Alfred Winslow Jones: The Father of the Hedge Fund Industry
In March of 1949, Alfred Winslow Jones published a monumental article titled Fashions in Forecasting (FIF). FIF was meant to be a relatively straightforward piece on stock markets, showcasing various types of rules-based investment strategies.
In conducting research for the article, however, Jones stumbled upon a revolutionary idea which caused him to abruptly quit his job and start the world’s first ever “hedge fund”.
At the time, Jones was 44 years old and working at Fortune magazine writing articles on topics that had little to do with finance. The fact that Jones did not have an active interest in finance at the time is important; it shows that he was able to think about a problem differently by looking at it through a unique lens.
The research he conducted for the article fascinated him. At the time, the general theory of the stock markets was that all information was priced in all the time. In other words, any fall or rise in the stock markets was associated with events concurrently happening. Often times, the line of thinking went like this:
How is the stock market performing? How is Company X performing? If Company X is performing worse than the stock market, then buy Company X and sell the general stock market.
In FIF, Jones writes:
“The standard, old-fashioned method of predicting the course of the stock market is first to look at facts and figures external to the market itself, and then to examine stock prices to see whether they are too high or too low.”
This type of arbitrage play can work, but often fails. Why? Because there is no competitive advantage at play. The true tenet of price discovery states that it is when there is information parity that prices will adjust to their true values. Therefore, a better argument would be this:
What information do I know about Company X? What information does the general public know (and has therefore priced in) for Company X? If there is information parity, then trade it and profit.
As investors in 2018, we are obviously well aware of this fact, but in 1949 — the year of this article’s publication — this was not the conventional notion. Jones warns us, however, of “systems” which falsely claim to beat the stock market. Again, in FIF, he writes:
“Market analysis must not be confused with any of the wonderful ‘systems’ for beating the market”
A Systems-Driven Approach
According to Jones, a true, successful investing methodology had to be systems-driven. The technical, numerical, analytical and statistical nature of generating systems fascinated him. In FIF, he references Mansfield Mill’s work Investment Survey and describes building a trend-following strategy based on daily advances/declines on each company.
Mills computes each day the amount of gain for each stock that goes up and multiplies it by the number of shares transacted that day…Mills thus gives an exhaustive view of the market as a whole…because [Mills] relies on Momentum, they provide a guarantee for being out of step for very long.
A “Hedged” Fund
Right before he published this article, Jones founded his own Investment Fund — A.W. Jones & Co (also in 1949). He quickly raised $100,000 from friends and family and got into business. In its first year, his fund generated a healthy 17.9% for its investors.
At the time, Jones had said that he felt he had an edge because he was always “hedged”. Today, what is known as a Long/Short strategy was first conceptualized and deployed by Jones.
The strategy, in itself, is simple. Even the best investors in the world know that at the end of the day, there’s not much you can do with a naked portfolio when dealing with market-wide risk. In 2008, the Dow fell 34%. In such a year, it is so incredibly difficult for any company to push against such a tide. Imagine having to start a hedge fund in early 2008 — how would you possibly withstand that tide with only long positions?
Jones created a solution. He pinned equally weighted baskets of stocks against each other — one half on the buy side, and one half on the sell side, such that regardless of how the market performed overall, his portfolio would always be “hedged”. His job as the Fund Manager was to simply buy the best quality stocks and to sell the poorest ones.
As the saying goes, the proof is in the pudding, and in Jones’ case, his results did all the talking. Warren Buffett quickly replicated Jones’ Long/Short hedged structure and over the course of 34 years, Jones’ investors lost money on only 3 years (as opposed to negative years for the S&P during the same time).
A Legacy that Lives On
Jones’ legacy will stand the test of time. After all, he’s the one we can all thank (or blame) for creating the infamous 20% performance fee profit-sharing structure. He’s also credited with creating the modern usage of ‘Beta’ (he referred to it as ‘Velocity’), which measures how closely a stock moves against the market (therefore, in a hedged portfolio, the Beta of all combined long positions should cancel out the Beta of all combined short positions). He had his toughest year in 1970 when his fund lost 35%. By the early 80’s, he transitioned his fund into a fund of funds (thereby further reinforcing his belief in being hedged) and by the mid 80’s, had all but retired from the Fund Management game. His belief in keeping things hedged spilled over into the non-financial world, when he tried to set up a Reverse Peace Corps in order to remove imbalances between countries and create a “level” playing field.
In the HF space, it is easy to paint all fund managers with the same, broad stroke. We assume that fund managers are all the same, deploying the same strategies, generating the same types of predictable, under-performing returns. It is for this very reason that pioneers like Alfred Winslow Jones are revered, simply for their ability to highlight and remind us of an important truth in life: it pays handsomely to be bold.
The author is a Cofounder at RAIN Technologies, an AI driven fund management company.
