A Brief History of the Hedge Fund Industry

by Derek Loosvelt | March 10, 2009

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In 1949 Alfred W. Jones established the first hedge fund-type structure when he borrowed funds (used leverage) to increase his long positions while adding a portfolio of short stocks in an investment fund with an incentive fee structure. Carol J. Loomis used the term "hedge fund" in her 1966 Fortune magazine article where she discussed the structure and investment strategy used by Jones. Jones had set up his pool of investors as a limited partnership and was, thus, able to avoid the reporting requirements to which mutual funds were subjected. What drew Fortune's attention to Jones was that his fund significantly outperformed traditional investments. From 1960-1965 Jones' investments returned 325 percent while the Fidelity mutual fund returned 225 percent. During the 10-year period from 1955-1965 Jones' fund returned 670 percent compared to the Dreyfuss fund, which only returned 358 percent.

After the Fortune article, other money managers found Jones' investment style both profitable and intriguing and, thus, a growth spurt in the hedge fund industry began. In an attempt to copy Jones' style (and hopefully performance), many money managers began selling short securities without prior experience. Haphazard short selling by new hedge fund managers adversely affected their performance during the bull market of the mid-late 1960s. These hedge fund managers were not actually "hedging" their positions at all; they were leveraged to the long side of the portfolio (betting that the market would go up), which was particularly risky entering the bear markets of the 70s (when the markets declined).

According to Alexander Ineichen in his book Absolute Returns, these managers produced substantial losses in 1969-70 and a major bloodletting ensued in the 1973-74 bear market. Ineichen's book is one of the most recommended books for those interested in learning in more depth about the hedge fund industry and its strategies.

The more experienced hedge fund managers survived the 1970s bear market. But, unfortunately many other hedge fund managers closed the doors. According to Gabelli in 1984, when Sandra Manske formed Tremont Partners and began researching the hedge fund industry, she was only able to identify 68 funds. It is hard to determine an exact figure for the funds at this time due to the lack of marketing and public registration. Ineichen also states that the hedge fund industry remained relatively small until the early 1990s, when the financial press once again highlighted the returns achieved by hedge fund superstars George Soros (Quantum Fund) and Julian Robertson (Tiger Fund and its offshore sister, Jaguar Fund). What differed about this new growth of hedge fund managers was that the hedge fund managers added a variety of trading strategies, including the infamous global macro strategy pursued by George Soros. Soros traded in the currency markets by buying and selling various currencies and most notably made over $1 billion betting against the British pound. Robertson employed modern financial derivatives such as futures and options, which didn't exist when Jones started his fund.

The ability to use futures, options, swaps and other complex derivatives led to an explosion in the number of trading strategies. These strategies are not allowed to be employed in the mutual fund industry. Therefore, managers who felt that they could exploit the markets using these tools had to set up hedge funds. At the end of 1999, Tremont Partners estimated as many as 4,000 hedge funds existed, 2,600 of which were tracked in its database.

Estimates show that there were 300 hedge funds in existence in 1990. By 2000 that number had increased to 3,000 and by 2003 there were reported to be over 6,000 hedge funds. According to Hal Lux, the doubling of the number of hedge funds over the past three years has been due to the ability of hedge funds to outperform traditional markets in the recent bear market and investors' increased interest in the advanced trading strategies that they employ. The growth in the hedge fund industry also stems from increased interest in the industry from institutional investors (pension funds and endowments) and from the number of hedge fund managers entering the industry. Between 1992 and 2000 the institutional investor's share of the overall hedge fund market increased 147 percent.

Filed Under: Finance

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