Hedge Fund History: LTCM, Tiger Fund, and Modern Hedge Funds (Part 2)

In Part 1, we covered the earliest roots of hedge funds, from Japanese rice traders to Karl Karsten’s statistical forecasting and Benjamin Graham’s value-oriented approach. Now we get to the person who took all those ideas and built something that actually changed Wall Street forever.

A.W. Jones, the Unlikely Hedge Fund Father

In 1966, Carol Loomis published an article in Fortune magazine called “The Jones Nobody Keeps Up With.” That article basically created the modern hedge fund industry overnight.

Here’s the thing, Alfred Winslow Jones was probably the least likely person to become a Wall Street legend. Born in 1900, he didn’t start managing money until he was 49. Before that? He worked as a purser on a steamship, was a statistician, joined the U.S. State Department, worked with the Leninist Organization in Berlin under a fake name, and tried to convince the British Labour Party to take military action against Hitler.

After returning to the US in 1934, he got a sociology PhD from Columbia, honeymooned at the front lines in war-torn Spain, and hung out with people like Ernest Hemingway and Dorothy Parker. Not exactly your typical finance guy.

But in 1948, Jones wrote an article for Fortune called “Fashions in Forecasting” about new technical methods for betting on stocks. That article apparently gave him ideas, because a year later, in 1949, he and four friends pooled $100,000 ($40,000 from Jones himself) and launched what many consider the first real hedge fund.

What Made Jones Different

So what did Jones actually do that was so special? Several things, actually.

Private partnership structure. Instead of creating a public fund like a mutual fund, Jones set up a private limited partnership. This kept him under the SEC radar and gave him freedom to use leverage and short selling. This is still how hedge funds are structured today.

Long and short books. Most investors at the time would keep some cash as a safety cushion. Jones thought that was wasteful. Instead, he built two portfolios side by side: a long book (stocks he expected to go up) and a short book (stocks he expected to go down). The short book acted as protection against market drops while also potentially making money if he picked the right stocks to short.

Investing his own money. Jones put $40,000 of his own $100,000 starting capital into the fund. He kept significant personal money in his fund for the rest of his life. Having skin in the game aligns the manager’s interests with the investors. This principle is still considered essential in hedge funds today.

Paying brokers for performance. Jones didn’t have great stock-picking skills himself, and he knew it. So he asked brokers to create paper portfolios with their best long and short ideas. He tracked their picks over time using his statistics background and figured out which brokers actually added value. Then he paid the good ones based on how well their recommendations performed. Brokers had real incentive to call Jones first with their best ideas, which gave him an edge over competitors.

This eventually turned into hiring in-house portfolio managers based on tracked records. Several hedge funds still use this method today.

The Invention of Beta (Before It Was Called Beta)

Here’s one of the most impressive things Jones did. He developed a concept he called “relative velocity” back in 1961. In his shareholder report, he explained that different stocks move at different speeds. You can’t just hedge $1,000 of a slow stock against $1,000 of a fast-moving stock and call it balanced.

For example, Sears stock moved about 80% as much as the S&P 500, while General Dynamics moved about 196% compared to the S&P 500. If you bought $1,000 of Sears and shorted $1,000 of General Dynamics, your hedge would be way off because General Dynamics was almost 2.5 times more volatile.

Jones used this “relative velocity” to calculate the true risk exposure of his entire portfolio. He measured every stock against the S&P 500 and adjusted positions accordingly. The team did these calculations by hand on about 2,000 stocks every two years.

So here’s what happened: Jones basically invented the concept of market beta and put it into practice, years before William Sharpe formally introduced it in his famous 1964 paper “Capital Asset Prices.”

Measuring Skill vs. Market Returns

Jones also wanted to know how much of his fund’s returns came from smart stock picking versus just the market going up. He developed a method to separate what we now call alpha (returns from skill) and beta (returns from market movement).

Travers walks through a clear example. Take a $100,000 account levered to $200,000, with $130,000 long and $70,000 short. Over one month, say the S&P 500 returns 1%, the longs gain $2,500, and the shorts lose $400. The total account gain is $2,100, or 2.1%.

To figure out how much came from skill versus market:

• Return from manager skill: 1.5% (1.2% from longs outperforming + 0.3% from shorts)
• Return from market moves: 0.6%
• Total: 2.1%

This kind of performance attribution is standard practice now, but Jones was doing it in the early 1960s.

The Long/Short Example That Explains Everything

Travers uses a great example from Jones’s own writings to show why the hedged approach works. Two equally skilled investors each start with $100,000.

Investor 1 (traditional): Puts $80,000 in stocks and $20,000 in bonds for safety. Net market exposure: 80%.

Investor 2 (Jones method): Uses leverage to go to $200,000 total. Puts $130,000 long and $70,000 short. Net market exposure: only $60,000, or 60%.

But here’s the problem for Investor 1. The Jones method investor has less exposure to overall market risk (60% vs 80%) while having more ability to profit from good stock picks because of the leverage. By combining two things that sound risky, leverage and short selling, Jones actually built something with less market risk and more return potential.

When Hedge Funds Lost Their Way

As the 1960s ended, Jones stepped back from active management. The portfolio managers he left in charge started questioning why they should bother with shorts. Markets had been going up for years, and the short positions were just dragging on performance.

So they hedged less and less. Net market exposure went way up.

Then 1969 hit and the market dropped. Jones’s fund suffered its worst losses ever. He came back to reinstate his hedging principles, but the damage was done.

And it wasn’t just Jones’s fund. The whole early hedge fund industry had drifted away from hedging. Funds held less liquid securities than they should have. Carol Loomis, the same journalist who had introduced Jones to the world in 1966, wrote another piece in Fortune in 1970 called “Hard Times Come to the Hedge Funds.”

The industry that seemed poised to take over asset management found itself on life support. It would take almost two decades before hedge funds became prominent again.

The Industry That Grew from $100K to $2 Trillion

Despite those early stumbles, the hedge fund industry came back. And then some.

According to BarclayHedge data that Travers presents, total hedge fund assets grew from $118 billion in 1997 to just under $2 trillion by the end of Q3 2011. The number of hedge funds went from around 4,000 in 1999 to 9,700 in the same period.

The composition of strategies also shifted dramatically. In 1997, the biggest category was Multi Strategy at $42 billion. By 2011, CTA (Commodity Trading Advisors) led with $269 billion, followed by Multi Strategy at $249 billion and Emerging Markets at $224 billion.

Some strategies grew enormously. Distressed investing went from $3 billion to $118 billion. Emerging markets jumped from $7 billion to $224 billion.

Key Takeaways from Chapter 1

The history of hedge funds is basically a story about a few really creative people building better tools for managing money.

Travers traces a clear line: Japanese rice traders invented technical analysis and short selling. Karl Karsten applied statistics to create hedged portfolios. Benjamin Graham added value investing, fee structures, and risk management. And A.W. Jones combined it all into the limited partnership structure that defines hedge funds today.

Jones’s list of innovations is long: the LP structure, investing alongside clients, multiple portfolio managers, paying for best ideas, leverage for both returns and protection, statistical evaluation of managers, separating alpha from beta, and creating an entirely new asset class.

But the chapter also carries a warning. When managers forget the “hedged” part of “hedge fund,” things go badly. The late 1960s proved that, and as we know from later history, it wouldn’t be the last time.

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