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The Rise of Hedge Funds: A Story of Inequality

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The rise of hedge funds from the almost unnoticed beginnings in the late 1940s to the pinnacle of global finance seventy years later is one of the most pivotal developments for the international political economy. It is the central thesis of this paper that the rise of hedge funds can only be explained by the notion of inequality: inequality between nearly unregulated hedge funds and the regulated rest of financial market actors; inequal-ity between offshore financial centers that provide minimal regulation and low taxation to hedge funds, and onshore jurisdiction that do not; inequality between very rich private individuals that invest in hedge funds and the "bottom 99 percent" that do not. Two countries play a central role for the rise of hedge funds, the US and the UK. Both adhere to the paradigm of "indirect regulation" of hedge funds, and both tolerated a drastically increased income inequality since the 1980s that fueled the rise of hedge funds. It is only in these two countries that the story of inequality that drives the rise of hedge funds could be ended.
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Zeitschrift für Sozialen Fortschritt
Vol. 2, No. 1, p. 3–20
Jan Fichtner, Institut für Politikwissenscha, Goethe Universität Frankfurt am Main, Robert-Mayer-Straße 5, D-60054
Frankfurt am Main, email: chtner@soz.uni-frankfurt.de
The Rise of Hedge Funds: A Story of Inequality
Jan Fichtner
Abstract
e rise of hedge funds from the almost unnoticed beginnings in the late 1940s to the pinnacle of global
nance seventy years later is one of the most pivotal developments for the international political economy. It
is the central thesis of this paper that the rise of hedge funds can only be explained by the notion of inequality:
inequality between nearly unregulated hedge funds and the regulated rest of nancial market actors; inequal-
ity between oshore nancial centers that provide minimal regulation and low taxation to hedge funds, and
onshore jurisdiction that do not; inequality between very rich private individuals that invest in hedge funds and
the „bottom 99 percent“ that do not. Two countries play a central role for the rise of hedge funds, the US and
the UK. Both adhere to the paradigm of „indirect regulation“ of hedge funds, and both tolerated a drastically
increased income inequality since the 1980s that fueled the rise of hedge funds. It is only in these two countries
that the story of inequality that drives the rise of hedge funds could be ended.
Keywords: hedge funds, inequality, regulation, nancial crisis
Der Aufstieg der Hedge-Fonds: Eine Geschichte der Ungleichheit
Zusammenfassung
Der Aufstieg der Hedgefonds von den fast unbemerkten Anfängen in den späten 1940ern an die Spitze der
globalen Finanzmärkte siebzig Jahre später ist eine der bedeutendsten Entwicklungen für die Internationale
Politische Ökonomie. Die zentrale ese dieses Papers ist, dass der Aufstieg von Hedgefonds nur durch den
Begri der Ungleichheit erklärt werden kann: Ungleichheit zwischen fast unregulierten Hedgefonds und dem
regulierten Rest der Finanzmarktakteure; Ungleichheit zwischen Oshore-Finanzzentren, die Hedgefonds mini-
male Regulierung und niedrige Besteuerung bieten, und Onshore-Jurisdiktionen, die dies nicht tun; Ungleichheit
zwischen sehr reichen Individuen, die in Hedgefonds investieren und den „unteren 99 Prozent“, die dies nicht tun.
Zwei Staaten spielen eine zentrale Rolle für den Aufstieg von Hedgefonds: die USA und Großbritannien. Beide
halten an der „indirekten Regulierung“ von Hedgefonds fest, und beide tolerierten eine drastisch gestiegene Ein-
kommensungleichheit seit den 1980er-Jahren, die den Aufstieg von Hedgefonds befeuerte. Nur in diesen beiden
Staaten könnte die Geschichte der Ungleichheit, die den Aufstieg von Hedgefonds antreibt, beendet werden.
Schlagwörter: Hedgefonds, Ungleichheit, Regulierung, Finanzkrise
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Vol. 2 (1)  Zeitschrift für Sozialen Fortschritt  ·  Journal for Societal Progress
1. Introduction
Hedge funds, in particular their allegedly inge-
nious managers, were called the new „Masters of the
Universe“ in  when the old ones, the large Wall
Street investment banks such as Goldman Sachs,
Morgan Stanley, Bear Stearns or Lehman Brothers,
almost entirely went down (Wolfe ). Hedge fund
proponent Mallaby (: ) sees them as the worthy
successors of investment banks: „Today, hedge funds
are the new Goldmans and Morgans of half a century
ago.“ Hence, the rise of hedge funds from the almost
unnoticed beginnings in the late s to the pinnacle
of global nance seventy years later is one of the most
pivotal developments for the contemporary internatio-
nal political economy.
Rather than to mystify hedge funds as masters
of the universe or as the „new elite“ (Mallaby ),
this paper seeks to contribute to the demystication of
hedge funds. erefore – in contrast to many studies
by mainstream economists –, the rise of hedge funds
is analyzed in a broad historical, socio-economic and
socio-political context. It is the central thesis of this
paper that the rise of hedge funds can only be explained
and comprehended by referring to dierent dimensi-
ons of inequality: inequality between nearly unregu-
lated hedge funds and the regulated rest of nancial
market actors; inequality between oshore nancial
centers that provide minimal regulation and low taxa-
tion to hedge funds, and onshore jurisdiction that do
not; and, nally, inequality between very rich private
individuals that invest in hedge funds and the „bottom
 percent“ that do not. Various notions of inequality
work to the benet of hedge funds and provide them
with the singularity that distinguishes them.
In order to tell this story of inequality thoroughly
and comprehensively this paper is divided into six
sections. Subsequent to this introduction section two
discusses the history of hedge funds and describes how
the story of inequality began. is section argues that
we have to separate the rise of hedge funds into two
periods, the rst one from the late s to the early
s when most hedge funds collapsed, and the second
one from the early s until today. Section three dis-
cusses the regulation, or rather, the non-regulation of
hedge funds. Today hedge funds are arguably the least
regulated major nancial market actor; this unequal
regulation vis-à-vis other nancial market actors is a
distinct advantage to hedge funds. Two single countries
make this unequal regulation of hedge funds possible –
the US and the UK; they refrain from any strict direct
regulation of the funds’ activities and also provide the
important oshore legal domiciles. Income inequality
and the rise of hedge funds is the topic covered in sec-
tion four. Income inequality increased drastically since
the early s – especially in the two centers of hedge
funds, the US and the UK. e fact that the super-rich
top . percent of the US population increased their
income more than threefold from the late s to
 is crucial for the rise of hedge funds, as these high
net worth individuals were the largest source of capital
by far. Section ve takes up the vital topic of income
inequality and discusses whether this stark inequality
coupled with hedge fund activities in subprime deriva-
tives represents one of the root causes of the nancial
crisis. In addition, this section exposes that in the US
and the UK hedge funds and their very rich managers
increasingly convert their unequal wealth into political
inuence. Finally, the sixth section concludes.
2. The history of hedge funds – how the story of
inequality began
Most accounts regarding the history hedge funds
begin by mentioning that Alfred Winslow Jones crea-
ted the rst hedge fund in . However, as Lhabitant
() reports, indicators of hedge fund-like activity
can be traced back to the US in the early s. Karl
Karsten, an academic primarily interested in statisti-
cal research, published two books which already then
described many key principles of hedge funds that
are still valid today. Karsten reportedly even created a
small fund drawing on savings by himself and his col-
leagues in order to test the forecasts of his six devised
„barometers“ of national economic activity (ibid.: ).
He invested according to his „hedge principle“ that
combined buying stocks he believed would rise and
short-selling stocks that were deemed to fall. World
War II then halted most of nancial market activity in
the early s, including this proto-hedge fund.
Aer the war the activity of nancial markets
picked up again. In  Alfred Winslow Jones created
what he called a „hedged fund“ (Mallaby : ). His
fund A.W. Jones & Co, set up as a general partnership,
was primarily aimed at outside investors, but Jones
also invested much of his personal wealth. Similar to
Karsten, Jones combined long positions in supposedly
undervalued stocks with short-selling stocks he and
his team believed were overvalued. In this way Jones
sought to create an investment fund whose perfor-
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Fichtner: Der Aufstieg der Hedge-Fonds: Eine Geschichte der Ungleichheit
mance (known as „alpha“) was protected (or hedged)
against the general movement of the market (known
as „beta“). In addition, he borrowed funds to amplify
returns – a method widely practiced today, known as
leverage (Eichengreen/Mathieson ). e fee struc-
ture of Jones’ fund was novel for that time; he only
charged a performance-based fee of  percent of rea-
lized prots that should align his incentives with those
of his investors (Rappeport ). In contrast to most
modern hedge funds that also charge an asset-based
management fee of around  percent, he charged no
xed fee. e crucial dierence was (and still is) that if
hedge fund managers take a share of the fund’s prots
they were taxed with the capital gains tax rate, which
was  percent at the time. In contrast, a management
fee was taxed at the personal income tax rate – and the
maximum personal income tax rate in the US during
the s was over  percent, and over  percent
from  on. Even though Jones told investors that
his fee structure was modeled aer the ancient practice
of Phoenician merchants, it seems more probable that
he was inspired by the tax law (Lhabitant ); this
unequal treatment of capital gains vis-à-vis regular
income marks the beginning of the story of inequality
that has propelled hedge funds ever since. In  Jones
changed his fund from a general partnership to a limi-
ted partnership in order to have maximum exibility
with constructing and managing his portfolio (Scara-
mucci ). Another important reason was that this
legal structure avoided virtually all of the regulation by
the Securities and Exchange Commission (SEC), the
nancial markets regulator in the US (Lhabitant );
the (non-)regulation of hedge funds will be discussed
in detail in the next section of this paper.
e personal background of Alfred Winslow Jones
was extraordinary. Reportedly, he graduated from
Harvard, worked for the State Department, ran secret
missions for the anti-Nazi group „Leninist Organiza-
tion“, attended the Marxist Workers School in Berlin,
and spent a honeymoon on the frontlines of the Spanish
civil war (Scaramucci ; Mallaby ). His doctoral
thesis, „Life, Liberty and Property“ was a survey among
dierent social classes concerning attitudes towards
property and became a standard sociology textbook
(Russell ). is personal background of Jones is
important, because it arguably enabled him to question
and defy the established Wall Street practices of his time.
