The government has clamped down on Wall Street banks, but that doesn’t mean money goes to sleep.
In a shift decades in the making, the hedge fund world has exploded in size, filling the void banks have left open to take finance’s biggest risks and reap its greatest rewards.
Sebastian Mallaby’s book ‘More Money Than God,’documents the rise of hedge funds, from the very first venture in 1949 to the giants that they are now. It also provides insight into how many of today’s star hedge fund managers go their starts.
We’ve gone through Mallaby’s book for you, and highlighted the most important people that made hedge funds into the powerful, driving market force it is today.
Alfred Winslow Jones started then first hedge fund when he discovered the benefits of 'hedging' -- short selling some stocks to offset risks of buying others.
Fund: A.W. Jones & Co. (1947 -- Present)
Background: Alfred Winslow Jones was a man in his 40s with almost no experience in finance. He had dabbled in public service, Marxist rebellion, and journalism. But by 1949, Jones had a family and two kids, and needed to make money. Jones raised $US60,000 from his friends and threw in $US40,000 of his own money.
Strategy: Jones created the hedging strategy, which used short selling to mitigate or 'hedge' the risks from buying long. He financially incentivized brokers to provide him with their best stock picks to fill his portfolio. Jones also began the standard of charging a 20% performance fee on top of the flat management fee.
Major wins/losses: In 20 years running, Jones saw a return of almost 5,000%. But leading up to the market crash of 1969, Jones' segment managers started taking too many leveraged risks, and Jones lost 35% of his investors' money.
How they changed the game: Jones' 'hedged fund' led to a flood of imitators and the start of a new financial movement. By 1968 there were 40 more hedge funds, and by 1969 there were anywhere between 200 and 500.
Legendary trader Michael Steinhardt then used the same model, but to bet against conventional wisdom.
Fund:Steinhardt, Fine, Berkowitz & Company / Steinhardt Partners (1967 -- 1994)
Background: Steinhardt graduated from University of Pennsylvania at age 19, and by 25 had already made a name for himself on Wall Street. Steinhardt known for his temper and contrarian attitude.
Strategy: Steinhardt developed an invaluable relationship with block traders. As investors began to pour money en masse into Wall Street, block traders stepped up to facilitate large trades and provide liquidity. Traders would come to Steinhardt because he controlled big decisions and big trades.
This allowed Steinhardt to take advantage of inefficient prices in the short-term, buying low and selling high. Steinhardt's firm was also the first to utilise monetary analysis and predict interest rates.
Major wins/losses: Steinhardt's firm was the only profitable hedge fund in 1971 because of its massive short positions during the 1969 market crash, with a total return of 361% since it started in 1967.
However, in 1994, Steinhardt lost a fortune in a huge European bond dump. His hedge fund wasn't able to recover, and he left the market shortly afterwards.
How they changed the game: Steinhardt's firm turned hedge funds from a method of controlling market exposure into a method of betting against conventional wisdom. The success of Steinhardt, Fine, Berkowitz & Company showed the hedge funds' capacity for contrarianism.
F. Helmut Weymar led one of the first 'quant' hedge funds that used mathematical models to trade commodities.
Fund: Commodities Corporation (1969 -- 1997)
Background: Weymar wrote his PhD dissertation on predicting the price of cocoa by using historical data. As a graduate student, he built a mathematical model to evaluate prices of frozen orange juice, which ended up turning him a profit. He cofounded Commodities Corporation with friends, after a stint trading at Nabisco with his cocoa price model.
Strategy: Commodities Corporation focused on econometrics, building models, and forecasting market conditions. The firm built a computer trading system that found price trends in data and traded based on these patterns, which was one of the first automated trading systems used by hedge funds.
Major wins/losses: After a corn catastrophe, Commodities Corporation's capital was decimated from $US2.5 million to $US900,000 in less than a week. Weymar then turned around the fund with a new approach to risk taking. By the end of the 1970s, Commodities Corporation had risen to $US30 million in capital.
