A.W. Jones holds the distinction of being the world’s first hedge fund. It was started in 1949 by a middle-aged journalist with a masters in sociology and little-to-no investing experience. It’s probably a bit of an understatement to say that hedge fund founders today — type-A personalities with an obsession with finance — would find its founder a little odd.
In his time, Alfred Winslow Jones was many things — a one-time Marxist, diplomat, sociologist, journalist, and author. But he is perhaps most famous for being the father of the hedge fund industry. This is the story of how Jones improvised his way to an investment style that has persisted for over half a century … and how he eventually left it.
Source: Wikipedia Commons.
Jones was born in September of 1900 to wealthy American parents living in Australia. His father managed the Australian operations of General Electric. Over the next two decades, the family moved back to New York and Jones finished college at Harvard University. The freshly minted graduate decided to join the crew of a tramp steamer as an accountant. Jones had inherited his father’s love for travel and spent the next year exploring the world by sea. On his return to America, he bounced around aimlessly, taking up a handful of random odd jobs including a stint as an export buyer and a statistician. Jones then joined the State Department and was sent to Berlin as America’s vice-consul in December of 1930.
Germany’s economy was in free fall when Jones reached Berlin. The nature of his job gave Jones the opportunity to examine the country’s social and political troubles. His relationship with Germany grew even more personal when he secretly married a left-wing anti-Nazi activist. This affair ended after a few months, but Jones continued his ideological sojourn with Marxism. The foreign service forced Jones to resign after discovering his secret wedding. He then spent the next two years working undercover in Berlin and London for a Leninist organisation. As German resistance to Hitler broke down, Jones returned to America in 1934 and enrolled as a graduate student of sociology at Columbia University. He married for a second time, and the young couple honeymooned in war-torn Spain in 1937.
Jones was affected by all he saw in Europe. At the time, Hitler was already chancellor in Germany, and he cast a growing shadow across the continent. When the time came to choose a thesis topic, Jones couldn’t help but think about his own country. The stock market crash of October 1929 had left Wall Street reeling. The depression that followed had forced thousands to destitution and buried the American dream. After witnessing the turmoil in Germany and Spain firsthand, Jones set about answering a fundamental question — could a similar crisis befall America?
Jones wrote his thesis on the link between the economic status of Americans and their attitudes about property. His thesis was published as part of a book in 1941, and was soon taught in sociology classes across the country. Jones leveraged its success to land a job as a journalist at Fortune magazine. Interestingly, his rendezvous with Marxism in his 30s had left him with moderate views in his 40s. In a piece for Fortune he wrote: “As conservative as possible in protecting the free market and as radical as necessary in securing the welfare of people.”
World War 2 ended in 1945. In 1948, a writing assignment for Fortune nudged Jones to think about finance. In an essay titled “Fashions in Forecasting,” Jones attacked the traditional approach to predicting the stock market through economic data like commodity prices and freight-car loadings. He proposed a new model that argued stock market changes were driven by patterns of investor psychology. For example, a rise in the market would drive investor optimism, which would, in turn, drive another rise in the market, and so on.
By the time this essay was published in March of 1949, Jones had left Fortune to start the world’s first hedge fund. It would’ve been convenient to imagine that penning this forecasting article had awoken Jones’s dormant passion for finance. But the reality was simpler. Years later, he wrote: “With a wife and two children, I needed something more lucrative, and turned to Wall Street.”
Jones did not even aim to get into investing. His original plan was to start a magazine, but he was forced to pivot when he failed to raise capital for his publishing venture.
Jones started A.W. Jones with initial capital of $100,000. He sourced $60,000 from four friends and put in $40,000 of his own money. The fund’s first office was a one-and-a-half room space that he rented from an insurance business owned by one of his investors. And then Jones’s new fund was open for business.
Jones wanted to try his hand at converting his observations on the market into tangible investment profits. But his real genius lay in how he innovated on prevailing approaches to investing. At the time, it was standard practice to buy stocks when the market was expected to rise, and sell them (and hoard cash) when it was expected to fall. (That investors couldn’t really predict market turns was not discussed — or at least, not discussed widely).
Jones took this approach and improved on it. In a bull market, he invested his entire capital and leveraged himself by borrowing additional sums to invest in new stocks. In a bear market, he reduced his exposure by selling stocks “short.” This meant he borrowed stocks from investors and sold them under the assumption that their price would fall. When the price did fall, he would repurchase the stocks at a profit. It was this approach that led him to his next innovation: even when the markets did not signal a fall, he shorted some portion of his capital as a routine precaution. He frequently described his investment strategy as using “speculative means for conservative ends.” Hence, a ‘hedged’ fund.
