Hedge Yourself!

Alfred Winslow Jones was an unlikely figure for Wall Street. He had a Ph.D. in sociology and then served in the Foreign Service in Berlin in the 1930s. Later, he became a journalist. He wrote for Fortune magazine and Time-Life, mostly on nonfinancial topics such as Atlantic convoys, farm co-ops and boys prep schools.

Somewhere in that cocktail of experiences, Jones hatched an idea for making money in stocks. In 1949, he cobbled together A.W. Jones & Co. with $100,000 in capital, $40,000 of which was his own money and the rest was from friends. Importantly, A.W. Jones & Co. was a partnership, not a mutual fund. So he escaped certain regulations and operated with greater freedom than his regulated peers. He could borrow money. He could “go short” (thereby profiting when stocks fell). He could operate with greater secrecy.

Jones’ fund was what many consider the first hedge fund. Actually, he called it a “hedged fund.” The original idea was to hedge against risks, such that the fund suffered less when the market fell.

Jones went on to compile the best record of his era. He made his original investors millionaires. Jones himself became a wealthy man.

Jones labored in obscurity for the most part until an April 1966 article in Fortune by Carol Loomis. I have a copy of the article in front of me as I write this. It’s titled “The Jones Nobody Keeps up With.” It features a picture of A.W. Jones, then a 65-year-old with dark-rimmed glasses and a white tuft of hair, on vacation in Mexico City.

Loomis lifted the veil of obscurity on Jones. She begins, “There are reasons to believe that the best professional manager of investors’ money these days is a quiet-spoken, seldom photographed man named Alfred Winslow Jones.”

The reasons were all found in his knockout performance figures. Over the previous five years, the best mutual fund in the business was Fidelity’s Trend Fund. It posted a gain of 225%. A.W. Jones & Co. made 325%. Over the previous 10 years, the best mutual fund was the Dreyfus Fund, up 358%. A.W. Jones crushed it. He was up 670%! Here was a Wall Street outsider, running circles around Wall Street’s best!

Jones described how he ran his fund with an example. Say he had $100,000. He would borrow $50,000 more against that. With $150,000, he would buy $110,000 in stocks and sell short $40,000 (thereby profiting if stocks fell). With $40,000 “hedged,” he had only $70,000 exposed to the market. “Speculative techniques for conservative ends,” is how Jones put it.

After Loomis’ piece, copycats sprang up everywhere and the hedge fund industry was born. By 1968, there were about 140 hedge funds in operation.

Jones, by the way, never approved of the morphing of his term “hedged fund” to “hedge fund.” The scholarly Jones once said his original expression was “the proper one” and that he still regarded “‘hedge fund,’ which makes a noun serve for an adjective, with distaste.”

But more than just the name changed, as the new funds strayed from Jones’ conservative hedged approach. As James McWhinney writes in his A Brief History of the Hedge Fund: “In an effort to maximize returns, many funds… chose instead to engage in riskier strategies based on long-term leverage.”

The results were predictable. In 1969–70, hedge funds took heavy losses for these riskier strategies. By the time the bear market of 1973–74 rolled around, a number of them were no longer around.

But hedge funds would come back. And blow up again. And come back again. Of more recent vintage, Long-Term Capital Management (LTCM) was probably the most infamous blowup, and an example of the extremes to which some professional investors would take Jones’ idea. LTCM was a star-studded fund. John Meriwether, a former vice chairman of Solomon Brothers, was a partner. So were two Nobel Prize-winning economists. LTCM had an army of Ph.D’s and high-powered computing power. Only select investors were allowed in — the head of Merrill Lynch invested, as did the CEOs of PaineWebber and Bear Stearns. The Bank of China was an investor. So was Julius Baer, a respected Swiss Bank. And many more. It was, as Edward Chancellor called it, the “Rolls-Royce of hedge funds.”

Yet it blew up in June 1998, losing $2 billion — half of its capital — in just one month when the market quaked on news that Russia defaulted on its bonds. Three weeks later, the Federal Reserve arranged a bailout, as LTCM disclosed it had a giant $1.4 trillion in positions against only $1 billion in equity. It was so big that many thought that if LTCM failed, a raft of banks and financial institutions would go also go under.

For those kinds of blowups, hedge funds earned a poor reputation. As Mario Gabelli once said: “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.”

You can’t blame Jones for that. John Brooks reflected on Jones achievement in The Go-Go Years: “[Hedge funds] were the parlor cars of the new gravy train. It was fitting that their key figure was a man who had taken up stock investing as a sideline, an elegant amateur of the market who liked to think of himself as an intellectual, above and beyond the profit motive.” Later in life, A.W. Jones became a philanthropist and took long Peace Corps assignments to South America and Africa. He died in his sleep at his home in Connecticut in 1989 at the age of 88.

In the volatile financial markets of 2011, Jones’ old idea of a “hedged” fund seems as timely as ever. Looking out over the coming decade, hedged strategies may become increasingly valuable.


Chris Mayer,
for The Daily Reckoning