HEDGE FUND- A BRIEF HISTORY

Hedge funds comprise one of the fastest growing sectors of investment management. With rare exception, their distinguishing characteristics today are(1) an absolute return investment objective, (2) the ability to be long and/orshort, (3) the freedom to use the widest possible range of financial instru-ments needed to implement the investment strategy, and (4) performance-related compensation. Typically, Tremont and TASS do not classify long-onlyfunds as hedge funds. However, we recognize certain exceptions in nichemarkets and where it is difficult to implement a short position—for exam-ple, specialist distressed securities and high yield managers.In 1949, when Alfred Jones established the first hedge fund in the UnitedStates, the defining characteristic of a hedge fund was that it hedged againstthe likelihood of a declining market. Hedging was employed by businesses as far back as the 17th century, mainly in the commodity industries whereproducers and merchants hedged against adverse price changes. In his original hedge fund model, Jones merged two speculative tools—short sales andleverage—into a conservative form of investing. At the time of the fund’sinception, leverage was used to obtain higher profits by assuming more risk.Short selling was employed to take advantage of opportunities. Jones usedleverage to obtain profits and short selling through baskets of stocks to con-trol risk.Jones’ model was devised from the premise that performance dependsmore on stock selection than market direction. He believed that during a ris-ing market, good stock selection would identify stocks that rise more thanthe market, while good short stock selection would identify stocks that riseless than the market. However, in a declining market, good long selections will fall less than the market, and good short stock selection will fall morethan the market, yielding a net profit in all markets.Jones’ model performed better than the market. He set up a general part-nership in 1949 and converted it to a limited partnership in 1952. Although his fund used leverage and short selling, it also employed performance-basedfee compensation. Each of the previous characteristics was not unique initself. What was unique, however, was that Jones operated in completesecrecy for 17 years. By the time his secret was revealed, it had already become the model for the hedge fund industry.Jones kept all of his own money in the fund, realizing early that he could not expect his investors to take risks with their money that he would not bewilling to assume with his own capital. Curiously, Jones became uncomfortable with his own ability to pick stocks and, as a result, employed stockpickers to supplement his own stock-picking ability. In 1954, Jones hired another stock picker to run a portion of the fund. Soon, he had as many as eight stock pickers, autonomously managing portions of the fund. By 1984,at the age of 82, he had created the firstfund of funds by amending his partnership agreement to reflect a formal fund of funds structure.Although mutual funds were the darlings of Wall Street in the 1960s,Jones’ hedge fund was outperforming the best mutual funds, even after the20 percent incentive fee deduction. The news of Jones’ performance created excitement; by 1968, approximately 200 hedge funds were in existence, mostnotably those managed by George Soros and Michael Steinhardt.During the 1960s’ bull market, many of the new hedge fund managers found that selling short impaired absolute performance while leveraging thelong positions created exceptional returns. The so-called hedgers were, infact, long leveraged and totally exposed as they went into the bear market of the early 1970s. During this time, many of the new hedge fund managers were put out of business. As Jones pointed out, few managers have the ability to short the market because most equity managers have a long-only men-tality.During the next decade, only a modest number of hedge funds were established. In 1984, when Tremont began tracking hedge fund managers, it wasable to identify a mere 68 funds. Fifteen years later, TASS, the investment research subsidiary of Tremont, was tracking 2,600 funds and managers(including commodity trading advisers). Most of these funds had raised assetsto manage on a word-of-mouth basis from wealthy individuals. Julian Robertson’s Jaguar Fund, Steinhardt Partners, and Soros’ Quantum Fund werecompounding at 40-percent levels. Not only were they outperforming in bullmarkets but in bear market environments as well. For example, in 1990,Quantum was up 30 percent and Jaguar was up 20 percent while the Standard& Poor’s 500 Index was down 3 percent and the MSCI $ World Index wasdown 16 percent. The press began to write articles and profiles drawing atten-tion to these remarkable funds and their extraordinary managers.During the 1980s, most of the hedge fund managers in the United Stateswere not registered with the Securities and Exchange Commission (SEC).Because of this, they were prohibited from advertising, relying on word-of-mouth references to grow their assets. The majority of funds were organizedas limited partnerships, allowing only 99 investors; the hedge fund managers,therefore, required high minimum investments. European investors were quick to see the advantages of this new breed of manager, which fueled the development of the more tax-efficient offshore funds. In the United Statesand Europe, the hedge fund industry of the 1980s was an exclusive club ofwealthy individuals and their private bankers.Hedge funds currently represent one of the fastest growing segments ofthe investment management community. During the 1990s, the number offunds increased at an average rate of 25.74 percent per year, showing a totalgrowth of 648 percent (including funds of funds). The reason for the unprecedented growth is simple: Money follows talent. Having attained significant personal wealth as fund managers or proprietary traders, the talented man-agers are leaving large companies to manage their own money. They are estab-lishing simple, corporate structures with limited employees and forming funds with absolute and risk-adjusted return objectives. These funds typicallycharge performance fees, usually 20 percent of the profits. By limiting the sizeof assets under management, these companies can react quickly to events inthe financial community, trading without impacting share prices. With fees earned as a percentage of profits, a company can earn as much money on a$100 million asset base as a traditional money manager earns on $1 billion.