A demystification of hedge funds

It is a mystery as to who planted the seed of the first hedge fund. Reference to ‘hedging’ as a term for offsetting risk is as old as the hills: Shakespeare may have been the first to use it more than 500 years ago in the Merry Wives of Windsor.

However, it is generally considered that Alfred Winslow Jones, a Wall Street journalist, grew what is considered the modern ‘hedge fund’ in 1949.

So, what is it?

Well, it has its roots in agriculture, where farmers bordered their land with thick bushes, often of hawthorn, which protected and sectioned the field in terms of size. The verb ‘to hedge’ became synonymous with the idea of a secure and limited risk.

In financial terms a hedge fund is essentially a privately owned company that invests in a wide range of investments on behalf of wealthy individuals, insurance companies and pension funds. The aim of the fund is to ‘hedge’ (offset) any potential risk while maintaining profit, whether the market goes up or down.

In 1949 Alfred Winslow Jones, starting with $40,000 of his own money, used leverage (bank borrowings) to buy shares and ‘hedged his bets’ with short-selling stock.

He borrowed stock from a broker, sold it on and ‘closed’ the deal when the price had fallen (‘short selling’). By buying back at a lower price, he kept the profit made and repaid the original loan.

His hedge fund typically used short and long positions (where stock is bought at a low price and sold when the price rises). This way he was covered whether the market went up or down.

By 1966 he was so successful that he had topped the competition’s profits by 87%. Within two years, in an attempt to keep up with ‘the Jones’, 140 hedge funds had been privately established to capitalise on the profits being made.

As a result of the economic booms of the 1980s and 1990s there has been a surge in hedge funds. They enjoy light regulation and almost unlimited investment potential; they set their own rules as to when and how often investors can retrieve their money.

They are collectively worth $2 trillion as at 2011 and deliver £5.3bn in tax revenues to the UK public purse.

Some prominent hedge fund managers have made headlines for a variety of reasons, not all good.

George Soros, the Hungarian investor, who ‘broke the Bank of England’ in the currency crisis of Black Wednesday in 1992, allegedly made $1bn by short selling sterling, causing then Chancellor of the Exchequer Norman Lamont to withdraw the pound from the European Exchange Rate Mechanism.

In 2007 hedge fund manager John Paulson and investment firm Goldman Sachs made $11.9bn by short selling sub-prime mortgage-backed securities and betting on a collapse in the sub-prime market, which in itself had catastrophic repercussions to the US banking and insurance sectors.

David Einhorn, another fund manager, aggressively sold short the shares of Lehman Brothers in a bet that they would go down. At the same time he published evidence that the investment bank’s accounts were unsound – a classic example of ‘hedging your bets’.

He made millions, but as a result Lehman Brothers’ collapse may have contributed in a small way to further worldwide economic turmoil.

The numbers remain huge. Ray Dalio overtook George Soros as the world’s most successful hedge fund manager after his fund Bridgewater Pure Alpha made $13.6bn for investors last year, with $72bn remaining under management.

In the past two years more than 500 hedge fund firms have been established. However, as hedge fund strategies depend on finding mispriced assets, this influx of money has created an ‘overcrowded trade’ where copycats are all trying to place the same bet.

This is leading to diminished returns. With fewer opportunities to create stellar profits, the hedge funds’ proverbial crown as elite investment strategists is slipping.

The leading lights of the mid-noughties, John Paulson and David Einhorn, have both had their share of troubles. Paulson recently lost $500m on a misjudged call on the Chinese forestry group Sino-Forest and his firm lost investors $9.6bn last year. Einhorn has been ordered to pay a £7.2m fine to the UK’s Financial Services Authority for market abuse.

From the relatively modest beginnings of the modern hedge fund of Alfred W. Jones, hedge fund managers have evolved to betting against almost anything, with mixed results.

The question is: with lower returns, higher charges, and a bus full of copycats, is it about time these hedges were pruned?

Frank Holmes is a partner of Gambit Corporate Finance LLP and has co-written this article with Will Strowbridge Hutton, a sixth former at St Johns College, Cardiff. William aspires to become an author.

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