The Changing Role of Hedge Funds in the Global Economy
1. THE CHANGING ROLE OF HEDGE FUNDS IN THE GLOBAL
ECONOMY
DR. EVERETT M. EHRLICH
September 2011
2. A rising number of institutional investors, including public and private pensions, university
endowments and philanthropic foundations, are devoting larger shares of their portfolios to
hedge funds.
Once considered an elite investment for wealthy individuals, a majority of hedge funds assets –
by one independent measure 65 percent – are now owned by institutional rather than private
investors. Thus, the role of hedge funds in the economy is changing as new classes of
investors come to embrace them.
This research explains the objectives of hedge funds, estimates their potential value to
institutional portfolios and examines some of the basic public policy concerns surrounding
the role of hedge funds in the financial markets.
3. When compared to a ―standard‖ portfolio without hedge funds, adding hedge funds to an investment portfolio
increases the probability of achieving positive returns and lowers volatility.
A modest allocation to hedge funds would improve returns to U.S. public pension plans by approximately
$13.67 billion annually.
Similarly, hedge funds have the potential to add $1.73 billion in expected annual returns to U.S. college and
university endowments and their affiliated foundations.
Hedge funds as an asset class display many of the characteristics we would find desirable in an investment.
Hedge fund managers’ incentives are closely aligned to the interests of their investors; they are generally too
small to affect the integrity of financial markets and therefore, systemic risk in the economy.
4. The objective of hedge funds is to offer investors an absolute, positive return regardless of market
conditions.
Hedge funds offer investors a rich variety of strategies to pursue this objective.
The defining characteristic of hedge funds is their focus on managing risk.
A hedge fund manager’s pay is directly correlated to his fund’s performance, aligning the interests
of the manager and the investor.
5. Estimated Growth in Hedge Fund Assets
1990-2012 (source, Hedge Fund Research)
$2,500,000
Q4 2012
$2,000,000 $2.375 Trillion
$1,500,000
$1,000,000
Assets (In $ Millions)
$500,000
$0
1990
1993
1996
1999
2002
2005
2008
2011
• The hedge fund industry has grown significantly from $38.9 billion in assets under
management in 1990 to $2.25 trillion in the fourth quarter of 2012
• Over the last 20 years, 40 percent of the growth in hedge fund assets has come from new
capital given to funds by their clients – the rest, or 60 percent, comes from the returns
earned by funds and then reinvested.
6. ◦ Hedge funds have evolved from an elite
investment to a tool used by pension
funds, colleges and universities, and other
institutions to diversify investments,
manage risk, and deliver reliable returns.
◦ Sixty-five percent of hedge fund assets are
held by institutional investors – pensions,
endowments, foundations, and others.
◦ These investments help provide critical
resources to fund retirement benefits,
scholarships, philanthropic grants and
other services.
7. ◦ By understanding the statistical distribution of
returns earned by each asset class (average
returns and the risk entailed) and the correlation
between asset classes, models can calculate
returns and risk for investment portfolios.
o By simulating the risk and returns of a portfolio
twice — once with hedge funds among the asset
classes and then once without hedge funds — it
is possible to estimate the contribution that
hedge funds make to this representative
portfolio.
8. ◦ Compared to a ―standard‖ portfolio, hedge fund investments can help increase the probability of
achieving positive returns.
9. ◦ Adding hedge funds to a diverse portfolio
reduces the probability of negative returns.
◦ Annually, hedge fund investments decrease
the likelihood of negative investment returns
by approximately 10 percent.
10. ◦ Adding hedge funds to a portfolio improves the probability of achieving positive returns.
◦ A modest allocation to hedge funds would improve returns to U.S. public pension plans by
approximately $13.67 billion annually.
◦ Similarly, hedge funds have potential to add approximately $1.73 billion in annual returns
to U.S. college and university endowments.
11. ◦ Hedge funds offer investors superior risk management techniques.
◦ A recent study performed by economists at Columbia University and the National Bureau of
Economic Research concluded that ―hedge fund leverage is fairly modest, especially compared with
the listed average of broker/ dealers and investment banks.‖
12. Given the relatively low level of hedge fund holdings among pensions, the pressures to improve returns,
and the modeling results provided in this research, we should expect greater hedge fund holding by
these institutions in the future.
13. Dr. Everett E. Ehrlich is former Undersecretary of Commerce in the Clinton Administration and now
President of ESC Company, an economics consulting firm in Washington, D.C.
The full study can be downloaded at http://bit.ly/pmVkxM