Wall Street in the late s saw leverage and short-
selling as „too racy for professionals entrusted with
other people’s savings“ (Mallaby : ); short-selling
was seen as „un-American“ in  (Scaramucci ).
Jones combined both techniques in a novel way and this
allowed him to achieve remarkable nancial returns by
beating the market indices for several years during the
s and s bull market (Lhabitant ). Jones
reportedly generated a staggering cumulative return of
almost , percent from  to  (Mallaby ).
From  to  Jones’ partnership returned  per-
cent, while the next best fund only achieved about 
percent (Lhabitant ). Even though these rates of
return are extremely high, Jones’ investment approach
was principally concerned with avoiding market risk.
He is quoted saying: „Hedging is a speculative tool used
to conservative ends“ (Russell ). In  an article
published in Fortune about the success of Jones’ fund
used the term „hedge fund“ for the rst time. And in
 a survey by the SEC found that about  hedge
funds operated in the US. In this period many new
hedge funds were created, among them the well-known
Quantum Fund by George Soros (Lhabitant ).
en in - the long bull market ended,
which made the situation much more dicult for many
hedge funds, as short-selling was used infrequently by
most hedge funds at the time and primarily as a means
of partially hedging against market risk, rarely as an
investment strategy on its own as today (Eichengreen/
Mathieson ). Finally, the - recession and
the ensuing oil crisis caused heavy losses and capital
withdrawals for many hedge funds, thus ending the
rst – yet almost unnoticed – rise of hedge funds that
began in the late s (Fung/Hsieh ). From  to
 the stock market moved sideways and the number
of hedge funds increased again, yet very slowly. Even
though this period was extremely hard for the still
tiny hedge fund industry, it laid the foundation for the
phenomenal rise of hedge funds that would prove to
be clearly visible to all keen observers of global nance
from the s onwards. In the early s the US uni-
laterally cut the backing of the US dollar by gold and
thus disbanded the Bretton-Woods system of interna-
tional monetary relations, in which the currencies of
the participating Western countries were pegged to the
US dollar at xed, yet adjustable rates. e result was
a shi from a government-led international monetary
system to a market-led international monetary system
(Padoa-Schioppa/Saccomanni ); in this new
system the exchange rates were determined by private
prot-motivated actors – such as hedge funds. Subse-
quently also the price of gold was entirely determined
by private market forces. Together with the abolition of
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Fichtner: The Rise of Hedge Funds: A Story of Inequality
Vol. 2 (1)  Zeitschrift für Sozialen Fortschritt  ·  Journal for Societal Progress
capital controls by the US and Britain in the s and
the liberalization and deregulation of their domestic
nancial systems in the s a whole new universe of
investment opportunities opened up for hedge funds
and other private investors. And most importantly the
initiatives by the US and the UK forced other Western
countries to follow them: „e liberalization decisions
in the US and Britain, as well as the broader deregu-
latory trends within their respective nancial systems,
played a major role in encouraging similar liberaliza-
tion moves elsewhere. Unless they matched the liberal
and deregulated nature of the British and US nancial
systems, foreign nancial authorities could not hope to
attract new nancial business and capitaal from abroad
or even maintain the nancial business and capital of
their own multinational corporations or international
banks“ (Helleiner : ). is international trend
towards the liberalization and deregulation of nan-
cial markets, initiated by the US and the UK, created
numerous new investment opportunities for hedge
funds in Western Europe and East Asia from the s
onwards.
e few hedge funds that operated during the early
s mostly had high minimum investment requi-
rements, „access thus being restricted to an exclusive
club of high net worth individuals informed by word of
mouth“ (Lhabitant : ); besides unequal tax treat-
ment and the avoidance of regulation this restriction to
very wealthy individuals represents another element of
the story of inequality that is behind the rise of hedge
funds. However, during the s a new breed of hedge
funds emerged whose investment approach was radi-
cally dierent from Jones’ original risk-averse concept
of investing in the stock market. e epitome of this
new kind of hedge funds was Julian Robertson’s Tiger
Fund, which had a compounded annual return of 
percent from  to  (Fung/Hsieh ). Based on
macroeconomic analysis Robertson took massive and
purely directional bets without implementing any spe-
cic hedging strategy. Furthermore, Robertson oen
is period has aptly been described as charac-
terized by nancialization: „the increasing role of nancial
motives, nancial markets, nancial actors and nancial ins-
titutions in the operation of the domestic and international
economies“ (Epstein : ). e rapid rise of hedge funds
would not have been possible without the trend of nanciali-
zation that roughly began in the early s.
Directional bets are speculative and unhedged
trades with whom the investor bets that particular securities
or entire markets move in a specic direction.
employed nancial derivatives, such as options and
futures, to enhance returns – nancial products that
did not exist when Alfred Winslow Jones operated his
fund. e strategy pioneered by Robertson and others
became known as „global macro“. Global macro hedge
funds have occasionally made large bets on the move-
ment of currencies or interest rates. From the s
onwards many (though not all) hedge funds ceased to
be hedge funds in the Jonesian sense, but should rather
be called wager or speculation funds; this period marks
the second and this time persistent rise of hedge funds.
In  the private data collection company Hedge
Fund Research (HFR) began monitoring the industry.
According to HFR the hedge fund industry consisted
of about  funds and had nearly  billion in assets
under management in . One of the largest, best
known and most successful bets of a global macro hedge
fund took place two years later in  when the Quan-
tum Fund run by George Soros speculated the British
pound out of the European Exchange Rate Mechanism
(ERM). Reportedly Soros built up a short position in
Sterling to the tune of  billion using leverage. Other
global macro hedge funds as well as institutional inves-
tors joined Soros. Hence, even though the Bank of Eng-
land spent  billion of its foreign exchange reserves
and raised interest rates from  to  percent, on Sep-
tember  (since then known as „Black Wednesday“)
Britain quit the ERM. e Quantum fund of George
Soros made a prot of approximately  billion with this
speculative bet. Essential to the success of Soros was the
fact that hedge funds are uniquely able to concentrate
their capital in a few investments – this is yet another
important dimension of the inequality of hedge funds.
According to Harmes () the episode of the ERM
crisis clearly demonstrated that global macro hedge
funds acted as market leaders that possessed normative
authority over many institutional investors that adhe-
red to herd mentality.
e s were an extremely good decade for
hedge funds, but also a decade in which it became
increasingly evident that hedge funds no longer were
„too-small-to-matter“ – a view oen expressed by
neoclassical economists (ibid: ). e industry sur-
passed the threshold of  billion in assets under
management for the rst time in  with over ,
individual hedge funds operating. e next year
hedge funds played a signicant, though arguably not
decisive, role in the Asian nancial crisis. is crisis
was not entirely caused by „crony capitalism“ in the
Southeast Asian countries most aected by the crisis,
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Fichtner: Der Aufstieg der Hedge-Fonds: Eine Geschichte der Ungleichheit
as some Western critics argued, but some problems
in these countries were surely created domestically.
Hedge funds, mostly global macro, sold ai baht
between  billion and  billion in . Arguably
this behavior did not cause the Asian nancial crisis
but surely exacerbated it (de Brouwer ). One year
later hedge funds were again discussed widely. In 
for the rst time in nancial history the collapse of a
highly leveraged hedge fund made regulators fear for
the stability of international nancial markets. e
hedge fund Long Term Capital Management (LTCM),
run by well-known hedge fund managers as well as
Nobel laureates in economics, bet on the convergence
of low-quality and high-quality bond yields. Due
to overcondence in the (seemingly) sophisticated
econometric models the fund excessively leveraged
its positions: „ey turned  billion equity capital
into  billion of assets, which were then used as
collateral for more than a trillion dollars of notional
over-the-counter derivatives“ (Lhabitant : ).
