More Money Than God_Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

  The answer began with short selling, which, as Jones observed in his report to investors, was “a little known procedure that scares away users for no good reason.”30 A stigma had attached to short selling ever since the crash and was to survive years into the future; amid the panic of 2008, regulators slapped restrictions on the practice. But as Jones patiently explained, the successful short seller performs a socially useful contrarian function: By selling stocks that rise higher than seems justified, he can dampen bubbles as they emerge; by repurchasing the same stocks later as they fall, he can provide a soft landing. Far from fueling wild speculation, short sellers could moderate the market’s gyrations. It was a point that hedge-fund managers were to make repeatedly in future years. The stigma nonetheless persisted.

  But there were other reasons why rival investors had not deployed the Jones method. Up to a point, shorting bad stocks is no more difficult than buying good ones: It involves the same intellectual process, only inverted. Instead of seeking out stocks with fast earnings growth, you look for slow earnings growth; instead of identifying companies with strong management, you look for companies led by charlatans. In other ways, however, shorting is harder. Because of the prejudice against it, shorting faces tougher tax and regulatory treatment; and whereas the investor who buys a stock can potentially make infinite profits, the short seller can only earn 100 percent—and that is if the stock falls to zero.31 Moreover, shorting only works as part of a hedging strategy once a further refinement is brought in. It was here that Jones was way ahead of his contemporaries.

  The refinement begins with the fact that some stocks bounce up and down more than others: They have different volatilities. Buying $1,000 worth of an inert stock and shorting $1,000 worth of a volatile one does not provide a real hedge: If the market average rises by 20 percent, the inert stock might rise by only ten points while the fast mover might shoot up by thirty. So Jones measured the volatility of all stocks—he called it the “velocity”—and compared it with the volatility of Standard & Poor’s 500 Index.32 For example, he examined the significant price swings in Sears Roebuck since 1948 and determined that these were 80 percent as big as the swings in the market average: He therefore assigned Sears a “relative velocity” of 80. On the other hand, some stocks were more volatile than the broad market: General Dynamics had a relative velocity of 196. Clearly, buying and selling the same number of Sears and General Dynamics stocks would not provide a hedge. If the Jones fund sold short 100 shares of volatile General Dynamics at $50, for example, it would need to hold 245 shares in stodgy Sears Roebuck at $50 to keep the fund’s market exposure neutral.

  In his report to his investors, Jones explained the point this way:

  Jones pointed out that the velocity of a stock did not determine whether it was a good investment. A slow-moving stock might be expected to do well; a volatile one might be expected to do poorly. But to understand a stock’s effect on a portfolio, the size of a holding had to be adjusted for its volatility.

  Jones’s next innovation was to distinguish between the money that his fund made through stock picking and the money that it made through its exposure to the market. Years later, this distinction became commonplace: Investors called skill-driven stock-picking returns “alpha” and passive market exposure “beta.”33 But Jones tracked the different sources of his profits from the start, revealing the facility with statistics he had honed amid Akron’s industrial tensions. Each evening, sometimes with the help of his children, he would look up the closing prices of his stocks in the World Telegraph or the Sun and note them in pencil in a dog-eared leather book.34 Then he would construct chains of reasoning like this one:35

  Our long stocks, worth $130,000, should have gone up by $1,300 to keep pace with the 1% rise in the market. But they actually went up by $2,500, and the difference, attributable to good stock selection, is $1,200 or 1.2% on our fund’s $100,000 of equity.

  Our short stocks, worth $70,000, should have gone up also by 1%, which would have shown us a loss of $700. But the actual loss was only $400, and the difference, attributable to good short stock selection, is a gain of $300 or 0.3%.

  Being net long by the amount of $60,000, the market rise of 1% helped us along by 1% of $60,000, or $600, or 0.6%.

  Our total gain comes to $2,100, or 2.1% of equity. 1.5 percentage points of the return were attributable to stock selection. The remaining 0.6 percentage points stemmed from exposure to the market.

  Jones’s calculations were impressive on two levels. In the precomputer age, figuring the volatility of stocks was a laborious business, and Jones and his small staff performed these measurements for about two thousand firms at two-year intervals. But, more than Jones’s patience, it was the conceptual sophistication that stood out. In a rough-and-ready way, his techniques anticipated the breakthroughs in financial academia of the 1950s and 1960s.

