A brief history of the hedge fund

Famed hedge fund manager Mario Gabelli wrote in 2002: "Today, if asked to define a hedge fund, I suspect most folks would characterize it as a highly speculative vehicle for unwitting fat cats and careless financial institutions to lose their shirts."

This characterization stems from the hedge fund's recent history, which began with the headline-making collapse of Long Term Capital Management in 1998 and continued with the sensational meltdown of the Tiger Funds in March of 2000, followed by the reorganization of the once high-flying Quantum Fund in April of 2000. These high-profile incidents overshadow more than half a century of hedge fund history that began when Alfred Winslow Jones launched the first hedge fund in 1949.

The father of the hedge fund

Alfred Jones was born in Melbourne, Australia in 1901 to American parents. He moved to the United States as a young child, graduated from Harvard in 1923 and became a U.S. diplomat in the early 1930s, working in Berlin, Germany. He earned a PhD in sociology from Columbia University and joined the editorial staff at Fortune magazine in the early 1940s.

It was while writing an article about current investment trends for Fortune in 1948 that Jones was inspired to try his hand at managing money. He raised $100,000 US(including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage in an effort to enhance returns.

In 1952, Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20 per centincentive fee as compensation for the managing partner. As the first money manager to combine short selling, the use of leverage, shared risk through a partnership with other investors and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.

The rise of the industry

When a 1966 article in Fortune magazine highlighted an obscure investment that outperformed every mutual fund on the market by double-digit figures over the past year and by high double-digits over the last five years, the hedge fund industry was born. By 1968, there were some 140 hedge funds in operation.

In an effort to maximize returns, many funds turned away from Jones' strategy, which focused on stock picking coupled with hedging, and chose instead to engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the bear market of 1973-74.

The industry was relatively quiet for more than two decades, until a 1986 article in Institutional Investor touted the double-digit performance of Julian Robertson's Tiger Fund. With a high-flying hedge fund once again capturing the public's attention with its stellar performance, investors flocked to an industry that now offered thousands of funds and an ever-increasing array of exotic strategies, including currency trading and derivatives such as futures and options.

High-profile money managers deserted the traditional mutual fund industry in droves in the early 1990s, seeking fame and fortune as hedge fund managers. Unfortunately, history repeated itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds, including Robertson's, failed in spectacular fashion.

The hedge fund today

With media attention still focused on the recent failure of some hedge funds, there has been an increasing move towards their regulation. In 2004, the Securities and Exchange Commission adopted changes that require hedge fund managers and sponsors to register as investment advisors under the Investment Advisor's Act of 1940. This greatly increased the number of requirements placed on hedge funds, including keeping up-to-date performance records, hiring a compliance officer and creating a code of ethics. This was seen as an important move in protecting investors. (For more information, see theSEC website.)

Despite troubles in the last few years, the hedge fund industry continues to thrive. The development of the "fund of funds", which is simplistically defined as a mutual fund that invests in multiple hedge funds, provided greater diversification for investors' portfolios and reduced the minimum investment requirement to as low as $25,000. The introduction of the fund of funds not only took some of the risk out of hedge fund investing, but also made the product more accessible to the average investor.

Conclusion

Hedge funds have evolved significantly since 1949. Modern hedge funds offer a variety of strategies, including many that do not involve traditional hedging techniques. The industry has also rapidly grown, with recent estimations pegging its size at $1 trillion quite the leap from the $100,000 used to start the first fund half a century ago.

With a fascinating past that has twice seen media-fostered publicity push the industry to stratospheric highs and vilify it when it fell from grace, it seems highly probable that the cycle will repeat itself at some point in the future. While it is easy to get sucked in by the hype or repelled by the negative press, it's always advisable to take a step back and conduct some due diligence, just as you would prior to making any investment. Take the time to learn more about hedge funds for example, you may want to start by reading ourIntroduction to Hedge Funds - Part 1andPart 2.

Before you put your hard-earned money at risk, you have to make sure you are choosing the right investment for the right reason. Don't blindly chase performance, and remember that past performance is not an indicator of future performance.