How they changed the game: Commodities Corporation was one of the first 'quant' hedge funds, using data to guide trades. However, its failure in 1971 also warned against placing too much confidence in mathematical models.
Fund: Caxton Associates (1983 -- Present)
Background: When Bruce Kovner applied to Commodities Corporation, he was working as a cab driver. A Harvard PhD dropout, Kovner had taught himself to trade, turning $US3,000 into $US22,000. He joined Commodities Corporation in 1977, averaging 80% returns a year.
Strategy: Kovner combined market intuition with extreme organisation. He had several assistants tracking numbers and creating charts for him at Commodities Corporation. Kovner thought trading without any fundamental information actually worked better -- he followed charts diligently and would wait for any indication of inside information that caused markets to shift.
Major wins/losses: Kovner predicted the market reversal before Black Monday and made a profit while the top three hedge fund managers all lost money. After the crash, he continued to pile money into bonds, and by 1990 was reported as the highest earner on Wall Street.
How they changed the game: While at Commodities Corporation, Kovner stumbled on what became a hedge fund staple -- that low forward rates meant that currency values were more likely to rise, since a high interest rate would drive inflation down.
Fund: Soros Fund / Quantum Fund (1973 -- 2011)
Background: Born in Hungary, George Soros survived the Nazi regime by leaving his Jewish family and assuming a Christian identity. After attending the London School of Economics he eventually went to New York City to work on Wall Street. By 1969, he had launched his own $US4 million stock-picking fund within a large Wall Street brokerage.
Strategy: Soros used a theory of 'reflexivity,' the idea that investor shortcuts in dealing with complex companies would create a real circumstances for profit. Instead of trading on investor sentiment or projected earnings, Soros waited for the moment when values became unsustainably high and would crash back down.
Major wins/losses: He made a fortune watching for unstable equilibriums to reverse, including a real-estate investment trust boom-bust and the rise and fall of U.S. dollar in 1985. And when Soros knew he was right, he piled on hard to rack up the profits.
In the aftermath of Black Monday, Soros found his positions too large to liquidate and lost $US840 million. He came back shortly afterwards in a short on the U.S. dollar.
How they changed the game: Soros' book, 'The Alchemy of Finance,' was influential in combining two different sides of hedge funds -- commodities and equity. Soros combined the charts and trends from commodities trading and fundamental analysis from equity trading. Soon, famous investors who had specialised in one or the other were just known as 'macro' investors.
Fund: Tiger Management (1980 -- 2000)
Background: Robertson, a talented stock picker that hailed from the south, was another financier inspired by A.W. Jones. In the 1970s, he worked at financial firm Kidder Peabody, where he met Bob Burch, A.W. Jones' son-in-law. When Robertson eventually started his own fund, Burch invested $US5 million from what remained of the Jones money.
After Robertson closed Tiger Management in 2000, he began training and mentoring a new wave of hedge funders, known as 'Tiger cubs.' By 2006, they were managing $US16 billion.
Strategy: Robertson's specialty was in evaluating companies, and Tiger had an amazing ability to pick good positions on the long and shor side. Another large advantage was Robertson's ability to charm and win people over.
Major wins/losses: By 1990, Robertson's fund became only the third hedge fund to manage more than $US1 billion. From 1988 to 1992, he beat the S&P 500 every single year. On the sixth year, he returned 64 per cent to his investors after fees.
How they changed the game: Many economists believed the theory that a random pick of stocks was statistically more likely to outperform a portfolio assembled by a trader. However, Robertson's stock-picking skill reinforced the idea that distinct styles could succeed. The 'tiger cubs' that trained under Robertson were also known to perform very well.
Paul Tudor Jones learned to trade successfully by watching other market players, rather than market information.
Fund: Tudor Investment Corporation (1983 -- Present)
Background: Paul Tudor Jones II did an apprenticeship with a cotton trader right out of college, and eventually landed at the New York Cotton Exchange. It was there he realised that prices were not driven solely by market information, but by other market players.
