From the November 2010 issue of Research Magazine • Subscribe!

The Birth of Hedge Funds

How an eclectic intellectual began a high-powered financial industry.

Alfred Winslow Jones was a financial journalist before he became a wildly successful investor who would be known as the father of the hedge fund industry. The moment of transition is captured in a March 1949 Fortune magazine article Jones wrote, titled “Fashions in Forecasting.”

The article was about technical analysis, which Jones looked at with a blend of skepticism and receptiveness. He noted weaknesses in the track record of some technical methods, but also distanced himself from the disdain that some academics already displayed toward chart reading (this being a decade and a half before the formal arrival of the efficient-markets hypothesis, with its sharp dismissal of the technical approach).

A brief intro to the piece mentioned that Jones’s “initial interest in the new methods of market analysis described in this article came from a small investment in one of the services mentioned,” an outfit known as Market Action. That gave a hint that Jones was inclined to be not only a journalistic observer of the investment world, but a participant.

In fact, by the time the article hit the newsstands, Jones was already well in the process of setting up his own investment firm, A. W. Jones & Co. While reporting on the latest investment strategies, Jones had begun to contemplate a new approach, one that would include selling short some stocks in a portfolio as a way to protect against the market’s uncertainties.

Such a portfolio, Jones would explain to his investors, was a “hedged” fund. In later decades, as the term “hedge fund” became well-known, the dropping of the letter “d” would take on a subtle significance. It suggested that while many in the hedge fund industry followed Jones in various ways — in having a limited-partnership structure, for example, and in being publicity-shy — they did not necessarily give the same priority he did to making sure a portfolio was prudently hedged.

Diverse Background
Jones was 48 when he founded his firm, and had compiled a rather eclectic résumé. Born in Australia in 1900, the son of a General Electric executive, he came to the United States with his family at age 4. He graduated from Harvard in 1923 and worked as a purser on a tramp steamer. By the early 1930s, Jones had joined the U.S. Foreign Service and was stationed in Berlin, watching the Nazis consolidate power.

In the early ’30s, Jones was married briefly to a daughter of German painter Josef Block. Later that decade, he married one Mary Carter, with whom he traveled in Spain during the Spanish Civil War to report on civilian relief for a Quaker organization. At one point, he hitchhiked to the front lines alongside writer Dorothy Parker.

Jones studied Marxism at a Berlin school and collaborated with an underground anti-Nazi group called the Leninist Organization. Did the man who would start the hedge fund industry have Communist sympathies for some time? Or was he rather making common cause against shared enemies? It’s unclear, but Jones certainly had an adventuresome life.

In 1941, Jones received a sociology doctorate from Columbia University. For his research, he interviewed 1,705 residents of Akron, Ohio about their attitudes toward corporations and property. He found that, despite local labor unrest and political tensions, Akron was not divided rigidly along class lines. His dissertation was published as a book titled Life, Liberty, and Property, which became a much-used text in sociology circles.

Jones was on staff at Fortune from 1941 to 1946, contributing later in the decade as a freelancer. The material for his articles ranged from financial matters to topics such as Atlantic convoys and boys’ prep schools. Fortune back then was a magazine that made a point of mixing cultural interests into its business coverage. Jones’s “Fashions in Forecasting” article, for instance, carried an elegant black-and-white overhead shot of Wall Street skyscrapers by famed photographer Berenice Abbott.

As he contemplated trying his hand as an investment manager, Jones studied the requirements of the Investment Company Act of 1940, discerning that its regulations would not apply if a fund had fewer than 101 investors. He decided to set up a limited partnership with not more than 99 investors. (In later decades, hedge funds tended to make use of subsequent regulatory exemptions for vehicles catering to “qualified” or “accredited” high-net-worth investors.)

Another distinguishing feature of the new fund was its high performance fee. Jones and his team would take a 20 percent cut of the profits. The sociology Ph.D. justified this arrangement with characteristic erudition, noting that it followed the practice of ancient Phoenician sea captains who kept a fifth of the profits from successful voyages.

