Thought Question: Technology and the Explosion of Hedge Funds

Tyler Cowen links to a new book by Claudia Goldin and Lawrence Katz, probably the leading two economic historians of education.  The thesis of the book, which Tyler summarizes in his NYT column, is that the root cause of the growing gap between the rich and the poor in this country (as opposed to the gap between the very rich and everyone else) is as follows:

• Improvements in technology have created new demand for jobs for those with the skills to handle complex, technology-rich tasks.
• In contrast to previous eras, however, the supply of workers to fill those jobs--college graduates--has stagnated.
• Therefore the returns to those jobs--the income premium they command--have increased.

The thesis is interesting in and of itself, so I plan to read the book (A lot of people in the hedge fund community are interested in the education gap in this country, so I recommend it to them too).  But it also got me thinking about hedge funds and technology.  Everyone knows that there are many, many more hedge funds today than there used to be.  I read recently that there are more hedge funds in the U.S. than Taco Bells, and there are a lot of Taco Bells.  Why is that?  Put another way, why weren't there already 9,000 hedge funds twenty years ago?  I think the conventional wisdom answers with the following:

1. There's so much more money sloshing around than there used to be.  That money needs to be invested
2. The long bull market created a rising tide that lifted all boats, allowing new funds to start based on good performance records that were not really true alpha, but rather bull market performance+leverage in disguise.

I'm not so sure.  In nominal terms there is of course more investment capital out there than there has ever been, but relative to GDP I don't think that's true.  Every economic system generates outputthat is either consumed or saved, and the savings must be invested.  I don't believe our system generates more savings relative to output than the previous ones.  As far as the bull market, this may have more validity, but I think it applies more to private equity rather than hedge funds, which after all are supposed to hedge. 

I wonder if improvements to technology--broadly defined--accounts for a lot of the proliferation of hedge funds in the past twenty or so years.  80 years ago there were probably plenty of good stockpickers (or stock manipulators), but almost none of them were solo operators.  Rather they called themselves "stockbrokers" and worked for NYSE member firms.  Many of them got plenty rich managing other people's money--look at the great old houses in Palm Beach and the Hamptons: they were built around this time--but they all had to give some of their economics to "the house."  During the Go-Go years of the 1960s it was similar but the "house" was more often a mutual fund.  In both cases the customer was investing his money not so much with the stockpicker as with the firm that employed the stockpicker, even though the stockpicker was generating most of the alpha.  So Mr. Merrill and Mr. Lynch got very rich, and later on Jack Dreyfus and Edward Johnson of Fidelity got very rich, but their employees less so. 

Starting in the 1980s, my sense is that it became easier for a talented investor, or for someone who could convince someone else of his talent, to separate himself from the house.  Maybe it was improvements in information technology which enabled small investors to follow markets and process trades more easily.  Maybe it became easier for small guys to engage in short sales or derivatives trading.  Whatever it was, it allowed employees to hang up their own shingle, and to keep more of the rewards they generated from their outperformance (or from a bull market in disguise).  Once this trend got going, it fed on itself: an industry grew up to serve new hedge funds (prime brokers, marketers, attorneys), which made starting even easier; and then investors grew more comfortable with the concept and more willing to invest in startup hedge funds.

What do you all think?  Why are there 10,000 hedge funds today vs. only a handful even twenty years ago?

Comments

[nick gogerty]

Hedge funds are Taco Bell's. Each is an independent franchise typically operating within a specified market. For taco bell it is fixed geography homogenous product, for hedge funds it is relatively fixed geography (NYCticut, London square mile) slightly differentiated product (all alpha all the time). Both rely heavily on marketing and offer their managers increasing rewards versus comparable roles (drive through window vs. big bank trader).
The customers are fairly clueless about what truly goes on the insides of the product. There is also the end effect of a short duration for the managers role. The average taco bell owner probably lasts the same length of time as the average hedge fund manager about 36 months. http://www.princeton.edu/~bmalkiel/Global%20Hedge%20fund%20NEW.pdf