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The first hedge fund that ever formed was by Albert Winslow Jones in 1949, as the main investment strategy was to take hedged equity investments. By ‘hedging’ -the act of removing risk in some investment by taking an investment in another investment- Winslow was able to eliminate a certain amount of market risk. Remarkably many of the ideas that he introduced over fifty years ago remain fundamental to today’s hedge fund industry.
Jones structured his fund to be exempt from the SEC regulations described in the Investment Company Act of 1940. This enabled Jones’ fund to use a wider variety of investment techniques, including short selling, leverage, and concentration (rather than diversification) of his portfolio. Jones committed his own money in the partnership and based his remuneration as a performance incentive fee, 20% of profits. Both practices encourage interest alignment between manager and outside investor and continue to be used today by most hedge funds.
Jones was the first to combine shorting and leverage techniques that give exposure to risk, and used them to instead hedge against market movements and reduce his risk exposure. He was an excellent stock picker, but a poor market timer. That is why he was comfortable with a market-neutral strategy of having equal long and short positions. Jones’ long-short strategy rewarded exceptional stock selection and created a portfolio that reacted less to the vagaries of the overall market. He also used the capital made available from short selling as leverage to make additional investments. Jones went on to also hire other managers and delegated authority for portions of the fund, and thus initiated the multi-manager hedge fund. The multi-manager approach later evolved into the first fund of hedge funds.
Hedge funds soon grew to become well-known after an article in Fortune Magazine in 1966 that mentioned Jones’s fund and its significant out performance against other Mutual Funds. In the mid-1960s, Jones’ fund was still active and began to inspire imitations, some from investment managers who once worked for Jones. An SEC report documented 140 live hedge funds in 1968. This article temporarily intrigued investors about hedge funds but the popularity faded as investors fell victim to the bear markets of 1969-70 and 1973-4. During the bear market, the S&P 500 declined by a third. Funds with leveraged long-bias strategies were damaged because of insufficient risk reduction techniques. As a result, many hedge funds went out of business, and hedge funds decreased in popularity for the next 10 years.
A decade later (1986), Robertson’s infamous Tiger Fund once again caught people’s interest in hedge funds. The Tiger Fund was one of several so-called global macro funds that made leveraged investments in securities and currencies, based upon assessments of global macroeconomic and political conditions. This fund achieved compound annual returns of 43% for 6 years after all expenses. Robertson’s Fund had a huge impact on the publicity of the hedge fund industry by showing the rapid expansion of hedge funds for more than 10 years until 1997. Hedge funds became admired for their profitability, and reviled for their seeming destabilising influence on world financial markets.
In 1992 during the European Exchange Rate Mechanism crisis, George Soros’ Quantum Fund, another global macro hedge fund, made over a billion dollars from shorting the British pound. During the “Asian Contagion” currency crisis in July 1997, the Thai Baht fell 23%. Quantum Fund had shorted the Baht and gained 11.4% that month. Similar success stories increased the appeal and fascination associated with hedge funds, but also established a reputation for benefiting from and contributing to financial market chaos.
As the number of hedge funds grew, a multitude of new hedge fund trading strategies evolved along with it which included the use of derivatives. Many investors were using investment strategies beyond simply hedging. To complicate matters, as hedge fund strategies developed, so did the strategies of other types of funds. Other funds started using Winslow’s equity hedging strategy too. Thus hedging was no longer unique to hedge funds.
Today, the word “hedge” in hedge funds has become a misnomer, more of a historical context that came from Alfred Winslow rather than a pertinent description.
While high net worth individuals remain the main source of capital, hedge funds are becoming more popular among institutional and retail investors. Funds of funds and other hedge fund-linked products are increasingly being marketed to the retail investors in some jurisdictions.
All together, there are a number of factors behind the rising demand for hedge funds.
The exceptional bull run in the US equity markets during the 90s increased investment portfolios. This lead both, fund managers and investors, to become more strongly aware of the significance of diversification. Hedge funds are seen as a natural “hedge” for controlling downside risk because they use exotic investments strategies expected to generate returns that are uncorrelated to asset classes.
Until recently, the wave of scandals that hit corporate America and the uncertainties in the US economy has lead to a general decline in the stock markets worldwide. This provided fresh momentum for hedge funds as investors searched for absolute returns.
The growth in demand for hedge fund products has brought changes on the supply side of the market. The prospect of potential riches has encouraged many former fund managers and proprietary trades to strike out on their own and set up new hedge funds. With hedge funds entering the main stream and becoming ‘respectable’, an increasing number of banks, insurance companies, pension funds, are investing in them.
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