In the process of updating some of our hedge fund research recently, a colleague was kind enough to pass along a copy of an April 1966 article in Fortune magazine called “The Jones Nobody Keeps Up With.” I had read about this article in other hedge fund readings, but—until recently I admit—I had not actually read the entire article. The article is more than 40 years old and credits Alfred Winslow Jones as the person to have created hedge funds as we know them today. Hedge fund attributes such as long positions offset by short sales, use of leverage and 20% incentive fees are all there. What struck me most about this article was Jones’s now famous quote regarding the use of short selling and leverage as “speculative tools used for conservative purposes.”
The following decade-by-decade overview of the history of hedge funds intends to highlight that hedge funds have not always maintained this thematic view. Philosophers can interpret investing in one of two ways. “Free-will” believers would argue that investors can shape their results—markets are not efficient and ultimately manager skill will add value. “Deterministic” believers argue that investment results will be what they will be—markets are efficient, and so they prefer passive over active investment management.
Looking at “free will” versus “determinism” in terms of hedge fund investing, one would typically align themself with free will to the extent that hedge fund investors are expected to employ broader skill sets to improve their risk-return results. The question in our minds are not the skill sets used by the hedge fund manager, but the ability for a solution to sustainably provide a complement to traditional investments. As the following summary demonstrates, hedge fund managers are just like traditional managers; they go through start-ups, acquisitions and collapses. Their results can be strong, flat or weak, and the strategies can be “Jonesian,” opaque or transparent. Sponsors must ensure that the hedge fund strategy that is employed or proposed to be employed in their program is right for their risk-return tolerances.
In the late 1940s, Jones created the first hedge fund by using an investment approach that hedged away the market risk of long stock positions by selling short other stocks and also used leverage to enhance returns. In the 1950s, Jones remained the main hedge fund player, transformed his general partnership into a limited partnership, and introduced a performance-based compensation system: a 20% incentive fee for the managing partner, which remains common today. The limited partnership enabled Jones to avoid the reporting requirements to which mutual funds were required to follow at the time.
In the 1960s, the aforementioned article in Fortune brought public attention to Jones’s investment approach. His partnership fund had outperformed the best performing mutual fund that year by 44 percentage points (pps) and the best five-year performing mutual fund at the time by 85 pps, net of all fees. The article highlighted the attractiveness to this type of investing from wealthy individuals and saw the emergence of similar hedge fund vehicles strategies. By the end of the decade, it was estimated that approximately 200 hedge funds were in operation. In the 1970s, the hedge fund industry faced significant losses due to rapid industry growth, which led to many funds abandoning the “conservative ends” that Jones suggested for riskier strategies based on long-term leverage. Many inexperienced managers were experimenting with short selling, and a number of hedge fund managers generated heavy losses. The bear market environment at the time further compounded problems.
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In the 1980s, futures and options derivatives were introduced, and currency trading allowed hedge funds to pursue additional risk-return strategies. By 1984—according to Tremont Partners—only 68 hedge funds were documented as being in business. Julian Robertson’s hedge fund, the Tiger Fund, gained media attention, and crowd behaviour once again seemed influenced by hedge fund activity. A number of high-profile fund managers were lured away from traditional mutual fund industry positions to hedge funds in anticipation of greater compensation prospects.
In the 1990s, the “growth/tech/concept” bull market pushed market index returns to record highs and facilitated the continued growth of hedge funds. By 1999, according to Tremont Partners, there were more than 4,000 hedge funds. However, some hedge funds experienced losses, despite the strong market momentum at the time. Others earned a negative reputation for causing significant market disturbances. In 1992, George Soros’s Quantum Fund made a speculative bet that the British pound would depreciate, driving Britain to pull out of the established exchange rate mechanism, and causing interest rates to spike by five percentage points. The result cost Britain around US$6 billion in losses. Soros and other hedge funds were also blamed for the depreciation of Thailand’s baht, due to excessive shorting of the currency. In 1998, Long-Term Capital Management (LTCM)—despite its well connected advisors—collapsed, despite efforts by the Federal Reserve Bank of New York and with 14 other financial institutions to rescue LTCM.
In the 2000s, the “tech bubble” burst and the subsequent market meltdown separated the “true” hedge fund managers from the ‘speculative’ hedge fund managers that employed directional strategies. Pension plans and endowment funds continued to commit assets to established hedge fund strategies and fund-of-fund strategies, and explored the possibility of “porting” hedge fund results onto traditional asset classes. All of these strategies became widely available on turn-key or commingled bases, enabling investors with limited investment resources to invest in hedge funds. The media’s scrutiny on past and recent hedge fund failures resulted in a move towards enforcing some regulations, but the industry has always and will likely continue to resist any regulations.
Presently, according to the Hedge Fund Association, there are about 9,000 hedge funds in an industry worth about $1.1 trillion.
Peter Arnold leads the Canadian Investment Consulting Practice for Buck Consultants, an ACS Company. He is responsible for the development and delivery of all investment and defined contribution consulting services in Canada.