What LTCM’s models did not (and of course could
not) predict was that Russia devalued the Ruble and
defaulted on its domestic debt, which caused an inter-
national ight to safety and thus a widening of spreads
between bond yields – and not a convergence. Due
to its high leverage LTCMs default would have led to
an enormous selling wave. us, LTCM was deemed
„too big to fail“, a term hitherto used exclusively for
large banks and entire countries. e Federal Reserve
Bank of New York orchestrated a bail out of LTCM
purportedly to avoid a systemic crisis. However, „a
minority of critics not only questioned the rescue at
that time but also suggested that those rescued and
those doing the rescuing had close associations, and
that this was an instance of crony capitalism on which
the Asian nancial crisis had precisely been blamed“
(de Brouwer : ). Shortly before the turn of the
century, hedge funds had almost  billion in assets
under management. is was the time of the dot-com
bubble when many experts said that tech stocks were
overvalued but the stock prices of „new economy“
rms just kept rising. Many neoclassical economists
proclaimed that „hedge funds are better positioned
to act as contrarian investors making markets more
liquid and ecient“ (Harmes : ). Proponents
of hedge funds usually ascribed a vital role to them for
the operation of nancial markets: „By buying irrati-
onally cheap assets and selling irrationally expensive
ones, they shi market prices until the irrationalities
disappear, thus ultimately facilitating the ecient
allocation of the world’s capital“ (Mallaby : ).
However, reality proved to be dierent from these
neoclassical ideals; Brunnermeier and Nagel ()
found that hedge funds did not exert a correcting force
on stock prices during the dot-com bubble. Instead,
they have „ridden“ the bubble because of predictable
investor sentiment and limits to arbitrage.
e real breakthrough of the hedge fund industry
came during and shortly aer the dot-com bubble bet-
ween  and  when hedge funds consistently
generated positive returns while most major stock
markets slumped. is caused a strong inow of
capital from institutional investors, which believed
that hedge fund performance was uncorrelated to the
major stock markets. It took the hedge fund industry
about ten years ( to end-) to increase assets
under management from  billion to  billion.
e next  billion were added in just four and a
half years until mid-. en, the next  billion
were added in less than two years until early ,
when about , hedge funds operated. us, hedge
funds had been on an exponential growth curve until
the outbreak of the nancial crisis. e role of hedge
funds for the nancial crisis will be discussed in sec-
tion ve. It suces to note here that the losses and
outows that were caused by the crisis were recou-
ped by the hedge fund industry by . In the third
quarter of , hedge funds hit a new all-time high of
, billion assets under management. Figure  gives
an instructive overview of the rise of the hedge fund
industry from the early s until the third quarter
of .
Hedge funds have grown tremendously from
the tiny beginnings in the late s to become an
industry with global importance – although it has to
be noted that the assets under management of the
hedge fund industry are still only a small fraction of
the total global stock of nancial assets. However, due
to leverage and the fact that hedge funds are uniquely
able to concentrate their capital in just a few selected
investments they are able to have a signicant impact,
as most other institutional investors such as mutual or
pension funds (have to) diversify their assets (Harmes
). Many observers attribute the success of hedge
funds to the allegedly superior investment skills of
hedge fund managers. However, what is oen neglec-
ted is the fact that hedge funds are considerably less
regulated than virtually all other institutional inves-
tors; this gives them a distinct advantage.
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3. The (non-)regulation of hedge funds – the first
ingredient of inequality
As mentioned before, Alfred Winslow Jones
structured his hedge fund as a limited partnership in
order to avoid SEC regulation. In fact, the legal struc-
ture of the limited partnership is still the dominant
model for domestic US hedge funds today. Limited
partnerships provide pass-through tax treatment;
that means that the hedge fund itself does not pay
any taxes on its investment returns, but the returns
are passed through so that all individual investors
pay tax with their personal income tax bills (Connor/
Woo ). Since the mid-s, however, an incre-
asing number of hedge funds has been structured as
limited liability companies, particularly in Delaware
as this US state has completely aligned its legal system
to business needs (Lhabitant ). In order to avoid
regulation, US domestic hedge funds traditionally
structured themselves in a way that takes into account
four central pieces of legislation: First, to be exempt
from the Investment Company Act of , which
contains disclosure and registration requirements
and imposes limits on the use of certain investment
techniques, hedge funds need to either have less
than  investors or investors must be „qualied
purchasers“ – individuals who own at least  million
in investments or companies with over  million
in investments (Edwards ). is exemption is
crucial to hedge funds, as it enables them to perform
„short-selling“, which is betting on the decrease in
value of stocks and other securities (Oesterle ).
Second, hedge funds typically try to be exempt from
the Securities Act of  in order to prevent having
to reveal proprietary trading strategies and other
information. erefore, hedge funds have to restrict
themselves to private placement, which means that
they are not allowed public advertisement and mar-
keting of their funds. In addition, hedge funds may
only accept „accredited investors“, which have a net
worth that exceeds  million at the time of purchase
(Edwards ). ird, to be exempt from the Invest-
ment Advisors Act of , hedge fund managers (or
„investment advisors“) had to restrict themselves to
less than  clients (i.e. individual hedge funds) per
year and do not advertise themselves publicly as an
investment advisor (Stulz ). is, however, chan-
ged with the Dodd-Frank Act of ; since March
 hedge fund managers have to register with the
SEC. Hedge fund managers advising only funds with
Figure 1: Assets under management by the hedge fund industry 1990–Q3/2012 ($ billions)
Source: Heinz (), HFR ()
0
250
500
750
1.000
1.250
1.500
1.750
2.000
2.250
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
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less than  million in assets under management in
the US, however, are exempt from this rule (SEC ).
Fourth, in order to avoid being aected by certain
parts of the Securities Exchange Act of , which
contains strict registration and disclosure require-
ments, hedge funds must ensure that they have less
than  investors (Horseld-Bradbury ).
It is this exempt legal status that denes hedge
funds and gives them their uniqueness. In fact, strictly
legally speaking there is no such thing as a hedge
fund. Hedge funds are best characterized by their
unparalleled freedom to pursue all investment stra-
tegies they suppose are protable: „A legal structure
that avoids certain regulatory constraints remains a
common thread that unites all hedge funds“ (Connor/
Woo : ). Edwards (: ) gives a concise, yet
also comprehensive denition of hedge funds: „ey
can buy and sell whatever assets or nancial inst-
ruments they want to, trade any kind of derivatives
instrument, engage in unrestricted short-selling,
employ unlimited amounts of leverage, hold concen-
trated positions in any security without restriction,
set redemption policies without restriction, and can
employ any fee structure and management compen-
sation structure that is acceptable to their investors.
In addition, hedge funds have very limited disclosure
and reporting obligations, to regulators, the public,
and their own investors.“
During the rst decades of the industry practi-
cally all hedge funds were legally domiciled in the US.
is has changed drastically. In  only  percent
of assets under management by the global hedge fund
industry belonged to funds domiciled in the US –
virtually all of them based in Delaware. But the most
important global legal domicile of hedge funds by far
were the Cayman Islands. e hedge funds registered
there managed  percent of global hedge fund assets
in . e British Virgin Islands ( percent), Jersey
(ve percent) and Bermuda (four percent) occupied
the third, fourth and h place, respectively (Jaecklin
et al. ). Hence, about  percent of all hedge fund
assets belonged to funds that were domiciled in these
four oshore nancial centers. However, these terri-
tories are not just random „sunny jurisdictions“ (Lha-
bitant : ); they are so-called „British Overseas
Territories“ (except for Jersey that is a UK „Crown
Dependency“), which means that they have autonomy
in areas such as tax legislation, but ultimately remain
under British sovereignty. In fact, it is legally correct
to still describe these territories as „colonies“ of the
UK (Hendry and Dickinson : ). ese oshore
nancial centers – also called tax havens – attract
hedge funds by oering very low levels of taxation
and regulation. For example, the Cayman Islands
Monetary Authority tolerates that a small group of
„jumbo directors“ sits on the boards of hundreds of
hedge funds (Jones ). Directors should in theory
be independent and protect the interests of investors.
It seems extremely dicult to fulll this duty for four
individuals that hold more than  directorships
each, another individual even held  directorships
in Cayman Islands-based hedge funds (ibid.). O-
shore nancial centers that are under the sovereignty
of the UK, such as the Cayman Islands, oer politi-
cal stability and the familiar Anglo-Saxon system of
common law – pivotal facts that distinguish them
from other sunny jurisdictions such as the Bahamas,
Barbados or Belize. In this context, Delaware has to
be described as a „de facto“ oshore nancial center
or as a „domestic tax haven“ of the US (Dyreng et al.
); Delaware performs exactly the same role as the
UK tax havens by providing low levels of regulation
and taxation, as well as a high degree of stability.
Including Delaware almost  percent of global hedge
fund assets are domiciled in oshore jurisdictions
that are under the sovereignty of the US and the UK.
Of course, hedge fund managers usually do not work
in these oshore territories but predominantly in
onshore nancial centers.
