NEW YORK -- Hedge funds were once the rock stars of the financial industry. The smartest people worked for them. The wealthiest gave them their money. They were an easy path to fortune.
But if that get-rich-quick narrative was an exaggeration before the financial crisis, it's even less true since. The hedge fund industry's performance has been spotty in recent years; its public image, bruised. SAC Capital Advisors became the latest high-flyer brought low when the Justice Department on Thursday accused it of allowing insider trading and making hundreds of millions of dollars illegally.
To critics, hedge funds are secretive, risky, loosely regulated playgrounds for the super wealthy. And while the industry keeps expanding, its performance does not. This year could be the fifth in a row that hedge funds underperform the Standard & Poor's 500 stock index, according to Hedge Fund Research, or HFR, which analyzes the industry. That's an unwelcome reversal: For the 19 years from 1990 to 2008, hedge fund returns beat or tied the S&P 500 15 times.
"Everyone says, 'Oh a hedge fund,' and acts like that's some kind of mark of excellence," said Heath Abshure, president of the North American Securities Administrators Association, a group of state securities regulators. "A hedge fund is just an unregistered investment company."
Hedge funds operate by convincing wealthy people to invest with them. They profit by trying to find opportunities that no one else has picked up on, wagering on everything from the price of copper to whether a company will cut its dividend. Some made fortunes predicting the downfall of the U.S. housing market.
The funds try to earn big returns for investors with a variety of strategies, typically including bets for and against the direction of a market. That is meant to provide a hedge, allowing the firm to survive in good economies and bad, and to beat the overall stock market.
Their birth is generally traced to 1949, but it wasn't until more recently that the industry really took off. In 1990, there were about 600 hedge funds managing $39 billion in assets. Now there are 10,000 firms managing $2.4 trillion, according to HFR.
The list of industry challenges is long. The explosive growth in the number of funds has increased the pressure to generate the biggest returns, and raised the temptation to take undue risks or goad companies for inside information.
The hedge fund industry says that it makes markets more efficient, allocating capital to where it's best used and turning around weak companies. Dan Loeb's involvement at Yahoo, where he successfully pushed for a new CEO and saw the stock price leap, is a case in point. When Loeb, founder of the hedge fund Third Point, announced Monday that he was selling most of his stake in Yahoo, other investors followed suit and the stock price fell 4 percent.
Most Americans don't have any direct involvement with hedge funds -- though their mutual funds, pensions or college's endowments might invest in one. When they do hear about one, it's often because of a scandal or other behavior that feeds the idea that hedge fund managers are billionaire pirates. Raj Rajaratnam, founder of the Galleon Group, is serving an 11-year prison sentence after being convicted of trading on inside information. Phil Falcone is accused by the Securities and Exchange Commission of using money from his fund, Harbinger Capital, to pay his taxes.
The industry gives money to communities, funding children's hospitals, schools and university research. But it spends richly on itself, too, with conferences that feature Maroon 5, complimentary cigar rolling, and models paid to mingle with attendees. Every once in a while, a fund manager will try to buy a sports team. Steve Cohen, head of SAC Capital, was known for larger-than-life habits, scooping up Picassos, Monets and more obscure art, once spending $8 million on a 14-foot tiger shark submerged in formaldehyde.
The average hedge fund CEO earned $1.3 million last year; the average junior portfolio manager earned about $469,000, according to estimates from the publication Institutional Investor's Alpha. For some, the paydays are far more lucrative: Alpha estimates that David Tepper of Appaloosa Management made $2.2 billion in 2012, topping all managers.
Randy Shain, founder of BackTrack Reports, which investigates hedge funds for investors, thinks the industry is getting too much of a bad rap -- and he thinks it was too lauded before the financial crisis.
"Five or six years ago, they could do no wrong," Shain said. "Now all of a sudden people look at them and think they stink ... Neither is true."
To understand the shift, it's helpful to understand the industry's recent performance.
Hedge funds have underperformed the S&P 500 every year since 2009. Kingpins like Ken Griffin of Citadel and John Paulson of Paulson & Co. suffered painful losses. This year, Hedge funds returned an average of nearly 4 percent as of June 30, compared with almost 13 percent for the S&P 500, according to HFR, but even that assessment might be generous. Hedge funds don't have to disclose much about their operations. Performance estimates are compiled from funds that volunteer to share information. Funds that do poorly often don't give results, and those that shut down usually aren't included.
Compared with mutual funds, hedge funds have far fewer clients and their portfolios are often less diversified. They charge fees known as "two and 20" in industry parlance -- a management fee equal to 2 percent of the assets, plus 20 percent of any profits. If a firm managed $1 billion in assets, it would take $20 million as a fee each year. If it returned 6 percent, it would generate a profit of $60 million, $12 million of which managers would keep. Because of the management fee, the hedge fund makes money even when its investors lose.
Sanjeev Bhojraj, director of the Parker Center for Investment Research at Cornell University, noted how the industry is still growing, even since the financial crisis. Assets are now at a record level and, after a brief dip, the number of firms has almost returned to its pre-crisis record.
"Memory is short," Bhojraj said. "People are always hoping at the end of the day that they can find the right manager and the right strategy."