History of Hedge Funds

Many people were totally unfamiliar with the hedge fund concept until only a few years ago.  It often surprises people to learn that hedge funds have existed in their basic form since Alfred Jones started his hedge fund in the early 1950’s.  In the following video, I give an overview of the history of hedge funds, what makes up a hedge fund and how hedge funds operate.

Video Transcript/SummaryThe strategies and tips provided within this video module include:

  1. Alfred Jones founded the first hedge fund in 1949 by matching short sales with long sales of stocks to manage risk in his portfolio.
  2. The term hedge fund refers to this method of investing and how it hedges risk by combining long and short bets.
  3. There are trillions of dollars in the hedge fund industry  and more money pouring into hedge funds every year.  
  4. Some of the earliest hedge fund managers were Warren Buffet and George Soros.
  5. The performance fee aligns the hedge fund manager’s interest with that of the investors.  
  6. Hedge fund portfolios can include almost anything which has led to a huge growth in the industry.
  7. Hedge funds are mostly restricted from direct marketing to retail investors and must market to accredited and institutional investors.
  8. The hedge fund industry can be highly-lucrative.
  9. Knowledge is the hedge fund manager’s most valuable asset, therefore they are very private.

Transcript for History of Hedge Funds

Hello, this is Richard Wilson and today we’re going to talk about the history of hedge funds or the history of the hedge fund industry. This is a topic which is often confused with the term hedge fund and what makes up a hedge fund especially with people that work outside of finance. Most people on the financial industry have a pretty good grasp of what a hedge fund is or is not. But people who work just in business or in journalism or media or other areas are often confused by what would make a hedge fund versus something else. So the history of a hedge fund can kind of clear that up.

So first of, in 1949 there was a person, Alfred Jones, who was a journalist. He was also an author and sociologist, and he basically started the first hedge fund. What he looked at was the performance of securities in the broader markets and he looked at how he could pair trade or mesh some short sales with long sales of stocks to kind of manage risks within a portfolio. And so in a very literal sense he was hedging his investments. He would invest in Intel but short with AMD or something such as that.

And so that’s how the term hedge fund came to be. What happened next was that this method of investing became popular, really not till the 50s and the 60s. And in the 1970s it was recorded that there was 150 hedge funds in the industry, probably more if you count really the small ones, and there was also close to a billion dollars in assets which is very small compared to today and then on what source you go to, there’s between $1T and $2T in assets and hedge funds. So an enormous industry compared to a billion dollars.

I’ll give you an example. Just last month $14B in new capital was invested in hedge funds which means besides withdrawals there was actually a $14B increase in total capital in the industry. So just last month it increased 14 times more than it was in the 1970s. Some of the earliest hedge fund managers were Warren Buffet, George Soros and Michael Steinhardt. And since hedge funds were first invented and since the 60s and 70s they’ve evolved and instead of a hedge fund being a fund or portfolio hedges, they’re security investments, a hedge fund has come to mean an investment, a private investment structure which charges both a management and performance fee.

And that performance fee is really key to making something, a hedge fund, because a mutual fund might charge a management fee, and ETF might charge a management fee. But a performance fee really kind of aligns the hedge fund manager’s interest with the investors. So another important thing to remember is that hedge funds now getting glued, commodity investments, bonds, real estate, patent portfolios, commercial financing, currencies, foreign exchange really can include almost anything and that is why hedge funds have grown to such size.

They include such a broad spectrum of investments and the term is used so loosely that the hedge fund industry is now enormous, whereas a term like private equity although has expanded in various types is more concentrated. It’s just one of those terms. Hedge fund has just been used more frequently for more types of investment structures over the years. So that’s why there’s some confusion and some very large growth and some of that confusion around the hedge fund industry has also been created over basically two reasons. The first reason is that in many places such as United States, hedge funds are restricted and how they do it in public marketing and how they perform in public relations.

They can’t do most types of direct marketing as a traditional company could. Because their investments into a hedge fund are mostly restricted to accredited or high-net-worth investors and institutional investors. So that just leads to some confusion because many hedge funds are scared to do any educational or marketing efforts and they’re restricted from doing lots of types of marketing and public relations efforts. And so that is one’s risk and confusion in the industry. The other source is really just out of competitiveness. The hedge fund industry can be very lucrative for a fund manager or a professional in the industry, whether they’re raising capital or managing a portfolio or being an analyst. It can be very lucrative.

And the result is that knowledge is power and knowledge is a hedge fund professional’s greatest asset. Knowledge about investment process research, risk management, fund operations to a hedge fund is there most valuable asset. And if somebody else has all of your knowledge that you can quickly copy everything about your track record and maybe some of your team pedigree. And so it’s actually a very valuable thing to have unique knowledge and the constantly growing set of specialized knowledge within the industry. And because of that, hedge fund managers are not likely to give away their knowledge to the press. They’re not as likely to write books and they’re not as likely to consult with other their hedge funds.

For example, Jack Welch after leaving GE spoke to many different companies and is on the boards of many companies and he has written books about his practices and you don’t find that as much in the hedge fund industry. When a hedge fund executive retires they either have so much money that they don’t care about doing those other things or they’re on the board of a few hedge funds which pay them very handsomely or they go and join as a strategic adviser to a very large hedge fund and they serve that one hedge fund. Typically, they’re not out giving speeches everywhere, writing 6 or 7 books, going on to Oprah, doing interviews with the media all of the time. It’s just more of a competitive, very knowledge-centric industry. And so that can cause some more confusion.

So I hope that helps with the general overview of the history of hedge funds and how it moved from being a hedge portfolio to being more popular in the 60s and the 70s and being more of a management performance fee combination that made up a hedge fund. And then also how it moved from being a billion dollars in assets just in the 1970s, 30 years ago and now just last month gained over $14B and depending on who ask there’s $1T to $2T in the industry. And then we covered the two reasons why hedge funds are a little bit confusing or hard to understand, and that is the first reason about the laws of hedge fund marketing and public relations that restricts them. And second, it’s a very competitive knowledge based industry.

So I hope that’s helped with your understanding of hedge funds. If you’re completing the CHP designation this is important information to know. If you work in the industry it’s probably something you at least already partially know and hopefully it helps. Thanks for your time.

I hope that this video has given you a better understanding of the history of hedge funds and how hedge funds have evolved over the years.

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About Richard Wilson