment Management Association and five other industry organizations filed a lawsuit against the SEC in response to these changes. More information on the new rules and rule amendments can be obtained at https://www.sec.gov/news/press-release/2023-155.
In the short term, the trend in the alternative investment sector is toward more regulation, but administrations and control of Congress change. In the future, the pattern may shift once again toward increased deregulation of the alternative investment industry.
Women Ared Gaining Ground in the Hedge Fund Industry
In January 2023, women comprised 26.5 percent of hedge fund employees worldwide, according to alternatives data provider Preqin. This is significantly lower than their percentage in the workforce, but an increase of 7.2 percent since 2019. Their representation is lower at managerial levels. Women comprised 19.5 percent of senior hedge fund staff. Here is the breakdown for women in various departments at hedge fund firms:
- investor relations: 39.8 percent of employees were women
- finance/accountancy: 37.3 percent
- operations: 31 percent
- investment team: 21.9 percent
- portfolio management: 19.5 percent
Given the continued underrepresentation 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.
But change is coming to the hedge fund sector. In 2023, the largest-ever woman-led hedge fund, SurgoCap Partners, debuted with $1.8 billion in assets under management (AUM). In 2022, Avala Global, another woman-led hedge fund launched with more than $1 billion AUM. “The rise of large, woman-led hedge funds is a welcome shift in the traditionally male-dominated sector, where only a small percentage of the thousands of hedge funds are run by women,” according to Preqin. “But many women-led hedge funds often struggle to attract large amounts of capital from investors and tend to be much smaller in size, leading to unequal performance outcomes. So high-profile debuts such as those with over $1 billion in AUM offer female managers a chance to overcome this pattern and break this cycle, signaling that change could be occurring in the world of finance.”
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 Finance, which was founded in 2001 by three female professionals who sought to bring 100 women into the investment 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 15,000 members in 26 locations across four continents. 100 Women in Finance has established the 30×40 Vision goal, in which women will occupy 30 percent of investment team and executive leadership roles by 2040. 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.
The COVID-19 Pandemic and Recovery
In late 2019, the coronavirus COVID-19 was detected in China and quickly spread to nearly every country causing hundreds of millions of infections, more than 7 million deaths, and massive business closures and job losses. In the short-term, the COVID-19 pandemic negatively affected the health of individuals; employment opportunities at businesses, nonprofits, and government agencies; and daily life and the job search process. It also had a major effect on the hedge fund sector. The number of hedge fund liquidations soared and the number of new hedge funds declined to a near-record low in the first three months of 2020. Many smaller hedge fund companies closed because they did not have the financial resources to compete with the big players.
The pandemic also affected job-seekers and employees. Most companies converted their in-person interviewing process to digital only, and many businesses required their employees to work at home some or all of the time. Forced business lockdowns and remote work accelerated digitization in the industry, and this trend is expected to continue. Hedge fund firms are increasing their investment in building and improving their technology and digital capabilities. The pandemic also further accelerated outsourcing trends in the hedge fund sector, especially as they relate to technology and regulatory compliance. “A lot of roles, including the chief technology officer, chief information security officer, and chief information officer roles are being outsourced because hedge funds don’t have the bandwidth to understand where regulation matches technology, so it makes more sense to outsource,” said George Ralph, global managing director at cloud services provider RFA, in an article about the trend published by Hedgeweek.