Strategy: Jones' trading style was described as a game of psychology and a high-speed bluff, playing off other traders' habits. He imagined the market in scripts, considering the emotional states of the market, how investor sentiment would change, and how to react.
Major wins/losses: Jones sold off bonds the Friday before Black Monday in 1987, and rode out the fall with a $US100 million profit. (Meanwhile, Soros, Steinhardt, and Robertson were all losing money.) Using his mental script, he made another large bond trade in the midst of the frenzy that turned into his most profitable trade ever.
How they changed the game: Jones developed a reputation for being able to move the market based on his trades and opinions. Instead of figuring out other people's scripts, he started writing the market's on his own.
Stanley Druckenmiller made bets based on government policy decisions, and showed hedge funds could be global players.
Fund: Duquesne Capital Management (1981 -- 2010)
Background: Stanley Druckenmiller started off as an equity analyst at a Pittsburgh bank. He launched Duquesne at the age of 28. Even with his own fund, George Soros offered him a top job at Quantum, and Druckenmiller eventually agreed in 1988.
After a dozen years managing Quantum, Druckenmiller went back to only managing Duquesne, exhausted in the wake of the dot-com burst.
Strategy: Druckenmiller earned billions by betting on and against foreign currencies and governments. This idea came from Paul Tudor Jones' insight that understanding the other players in a market would indicate the best way to trade. But for governments, their motives were even easier to read.
Major wins/losses: While working for Soros at Quantum, Druckenmiller loaded up on the German mark and sold British pounds based on the tension of interest rates between the two countries. Once everyone started selling sterling, Britain lost $US3.8 billion of taxpayer money to hedge funds and investors. Quantum itself took home the largest amount, over $US1 billion.
How they changed the game: Druckenmiller's success in betting against governments indicated hedge funds' entrance into influencing global finance and monetary policy.
In 1994, John Meriwether launched a hedge fund so powerful that it almost took down all of Wall Street.
Fund: Long-Term Capital Management (1994 -- 1998)
Background: John Meriwether traded bonds at Salomon Brothers in the 1980s, where he discovered the profitability of arbitrage. After he was forced to leave Salomon, he launched LTCM with many of his academic hires, including Robert Merton and Myron Scholes who would later win the Nobel Prize.
Strategy: Meriwether was one of the first Wall Street executives to value quantitative strategies and financial engineering over gut trading. Long-Term and Meriwether's strategy took advantage of imperfect pricing in the markets, knowing that eventually the prices between bonds traded would converge and earn them a profit.
Instead of betting on which direction the market would move, Meriwether was betting simply that the market would move -- on volatility itself.
Major wins/losses: Long-Term saw astronomical returns in its first couple years, raking in billions in profits. However, after unforeseen geopolitical events including Russia's default, the firm lost almost all its capital in a matter of months. Long-Term's positions were so highly leveraged, the crash necessitated a bailout from the biggest banks on Wall Street, totaling $US4 billion in order to keep the market from deteriorating.
How they changed the game: LTCM was the first instance in which a large hedge fund threatened to disrupt the entire financial system, which prompted concern from regulators and the general public.
Fund: Farallon (1985 -- Present)
Background: Tom Steyer had worked at Morgan Stanley and Goldman Sachs, but quit because he didn't like the way investment-bank advisors could still be rewarded when they were wrong. He set up his own fund so he could focus on his investment skill.
Strategy: Steyer took a new approach to investing that led to 'event-driven' hedge funds. He developed analytical skills to assess events in which market prices would be driven up or down, such as mergers and bankruptcies.
Major wins/losses: Between 1990 and 1997, Farallon made straight profits, and even survived the dot-com bubble that killed Druckenmiller and Robertson.
How they changed the game: In 1990, Farallon was the first hedge fund to receive an investment from a university endowment -- $US300 million from Yale. Afterward, other universities began investing in hedge funds as well, from 0% allocation in 1990 to 7% in 2000. By 2009, half of the capital poured into hedge funds came from institutions rather than individual investors.
