Hedge Fund History: From Alfred Jones to George Soros (Part 1)

Chapter 1 of Travers’s book opens with a quote from Mark Twain: “History doesn’t repeat itself, but it does rhyme.” And then Travers immediately proves it by describing a 1970 article from Fortune magazine that sounds like it was written yesterday. Hedge funds losing money, managers getting overconfident, regulators circling. That article is from 1970. Let that sink in.

So here’s what happened. The history of hedge funds goes back way further than most people think. And the characters involved are way more interesting than you’d expect.

The Japanese Rice Trader (1700s)

Before Wall Street even existed, a Japanese rice trader named Munehisa Honma was basically running the world’s first trading operation.

During the Tokugawa shogunate, Japan had a rice exchange in Osaka called the Dojima Rice Exchange. Rice was basically money. Merchants traded “coupons” for future rice delivery, which let people go long or short. This was the world’s first futures market.

Honma took over his family business in 1750 and became legendary. He studied hundreds of years of price, weather, and crop data to predict harvests. Nobody else was doing this. He combined historical price patterns with fundamental analysis to get an edge.

But here’s the clever part. Honma was based in Sakata, far from Osaka where the prices were set. So he built a flag signaling system, with people on rooftops relaying price information across the distance between the two cities. Not exactly fiber optic cables, but it gave him prices before anyone else in his town. Today we’d call this “low latency” trading.

He became so successful he was given the honorary title of samurai. He wrote one of the first books on market psychology, arguing that investor sentiment creates temporary mispricings that smart traders can exploit. His charting techniques became the basis for Japanese candlestick charting, still used today.

Karl Karsten, The Academic (1931)

Most people have never heard of Karl Karsten. But here’s the thing, he might be the most underrated figure in hedge fund history.

In 1931, Karsten published a book called “Scientific Forecasting” that detailed eight years of statistical analysis. His firm, the Karsten Statistical Laboratory, tried to build a systematic method of beating the stock market using publicly available data. All the regressions and correlations were computed by hand.

He identified thirteen economic indicators, both broad market and industry-specific, and built six “barometers” to forecast stock price movements.

Then he did something really ahead of his time. He ranked six market sectors from most attractive to least attractive, bought the top two and shorted the bottom two in equal dollar amounts. This is what we now call dollar-neutral investing.

He tested it first on paper. The results were impressive: investing $100 on March 1, 1928, his paper portfolio grew to $819 while the same $100 in the Dow became $88. And the two return streams had almost zero correlation to each other (0.06).

Then he ran real money starting December 17, 1930. Over about six months, his portfolio gained 78% while the Dow fell 21%. The portfolio only declined in 4 out of 24 weeks.

Here’s what makes Karsten historically important. He coined the term “hedge fund.” Chapter 12 of his book is literally titled “The Hedge Funds on Paper.” He also pioneered concepts like alpha investing, diversification as a risk tool, market-cap weighting, and using leading and lagging indicators in statistical models. All in 1931. All computed by hand.

Benjamin Graham, The Legend

You probably know Benjamin Graham as the father of value investing and Warren Buffett’s mentor. What most people don’t know is that Graham was basically running a hedge fund decades before the term became popular.

Graham started on Wall Street before World War I. His first arbitrage trade in 1915 involved the Guggenheim Exploration Company, where he figured out the breakup value was 10.7% higher than the market price. He bought Guggenheim and shorted the underlying holding companies. When the dissolution went through in 1917, Graham’s reputation grew.

His first money management gig was informal. A Columbia professor gave him $10,000, profits split 50/50. After some success, illiquid picks got crushed in a WWI liquidity crunch. It took years to recover, which introduced what we now call a high water mark.

In 1923 he formed the Grahar Corporation (“Gra” from Graham, “har” from investor Louis Harris). A notable trade: DuPont owned a big chunk of GM shares but traded at similar levels. You could buy DuPont and get the DuPont business for free. He went long DuPont, short GM. Classic relative value trade.

By 1926, Graham launched the Benjamin Graham Joint Account with $450,000 that grew to $2.5 million. But then 1929 happened. He’d covered shorts at nice profits but didn’t put new ones on because stocks looked cheap. Too exposed on the long side, the account dropped 20% in 1929, then 50% in 1930. Over four painful years, the total return was negative 70% versus negative 74% for the Dow.

