The story of the first ever hedge fund
There is no real consensus about who invented the first ever hedge fund. When did hedge funds start? Whose name was the first behind them?
While some believe it to have been Alfred Winslow Jones, others believe it to have been Benjamin Graham. So in this article on the history of hedge funds, we’ll be looking at both men, and whose claim is stronger:
Alfred Winslow Jones
Tradition has it that Alfred W. Jones was the first person to come up with the term ‘hedged fund’, from which we get the modern version. What he meant by this was a fund people could invest in which was free of risk.
From this theory, Jones built a whole structure – akin to the traditional infrastructure of today’s hedge funds – and used his calculations to invest as well as hedging for any potential losses.
Background and Harvard’s Degree
Though he’s credited as being the inventor of the first hedge fund, it’s worth noting that history shows that Jones was actually more of an intellectual than a financier. After first finishing a degree at Harvard and then later a Ph.D. in Sociology, the idea for his ‘Hedged fund’ was first printed in Fortune. Having worked for them full-time but then leaving to work freelance, the theory first came to him while researching for an article called ‘Fashions in Forecasting’.
His research into technical stock market analysis was the trigger for his new idea. According to his way of thinking, the technical analysis he had done was inconsistent at predicting trends in the market. It was simply too risky, and he realized there must be another way to minimize the risks attached to investors.
Instead of using technical analysis, he suggested alternative investment funds where a fund manager could use two techniques simultaneously: they could buy stocks with a margin while, at the same time, shorting other stocks they had already bought. Shorting means betting on the fall of a stock’s price.
While on their own, both tactics would be risky and dependent on speculation, together he thought they would make the investment portfolio less risky and more successful. Investors no longer had to worry about market movements, they just needed to pick good stocks per time, running a market-neutral portfolio.
Just like in many other industries (not excluding virtual data rooms), sometimes, it is rather more important who brings the concept to life than who invents it.
Achievements and Hedge Fund Performance
Just like in many other industries (not excluding virtual data rooms), sometimes, it is rather more important who brings the concept to life than who invents it. It took until 1949 for Jones to put his theory into practice.
After scraping together around $100,000, Jones’ plan was to cut the risks he was making on long-term stocks through short selling, where necessary, any stocks which the fund was running which weren’t performing as well as hoped. But he didn’t get his first hedge fund strategy right straight away, and it took trial and error before he realized it would be necessary to use a limited partnership model to run the fund, rather than a general one.
First, he designed his fund to exempt it from the Investment Company Act of 1940 from the Securities and Exchange Commission. This gave him more freedom to use various investment techniques, including shorting, leveraging (borrowing money to maximize a bet), and concentration (as opposed to diversification).
He also introduced a performance incentive fee for fund managers to ensure that the manager’s interest was fully aligned with those of their investors. The standard fee at that time was 20%, and many funds are still charging as much today.
His hedge fund products shielded against market volatility, raking in steady profits regardless of the mood in the market. He’d leverage on long-term picks while short-selling poor-performing stocks to concentrate on the well-performing ones.
The funds grew in leaps and bounds over the years, and soon enough, Jones would have to delegate important responsibilities to his managers. The investment managers have portions of assets under management, looking after investments in equity, currency, and commodity markets, and other alternative investments. This new multi-managerial approach would go down as the first hedge fund.
Throughout the 60s, Jones’s hedge fund achieved eyebrow-raising returns. In 10 years, he notched cumulative returns of over 1,000%, and by the late 60s, his firm had secured over a 5000% return on their investments.
Alfred Winslow Jones’ Meteoric Rise
Though the fund had a remarkable track record during its first twelve or so years, spawning a second fund, like many trendsetters, Jones was only recognized for his contribution to the industry in the 1960s.
His groundbreaking hedge fund investment strategies didn’t draw any significant attention until a Fortune Magazine edition from 1966 shone a light on a little-known fund that was outperforming every mutual fund by double digits over the past five years.
A few years later, over 140 new hedge funds reportedly sprung up, according to the SEC. Most were founded by Jones’ former managers and employees, as well as admirers and imitators. Since then, Jones has become known as the Father of Hedge Funds.
How Does Jones’ Hedge Fund Compare to Hedge Funds of Today?
The decades following Jones’ rise to fame would prove decisive for the hedge fund industry, witnessing many hedge fund crashes. Jones himself ran into a few years of losses after more than 12 years of an unbroken run of healthy profits. He was quick to recover, though.
However, after him, there would be no news of hedge funds pulling remarkable performances for the next 20 years. The bear market of the late 60s and early 70s would dampen fledging interests from investors. A major bane was the widespread departure from the founding principles of the trade.