Fund: Renaissance Technologies Medallion Fund (1988 -- Present)
Background: James Simons was a mathematician and code breaker who previously worked at the Pentagon's Institute for Defence Analyses, but he was fired from the Pentagon for opposing the Vietnam War. In the 1970s, Simons recruited several brilliant minds to help him create a new trading program. The Medallion Fund was named for the awards Simons and his partner received for mathematical work.
Strategy: While other algorithms were created around how markets might behave intuitively, Medallion traded solely on objective patterns found in past data. Medallion's scientists thought about patterns in the way a computer would, rather than a human trader. Simons never hired economists or Wall Streeters. This approach to data was called 'ghost hunting.'
Major wins/losses: By 1989, everyone was following trends, and Medallion pivoted to focus on the short-term signals rather than the traditional trend-following model. This approach boosted capital by 56 per cent the first year afterwards.
In 2005, Simons launched another fund, which earned more than $US25 billion in two years. Simons retired in 2009, but Medallion continued to perform exceptionally after he left.
How they changed the game: The Medallion Fund's rise mitigated concerns about black-box trading that followed LTCM's collapse, and widely popularised quantitative trading systems among investors.
Ken Griffin led the movement into multistrategy hedge funds, rather than focusing on one speciality.
Fund: Citadel (1990 -- Present)
Background: Griffin got his start to finance by trading convertible bonds out of his Harvard dorm room. By age 31, he was managing $US2 billion in assets.
Strategy: Citadel embodied the new structure of multistrategy hedge funds, in which firms hired from a wide array of experts and used many different tactics at once. This allowed the fund to diversify and reduce risk, as well as adjust capital to whatever was doing best in the current market condition.
Major wins/losses: Having constructed itself similarly to investment banks, Citadel itself almost crashed amid the financial crisis with Bear Sterns, Lehman Brothers, and Merrill Lynch. As a hedge fund, Citadel didn't get emergency funding from the Federal Reserve. But Griffin pulled through, after losing $US9 billion in capital in the very worst of it.
How they changed the game: Because he was interested in multiple strategies, Griffin helped buy failing hedge funds like Sowood and Amaranth, which lost $US6 billion in capital, and added them to Citadel.
Fund: Paulson and Company (1994 -- Present)
Background: After graduating from Harvard Business School in 1980, John Paulson went to work at a management consultancy. He then moved to hedge fund Odyssey Partners, then Bear Stearns. In 1994, he launched Paulson and Company with $US2 million.
Strategy: Paulson specialised in merger arbitrage focusing on long odds, and valued contrarian ideas. He liked to look for the coming downturn in booms, and trade on failing and bankrupting companies. He kept Paulson and Company small and out of the spotlight, with only seven employees.
Major wins/losses: Paulson was one of the most highly rewarded hedge fund managers in the subprime mortgage crisis. After becoming bearish on the market in 2005, Paulson began looking for contrarian trades to make the most out of when the bubble burst. He took a $US7.2 billion position in insurance on subprime bonds. In February 2007, he made $US1 billion in one day as the largest subprime lenders began to go under.
How they changed the game: Paulson's enormous subprime mortgage trade symbolized a shift in power from macro hedge funds to credit hedge funds.
Jim Chanos is Wall Street's foremost forenzic accountant, and shorts companies that he discovers are failing.
Fund: Kynikos Associates (1985 -- Present)
Strategy: Chanos specialised in short selling, and investigated companies to find which ones were failing, and short them.
Major wins/losses: Chanos was one of the first to uncover Enron's fraud in 2001. He also saw a 30% return in 2007, by betting against investment banks such as Citigroup and Merrill Lynch.
How they changed the game: In 2007, Jim Chanos of Kynikos Associates was asked about the financial stability and risk in hedge funds. He responded that the real concern should be directed towards large banks -- and in 2008, he was right.
As Bear Stearns was reaching its end, CEO Alan Schwartz requested that Chanos appear on CNBC and restore faith and support in the company. Chanos turned him down, but the call represented the changing of power from banks to hedge funds.
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