The first hedge-fund manager, Alfred Winslow Jones, did not go to business school. He did not possess a PhD in quantitative finance. He did not spend his formative years at Morgan Stanley, Goldman Sachs, or any other incubator for masters of the universe. Instead, he took a job on a tramp steamer, studied at the Marxist Workers School in Berlin, and ran secret missions for a clandestine anti-Nazi group called the Leninist Organization. He married, divorced, and married again, honeymooning on the front lines of the civil war in Spain, traveling and drinking with Dorothy Parker and Ernest Hemingway. It was only at the advanced age of forty-eight that Jones raked together $100,000 to set up a "hedged fund," generating extraordinary profits through the 1950s and 1960s. Almost by accident, Jones improvised an investment structure that has endured to this day. It will thrive for years to come, despite a cacophony of naysayers.
Half a century after Jones created his hedge fund, a young man named Clifford Asness followed in his footsteps. Asness did attend a business school. He did acquire a PhD in quantitative finance. He did work for Goldman Sachs, and he was a master of the universe. Whereas Jones had launched his venture in his mature, starched-collar years, Asness rushed into the business at the grand old age of thirty-one, beating all records for a new start-up by raising an eye-popping $1 billion. Whereas Jones had been discreet about his methods and the riches that they brought, Asness was refreshingly open, tearing up his schedule to do TV interviews and confessing to the New York Times that "it doesn't suck" to be worth millions. By the eve of the subprime mortgage crash in 2007, Asness's firm, AQR Capital Management, was running a remarkable $38 billion and Asness himself personified the new globe-changing finance. He was irreverent, impatient, and scarcely even bothered to pretend to be grown up. He had a collection of plastic superheroes in his office. Asness freely recognized his debt to Jones's improvisation. His hedge funds, like just about all hedge funds, embraced four features that Jones had combined to spectacular effect. To begin with, there was a performance fee: Jones kept one fifth of the fund's investment profits for himself and his team, a formula that sharpened the incentives of his lieutenants. Next, Jones made a conscious effort to avoid regulatory red tape, preserving the flexibility to shape-shift from one investment method to the next as market opportunities mutated. But most important, from Asness's perspective, were two ideas that had framed Jones's investment portfolio. Jones had balanced purchases of promising shares with "short selling" of unpromising ones, meaning that he borrowed and sold them, betting that they would fall in value. By being "long" some stocks and "short" others, he insulated his fund at least partially from general market swings; and having hedged out market risk in this fashion, he felt safe in magnifying, or "leveraging," his bets with borrowed money. As we will see in the next chapter, this combination of hedging and leverage had a magical effect on Jones's portfolio of stocks. But its true genius was the one that Asness emphasized later: The same combination could be applied to bonds, futures, swaps, and options--and indeed to any mixture of these instruments. More by luck than by design, Jones had invented a platform for strategies more complex than he himself could dream of.
No definition of hedge funds is perfect, and not all the adventures recounted in this book involve hedging and leverage. When George Soros and Stan Druckenmiller broke the British pound, or when John Paulson shorted the mortgage bubble in the United States, there was no particular need to hedge--as we shall see later. When an intrepid commodities player negotiated the purchase of the Russian government's entire stock of non-gold precious metals, leverage mattered less than the security around the armored train that was to bring the palladium from Siberia. But even when hedge funds are not using leverage and not actually hedging, the platform created by A. W. Jones has proved exceptionally congenial. The freedom to go long and short in any financial instrument in any country allows hedge funds to seize opportunities wherever they exist. The ability to leverage allows hedge funds to size each bet to maximum effect. Performance fees create a powerful incentive to coin money.
Copyright © 2010 by Sebastian Mallaby. All rights reserved.