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Defining Events

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 Eze Software Group’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. “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 2019, high-frequency trading firms accounted for about 55 percent of all U.S. equity trading volume, according to the Congressional Research Service. 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.”

The industry is increasingly using artificial intelligence and machine learning 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 (AIML) 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. “With AIML developing in capability and delivering returns, more applications of AIML are being seen across the market.” According to the report, 23 percent of systematic hedge funds launched in 2019 used AIML—up from only 10 percent in 2016.  

Economic Crises and Corporate Financial Scandals Increase 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

In 2019, women comprised only 19.3 percent of hedge fund employees worldwide, according to Preqin. This is significantly lower than their percentage in the workforce. Their representation is much lower at managerial levels. Women comprised only 11 percent of senior hedge fund staff, compared to 29 percent of junior employees. Only 10 percent of portfolio management employees were female. Women were most likely to hold the senior role of chief operating officer, 18 percent of whom were women. The position of chief information officer was dominated by males, with only 4 percent of positions held by women.  

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 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

In late 2019, the coronavirus COVID-19 was detected in China and quickly spread to more than 210 countries, causing tens of millions of infections, hundreds of thousands of 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. A member-survey conducted in spring 2020 by the Alternative Investment Management Association (AIMA) found that 67 percent of hedge fund employees were working entirely at home as a result of the pandemic, and 25 percent were working mostly at home. Many hedge fund professionals believe the short-term work environment changes prompted by the pandemic would create permanent changes in the workplace. Fifty-eight percent of hedge fund managers surveyed by AIMA expected to adopt more liberal work-from-home policies in the future. Thirty-four percent said that doing so was a possibility. Only 9 percent said that they would not implement more flexible work-at-home options. Studies show that small firms were more apt than large firms to have work-at-home policies in place before the pandemic.

A survey of alternative investment managers by the law firm Seward & Kissel found that 69 percent of those surveyed believed that office layouts would change in the future in response to the pandemic. Twenty-eight percent of respondents from New York (a major employment area for hedge fund professionals) believed that their firms would reduce their office space because of the pandemic. Only 5 percent of respondents outside New York City felt that their employers would do the same.     

The hedge fund sector bounced back later in 2020, but its long-term prospects are uncertain. Despite the uncertainty, 57 percent of hedge fund managers surveyed for a study by AIMA and KPMG in late-summer 2020 said that they had hired or planned to hire new workers. Firms with at least $1 billion in assets under management were more likely to be seeking new employees than smaller firms.

The pandemic also further accelerated outsourcing trends in the hedge fund sector. Seventy-one percent of managers surveyed by AIMA and KPMG said that the productivity of its remote workers encouraged them to outsource certain operational and technological tasks to reduce costs and improve efficiency.   “The hedge fund industry has been innovative, agile, and resilient through the pandemic,” and our survey bears this out,” said Andrew Weir, global head of asset management, KPMG International, in a press release about the survey. “Our research shows that a good number of hedge funds see this as a time to attract new talent to their firm. They are evaluating their existing operating model and adjusting their core processes, cost structures, and work environments so they are positioned to grow and meet the changing needs of investors.”