Graham eventually formed the Graham-Newman Corporation in 1936. Their policy: buy securities below intrinsic value, engage in arbitrage and hedging. They did distressed investing, merger arbitrage, hedged positions, and charged a base fee plus performance fee. Basically a modern hedge fund in everything but legal structure.

Alfred Winslow Jones, The Innovator

And now we get to the man most people consider the father of hedge funds.

In 1966, Carol Loomis published an article in Fortune called “The Jones Nobody Keeps Up With.” It revealed that Alfred Winslow Jones had been running a “hedged fund” that crushed every mutual fund in the country. His fund gained 670% over ten years versus 358% for the best mutual fund (the Dreyfus fund). Over five years, he more than doubled the return of the Dow.

But here’s what makes Jones fascinating. He was the least likely hedge fund manager ever. Born in 1900, he didn’t start his fund until age 49. Before that he was a purser on a tramp steamer, a statistician, a State Department employee in Germany, an undercover operative for a Leninist organization, and a sociology PhD from Columbia. He honeymooned at the front lines of the Spanish Civil War and ran with Dorothy Parker and Ernest Hemingway.

In 1949, Jones and four partners pooled $100,000 ($40,000 from Jones himself) to create what many consider the first modern hedge fund. He converted it to a limited partnership in 1952.

His innovations were brilliant in their simplicity:

Private partnership structure. By keeping the fund private (not public like mutual funds), Jones avoided SEC scrutiny and gained the freedom to use leverage and short selling.

Long/short portfolio instead of cash hedging. Instead of holding cash to reduce risk (like mutual funds did), Jones built a portfolio with two books. A leveraged long book to capture stock gains and a short book to reduce market risk. Consider his example: a traditional investor puts $80K in stocks and $20K in safe bonds, having $80K of market exposure. Jones’s approach takes $100K, levers it to $200K, goes $130K long and $70K short. Net market exposure is only $60K, less than the traditional investor, while having more money working.

Multiple portfolio manager model. Jones admitted he wasn’t a great stock picker. So he had brokers create model portfolios, tracked their results, and paid brokers based on how well picks performed. This gave him first call on the best ideas. Eventually he hired in-house portfolio managers using the same tracking system.

Relative velocity (aka beta). Hedging $1,000 of a slow stock against $1,000 of a volatile stock isn’t a real hedge. Jones measured each stock’s movement relative to the S&P 500. Sears moved about 80% as much as the market, General Dynamics moved 196%. He created the concept of beta years before William Sharpe formally introduced it in 1964.

Performance attribution. Jones built a method to separate how much return came from stock picking versus market movements, what we now call alpha versus beta.

The First Crash

As the 1960s ended, Jones stepped back from active management. His portfolio managers, riding a multi-year bull market, started questioning why they should bother hedging. Shorts were a drag on returns. So they hedged less and less, and the fund’s net market exposure climbed.

When the market dropped in 1969, Jones’s fund got hit hard. He came back to reinstate the hedging discipline and try to recover losses.

But it wasn’t just Jones. The whole industry had lost its way. That 1970 Fortune article Travers opened with tells the same story across the industry: funds hedged less, owned illiquid securities, and got crushed. The hedge fund industry, which had grown to about 140 funds, went into a “dark period” that lasted almost two decades.

The Takeaway

The early history of hedge funds is full of smart people who independently discovered the same idea: you can make money regardless of market direction if you combine long and short positions intelligently.

But the history also shows a repeating pattern. Success leads to overconfidence. Overconfidence leads to abandoning hedging. Abandoning hedging leads to big losses when markets turn. As Twain said, history rhymes.

The industry grew from Jones’s $100,000 in 1949 to $118 billion by 1997 and nearly $2 trillion by 2011. In Part 2, we’ll look at the major figures who drove that growth, from George Soros to Julian Robertson.

This post is part of a series retelling “Hedge Fund Analysis” by Frank J. Travers. The ideas and frameworks come from the book. I’m just explaining them in simpler terms.

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