More Money Than God takes a critical look at hedge funds, the powerful and often mysterious organizations that have a huge impact on global finance and our day-to-day lives. By looking back at the history of this influential investment practice, it reveals how hedge funds developed and how they operate today.
Sebastian Mallaby is an editor at the Financial Times and the Paul Volcker Senior Fellow in International Economics at the Council on Foreign Relations.
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Start free trialMore Money Than God takes a critical look at hedge funds, the powerful and often mysterious organizations that have a huge impact on global finance and our day-to-day lives. By looking back at the history of this influential investment practice, it reveals how hedge funds developed and how they operate today.
You’ve probably heard the term hedge fund before. What does it mean and how do hedge funds actually work?
In 1949, A. W. Jones founded the first “hedged fund,” as it was called at the time. Since then, hedge funds have become major financial institutions.
Today, the vast majority of hedge funds closely follow Jones’ initial model, which took a mixed approach to stock market trading.
Here’s what that means: Like other investors, hedge fund managers buy long – selecting stocks in promising companies and hoping the values increase, thus earning a profit.
But what makes hedge funds special is that they also buy shares with the hope that the stocks' values will decrease. This practice is called selling short and it entails borrowing stocks in less promising companies, selling them, and buying them back as soon as the price falls.
For example, let’s say you think a certain company is overvalued. So you call a broker and ask him to lend you 50 stocks from that company, which you then sell for $2 apiece. Now you’re “short” 50 stocks. Luckily, the following week, shares from the company fall to $1, so you buy up 50 and give them back to the person who lent them to you. In the end, you earned a $50 profit from the exchange.
Essentially, the people who run hedge funds understand the market deeply: They know how to buy long and sell short to maximize profits, but often they have little capital. So they find investors to lend them large sums, which allows the hedge fund to invest on a massive scale. This is how they earn money.
And although they often invest other people’s money, hedge fund managers actually keep a portion of the profits they earn as a performance fee, which motivates them to trade successfully.