At the end of  roughly  percent of all hedge
fund managers worked in the US, mainly in New York
and Connecticut. Nearly  percent worked in the
UK –  percent in London and nearly two percent
in the „Crown Dependencies“ of Jersey and Guernsey
(eCityUK ). Hence, approximately  percent
of all global hedge fund managers worked in just two
single countries, the US and the UK. is is an ext-
reme – and arguably sui generis – concentration of
one major global nancial industry in just two coun-
tries. us, it seems justied to call hedge funds an
exclusively Anglo-American industry. Both countries
traditionally adhered to the so-called „indirect regu-
lation“ of hedge funds. „e indirect model“, writes
Fioretos (: ), „is based on the principle that
unfettered markets impose discipline on hedge funds
in whose self-interest it is to adopt responsible tra-
ding and leverage strategies. Because counterparties
acting as prime brokers (typically investment banks)
manage derivatives and lend the money that enable
high levels of leveraging, the indirect approach is
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Vol. 2 (1)  Zeitschrift für Sozialen Fortschritt  ·  Journal for Societal Progress
based on the principle that regulators can also guard
against systemic risks by imposing disclosure requi-
rements and leverage ratios on counterparties rather
than directly regulate hedge funds.“ It is important to
note that this indirect model of hedge fund regulation
does not require a distinct legal status of hedge funds.
erefore, the hedge funds themselves do not have
to register in the US and the UK, but only the hedge
fund managers. at is also the reason why the mana-
gers of hedge funds are the targets of the Alternative
Investment Fund Managers (AIFM) directive by the
European Union. e AIFM directive will come into
force in mid- and introduces some moderate
regulations mostly concerning disclosure and trans-
parency of hedge funds. e directive does not, how-
ever, bring about a strict international regulation of
hedge funds, as there are important exemptions until
 and funds that do not actively market themselves
within the EU are not aected by the directive at all
(Norton Rose ). Hence, the AIFM directive does
not directly threaten the exempt legal status of hedge
funds in the UK and the US.
Edwards (: ) argues that the exempt legal
status that hedge funds enjoy in the US „is premi-
sed on the philosophy that wealthy investors should
be free to make their own decisions unhindered by
government regulation and its associated costs, and
in return should have to bear the full consequences
of their investment decisions – good or bad. In eect,
this means that wealthy individuals and institutional
investors are able to access non-traditional ‚alterna-
tive‘ investment strategies that may provide superior
returns with possibly greater risk, while less well-
o investors are protected by being excluded from
participating in these investments.“ While Edwards
stresses that ordinary investors are „protected“ by
this legislation, one could also say that hedge funds
and, by implication, their wealthy investors enjoy a
privileged or unequal treatment. is legal inequality
of hedge funds and their investors is of central impor-
tance for the rise of hedge funds. In addition, the
US and the UK enabled another important element
of legal inequality that works to the benet of hedge
funds – the development of oshore nancial centers
that function as legal domiciles of hedge funds. As
noted above, oshore nancial centers, such as the
Cayman Islands but also Delaware, have levels of
regulation and taxation that are considerable lower
than „onshore“ jurisdictions. is provides hedge
funds with an advantage over other institutional
investors but also benets very rich individuals who
transfer their wealth to oshore nancial centers in
order to save taxes, or even to pay no taxes at all. A
recent report by Tax Justice Network estimates that
a staggering  to  trillion of wealth deposited
oshore is unrecorded. e vast majority of this
wealth is very probably enjoyed by the top one percent
of the world’s population (Shaxson et al. ). Rich
private individuals, i.e. mainly the top one percent of
the world’s population, were by far the most impor-
tant group of investors in hedge funds until recently.
Hence, the rise of hedge funds is inexplicable without
the enormous investments by these high net worth
individuals. us, when we analyze the rise of hedge
funds we necessarily have to study income inequality.
4. Income inequality and the rise of hedge funds –
the second ingredient
In order to have a broad overview of the historical
development of income inequality in an international
perspective, we plot the income share (excluding capi-
tal gains) by the top one percent of the population for
ve selected countries between  and  (Figure
). e data are taken from the seminal World Top
Incomes Database, which for the rst time enables
cross-country comparisons of income inequality for
long periods of time (Alvaredo et al. ; Atkinson
et al. ). e US and the UK have been selected
because they form the core of the hedge fund industr y,
as described above. In addition to providing the legal
domiciles for hedge funds and being the two domi-
nant centers for hedge funds managers, both coun-
tries are the two largest sources of capital invested in
hedge funds today; in  approximately  percent
of the investors in hedge funds were US-based, while
 percent came from the UK (Preqin ). France,
Japan and Sweden have been selected as points of refe-
rence to the US and the UK. France to a certain degree
represents continental Europe, Japan is one of the
few Asian high-income countries, and Sweden is the
classical case of a highly egalitarian country. Further-
more, these three countries have a higher availability
of data regarding the income of the top one percent
for the selected time period than most other countries
covered by the World Top Incomes Database.
Figure  clearly shows that from  to the early
s there was a high level of income inequality in
all ve countries. Just before the stock market crash of
, the top one percent in the US had nearly  per-
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Fichtner: Der Aufstieg der Hedge-Fonds: Eine Geschichte der Ungleichheit
cent of the national income. e same is true for Japan
in . Although Sweden is generally below the other
four countries, in  the top one percent had still over
 percent of the national income. e period from
the mid-s until the early s can be described
as the „Great Convergence“ or „Great Compression
(Goldin/Margo ); the income share of the top one
percent of the population dropped signicantly in all
ve countries during the s and s and stayed in
a narrow range roughly between six and nine percent
of total income (except for France during the s
and Sweden where it dropped below ve percent in the
s). us, income inequality decreased signicantly
in all ve countries. is period ended in the early or
mid-s when the „Great Divergence“ began (Krug-
man ; Noah ); income inequality increased
again. is trend is particularly pronounced in the US
and the UK. In the US the share of the top one percent
(i.e. approximately the top . million families) more
than doubled from eight percent in  to well over 
percent in . During the same period the share of
the top one percent increased from over six percent to
over  percent in the UK. e share of the top one per-
cent also increased in France, Japan and Sweden, but
to a much smaller extent. Hence, the development of
the share of the top one percent in the US and the UK
from  to  has a „U“-shape, whereas in France,
Japan and Sweden the graph rather has an „L“-shape,
i.e. income inequality dropped in the s and s
and then stayed more or less on this level.
In order to belong to the top one percent income
group in the US one had to earn at least roughly
, per year in  (Saez/Piketty ). How-
ever, the main target group of hedge funds is high
net worth individuals (HNWIs) that have investable
wealth over  million. us, a better proxy for the
group of HNWIs that primarily invest in hedge funds
is the share of the top . percent, i.e. the top decile
of the top one percent – or, the top , families
of the US that each earned more than . million
in . Figure  shows the income share of the top
. percent from  to  including and excluding
capital gains. In addition, the top marginal income
tax rate and the capital gains tax rate are shown.
Both income shares of the top . percent display
the „U“-shape that also characterized the share of the
top one percent. However, Figure  shows that the top
. percent beneted disproportionally from capital
gains. In  the top . percent had about eight
percent of total income, which increases signicantly
to . percent when we include capital gains, which
are mainly generated in the stock market. e graph
including capital gains clearly shows the great stock
market booms and crashes of the twentieth century.
3
5
7
9
11
13
15
17
19
21
1925
1930
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
Figure 2: Top 1% income share excluding capital gains 1920–2010 (%)
France Japan Sweden United Kingdom (from 1937) United States
Source: Alvaredo et al. ()
Figure 2: Top 1% income share excluding capital gains 1920–2010 (%)
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Vol. 2 (1)  Zeitschrift für Sozialen Fortschritt  ·  Journal for Societal Progress
Source: Alvaredo et al. (), Citizens for Tax Justice ()
Figure 3: Top 0.1% income share and top tax rates United States 1920–2010 (%)
e drop in  was of course particularly steep. e
drop in – marked the period when the com-
mencing bear market sent most hedge funds out of
business and thus ended the rst rise of hedge funds –
but has also to do with the increase of the capital gains
tax rate at that time, which was raised from  percent
to eventually over  percent. e stock market cra-
shes of ,  and  are clearly shown in steep
drops of the share of the top . percent including
capital gains. It is remarkable that this share reached
a new peak of extraordinarily high . percent in
, thus clearly surpassing the previous maximum
of . percent in . is is in marked contrast to
the share of the top one percent, which is still below
its peak of . is shows that the super-rich have
increased their income share much faster than the
rich. In fact, the income of the rich top one percent
of the US population more than doubled from  to
, but the income of the super-rich top . percent
more than trebled, and the income of the „ultra-rich“
top . percent (i.e. the top , families that each
earned at least . million in ) even quadrupled
over the same period. On the other hand, the income
of the bottom  percent dropped by almost ve per-
cent from  to  (Shaxson et al. ; Piketty/
Saez ). Hence, during these thirty years income
inequality in the US increased extremely with the
highest income brackets increasing their incomes at
the highest rates.
