The History of Hedge Funds Louisville KY

provided by:


For Dummies is a registered trademark of Wiley Publishing, Inc. in the United States and other countries. Used here by license.



Hedge funds haven’t been around forever, but they aren’t exactly new, either. Their fortunes have varied with those of the markets, and their structures have evolved with the development of modern financial-management theories and techniques. Knowing the history of hedge funds will give you a sense of how the modern hedge fund market came to be. You’ll understand how some of the myths of funds originated and why some of the practices (like fee structure and secrecy) developed over time. And, the history is interesting. Isn’t that reason enough? In this section, I cover some of the highlights and lowlights that have come since the development of the first hedge fund in 1949.

Alfred Winslow Jones and the first hedge fund
Alfred Winslow Jones wrote a book in 1941 that examined the attitudes of residents of Akron, Ohio toward large corporations. The book, Life, Liberty, and Property: A Story of Conflict and a Measurement of Conflicting Rights, is still in print by the University of Akron Press. When it came out, the magazine Fortune reprinted sections of the book, and Jones eventually joined the magazine’s editorial staff. While at Fortune, he learned quite a bit about investing, and in 1949, he quit the magazine to form a money-managing firm, A.W. Jones & Co., which is still in business in New York. At Fortune, Jones covered some of the developing theories in modern finance — especially the notion that markets were inherently unpredictable. He was determined to find a way to remove the risk from the market, and the way he found was to buy the shares of stocks expected to go up while selling short the stocks expected to go down. With this strategy, he could remove much of the risk of the market, and his fund would have steady performance year in and year out. I describe this style of investing, sometimes called long-short investing, in Chapter 11. And in a twist of fate, Fortune first used the term “hedge fund” to describe Jones’ fund in a 1966 article. Alfred Winslow Jones had two other innovations for the modern hedge fund, both of which have overshadowed his investment style:

His analysis of the Investment Company Act of 1940: In the analysis, he stated that a private-partnership structure can remain unregistered as long as its investors are accredited.

His fee. He charged his investors 20 percent of the fund’s profits. More than 50 years later, few hedge fund managers still hedge the way that Jones did, but almost every manager copies his partnership structure and fee schedule.
1966 to 1972: Moving from hedging to speculating

After Alfred Winslow Jones developed a nice business collecting 20 percent of the profits from his partners by using his hedging strategy, other money managers wondered if they could also set up private partnerships and charge 20 percent while following different investment strategies. The answer? Yes. The name “hedge fund” stuck, but the emerging funds were more speculative than hedged. Hedging is the process of reducing risk. Speculating is the process of seeking a high return by taking on a greater-than-average amount of risk. Although hedging and speculating are opposing strategies, many hedge funds today use both. The change in strategy took place partly because the stock market was really strong, so short-selling proved to be a losing game. Also, because the stock market was so strong, money managers could make a lot of money by borrowing and buying stock. And then, in 1972, the bottom dropped out. A stock-market bubble that formed at the end of the 1960s finally and totally burst, leaving hedge fund managers with big losses. Some managers who had borrowed heavily found themselves insolvent. Most of the newly formed hedge funds shut their doors, and the aggressive style of investing fell out of favor for about a decade.
George Soros, Julian Robertson, and hedge-fund infamy

George Soros, who co-founded the Quantum Fund with Jim Rogers, and Julian Robertson, who founded the Tiger Fund, are two legendary names in the hedge-fund business. They both formed their funds in the late 1960s to early 1970s go-go era, managed to hold on through the market collapse that took place in 1972, and then started posting spectacular profits in the 1980s. Both funds followed a macro strategy, which means they looked to profit from big changes in the global macroeconomy. They took bets on changes in interest rates, exchange rates, economic development, and commodities prices. They also used options and futures to improve their returns and manage their risks. (In 1988, George Soros published a book about his unconventional approach to investing, The Alchemy of Finance [Wiley].) Both fund managers achieved icon status of sorts in the 1990s, and then both managers ran into trouble. Soros made huge profits by betting (and investing accordingly) that the currencies of several Asian countries were overvalued. He was right, but the resulting collapse of the currencies led to political unrest in Indonesia and Malaysia and turned Soros into a pariah. Julian Robertson believed that the huge increases in technology stocks were overdone in the 1990s, and he was proven right in 2000, but his performance suffered terribly until then.

