The first hedge-fund manager, Alfred
Winslow Jones1, did not go to business
school. He did not possess a Ph.D. in
quantitative finance. He did not spend
his formative years at Morgan Stanley,
Goldman Sachs or any other incubator for
masters of the universe. Instead, he took
a job on a tramp steamer, studied at the
Marxist Workers School in Berlin and ran
secret missions for a clandestine anti-Nazi
group called the Leninist Organization.
He married, divorced, and married again,
honeymooning on the front lines of the
civil war in Spain, traveling and drinking
with Dorothy Parker and Ernest Hemingway. It was only at the advanced age of 48
that Jones raked together $100,000 to set
up a “hedged fund,” generating extraordinary profits through the 1950s and 1960s.
Almost by accident, Jones improvised an
investment structure that has endured to
this day.
Half a century after Jones created his
hedge fund, Clifford Asness followed in
his footsteps. Asness did attend a business
school and did acquire a Ph.D. in quantitative finance. He did work for Goldman Sachs, and he was a master of the
universe. Whereas Jones had launched
his venture in his mature, starched-collar
years, Asness rushed into the business
at the grand old age of 31, beating all
records for a new start-up by raising an
eye-popping $1 billion. Whereas Jones
had been discreet about his methods and
the riches that they brought, Asness was
refreshingly open, tearing up his schedule
to do TV interviews and confessing to The
New York Times that “it doesn’t suck” to
be worth millions.
Asness freely recognized his debt to
Jones’s improvisation. His hedge funds,
like just about all hedge funds, embraced
four features that Jones had combined to
spectacular effect. To begin with, there was
a performance fee: Jones kept one-fifth of
the fund’s investment profits for himself
and his team, a formula that sharpened
By Sebastian Mallaby
the incentives of his lieutenants. Next,
Jones made a conscious effort to avoid
regulatory red tape, preserving the flexibility to shape-shift from one investment
method to the next as market opportunities mutated.
But most important, from Asness’s perspective, were two ideas that had framed
Jones’s investment portfolio. Jones had
balanced purchases of promising shares
with “short selling” of unpromising ones,
meaning that he borrowed and sold them,
betting that they would fall in value. By
being “long” some stocks and “short” others, he insulated his fund at least partially
from general market swings; and having
hedged out market risk in this fashion, he
felt safe in magnifying, or “leveraging,” his
bets with borrowed money. This combination of hedging and leverage had a magical
effect on Jones’s portfolio of stocks. But
its true genius was the one that Asness
emphasized later: The same combination
could be applied to bonds, futures, swaps
and options — and indeed to any mixture
of these instruments.
For much of their history, hedge funds
have skirmished with the academic view of
markets. From the mid 1960s to the mid
1980s, the prevailing view was that the
market is efficient, prices follow a random
walk and hedge funds succeed mainly by
being lucky.
There is a powerful logic to this account.
If it were possible to know that the price
of a particular bond or equity is likely
to move up, smart investors would have
pounced and it would have moved up
already. Pouncing investors ensure that all
relevant information is already in prices,
so the next move of a stock will be determined by something unexpected. It follows that professional money managers
who try to foresee price moves will generally fail in their mission. Therefore, plenty
of hedge funds have no real “edge.” But
for the successful funds that dominate the
industry, the efficient-market indictment
is wrong. These hedge funds could drop
their h and be called edge funds.
Where does this edge come from?
Sometimes it consists simply of picking
the best stocks. Despite everything that
the finance literature asserts, A.W. Jones
and many early hedge fund practitioners
clearly did add value in this way. But
frequently the edge consists of exploiting
kinks in the efficient-market theory that
its proponents conceded at the start, even
though they failed to emphasize them.
The theorists stipulated, for example, that
prices would be efficient only if liquidity
was perfect — a seller who offers a stock
at the efficient price should always be able
to find a buyer, since otherwise he will
be forced to offer a discount, rendering
the price lower than the efficie