Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949. Jones believed that changes in asset prices can be attributed partly to factors specific to the asset in question and partly to trends in the market as a whole. To neutralize the effect of overall market movement, he balanced his portfolio by buying assets whose price he expected to increase in the future, relative to the overall performance of the market, and selling short assets whose price he expected to decrease. He saw that price movements due to the overall market would balance out because, if the overall market rose, the loss on shorted assets would be cancelled by the additional gain on longed assets and vice-versa. By taking this approach his investment strategy was market neutral, as returns depended only on him picking the right stock, not on whether the stock market went up or down. Jones referred to his fund as being “hedged” to describe how the fund managed risk exposure from overall market movement. This type of portfolio became known as a hedge fund.
Jones added a 20% performance fee in 1952 and converted his fund to a limited partnership, and thereby became the first money manager to combine a hedged investment strategy, leverage and shared risk, with compensation based on investment performance. At this time, only a few investors had adopted Jones’ investment structure as it was not well known in the financial community. Attention was drawn to the fund and Jones’ strategies in 1966 when Carol Loomis, a writer for Fortune magazine, wrote an article about Jones called “The Jones Nobody Keeps Up With”. The article noted that Jones’ fund outperformed the best mutual funds even after the 20% performance fee and this news led to great interest within the financial community.
By 1968 there were around 200 hedge funds, and the first fund of hedge funds was created in 1969 in Geneva. Many of the early funds ceased trading due to the market downturns in 1969-70 and 1973-74 as they did not manage their risk. In the 1970s hedge funds typically specialized only in one strategy, and most fund managers followed the long/short equity model created by Jones. Hedge funds lost their popularity during the downturn of the 1970s but received renewed attention in the late 1980s, following the success of several funds profiled in the media. During the 1990s the number of hedge funds increased significantly, with investments provided by the new wealth that was generated in the 1990s stock market rise. The increase in the number of hedge funds resulted from traders and investors being attracted to the aligned-interest compensation structure and the freedom of participating in an investment vehicle that was not benchmark-driven. Over the next decade there was also a marked diversification in the strategies funds utilized, including: credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy, among others. This industry expansion led to hedge funds becoming more heterogeneous than they had before.