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Insights: Finance

A brief history of hedge funds, and how you can buy in
Mario J. Gabelli
From the Print Edition:
Dennis Hopper, Jan/Feb 01

An individual investor can earn a return on his capital in many ways. First, you would consider whether you want to earn an absolute or a relative return. That is, if you start with $1 million, would you like to have $1.1 million at the end of 12 months (absolute return), or would you want to earn a relative return by benchmarking your capital to an index, such as the Standard & Poor's 500 or, more recently, NASDAQ, and earn a return that matches that index?

Once your goal is set, you can invest in equities or fixed-income securities. Equities can be either global or U.S.; they can be growth or value; large cap or small cap. Your assets could be actively managed by a professional or by yourself, or they could be in an index fund.

In past articles we talked about investing in growth stocks, value stocks and gold. In this issue, we focus on what some would view as a black art -- hedge funds.

Hedge funds have been making headlines in the past 18 months. In 1998, the near collapse of Greenwich, Connecticut-based Long-Term Capital Management spawned a global liquidity crisis and calls for regulatory scrutiny in the financial services industry's last largely unregulated domain. More recently, the much publicized performance problems of George Soros's Quantum Fund and the dissolution of another legendary hedge fund, Julian Robertson's Tiger Fund, cast another shadow on the hedge fund business. Today, if asked to define a hedge fund, I suspect that most folks would characterize it as a highly speculative vehicle for unwitting fat cats and careless financial institutions to lose their shirts.

Nothing could be further from the truth.

With the significant help of Tremont Partners Inc., a publicly traded company on NASDAQ, and its research arm, TASS Investment Research Ltd., the world's leading experts on the hedge fund industry, I present the following history of hedge funds and give a few reasons that I believe hedge funds (Gabelli Funds Inc. has four) offer an attractive alternative for sophisticated investors. (In the spirit of full disclosure, I point out that Gabelli Funds is a large shareholder of Tremont.)

Meet Mr. Jones

In 1949, Alfred Winslow Jones formed the first hedge fund. A truly remarkable individual, Jones graduated from Harvard University in 1923, then toured the world working as a purser on tramp steamers, served as a U.S. diplomat in Germany during the rise of Nazism in the 1930s, and worked as a journalist covering the Spanish Civil War. In 1941, he received his doctorate in sociology from Columbia University and became a reporter for Fortune magazine. In researching and writing a 1948 Fortune article on the current fashions in investing and market forecasting, Jones came to the conclusion that he had a better system for managing money. In 1949, he raised $100,000 ($40,000 of which was his own money) and began putting his theories to practice in a general investment partnership.

The foundation of Jones's novel investment approach was "hedging" his long stock positions by selling short other stocks to protect against market risk. Thus, the term hedge fund was born. He also used leverage (borrowed money) to enhance the potential return on the partnership's assets. Jones called short selling and leverage "speculative tools used for conservative purposes." In 1952, he transformed his general partnership into a limited partnership and introduced another wrinkle, an incentive fee of 20 percent of the profits for himself as managing partner. His entire liquid net worth remained in the partnership. This one fellow was responsible for combining short selling, leverage, incentive fees and shared risk -- the four most common characteristics of the classic hedge fund -- into one investment package.

And quite a package it turned out to be. Operating in almost absolute obscurity for 17 years, Jones's success was finally brought to the public's attention in a 1966 Fortune article titled "The Jones That Nobody Can Keep Up With." In addition to detailing Jones's unique investment strategy, the article revealed that his partnership had outperformed the best performing mutual fund that year by 44 percent and the best five-year performing mutual fund at the time by 85 percent, net of all fees. The article attracted the attention of both wealthy individuals seeking better investment returns and talented professional investors willing to sacrifice big salaries for profit participation in the portfolios they managed. By 1968, approximately 200 hedge funds had sprouted, including those formed by investment industry legends George Soros, Michael Steinhardt and Warren Buffett.


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