We Asked An Expert Why Hedge Funds Still Exist

If the hedge fund bro is less and less useful to the One Percent, does that mean he'll vanish from the Earth?

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May 13 2016, 6:00pm

I vividly remember the valedictorian from my high school class saying he was going to Princeton to "study the stock market." It was the most mad I'd ever felt in my life. For one thing, "the stock market" is not a fucking major; also, this guy was basically blowing an opportunity to study under Toni Morrison that I'd never get studying English at a state school in Florida. Being the insufferable 16-year-old that I was, I yelled out, "Asshole!" which promptly inspired him and his girlfriend to unfriend me on Facebook. I don't regret it, though, because if I've learned anything in the past ten years, it's that the Wall Street Guy may be the single American professional archetype it's socially acceptable to despise.

In fact, the only people who seem to catch even more shit than Wall Street bankers these days is a similar but somewhat more exotic species: the hedge fund bro.

The task of the hedge fund manager—if we're being formal—is to find places for rich individuals and institutions, like pension funds and universities, to put their money. If you don't live in a big city like New York, you may not know any of these guys, but they're some of the wealthier and more influential people in the country. Former (and possible future) First Daughter Chelsea Clinton's husband Mark Mezvinsky, for example, is deep in the hedge fund game, though his firm has had a rough go of it lately after one of its funds invested heavily in Greece of all places. In theory, hedge fund guys (they are almost always men) are supposed come up with strategies that don't depend on the whims of the stock market; traditionally, that's meant taking both long and short positions, which is to say betting on some things and against others.

But in the last decade or so, as the number of hedge funds has ballooned, managers have begun flipping the script.

Some Americans seem to dislike financial professionals because they appear to get filthy rich performing nebulous alchemy that serves to make rich people richer. When it comes to hedge funds, that first part is beyond dispute: According to an annual ranking released on Tuesday, the top ten hedge fund managers in the world took home more than $10 billion last year. But the crazy part is that five of the top 25 earners in the field actually lost their investors money. That revelation comes amid a growing effort by activists to get public pensions to ditch hedge funds, which typically charge exorbitant fees and often deliver returns that aren't any better than sticking money in an index fund and forgetting about it. Every year, there's a three-day conference to celebrate the industry, but the Wall Street Journal described the latest iteration, which just wrapped up, as "anything but festive."

"The hedge-fund model is under challenge," one manager remarked on Wednesday. "It's under assault."

If the hedge fund bro is increasingly reviled by activist types and growing less and less useful to the One Percent, does that mean he'll vanish from the Earth? I asked Mark Melin, an alternative investment practitioner and adjunct professor at Northwestern University, to walk me through what the future holds for some of the most privileged men in America.

VICE: I think the idea of the hedge fund guy is mystifying to a lot of people. What does he do all day? Is he just shaking hands and collecting cash?
Mark Melin: A fair amount of it is networking, but a lot of that happens after work. They read a lot of research. They do work hard. They're very well informed about what's going on. They're looking at the world for opportunities that most people don't necessarily see. The win percentage on that could be spotty. I have a personal hobby of trying to find bands before they become popular, trying to find a band that can jump above the rest. I'll get a couple wins, but I'll get way more losses.

So what they do every day is try to figure out where the markets are going, and there's a lot of communications between hedge fund managers. They look at the positions of one another. They're trying to figure out how to maneuver within the markets, is the bottom line.

So how did things go wrong for these guys?
The quote that best sums it up is, "Hedge funds aren't hedging." Hedge funds were designed to be a counterbalance to the stock market. But what's happened recently is that hedge funds have been exposed as nothing more than long exposure to the stock market. In my opinion, 2008 was a disaster for a lot of hedge funds, [because] given the volatility of the market, that would [seem to] be a valid reason to invest in them. But the majority have failed to be independent of the stock market, which was their original purpose. Now there are different groups and pockets where there's truly non-correlated performance—I expect those strategies to do much better in this environment. But strategies that are long only are going to have increased difficulty going forward.

But "hedge" is in the name. How is it still a hedge fund if there's no hedging?
Bingo. Hedge funds are there because they provide a counterbalance. The Wall Street banks have been promoting ones that don't hedge, and that's wrong. There are some incredibly smart people who work at banks, but in general, they are promoting strategies that are long only. I know it's touchy picking on the banks, but I think it's appropriate.

