My summary of this new book by Sabastian Mallaby. :
*Hedge funds (see definition below) sometimes earn great returns for their investors.
*They can have a place for investors who have more money than God to put at risk - generally high 6 figures and up.
* They can be very risky and thus they sometimes blow up spectacularly.
*They demonstrate that carefully calculated analysis, timing and guts can result in market beating performance.
*They also show that even a room full of phd "rocket scientists" can get things wrong with devastating results.
If you are interested on how hedge funds have succeeded and how some have failed this book will give that to you. It is well documented and provides interesting reading on how these funds effected currencies, industries and whole economies.
At the end of the book, Mallaby argues that some of the structure of hedge funds may hold some guidance for financial reform. Specifically, the incentive that, when your own money is at risk, your behavior is different than the Wall St bankers who did not have money at risk and the result was the banking and financial crisis of 2008.
A hedge fund is defined by four characteristics:
1. They stay under the radar screen of regulatory authorities
2. They charge a performance fee - generally the managers keep 20% of the returns. But managers have their own money in the fund and at risk.
3. They are partially isolated from general market swings.
4. They use leverage (borrowing) to take short and long positions on markets - when most people invest in the market they invest in the hope that the market goes up, they are long. A short position is a bet that the market or stock is going down. A hedge fund will take big risks but balance it with an opposite bet in the event the risk fails.
For me, the biggest issue is whether the fees justify the risk and return. Mallaby argues that hedge funds can consistently outperform the market and that markets are not efficient. I do not think that this book closes the case on this idea.
A recent WSJ article sheds light on the performance of hedge funds and seems to counter the idea that hedge funds can consistently outperform the market.
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