Sunday, October 3, 2010

Birth of the Hedge Fund

Every day UPS delivers to my office at least one or two, sometimes three or four, review copies of new business books from publishers. Only a tiny fraction make it into "Book It: Best Bets for Board Reading" — a popular section of each issue of Directors & Boards that spotlights a handful of these new books.

It is one of my favorite pieces of each edition to pull together. I select the chosen few for "Book It" and present a brief passage from each book that serves two purposes: 1) to give the Directors & Boards reader a taste of the book, and 2) the passage must be a sprightly written and observed pointer in leadership that stands alone in the telling. If both objectives are achieved, the hope is that "Book It" prompts a few extra sales of the spotlighted books. My colleagues in the book publishing industry tell me how much they like our "Book It" feature for bringing some much-needed attention to their offerings in a crowded market.

I learn a lot in editing the "Book It" feature. For example, in considering Randall Lane's book, The Zeroes (Portfolio, 2010), I learned about something I had not given much thought to – the birth of hedge funds (and, yes, the breathtaking hedge fund fee structure). Let me share Lane's interesting bit of business history:

A writer for Fortune named Alfred Winslow Jones, in the course of preparing a story on stock market forecasting, developed a strategy that held that selling some stocks short (betting that some prices would go down) while simultaneously buying others, and borrowing against both types of trade for added oomph, would provide a “hedge” against market risk, at least matching the overall market in good times while greatly outperforming it in bad. “Speculative techniques used for conservative ends,” as he put his leveraged “long-short” philosophy.

In 1949, he raised $100,000 — $40,000 of which was his own — and thus the first “hedge fund” was born.

By the mid-1960s, Jones had proven phenomenally successful, and copycats abounded, notably Michael Steinhardt and George Soros. Most, however, did not adhere to Jones’s long-short model, and the roiling 1970s markets efficiently punished that oversight; by 1984, a researcher could locate only 68 hedge funds globally.

But Jones’s influence was far from finished. In 1952, three years into his fund, Jones institutionalized an innovative compensation system for himself. He didn’t follow the structure of a mutual fund, which generally charges 2% of all money managed to cover costs and its fee. Rather, Jones arranged to get 20% of the profits. In other words, while a mutual fund manager was mostly incentivized to not lose money, Jones was incentivizing himself to make money, and taking an outsized cut if he did.

For some boards that get into their gunsights, hedge fund managers are not the most popular people. The next time a hedgie starts upsetting your boardroom apple cart, you might let out a little curse directed at that Fortune writer who got hit by a Newtonian apple in the 1940s about a new way to coin money in the capital markets.