What we can generally see in Figure  is that there
seems to be an inverse relation between the top mar-
ginal income tax rate and the maximum capital gains
tax rate on the one hand, and the income share of the
top . percent on the other. In the mid-s both tax
rates were drastically lowered; this corresponds with
a peak of the income share of the top . percent of
the US population. During the Great Convergence the
top marginal income tax rate was above  percent
from  to  and remained at  percent until
. e maximum capital gains tax remained at
 percent from  to , but this had not a large
impact as the stock market did not play an important
role during that period. Since the late s there is a
more or less clear trend towards lowering both cen-
In comparison, P- increased by more than 
percent and P- increased nearly  percent from  to
 (Piketty/Saez ).
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Fichtner: Der Aufstieg der Hedge-Fonds: Eine Geschichte der Ungleichheit
tral tax rates in the US – this is especially true for the
period since the mid-s, as Figure  shows. e
top . percent – the primary group of hedge fund
investors – has beneted enormously at the expense
of the bottom  percent; the share of the top .
percent (including capital gains) more than doubled
from about . percent in  to . percent in ,
then it nearly doubled again to almost  percent in
. is unparalleled surge in the income share
of the top . percent fueled the growth of the hedge
fund industry, as very rich individuals have a much
higher propensity to save, that is to invest in hedge
funds that promise high returns. Most mainstream
economists attribute the increased income inequality
in the US primarily to technological change and the
thereby changed supply and demand of skills (Chi-
cago Booth ); or, in the words of Acemoglu (),
„technical change favors more skilled workers“. How-
ever, managing a hedge fund is not principally about
cutting-edge technology, but rather about identifying
lucrative investment opportunities. In addition, tech-
nological change also aected countries such as Japan,
France and Sweden that do not show a drastically
increased income inequality. Hence, besides tax rates,
other factors probably include (lack of) education and
welfare transfers. Another plausible explanation is
the signicantly changed balance of power between
workers and employers in the US since the late s
(Schmitt ). On balance, the rise of hedge funds is
inexplicable without taking into account the income
inequality in the US (and the UK) that signicantly
increased since the early s.
Somewhat surprisingly, however, wealth inequa-
lity did not increase from  to . e wealth
share of the top one percent stayed at about  percent
of total US net worth (Wol ); though this gure
clearly reveals an even more extreme inequality than
regarding income. In the face of drastically increased
income inequality this is clearly a paradox: „We have
this income data where incomes are quadrupling, and
tripling, and doubling, over a period of three decades
– and the wealth gures show just a tiny, tiny little
blip in that wealth concentration. at fantastic incre-
ase in incomes has to go somewhere“ (Shaxson et al.
). Undisclosed and unrecorded wealth deposited
in oshore nancial centers – such as Switzerland,
Luxembourg, Ireland, the UK territories Cayman
Islands, Bermuda or Jersey, and the domestic tax
haven Delaware – seems to be the most plausible mis-
sing link in explaining this pivotal paradox. What is
clear, however, is that HNWIs are the one group that
benets the most from this enormous wealth that is
hidden oshore; as Ötsch (: ) has argued: „e
oshore economy represents a nancial and economic
system, which provides a dierent legal framework
for the benet of elites at the expense of the majority.
Figure  shows that in  at least  percent of
all the capital invested in hedge funds came from
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1992
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
High Net Worth Individuals Funds of Hedge Funds Pension Funds
Endowments & Foundations Corporations & Other
Source: Alvaredo et al. (), Citizens for Tax Justice ()
Figure 4: Top 0.1% income share and top tax rates United States 1920–2010 (%)
14
Fichtner: The Rise of Hedge Funds: A Story of Inequality
Vol. 2 (1)  Zeitschrift für Sozialen Fortschritt  ·  Journal for Societal Progress
HNWIs. e second largest category of investors was
„Funds of Hedge Funds“. A fund of funds adds an
additional layer between the investors and the hedge
funds; their supposed benets are better risk diver-
sication, access to closed funds and better transpa-
rency through experienced funds of funds managers
(Lhabitant ). Furthermore, funds of hedge funds
have generally lower minimum investment require-
ments than hedge funds. Due to a lack of data about
which types of investors allocate how much capital to
funds of funds this category is a „black box“ when we
want to know the ultimate sources of capital of hedge
funds – and this black box grew from  percent to 
percent in , and even to  percent in .
However, all types of investors allocate capital
to funds of hedge funds. erefore, due to a lack of
available data, we assume that their shares in funds of
funds are the same as in hedge funds excluding funds
of funds. In the absence of available data this method
should provide a reasonably good approximation of
the ultimate sources of capital of hedge funds. Figure
 shows the approximate ultimate share of high net
worth individuals in the hedge fund industry in 
and from  to . In  this share still was at 
percent; from  to  the share of high net worth
individuals dropped from  percent to  percent.
Aer a brief rise in  and , the share dropped
signicantly to a low of  percent in .
It is not yet clear why the share of high net worth
individuals is more or less continually falling since
the early s. One of the most probable explana-
tions is that institutional investors, such as pension
funds, and corporations cast o their reluctance
towards the perceived risky hedge fund industry over
time. However, very recently there was anecdotal evi-
dence that many high net worth individuals feel that
the fees charged by most hedge funds are too high
– the typical fee structure of hedge funds is known
as „ & “: a performance-based fee of  percent of
prots plus a high management fee of two percent.
In addition, „rich private investors are turning their
backs on hedge funds because moves to attract more
conservative pension fund clients mean managers no
longer deliver the big returns they crave“ (Wilkes/
Vellacott ). Chapman () argues that from
 to  the „hedge fund community“ (hedge
funds plus their prime brokers) has outperformed
„the market“ (the US S&P  and the UK FTSE All
Share stock indices) in every single year except .
However, when accounting for hedge fund fees and
prime broker fees, the ultimate returns of hedge fund
investors were below market returns in seven out
Source: Authors calculations based on eCityUK ()
94%
74%
71%
66% 65% 65%
60%
58% 58%
61%
63%
52%
45% 44%
37%
31% 32%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1992
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Figure 5: Approximate share of individuals in hedge fund industry 1992, 1996–2011 (%)
Figure 5: Approximate share of individuals in hedge fund industry 1992, 1996–2011 (%)
15
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Fichtner: Der Aufstieg der Hedge-Fonds: Eine Geschichte der Ungleichheit
of these  years (ibid.). A study by Lack () even
found that from  to  hedge fund managers
have pocketed a staggering  percent to  percent of
all returns generated by the entire hedge fund indus-
try: „What investors have paid compared with what
they’ve received is almost breathtaking. Hedge fund
managers and funds of hedge funds have succeeded in
generating substantial prots. However, they’ve also
managed to keep most of the gains for themselves,
while at the same time successfully propagating the
notion that broad, diversied hedge fund allocations
are a smart addition to most institutional portfolios.
at’s quite a trick!“ (Lack : )
is arguably means that HNWIs exclusively
enjoyed the high (out-)performance of hedge funds
during the s and s, but when institutional
investors increased their share in the rapidly growing
hedge fund industry vis-à-vis HNWIs in the mid-
s, the outperformance of hedge funds decreased
signicantly. Although in  hedge funds per-
formed far less badly than the major stock markets,
from  until  the hedge fund industry nearly
continually underperformed them (Chapman ).
Hence, as institutional investors such as pension
funds or insurance companies (part of Corporations
& Other in Figure ) increased their allocations to
hedge funds, a larger share of the very high (and
increasingly undue) fees was indirectly paid by people
of the “bottom  percent”. Lack () estimates
that between  and  the hedge fund industry
received fees in the order of between  billion and
 billion. It should not be entirely surprising, then,
that the top  individual hedge fund managers alone
earned . billion between  and  (Figure
).
Even , when virtually all nancial markets
slumped, the top  highest-earning hedge fund
managers together made . billion. In  the
top  hedge fund managers alone made . billion.
is enormous income in the hands of very few hedge
fund managers represented roughly six percent of the
total income share of the „ultra-rich“ top . percent
of the US population – the top , families that
collectively had an income of about  billion (Saez/
Piketty ). Hence, extraordinarily high income of
the top hedge fund managers is further increasing
income inequality in the US. Signicantly increased
income inequality was identied by many heterodox
political economists as one of the root causes that led
to the nancial crisis that began as the „Great Reces-
sion“ in .
3,7
2,0
5,5
6,5
9,4
13,4
22,3
11,6
25,3
22,1
14,4
0,0
2,5
5,0
7,5
10,0
12,5
15,0
17,5
20,0
22,5
25,0
27,5
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Figure 6: Income of the top 25 highest-earning hedge fund managers 2001–2011 ($ billions)
Source: Institutional Investor’s Alpha ()
Figure 6: Income of the top 25 highest-earning hedge fund managers 2001–2011 ($ billions)
16
Fichtner: The Rise of Hedge Funds: A Story of Inequality
Vol. 2 (1)  Zeitschrift für Sozialen Fortschritt  ·  Journal for Societal Progress
5. The financial crisis – inequality and hedge funds
at work
One of the rst prominent economists to high-
light the link between increased income inequality
and the nancial crisis since  was Rajan ().
