The IMF on Hedge Funds
With hedge funds taking so much crap these days from the ignorant unwashed masses, perhaps it might be good to take a look at where exactly they came from. Lucky for us, the IMF wrote an entire paper about it.
From Hedge Funds: What Do We Really Know?:
In 1949 A.W. Jones established in the United States what is regarded as the first hedge fund. Jones combined two investment tools--short selling and leverage. Short selling involves borrowing a security and selling it in anticipation of being able to repurchase it at a lower price in the market, at or before the time when it must be repaid to the lender. Leverage is the practice of using borrowed funds. (Financially leveraged firms thus have high debt-to-equity ratios.)
Both short selling and leverage are regarded as risky when practiced in isolation. Jones is credited with showing how these instruments could be combined to limit market risk. Jones's insight was that there were two distinct sources of risk in stock investments: risk from individual stock selection and risk of a drop in the general market. He sought to separate out the two. Jones maintained a basket of shorted stocks to hedge against a drop in the market. Thus controlling for market risk, he used leverage to amplify his returns from picking individual stocks. He went long on stocks that he considered "undervalued" and short on those that were "overvalued." The fund was considered "hedged" to the extent the portfolio was split between stocks that would gain if the market went up, and short positions that would benefit if the market went down. Thus the term "hedge funds."
Jones's fund had two other notable characteristics that, with variations, continue to this day: he made the manager's incentive fee a function of profits (in his case, 20 percent of realized profits) and agreed to keep his own investment capital in the fund (ensuring that his incentives and those of his investors were aligned).
Hedge funds proliferated in the "go-go" years 196668, as the stock market rose and Jones's fund garnered favorable publicity. A 1968 U.S. SEC survey enumerated 215 investment partnerships, 140 of which were categorized as hedge funds. These funds concentrated on investments in corporate equities. With the market on an upward trend, fund managers relied more on leveraging, since hedging a portfolio with short sales was difficult, time consuming, and costly. As a result, managers increasingly resorted to strategies with only token hedging--rendering the funds vulnerable to the extended market downturn that started at the end of 1968. By one estimate, assets under management by the 28 largest hedge funds had declined by 70 percent by the end of 1970.