I'm still trying to figure out what a hedge fund is if managers can take any sort of position they want. Do they only accept money from rich people?
You're touching on a very valid point. To a certain extent, these people have been told that the hedge funds could beat the market. I come from a world of non-correlated hedge funds. This managed futures CTA [commodity trading advisor] world, which is a very niche category. But in my eyes, if you're correlated, you're not a hedge fund. So you're speaking my language when you ask that question. A lot of the hedge funds have been sold as being able to beat the market, which you can't do statistically. No one consistently beats the market. But sometimes you've gotta question. When you are being told that you can consistently beat the market, that's an unsupported claim.

And yes, most of these hedge funds are––by regulatory definition––not allowed to accept money from non-accredited individuals. It means if you're not wealthy, or you're not a professional, you can't participate in a hedge fund. [Editor's note: An accredited investor, according to the Securities Exchange Commission, is someone who earned more than $200,000 each of the past two years and expects to continue raking it in.]

So if people are being told they can beat the market, but hedge fund managers aren't, why do they keep getting paid big fees to manage money?
I don't think there is a valid reason. If a hedge fund doesn't deliver a performance that's not correlated to the stock market, there's no reason to invest. I think pension funds should be invested in ETFs [exchange-traded funds] and low-cost exposure to the stock market. When stock market crisis hits, these non-correlated investments deliver performance.

Wait, do hedge fund managers even have to disclose their rates of return?
Here's the issue: Certain hedge funds are required to report all of their returns. In fact, certain hedge funds have their returns audited by a regulator and are pretty safe. But most get exemptions from having to do this, which I find just absolutely noxious.

Someone recently told me he thought only about 5 percent of hedge funds beat the market last year. How is that possible?
You've painted the question so it's an either/or. Again, I think there are certain sectors in the hedge fund industry that are gonna benefit. The non-correlated hedge funds will survive. There's a lot of stuff the general public doesn't see. I read bank research every day. They are noting some difficulty coming up. This time next year, we will have experienced another crash. So the need for not correlated hedge funds is definite. I think what's gonna happen is we'll see a market shake out, and hedge funds that don't hedge will not be as popular in the future. Pensions funds have workers retirement savings in their hands. They have a fiduciary responsibility.

How they make investments in some of these hedge funds just boggles my mind. I've been in these meetings. Hopefully, if we can put hope into this conversation, despite it being a four-letter word, these pension funds will reduce their investments in long-only pension funds and go to very low-cost exposure to the stock market. This idea that pension funds can beat the stock market is just wrong.

No matter what happens in the hedge fund industry, young guys with business degrees are going to want that job because the money's amazing, right?
They get a two percent management fee—do the math. What's interesting is that when you have a smaller hedge fund, like $100 million, those guys have to actually perform. So in order for them to make a go of their business, they have to deliver returns to investors. Once they get bigger, they can just live off the management fee.

So once you get to a certain level, like a teacher with tenure, you can basically never lose your job.
It's a weird, self-perpetuating system where once they get big and their name is well known, the banks recommend them to pension funds. Once you get to that stage, it's like people don't look at the performance. I've always wanted to confront this situation a little bit––the fact that people are investing people's retirement savings in the hope that some guy's gonna beat the market.

And how did we arrive at the famous two and twenty standard—two percent of the total assets as fee, plus twenty percent of profits—again?
Look, it's a business, so people take as much as they can get. I used to be in the business of recommending hedge funds, and some of the smaller guys would take fifty percent of the profit. But they were like cowboys, they would bring in sixty percent one month, either way, plus or minus. When people deliver performance, it used to be that was prized. This two and twenty thing is now being questioned, quite frankly. Any pension fund that's paying two and twenty is not doing their job.

So people are paying tons of money for something that doesn't really work? Are they just assuming they must be getting the best possible service if there's a big fee? Is it a status thing?
I don't think that what you describe is that far off. I think there's valid reasons [to use hedge funds]. Like if their reason is non-correlation with the stock market, that's a valid reason. There was a thought process that these guys were smart and gonna provide returns over and above the market. At one point in time, that drove some decisions, but the real justification for hedge funds [existing] going forward is the funds that actually hedge.

This interview has lightly edited and condensed for clarity.

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