Rajan argued that the decline in their relative incomes
since the  led many of the „bottom  percent“
consumers in the US to increase debt in order to keep
consumption high. A considerable portion of the debt
by the low-income households took the form of sub-
prime mortgages. is behavior has temporarily kept
private consumption high, despite stagnating or falling
incomes for many households. See van Treeck/Sturn
() for a comprehensive survey about this „Rajan
controversy“ and the current debates about the role of
income inequality as a cause for the Great Recession;
they conclude: „Rising income inequality seems to have
contributed to the emergence of a credit bubble which
eventually burst and triggered the Great Recession
(ibid: ). Some scholars, notably Livingston () as
well as Kumhof/Rancière (), stressed high income
inequality, and thereby induced high household debt-
to-income ratios, as similarities between the Great
Recession of  and the Great Depression of .
In a recent working paper Stockhammer (: )
argued that „the economic imbalances that caused the
present crisis should be thought of as the outcome of
the interaction of the eects of nancial deregulation
with the macroeconomic eects of rising inequality“.
Extending Rajan’s analysis, Stockhammer identied
the increased income of the rich and super rich as
one key channel that contributed to the crisis. Richer
households tend to hold riskier nancial assets than
lower income groups. Hence, according to Stockham-
mer, particularly the rise of subprime derivatives, but
also the rise of hedge funds, can be linked to the rise
of the super rich and their appetite for risky assets that
promise high returns.
Lysandrou () even argued that there was a „pri-
macy of hedge funds in the subprime crisis“. According
to this interpretation of the crisis, hedge funds contri-
buted signicantly to the development of a market for
subprime derivatives through their close relationship
with the prime broker divisions of the large investment
banks. Most hedge funds found it increasingly dicult
to generate high returns in the years aer the dot-com
crash, from  to , due to a very low level of
interest rates, the tightening of bond yield spreads, and
higher competition by the increasing number of other
hedge funds (Lysandrou ). Hence, they sought new
investment opportunities, such as subprime derivati-
ves. is argument is conrmed by the fact that at the
end of  the hedge fund industry held  percent of
the total stock of Collateral Debt Obligations (CDOs),
while its assets under management amounted to only
a little over one percent of the world’s total stock of
securities (Lysandrou ). is is an extreme concen-
tration of hedge fund investments in one arcane asset
class – of course, such a concentration was only pos-
sible because of the unequal regulation of hedge funds
discussed in section three. is alternative interpreta-
tion of the nancial crisis stresses the fact that hedge
funds exerted a strong buy-side pressure to create
CDOs. Investment banks (prime brokers) passed this
demand pressure on to mortgage brokers, which then
increased the amount of subprime loans that could be
„sliced and diced“ into CDOs. As we all know today
these subprime CDOs acted as the spark that ignited
the nancial crisis.
Many hedge funds, such as a fund called Magnetar,
reportedly realized the toxic nature of many subprime
CDOs they held. However, apparently they did not
simply sell these arcane nancial instruments. On the
contrary, Magnetar cooperated with investment banks
to design and create even more CDOs. en, Magnetar
and other hedge funds wagered against the very same
CDOs they helped to create using another arcane nan-
cial instrument – credit default swaps (CDS) (Eisinger
and Bernstein ). e hedge fund Paulson & Co
cooperated with the investment banks Goldman Sachs
and Deutsche Bank to create CDOs and then wagered
on their collapse – Goldman Sachs later agreed with
the SEC to pay a record-breaking  million ne
to settle the case (Economist ). As Zuckerman
(: ) writes, some observers „argued that Mr.
Paulson’s actions indirectly led to more dangerous
CDO investments, resulting in billions of dollars of
additional losses for those who owned the CDO slices“.
It is estimated that in  alone Paulson & Co made a
staggering  billion with such bets on the crash of the
real-estate market in the US. In that year John Paulson
himself earned about  billion in performance fees
from „the greatest trade ever“ (Zuckerman ).
At the beginning of the subprime crises in mid-
 three hedge funds managed by the investment bank
Bear Stearns that were heavily invested in CDOs collapsed
and had to be rescued by the bank thus foreshadowing its
own collapse in .
17
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Fichtner: Der Aufstieg der Hedge-Fonds: Eine Geschichte der Ungleichheit
As mentioned before, performance-based fees
of US hedge fund managers (and private equity fund
managers) – which are also known as „carried inte-
rest“ – are taxed only with the capital gains rate. e
maximum capital gains tax rate was continually lowe-
red from about  percent in  to roughly  per-
cent since  (as shown in Figure ). In contrast,
the top marginal income tax rate is much higher at 
percent since . is unequal treatment of capital
gains beneted hedge fund managers enormously; they
could earn billions of dollars per year and only pay a
comparably low tax rate. In  President Obama pro-
posed to tax carried interest with the normal income
tax rate. Stephen Schwarzman, the founder and chair-
man of the large private equity company Blackstone,
ercely criticized this proposal even saying in private:
„It’s war. It’s like when Hitler invaded Poland in “
(Quinn ). Although Schwarzman later apologized
for this obscene statement it shows the vested interests
in this unequal treatment of capital gains.
In the US rich hedge fund managers (and private
equity fund managers) started to convert their private
wealth into political inuence. Whereas in  hedge
fund managers contributed just ,, this sum
increased to . million in , to over  million
in  and then to over  million in . In the
 election cycle hedge funds contributed over 
million –  percent to Democrats and  percent
to Republicans. Private equity and investment rms
contributed over  million (Center for Responsive
Politics ). ese are still comparably small shares
of total party contributions, but they are rising fast. In
 the US Supreme Court allowed unlimited private
contributions through opaque „super PACs“ (political
action committees) that theoretically operate indepen-
dent of the campaigns they support, but in reality do
not (Potter ). Hence, contributions from ultra-rich
hedge fund managers are likely to increase further. In
the UK, hedge funds and private equity rms even
contributed a staggering  percent of all donations
to the ruling Conservative party in  (Mathiason
); this arguably makes sure that the UK remains a
staunch supporter of lax hedge fund regulation. Even
though hedge fund managers could not prevent the re-
election of President Obama in November  with
their contributions to the Republicans, it currently
seems very probable that their political inuence in
the US – and also the UK – will further increase in the
future, as they have just begun to convert wealth into
inuence.
6. Conclusion
It was the purpose of this paper to show that the
rise of hedge funds was indeed a story of inequality.
Whereas the rst rise of the hedge fund industry –
from the late s until the early s when most
funds collapsed – had virtually no consequences,
the second rise – from the early s until today –
impacted the global nancial markets signicantly.
Hedge funds have risen to the very pinnacle of global
nance. e rise of hedge funds was made possible by
various interdependent dimensions of inequality: e
marked inequality between the (non-)regulation of
hedge funds and the much stricter regulation of other
nancial market actors – supplemented by the fact that
hedge funds have a distinct advantage by shiing their
legal domicile to oshore nancial centers that provide
lower levels of regulation and taxation; furthermore, the
drastically increased income inequality since the early
s, primarily in the US and the UK. Both dimensi-
ons of inequality are closely connected, because hedge
funds may only accept investments by high net worth
individuals (HNWIs) that have more than  million
in investable wealth (and by institutional investors) in
order to be exempt from most US and UK regulation.
e exempt legal status provides hedge funds
with a number of distinct advantages over institutio-
nal investors such as mutual or pension funds. Hedge
funds (at least global macro funds) are able to concen-
trate their capital in a few selected investments – as in
 when Soros was able to „bet everything on one
card“ and succeeded in forcing the UK out of the ERM.
Hedge funds can build up high leverage to enhance
returns – but this also can drastically increase risk as
the episode of LTCM showed. In addition, hedge funds
face much lower reporting and disclosure standards
than other institutional investors. Although both the
US and the UK have recently tightened the regulation
of hedge funds a little bit, for example by mandatory
registration of hedge fund managers, both countries in
principle still adhere to the indirect regulation para-
digm. e traditional rationale for refraining from
strict direct regulation was that hedge funds were too
small to matter and that HNWIs should be free from
government regulation in their investment decisions.
Both rationales have become obsolete in the course of
the nancial crisis. As Lysandrou showed, hedge funds
did play a crucial role in the nancial crisis. Hence,
they are clearly not too small to matter anymore. Fur-
thermore, the benecial role ascribed to them by many
18
Fichtner: The Rise of Hedge Funds: A Story of Inequality
Vol. 2 (1)  Zeitschrift für Sozialen Fortschritt  ·  Journal for Societal Progress
mainstream economists has to be doubted aer the
crisis. Financial regulation should protect the interests
of the entire population not just those of HNWIs. Dras-
tically increased income inequality and hedge fund
involvement in the expansion of subprime mortgages
played a vital part for the nancial crisis. Hence, there
is good reason to argue that the exempt legal status of
hedge funds should be abolished and consequentially
that they should be regulated like any other institutio-
nal investor. e AIFM directive by the EU is a step in
that direction but arguably not a decisive one.