Long-Term Capital Management
One infamous hedge fund, Long-Term Capital Management, had spectacular performance year after year until it nearly caused a global financial meltdown in 1998. The history of this firm tells a tale of just how little hedging takes place at some of the biggest and best-performing hedge funds. The 1960s and 1970s brought about huge changes in the way that people thought about finance and investing. Experts developed several new academic theories. Some academics realized that they could earn more by managing money than they could by teaching students how to do it, so they quit their university jobs and started hedge funds. In 1994, John Meriwether, an experienced bond trader at Solomon Brothers, joined with other traders and two professors, Robert Merton and Myron Scholes, to form a fund. The fund’s managers took advantage of relatively small differences in the prices of different bonds. Most of their trades were simple and low-risk, but they used a huge amount of borrowed money (known as leverage) to turn their simple trades into unusually large returns. In 1997, Merton and Scholes shared the Nobel Prize in Economics, giving their fund a highly academic aura. People thought the fund was filled with investors who had discovered an unusually low-risk way of generating unusually large returns. In the summer of 1998, the Russian government defaulted on its bonds, which caused investors to panic and trade their European and Japanese bonds for U.S. government bonds. Long-Term Capital Management bet that the small differences in price between the U.S. bonds and the overseas bonds would disappear; instead, the concern over Russia’s problems led to large differences in price that steadily widened. The mistake made it difficult for Long- Term Capital Management’s managers to repay the large amounts of money that the fund had borrowed, which put pressure on the investors who had given the loans. The Federal Reserve Bank then organized a restructuring plan with the banks that Long-Term Capital Management dealt with in order to prevent a massive financial catastrophe. In total, Long-Term Capital Management lost $4.6 billion dollars.

The Yale Endowment
The Yale University Endowment, which operates in the financial and trade press, has $15.2 billion under management as of press time, making it the second-largest college endowment in the world. Its success has driven most of the institutional interest in hedge funds, and institutional interest has created all the demand in the market. The performance of the Yale Endowment is considered a milestone. It has long kept 25 percent of its assets in hedge funds, and in this avenue, it performs the best out of all the major university endowments. The fund’s manager, David Swensen, earned a doctorate in finance at Yale and worked on Wall Street before joining Yale’s staff in 1985. Once on board, he decided to diversify the university’s money into holdings other than stocks and bonds, adding investments in private equity, oil, timberland, and hedge funds. Management members at other endowments and foundations have long looked at Yale’s performance with green-eyed envy. They’ve witnessed one of the richest colleges get richer, in part due to hedge-fund investing, and they want to do the same. By 2005, the National Association of College and University Business Officers reported that 8.7 percent of all college-endowment money was invested in hedge funds, up from 1.8 percent in 1996. And, in 2005, 21.7 percent of the money in endowments larger than $1 billion was invested in hedge funds.

Generating Alpha
Hedge fund managers all talk about alpha. Their goal is to generate alpha, because alpha is what makes them special. But what the heck is it? Unfortunately, alpha is one of those things that everyone in the business talks about but no one really explains. Alpha is a term in the Modern (Markowitz) Portfolio Theory (MPT). The theory is a way of explaining how an investment generates its return. The equation used to describe the theory contains four terms:

The risk-free rate of return

The premium over the risk-free rate that you get for investing in the
market

Beta

Alpha

Beta is the sensitivity of an investment to the market, and alpha is the return over and above the market rate that results from the manager’s skill or other factors. If a hedge fund hedges out all its market risk, its return comes entirely from alpha. People aren’t always thinking of the Modern (Markowitz) Portfolio Theory when they use alpha. Instead, many people use it as shorthand for whatever a fund does that’s special. In basic terms, alpha is the value that the hedge fund manager adds. In theory, alpha doesn’t exist, and if it does exist, it’s as likely to be negative (where the fund manager’s lack of skill hurts the fund’s return) as positive. In practice, some people can generate returns over and above what’s expected by the risk that they take, but it isn’t that common, and it isn’t easy to do.

provided by:


For Dummies is a registered trademark of Wiley Publishing, Inc. in the United States and other countries. Used here by license.

HillStreet Capital Inc.

(513) 651-0800
807 Elm Street
Cincinnati, OH