A Short History of Hedge Funds

From Aristotle to Amaranth, the funds have lured investors with dreams of heady profits and terrified them with nightmares of risk.

Many think of hedge funds as the current flavor of the month in investing and capital markets. But scholars trace the funds’ roots back to a tale told by Aristotle in which the philosopher Thales bet on a bumper olive crop. Thales cannily wrangled with the owners of olive presses until he gained the exclusive rights to use the equipment in the upcoming harvest. Like today’s hedge fund advisers, he used a contrarian trade to profit mightily.

Other experts attribute the invention of today’s lightly regulated capital pools to a eureka moment by Alfred Winslow Jones nearly sixty years ago. In 1949, Jones, an academic and journalist, penned an article in Fortune about new fashions in financial forecasting.

Captivated by the subject, he dropped journalism and decided to try finance himself. He created A.W. Jones & Co., a partnership of four friends, and invested $100,000 in stocks, using a mix of long and short positions buttressed by a healthy dose of debt. He also implemented a scheme to make the manager’s fee 20 percent of profits, purportedly aligning his incentives with those of investors. That incentive structure remains typical of hedge funds today.

A year after he formed the fund, it earned 17.3 percent, and during the next decade it outperformed every mutual fund by 87 percent, according to Alexander Ineichen’s Absolute Returns: The Risk and Opportunities in Hedge Fund Investing, which also mentions the tale of Thales.

The Early Years

Seventeen years after Jones’s groundbreaking article, Fortune journalist Carol Loomis wrote about her precursor’s success, referring to his strategy as a “hedge fund.” Soon after Loomis’ article, hedge funds seemed to be pop up everywhere.

In 1968, the Securities and Exchange Commission counted 140 investment partnerships that it considered hedge funds, according to research by economists Barry Eichengreen, of the University of California at Berkeley and Donald Mathieson of the International Monetary Fund in a report on hedge funds.

Early forays into the field were typified by short selling, which put hedge fund managers. But inexperienced hedge fund managers soon grew tired of hedging their bets and began wagering more heavily on long investments and less on short ones, thus exposing themselves to the stock market. When markets started to slide, so did many hedge funds. According to Eichengreen and Mathieson, assets managed by the 28 largest hedge funds had declined by 70 percent in 1970. Many were liquidated, and the total value of the remaining hedge funds at the time was $300 million.

Because little was heard from the funds during the late 1970s and early 1980s, many came to regard them as a relatively new phenomenon. But in the mid-1980s, now-famous investors such as Julian Robertson and George Soros were still at it: attracting capital, out-running the markets and using high-return instruments and unregistered funds to make eye-popping profits. “All these high-worth individuals started saying, ‘Get me into a hedge fund, get me into a hedge fund,’” says Stephen Brown, a finance professor at New York University’s Stern School of Business who has written widely on hedge fund performance.

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