On balance, the rise of hedge funds was signi-
cantly driven by surging income inequality in the US
(and the UK) since the early s, as HNWIs sought
(risky) investments that promised high returns. Hence,
HNWIs had the privilege to make use of potentially
very lucrative investment opportunities that were not
accessible to the rest of the population. From the s
onwards many hedge funds ceased to be hedge funds
in the risk-averse way characterized by Alfred Winslow
Jones, but should rather be called wager or speculation
funds. e reemergence of global nance that began in
the s – primarily enabled by the US and the UK –
paved the way for the rise of hedge funds that began
one decade later. It remains to be seen if the hedge fund
industry will really more than double to  trillion by
 as recently predicted by Citigroup (Businesswire
). However, it seems probable to conclude that
the rise of hedge funds will continue until the story of
inequality, which enables and fuels this rise, will nally
come to an end.
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... To date, no universally accepted definition of hedge funds exists. In general, hedge funds are private and largely unregulated investment vehicles that primarily cater to wealthy individuals and institutional investors and are able to employ any investment strategy (Fichtner, 2013a). ...
... Hedge funds are also very active investors, representing high shares of the trading in many segments of financial markets. Hence, hedge funds have become influential actors in many markets (Fichtner, 2013a). ...
Preprint
Full-text available
During the last decades, institutional investors gained an ever more important position as managers of assets and owners of corporations. By demanding (short-term) shareholder value, some of them have driven the financialization of corporations and of the financial sector itself. This chapter first characterizes the specific roles that private equity funds, hedge funds, and mutual funds have played in this development. It then moves on to focus on one group of institutional investors that is rapidly becoming a pivotal factor for corporate control in many countries – the “Big Three” large passive asset managers BlackRock, Vanguard and State Street.
... To date, no universally accepted definition of hedge funds exists. In general, hedge funds are private and largely unregulated investment vehicles that primarily cater to wealthy individuals and institutional investors and are able to employ any investment strategy (Fichtner, 2013a). ...
... Hedge funds are also very active investors, representing high shares of the trading in many segments of financial markets. Hence, hedge funds have become influential actors in many markets (Fichtner, 2013a). ...
Chapter
Full-text available
Since the 1980s, institutional investors have increased their assets under management enormously. This trend has been driven both by rapidly growing equity markets and by the fact that households increasingly shifted from direct stock ownership to holdings via asset managers. Moreover, institutional investors benefited from the development that many countries changed their pension systems from “defined benefit” to “defined contribution” schemes that involve investment via asset managers (Rutterford and Hannah 2016). Through these developments, institutional investors have become large owners of publicly listed corporations in virtually all countries that have developed equity markets. This chapter focuses on how institutional investors have shaped and driven the financialization of listed companies and the financial sector itself, primarily by demanding the maximization of short-term shareholder value. The main measures to increase shareholder value have included share buybacks and special dividends as well as mergers. Additionally, many institutional investors have pushed for an alignment of (short-term) interests between managers and shareholders through stock-based forms of remuneration, thus reinforcing the financialization of listed corporations.
... In the liberal market economies of Anglo-American pedigree firm behaviour generally is much more oriented towards the maximization of short-term profits, often driven by 'impatient capital'. Activist hedge funds epitomize this impatient capital that continuously seeks to extract short-term financial gains (Buchanan et al., 2018;Fichtner, 2013aFichtner, , 2013bFichtner, , 2015Goyer, 2011). The rise of BlackRock, Vanguard and State Street as the New Permanent Universal Owners introduces somewhat of a paradox into this comparative political economy debate, as it is increasingly clear that these Big Three American based asset managers do not have the short-term orientation we typically connect to shareholder incentives in liberal market economies. ...
Article
Full-text available
Fundamental change is happening in global finance – the shift from active management to index funds. This money mass-migration into index funds has far-reaching socio-economic consequences, as it has the potential to transform the nature of shareholder capitalism. We call BlackRock, Vanguard and State Street the ‘New Permanent Universal Owners’ that are invested indefinitely in thousands of firms. We provide novel findings on the combined ownership of the Big Three in European countries and Japan and investigate how this signals a shift away from the shareholder capitalism that has been dominant for the past three decades. We discuss the future role(s) of the New Permanent Universal Owners in corporate governance including whether they foster patient capital and introduce the distinction between feeble and forceful stewardship.
... In this situation, the holdings would be classified as direct investment. If, on the other hand, an activist investor such as a hedge fund owns a stake of 9% in a foreign target firm and successfully influences the company to pay a special dividend, initiate a share buy-back program or sell itself to another corporation, the holdings would be treated as portfolio investment (see Fichtner 2013aFichtner , 2013bFichtner , 2015 for analyses of hedge funds). Hence, there is no objective rationale for the arbitrary division between direct and portfolio investment at the 10% threshold. ...
Article
Full-text available
This paper presents the Offshore-Intensity Ratio – a simple and straightforward way to identify which countries and jurisdictions could be seen as offshore financial centres (OFCs). By setting the aggregated amount of external capital booked in a jurisdiction in relation to the size of its domestic economy, we get a ratio that expresses the strength with which the particular jurisdiction has acted as a magnet for foreign capital. Sixteen jurisdictions are identified as probable OFCs, including the Cayman Islands, the British Virgin Islands, Bermuda and Luxembourg, but also Ireland and the Netherlands. A novel visualization shows the role of the largest offshore centres in contemporary global finance.
... The average salaries in the US financial sector have strongly increased during the process of financialisation, and in 2014 have reached nearly five times the level of 1980 in nominal terms (Gordon, 2014). Hedge funds in particular have become a synonym for inequality (Fichtner, 2013). Anecdotally, the remuneration of hedge fund managers such as David Tepper (Appaloosa Management) with nearly 10 Million US dollars per day in 2014 has even been called into question in circles that usually are in favour of neo-liberal economic policies (FAZ, 6 May, 2014). ...
Article
Full-text available
For more than three decades, increasing financialisation has been a core feature of the European economy. This process does not only lead to economic instability, but also to social inequality. A driving force of financialisation in Europe are the internal market institutions of the European Union, aggravated through the introduction of the Euro and the programmes for rescuing the common currency. The European Union, principally, should be the most suitable institution to limit financialisation in favour of a more social Europe, given that it is often considered to be a shield against the harsh winds of globalisation. However, both the legal foundations as well as the political power relations within the Union are more likely to rather pave the way towards a deepening of financialisation and social inequality.
... One extreme example are the incomes of the top 25 hedge fund managers. In 2001, they earned a cumulative 5 billion USD and this grew to well over 25 billion USD in 2009 [Fichtner (2013)]. If a similar trend is apparent in Germany, it would contribute to inequality. ...
Article
Income inequality is rising in Germany. This is true for both functional as well as personal income distribution. After reunification in 1990, a general increase in inequality can be observed. This trend becomes particularly pronounced in the 2000s. In the literature on financialisation a link between the developments in the financial sector, the financing behaviour of firms, and income distribution is established. Also, in the varieties of capitalism literature a connection between the prevailing institutions, among them the financial institutions, and the tendency of an economy towards higher or lower inequality is made. This study attempts to investigate if changes in the financial sphere may have caused the higher inequality in Germany. There are different ways in which the financial sector could have contributed to the increased inequality. Growth of the financial sector or large increases in incomes paid in this sector could lead to higher inequality directly. Alternatively, different behaviour of financial institutions and new financial actors could affect distribution in the non-financial sector so that the financial sector indirectly affects inequality.
Article
Hedge funds play an important role in investment markets, but high-profile frauds and market manipulation have necessitated increased scrutiny for the detection and prevention of such activities. Market metrics which signal fraudulent activity quickly, early, and reliably are scarce and sometimes provide fallacious results. The bias ratio in conjunction with other metrics could provide a solution as it compares the real asset return distribution to that of unbiased returns. High bias ratios combined with statistical moments which differ considerably from those expected from normal distributions provide compelling evidence for possible return manipulation. Application of these metrics to known fraud cases shows that—used historically and in tandem—they would have provided powerful early indicators of suspicious investment activity. Uncovering these frauds earlier could have potentially saved investors considerable resources. The bias ratio also shows promising results in detecting other possible market scams such as insider trading.
Chapter
Hedge funds may be established anywhere in the world, both onshore and offshore. To shed more light on the offshore hedge fund industry, with main focus on the following offshores jurisdictions: Cayman Islands, British Virgin Islands, Mauritius, and Delaware, the current chapter focuses at first on the differences between onshore and offshore funds from the point of view of their legal structures, and particularly with regard to tax requirements. Indeed, there are plenty of benefits for hedge funds in moving offshore, the most important being for sure the tax neutrality, as these locations are known also under the name of “tax havens.” Also, there is a major focus on advantages and disadvantages of legal fund vehicles and structures which operate in offshore places. The current chapter analyzes only three regions of the world’s most important locations for offshore funds: the Caribbean, more precisely the Cayman Islands and the British Virgin Islands, United States, respectively Delaware, and Africa—Mauritius. The chapter provides an in‐depth analysis of the four jurisdictions from the point of view of hedge funds. Despite increasing convergence, meaningful differences between the four regimes can be observed. The chapter explores several of these similarities and differences, as well of advantages and disadvantages offered by each jurisdiction. The Cayman Islands is one of the largest financial centers globally speaking, as well as a key node in contemporary global finance, standing as the legal domicile of choice for the global hedge fund industry. Delaware is perceived as a de facto offshore financial center or as a “domestic tax haven” of the United States, performing similar to the Cayman Island, providing low levels of regulation and taxation, as well as a high degree of stability. Both UK and US hedge funds are attracted by the British Virgin Islands, mainly because this country is historically tied to the United Kingdom and geographically to the United States. The British Virgin Islands stands as one of the best, highly respected hedge funds’ domiciles, globally speaking. In addition to its modern, efficient banking system stands the government’s public policies focused mainly on developing strict money laundering and tax evasion standards, this earning for the British Virgin Islands a leading reputation in the financial world. Last but not least, Mauritius is the favorite offshore center for Far East investing.
