The purpose of a hedge fund is to hedge the bet someone made in the market. For example, I have a lot of money invested in airlines. I am worried that if the price of gas goes up, my stock will go down.
Therefore, I buy a hedge fund in say gas futures. If the price of gas goes up and my airline stocks go down, my gas futures will help offset my loss in the airline stock.
Because hedge funds were special purpose funds, and they were only for the very wealthy investors, they were not regulated by the Securities and Exchange Commission. The thinking was that wealthy investors know the market better than the average investor, and didn’t need the protection of the SEC. Because these funds are very narrow in scope and very complex to setup, making these funds prepare a detailed prospectus could be impossible.
Besides, the amount of money in these funds is quite small. It’s not like the very rich will play all sorts of games with them and bring the entire national economy to a screeching halt!
Well, because they weren’t regulated, they could play all sorts of games that other funds couldn’t play. Because they were small, they could usually make more money than the more tightly regulated funds.
In the end of the 20th century, investors started getting interested in using hedge funds as a main investment vehicle instead of as a strictly insurance fund to protect against losses in other investments. More money poured into these funds, and fund managers started taking riskier and riskier bets to keep up the large returns that many investors expected.
Funny thing: It turns out that people with money are just as stupid as people without money. But as the old saying goes: If you owe a bank a hundred thousand dollars and cannot pay, you’re in trouble. If you owe a bank a hundred billion dollars and cannot pay, the bank is in trouble.