Leverage and short-selling had earned a bad reputation after the markets crashed in 1929. The effects of the crash were long lasting. When Jones started his fund two decades later, professional money managers — called “trustees” — were charged with conserving the capital entrusted to them, not growing it. Jones did things differently. In the first twenty years of his fund’s life, he earned his investors a cumulative return of just under 5000%. In More Money Than God, author Sebastian Mallaby summarises the benefits of Jones’s dynamic approach with the following quip:
“...the hedged fund does better in a bull market despite the lesser risk it has assumed; and the hedged fund does better in a bear market because of the lesser risk it has assumed.”
To be sure, there were other, more practical reasons that explained why rival investment funds did not short stocks. The prejudice against short-selling had led the government to impose higher taxes and stricter regulatory treatment on shorts. Further, the upside to shorting was limited to 100% if the value of the stock fell to zero (an investor who bet long, on the other hand, could potentially make infinite profits as the stock rose as a reflection of market exuberance or business success). But most importantly, for short-selling to be profitable it needed to become a cohesive part of a hedge fund’s strategy — and this was what Jones perfected.
Jones thought hard about how his longs and shorts would work together. He started by recognizing that different stocks are differently volatile. This means that the value of some stocks change more erratically than others; buying an inert stock and shorting a volatile stock of the same value does not create a real hedge. To counter this, Jones measured the volatility of stocks against the volatility of the S&P 500. He called this parameter “velocity” and used the data he collected to inform his hedging decisions. Jones’s second innovation was to distinguish between returns earned from stock picking and returns earned from exposure to the market. Today these ideas are well-established, proven concepts — the former is typically called ‘alpha’ and the latter named ‘beta’. But it is hard to overstate how novel they were when Jones used them over half a century ago.
Whilst Jones found many of these ideas useful, he had some difficulty putting them to practise. Jones and his employees had no access to computers — this was the 50s, after all. So they used labour-intensive methods to get at rough estimates. Richard Radcliffe, Jones’s first fund manager, said of the velocity calculation:
“We took the last five market highs and the last five lows and we looked up what the stocks had done in those highs and lows…Sometimes there weren’t five really good moves, so it was very crude…”
Jones’s methods to distinguish between gains from market exposure and gains from stock picking were no different. He would check this himself by analysing the closing prices of stocks recorded in the newspaper.
Years later, academic papers would be published that explained the full power of Jones’s methods. For instance, in 1952 — not too long after Jones started his fund! — Harry Markowitz published a paper redefining the objective of investing as maximising risk-adjusted return, as opposed to simply maximising return. He also proposed that the amount of risk an investor takes depends not only on the stock he owns, but also on the correlations between them. Markowitz’s bold conclusions were largely ignored by Wall Street because the computing power to calculate correlations between multiple stocks did not exist. William Sharpe came up a simple solution in 1963 — calculating a single correlation between each stock and the market index. By that time, though, Jones had already been doing this for over a decade.
Another example of Jones’s foresight was a hypothesis advanced by James Tobin in 1958. Tobin argued that an investor’s stock selection should be considered distinct from his risk appetite. This went against the widespread belief that certain stocks were suitable for certain types of investors. For instance, ambitious young executives were taught to invest in flashy, risky stocks; grandmothers were supposed to buy safer issues. According to Tobin's hypothesis, a risk-hungry investor and a risk-averse investor could choose the same stocks to invest in. However, the former could borrow money to invest a larger sum, while the latter could invest a smaller part of their savings. In other words, bet sizing was a thing. Jones’s firm, it turned out, had been following this approach since inception: Jones’s team decided which stock to own and then adjusted for risk by playing with bet size and leverage.
Even the way Jones managed his fund was different from his contemporaries. He created a structure where all key participants in the fund had tangible skin in the game. This included the fund’s network of brokers, fund-managers, and partners.
Jones devised an ingenious system to incentivize brokers to call him with tips for good stocks. He would invite brokers to manage a “paper” portfolio for his fund. These brokers would choose stocks and call him with changes in their position as the market moved. For the fund, Jones would pick the best stock ideas from a collection of the paper portfolios. He would then compute each broker's performance by differentiating between the returns they earned from market exposure, as compared to the returns from stock picking. Jones would then pay them a commission based on how well their suggestions worked. The brokers were incentivized to give Jones’s firm their best tips because of the clear link between their efforts and the compensation they received.