Article
The man they called “Smiley” died in February 1938 on an operating table in Kingston, Jamaica. His stomach cancer, only recently discovered, was quickly deemed inoperable by a doctor in the Cayman Islands, where he lived with his pregnant wife and four children. In Cayman, there had been no public hospital. Instead, a British heiress paid to build a four-bed emergency ward and dispensary meant to serve the island's 6,500 residents. Four beds for more than six thousand. Such insufficiency represented the extent of institutionalized health care at the edge of the British Empire.
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Financialization has become the go-to term for scholars grappling with the growth of finance. This Handbook offers the first comprehensive survey of the scholarship on financialization, connecting finance with changes in politics, technology, culture, society and the economy. It takes stock of the diverse avenues of research that comprise financialization studies and the contributions they have made to understanding the changes in contemporary societies driven by the rise of finance. The chapters chart the field’s evolution from research describing and critiquing the manifestations of financialization towards scholarship that pinpoints the driving forces, mechanisms and boundaries of financialization. Written for researchers and students not only in economics but from across the social sciences and the humanities, this book offers a decidedly global and pluri-disciplinary view on financialization for those who are looking to understand the changing face of finance and its consequences.
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Zusammenfassung In diesem Beitrag stelle ich dar, dass sich über Offshore-Ökonomie eine Parallelökonomie ausgebildet hat, die Eliten nützt und die Mehrheit der BürgerInnen benachteiligt. Offshore-Ökonomie ist kein Randphänomen, sondern ein v.a. von Unternehmen und reichen Privatpersonen genutzter zentraler Bestandteil des Weltwirt-schafts-und Finanzsystems. Bis zur Finanzkrise 2007/2008 wurde Offshore-Ökonomie entweder nicht oder nur halbherzig reguliert; nach der Krise positionierten sich PolitikerInnen zwar rhetorisch gegen Steuer-und Regulierungsflucht, umfassende Maßnahmen blieben aber aus. Wenngleich sich die generelle Einstellung vieler BürgerInnen zu Offshore-Ökonomie gewandelt hat, setzen sich die Interessen von Eliten nach wie vor durch, v.a. wegen ihres Zugangs zu spezifischem Fachwissen und der Kompliziertheit von Finanz-und Steuersystemen und wegen ihrer Fähigkeit, Diskurse zu ihren Gunsten zu steuern. Eliten gelingt es, eigene Interessen als nationale oder die anderer BürgerInnen darzustellen. Forderungen und Aktivitäten der Zivilgesellschaft sollten sich neben technischen Fragen mit Elitediskursen beschäftigen und diesen eigene entgegensetzen.
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When the subprime crisis broke out in the summer of 2007, the hedge funds avoided blame by disassociating from those that supplied the subprime-backed products and by disappearing among those that bought these products. This twofold defense strategy has worked to perfection because almost everyone who has studied the crisis is convinced that it is the banks and not the hedge funds that were chiefly responsible for causing it. This article puts forward a different interpretation of events. Its central argument is that had it not been for the hedge funds' intermediary position between the investors seeking yield on the one hand and the banks that created the high yield bearing securities on the other, the supply of these securities would never have reached the proportions that were critical in precipitating the near collapse of the whole financial system. Take away hedge funds and a general financial crisis could still have occurred in 2007–8, but it is only because of the hedge funds that the crisis that actually occurred initially took on the form of a subprime crisis. The policy implication of this analysis is that regulatory controls on hedge fund activities must be far tighter than those currently proposed.
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The paper argues that the economic imbalances that caused the present crisis should be thought of as the outcome of the interaction of the effects of financial deregulation with the macroeconomic effects of rising inequality. In this sense rising inequality should be regarded as a root cause of the present crisis. We identify four channels by which it has contributed to the crisis. First, rising inequality creates a downward pressure on aggregate demand since it is poorer income groups that have high marginal propensities to consume. Second, international financial deregulation has allowed countries to run larger current account deficits and for longer time periods. Thus, in reaction to potentially stagnant demand two growth models have emerged: a debt-led model and an export-led model. Third, (in the debt-led growth models) higher inequality has led to higher household debt as working class families have tried to keep up with social consumption norms despite stagnating or falling real wages. Fourth, rising inequality has increased the propensity to speculate as richer households tend hold riskier financial assets than other groups. The rise of hedge funds and of subprime derivatives in particular has been linked to rise of the superrich.
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The global financial crisis was caused because the volume of toxic assets in the financial system had grown to the point where the system could no longer cope. The dominant view among heterodox economists is that this point of critical mass was reached because of various failures in the financial system. This paper puts the accompanying view that the toxic assets were created largely in response to external pressures, a principle source of which was global inequality: while income inequality was an important factor behind the supply of those assets, wealth concentration was a major factor behind the demand for them. The policy implications of this analysis are that income distribution and wealth ownership have to be more equitably structured if global financial crises are to be avoided in the future. This is not to exclude other proposals for making the financial system more transparent and accountable. The point, rather, is that these proposals are insufficient on their own. No matter how radical the re-structuring of the financial system, as long as there remain external pressures on it to create products or to indulge in practices that are harmful to it, such products and practices will continue to be introduced and financial crises will continue to occur.
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The massive growth of hedge funds has sparked warnings of instability and demands that the industry be regulated. But the fear of hedge funds is overblown, based on a misunderstanding of their role in the international financial system. In reality, hedge funds do not increase risk; they manage it-and policymakers, rather than clamping down, should make sure hedge funds have the tools to perform this function well.
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Raghuram Rajan was one of the few economists who warned of the global financial crisis before it hit. Now, as the world struggles to recover, it's tempting to blame what happened on just a few greedy bankers who took irrational risks and left the rest of us to foot the bill. In Fault Lines, Rajan argues that serious flaws in the economy are also to blame, and warns that a potentially more devastating crisis awaits us if they aren't fixed. Rajan shows how the individual choices that collectively brought about the economic meltdown--made by bankers, government officials, and ordinary homeowners--were rational responses to a flawed global financial order in which the incentives to take on risk are incredibly out of step with the dangers those risks pose. He traces the deepening fault lines in a world overly dependent on the indebted American consumer to power global economic growth and stave off global downturns. He exposes a system where America's growing inequality and thin social safety net create tremendous political pressure to encourage easy credit and keep job creation robust, no matter what the consequences to the economy's long-term health; and where the U.S. financial sector, with its skewed incentives, is the critical but unstable link between an overstimulated America and an underconsuming world. In Fault Lines, Rajan demonstrates how unequal access to education and health care in the United States puts us all in deeper financial peril, even as the economic choices of countries like Germany, Japan, and China place an undue burden on America to get its policies right. He outlines the hard choices we need to make to ensure a more stable world economy and restore lasting prosperity.
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After years of acrimonious debate among leading industrialized states, the G20 reached an agreement in 2009 on the regulation of hedge funds. Anchored in an institutional theory of government action that draws on historical institutionalism, this article finds that cleavages between liberal market economies (US, Britain) and organized market economies (Germany, France) determined the failure to regulate hedge funds in the 1990s, the origins of a self-governance regime in the mid-2000s, as well as the nature of the G20 agreement in 2009. Historical institutionalism offers an important complement to theoretical traditions in international political economy (IPE) that stress the role of states’ market power in shaping international regulatory regimes, especially in accounting for how the evolution of state preferences affect the nature of international regulation over time. The article concludes with suggestions for how historical institutionalism can be extended beyond its typical purview in comparative politics to give analytical and substantive nuance to the study of international market regulation.
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Many accounts of the globalization of financial markets over the past three decades explain it as a product of unstoppable technological and market forces. This article emphasizes that the behaviour of states was also of central importance in encouraging and permitting the process. States are shown to have supported financial globalization in three ways: (1) granting freedom to market actors through liberalization initiatives; (2) preventing major international financial crises; and (3) choosing not to implement more effective controls on financial movements. These roles are illustrated historically through a description of five sets of episodes since the late 1950s. States are found to have increasingly embraced the globalization trend because of: a competitive deregulation dynamic, political difficulties associated with the implementation of more effective capital controls, the ‘hegemonic’ interests of the US and Britain, the growing domestic prominence of neoliberal advocates and internationally‐oriented corporate interests, and the unusually cooperative nature of central bank interaction.