Success and Fame
A. W. Jones & Co. began with $100,000 in capital, of which $40,000 was Jones’s own money. The firm traded with heavy leverage — another characteristic that became a hallmark of the hedge fund industry. But it also limited its risk through the strategy of combining long and short positions. The business operated very quietly for its first decade and a half. New clients arrived through word of mouth. New hires were made without fanfare, as Jones assembled a crack team of managers and analysts.

Then, in the 1960s go-go market, Jones allowed his former employer, Fortune, to shed some light on the firm’s workings. Carol Loomis, a hard-driving financial journalist, wrote an April 1966 article titled “The Jones Nobody Keeps Up With.” This piece coined the term “hedge fund” and sketched out the basics of Jones’s hedging method. “To those investors who regard short selling with suspicion,” wrote Loomis, “Jones would simply say that he is using ‘speculative techniques for conservative ends.’”

The figures provided in the article were certain to get attention. Loomis reported that A.W. Jones had achieved a 325 percent return over five years and 670 percent over a decade. These returns outpaced the top-performing mutual funds of the same periods.

When Loomis’s article came out, Jones already had a few imitators, mostly run by people who once had worked for him. Now, however, hedge funds became a craze, as the number of such vehicles soared to roughly 150 during the late 1960s. An October 1968 article by journalist Peter Landau in New York magazine described hedge funds as a “supercharged way of investing that is spreading rapidly throughout the financial world.”

Landau highlighted Jones as the man who had started this trend, noting however that the sociology Ph.D. “actually seems to be more interested in things other than finance,” including finding self-improvement alternatives to welfare and organizing a Reverse Peace Corps to bring foreigners to work with poor Americans. Jones was quoted complaining that “too many men don’t want to do something after they make money.” Many of Jones’s early investors, Landau wrote, were scholars, social workers and others whom Jones had met over the years and was trying to free from financial concerns.

As the 1960s sputtered out into a bear market, the bottom lines of A.W. Jones and other firms in the recently expanded field came under pressure. Loomis wrote an article titled “Hard Times Come to the Hedge Funds” for the January 1970 Fortune, in which she described Jones as regretting he had not been more thoroughly hedged and resolving now to “aim for moderate, steady growth.” Loomis added, however: “‘Moderate’ to Jones, if not to most people, seems to mean gains of 20 to 30 percent a year.”

Hedge funds generally receded from public attention through the bearish 1970s, and Jones resumed the low profile with which he was most comfortable. He died in 1989 at age 88, having continued to advise the firm in his later years. During the 1980s, under Jones’s son-in-law Robert L. Burch III, the firm took on a fund-of-funds structure and placed a large allocation in Julian Robertson’s Tiger Management hedge fund.

A 1986 Institutional Investor article about Tiger Management’s excellent performance helped spark new public interest in hedge funds. Even more attention arose in the early 1990s after George Soros’s successful bet against the British pound. By then, memories of Alfred Winslow Jones were fading and articles by and about him were buried in magazine archives. Many people thought of hedge funds as something new.

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Debating Hedge Funds

Do hedge funds contribute to the problem of financial turmoil — or are they part of the solution? That debate has intensified in the aftermath of the financial meltdown.

In his recent book More Money Than God: Hedge Funds and the Making of a New Elite, Sebastian Mallaby of the Council on Foreign Relations argued that hedge funds pose little risk to systemic stability, since their managers are heavily invested in their own funds and have no expectations of a bailout if things go badly.

Reviewing Mallaby’s book in the liberal magazine The New Republic, journalist Noam Scheiber took a more jaundiced view. “As hedge funds get bigger, their benefits (nimble, contrarian thinking) get muddled and their potential drawbacks get magnified (heaping piles of leverage and tiny shreds of regulation).”

Citing the collapse of Long-Term Capital Management, Scheiber added: “Big, highly-leveraged hedge funds turn out to resemble big banks in at least one respect: Their mistakes can threaten the financial system.”

Felix Salmon, a blogger for Reuters, took issue with Scheiber’s argument, stating that “in general there’s one thing that the hedge fund system does well, and that’s confine hedge fund losses to the investors in those funds.”

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