Note: There is a crucial difference between Jones’ theory of a ‘Hedged fund’ and a ‘Hedge fund’ since he believed his fund’s being ‘hedged’, i.e. safe, was its most important feature. In fact, many of today’s hedge funds are unregulated financial institutions unlike Jones’, though they may also have a structure which still compensates its managers on the basis of strong investment performance.
In a bid to maximize profits, many hedge funds have been over-leveraged and managed with inadequate risk reduction techniques.
“We grew into this culture of gunslingers,” said Bill Fleckenstein, founder and president of Fleckenstein Capital, a hedge fund based in Seattle. Today, risk aversion — the cornerstone of classic hedge funds — is a “recipe for getting fired“, according to Fleckenstein. “All anyone really wanted was performance, and managing risk was a drag on a fund’s performance,” he added.
The neglect of the traditional hedge fund strategy has led to many scandals in the hedge fund sector, including Bernie Madoff’s infamous Ponzi scheme. In fact, the reckless hedge fund managers had a major hand in the 2008 global financial crisis. According to historical hedge fund data, there were over 700 cases of hedge fund closures, and the industry’s investment pool shrunk from almost $1.5 trillion at the previous high to a mere $1.6 billion.
However, many firms still offer lucrative hedge fund returns, especially for the ultra-wealthy and institutional investors.
The lesson here is that there are many hedge funds out there that are a misnomer. They look nothing like Jones’ original hedge funds.
The main supporter of Graham’s role as the first ever hedge fund manager and inventor is Warren Buffett, the world’s most successful investor, who is himself worth $66.7 billion, and was one of Graham’s underlings.
According to Buffett, “Ben Graham managed a hedge fund in the mid-1920s […] It involved a partnership structure, a percentage-of-profits compensation arrangement for Ben as a general partner, a number of limited partners and a variety of long and short positions.“
Background and the Graham-Newman Partnership
Graham, together with his lifelong partner Jerome Newman, rode the waves of the ‘roaring 20s, flourishing along with a crop of new private investment firms, including investment banks, at the peak of the 20’s bull market. He focused on deep-value investments, looking beyond the common matrices of the day to assess a company’s potential for profitability and sustainability.
However, Graham’s company was hit badly at the depth of the recession. He was so enmeshed in debt, his modern-day followers would have a hard time arguing he’s the father of hedge funds.
However, the Graham-Newman fund outperformed everyone at the time. He managed to recover most of those losses a few years later.
Thanks in a huge part to their deep value investment, they were able to weather short-term losses and sail into positive territories within a few years. They were barely scraping by but were able to prevent long-term capital losses by investing in securities that had ‘intrinsic value’ and could withstand short-term bearish environments. This was a solid long-term capital-management strategy that secured a solid capital base to fall back on and launch comebacks, which is the essence of hedge fund strategies.
According to Buffett, Graham and Newman invented not one but two companies, decades before Jones had, both of which had all the characteristics of a standard hedge fund. After emerging from the tumultuous season in the mid 30’s, the Graham-Newman partnership was upgraded to the Graham-Newman Corporation. They mostly operated like mutual funds, posting earnings per share in addition to dividends and net asset value annually. Many experts believe, on a deeper level, their operations revolve around hedge fund strategies.
Achievements and Hedge Fund Performance
Buffett claims that when he started up his own fund way back in 1956, he took inspiration from the partnership that his mentor, Graham, had been running. That being said, Buffett has since rescinded his claim that Graham’s was the first hedge fund in existence, stating instead that it was simply the first he had heard of, meaning it looks like a convincing victory for Jones.
Graham didn’t leave empty-handed, though. Among many things, he is widely regarded as the father of value investing, one of the pillars of traditional hedge fund strategies.
The story of the first hedge fund highlights the history of hedge funds and how the hedge fund industry has evolved. It shows how the departure from traditional hedge fund strategies led to catastrophic consequences.
Jones’ Funds from the 60s revolved around techniques that helped consolidate profitable securities while systematically eliminating bad performers. However, many hedge funds today have stretched the rules almost beyond recognition. And the chicken has come back home to roost on several occasions.
Both Jones and Newman had their own fair share of losses during economic downturns, but it was nowhere near as spectacular a fall as those of many funds that flaunted the founding principles of hedge fund investing.
That isn’t to say that firms can only make it when they operate like the first hedge funds. Today, many hedge funds employ a host of other techniques to secure a steady stream of profits for their clients. At the height of its meteoric rise, the first mutual fund was overseeing $100 million in investments. That sounds like a drop in the ocean compared to the current market size of hedge funds, pegged at $1 trillion.