As for his in-house fund managers, Jones empowered them with free reign over their portfolios. He indicated the desired level of market exposure for the portfolio and then left them to manage it as they saw fit. The managers were motivated because the fees earned by the fund were allocated proportionately to how their segment performed. Successful fund managers were also given extra capital to manage, increasing their chances of generating higher profits in the coming years. Decades later, the fundamental structure that Jones pioneered came to be known as ‘multi-strategy hedge funds’ or ‘pod shops’; a 20 May 2024 article on Bloomberg declared that these funds were ‘all the rage’ on Wall Street.
Finally, Jones required his partners to invest their own capital, so that their wealth and income was dependent on their performance.
One final key to Jones’s success in those early years was his savvy manoeuvring through a difficult regulatory landscape. Three laws applicable to certain kinds of funds — the Securities Act of 1933, the Investment Advisers Act of 1940, and the Investment Company Act of 1940 — imposed limits on leverage and short-selling. Jones did everything possible to make sure his funds fell outside the ambit of these laws. He denied the applicability of the Acts on the ground that his fund was “private.” To this end, he never publicly advertised his services. All his marketing efforts were limited to exclusive dinners behind closed doors. Jones was also careful not to let the total number of investors in the fund cross the threshold (99 investors) that would trigger registration. When this came close to happening, Jones set up a second fund in 1961. Jones also laid out separate investment strategies for this fund so it did not seem like he was only trying to skirt the law.
As the fund grew larger and more successful, Jones took a step back from its day to day affairs. He spent an increasing amount of time indulging his passions, as fund employees managed client portfolios. Some of his fund managers grew resentful. They realised that they could leave the fund and start their own firms, where they would have a bigger piece of the pie. Starting in 1964, Jones’s firm began bleeding talent.
It was ironic, then, that Jones began to become widely known in the late 60s. Carol Loomis published an article in Fortune titled "The Jones Nobody Keeps Up With", lionising him. The opening words read “There are reasons to believe that the best professional money manager of investors' money these days is a quiet-spoken seldom photographed man named Alfred Winslow Jones.” This was the article that coined the term ‘hedge fund’.
As Jones’s fund managers joined competing firms, his unique investment strategies spread across the market. Rival funds began to catch up to him. To add to Jones’s troubles, his managers slowly abandoned the firm’s core principles around hedging. Malaby writes, in More Money Than God:
... the multimanager structure that empowered go-go segment managers was not designed to save Jones from a sudden reversal—a problem that multimanager hedge funds were to discover later. On the contrary: The more the market rose, the more Jones’s performance-tracking system rewarded aggressive segment managers who took the most risk. There was no mechanism for getting out before disaster struck.
Which is a succinct summary of what happened next. Clark Drasher, a young fund manager for Jones’s fund of funds, would later say (again, to Mallaby):
“Most of the time we were not balanced. We would get carried away in rising markets. You’d hate to be short much of anything in the 1960. So when the bad times came in 1969 we got hit.”
In May of 1969 the stock markets fell hard, losing a quarter of their value over the course of a year. Jones’s funds — now overleveraged and under-hedged after years of exuberant returns — bore the brunt: in the year ending May 1970 he had to tell his clients that he had lost 35% of their money.
Jones was 70 years old in 1970. After two decades in the markets, the competition had finally caught up with him.
Jones died nearly a decade later, at age 88. But that wasn’t the end of A.W. Jones, the firm Jones founded. A 2007 New York Magazine article titled Long-Short Story Short notes:
... his firm lives on as a so-called fund of funds, directing $200 million of its clients’ money to firms that employ Jones-like principles. “I’d say a lot of the industry is still based on the long-short model,” says Robert L. Burch IV, Jones’s 32-year-old grandson who runs the firm with his father, Jones’s son-in-law, and operates his own tiny hedge fund on the side. “You just hear a lot less about them.” That may be because such assiduous risk avoidance has gone out of style. If Jones was obsessed with beta, today’s investors are all about alpha, the singular pursuit of the above-market return, which is based on the conviction that you can, in fact, outsmart the market.
The fund is still running; you can visit its website here. In 2008, Jones was inducted Institutional Investors Alpha's Hedge Fund Manager Hall of Fame. He may have had an odd, circuitous path in his youth — only starting his fund at age 49 — and the arc of his success was perhaps muted in his last decade. But, at the end, Jones is remembered for having invented so many aspects of the hedge fund approach.
He died a true pioneer.
Sources:
More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby. Published in 2010.
“Carol J. Loomis, “The Jones Nobody Keeps Up With,” Fortune, April 1966, pp. 237–47.”