  IN 1952, THREE YEARS AFTER JONES HAD LAUNCHED HIS fund, modern portfolio theory was born with the publication of a short paper titled “Portfolio Selection.” The author was a twenty-five-year-old graduate student named Harry Markowitz, and his chief insights were twofold: The art of investment is not merely to maximize return but to maximize risk-adjusted return, and the amount of risk that an investor takes depends not just on the stocks he owns but on the correlations among them. Jones’s investment method crudely anticipated these points. By paying attention to the velocity of his stocks, Jones was effectively controlling risk, just as Markowitz advocated. Moreover, by balancing the volatility of his long and short positions, Jones was anticipating Markowitz’s insight that the risk of a portfolio depends on the relationship among its components.36

  Jones’s approach was more practical than that of Markowitz. For years the 1952 paper was ignored on Wall Street because it was impossible to implement: Working out the correlations among a thousand stocks required almost half a million calculations, and the requisite computer power was not yet available. In the mid-1950s Markowitz attempted to estimate correlations for just twenty-five stocks, but he found that even this demanded more computer memory than the Yale economics department could provide for him. And so it fell to another future Nobel laureate, William Sharpe, to develop a variation that would render Markowitz’s work useful: In a paper titled “A Simplified Model for Portfolio Analysis,” Sharpe replaced the hopeless injunction to calculate the multiple relationships among stocks with the simpler idea of calculating a single correlation between each stock and the market index. This was precisely what Jones’s velocity calculations were designed to do. By the time Sharpe published his paper in 1963, Jones had been implementing its advice for more than a decade.

  Jones also anticipated the work of James Tobin, another Nobel Prize–winning father of modern portfolio theory. In 1958 Tobin proposed what came to be known as the separation theorem, which held that an investor’s choice of stocks should be separate from the question of his risk appetite. Most investment advisers in the 1950s assumed that certain types of stocks suited certain types of investor: A widow should not own a go-go stock such as Xerox, whereas a successful business executive should have no interest in a stodgy utility such as AT&T. Tobin’s insight was to see why this was wrong: An investor’s choice of stocks could be separated from the amount of risk he wanted. If an investor was risk averse, he should buy the best stocks available but commit only part of his savings. If an investor was risk hungry, he should buy exactly the same stocks but borrow money to buy more of them. Yet nine years before Tobin published his ground-breaking article, Jones was onto the same point. His fund made one judgment about which companies to own and a second about how much risk to take, adjusting the risk as it saw fit by using the device of leverage.37

  In the 1950s and into the 1960s, almost nobody understood Jones’s investment methods; in his secrecy as in much else, Jones anticipated the future of the hedge-fund industry. His clandestine activities in Europe had taught him how to stay under the radar, and he had multiple reasons to approach finance in
the same fashion.38 To begin with, Jones wanted to protect his investment methods from competitors: Brokers who visited the A. W. Jones offices on Broad Street were cross-examined vigorously about the stocks they were touting, but they left the place with no idea what the Jones men were thinking. Equally, Jones wanted to avoid drawing attention to the tax loopholes devised for him by Richard Valentine, an attorney at the firm of Seward & Kissel. Valentine was a creative genius who could be cartoonishly absentminded in his personal dealings: He once phoned a colleague’s home and launched into a lengthy exposition of his latest tax idea, oblivious to the fact that he was talking to his colleague’s five-year-old.39 It was Valentine who realized that if managers took a share of a hedge fund’s investment profits rather than a flat management fee, they could be taxed at the capital-gains rate: Given the personal tax rates of the times, that could mean handing 25 percent to Uncle Sam rather than 91 percent.40 Jones duly charged his investors 20 percent of the upside, claiming that he had been inspired to do so by Mediterranean history rather than tax law: He told people that his profit share was modeled after Phoenician merchants, who kept a fifth of the profits from successful voyages, distributing the rest to their investors. Dignified by this impressive cover story, Jones’s performance fee (termed a “performance reallocation” in order to distinguish it from an ordinary bonus that would attract normal income tax) was happily embraced by successive generations of hedge funds.

  Jones’s reasons for secrecy went beyond a desire to stave off competitors and reduce tax: He was anxious to escape regulation. He declined to register under the Securities Act of 1933, the Investment Company Act of 1940, and the Investment Advisors Act of 1940, arguing that none of these laws applied to him, principally because his funds were “private.” Not registering under these laws was essential: They restricted investment funds from borrowing or selling short, the two central components of Jones’s hedging strategy, and also imposed fee restrictions. To sustain the idea that his funds were private, Jones never advertised them publicly; he marketed them by word of mouth, which sometimes meant a word between mouthfuls at his dinner table. Much of his capital came from his network of intellectual friends, including Louis Fischer, a biographer of Lenin, and Sam Stayman, the inventor of the bridge convention “Stayman over no-trump.”41 Jones also took care not to allow too many investors into his fund. In 1961 he set up a second partnership rather than allow his first one to cross the permissible threshold of one hundred members.42

  This stealth allowed Jones and his later imitators to escape regulatory oversight. But it came at a price. There is nothing like secrecy to pique the public’s curiosity, and by the mid-1960s, hedge funds had begun to attract the sort of breathless commentary that later grew commonplace. They were “Wall Street’s last bastions of secrecy, mystery, exclusivity, and privilege,” according to the writer John Brooks; they were “the parlor cars of the new gravy train.”43 Perhaps the threat of deadening regulation made Jones’s clandestine style inevitable. But thanks to the pattern that he established in those early years, hedge funds have been forever mysterious, shadowy, and resented.

  EVEN AS HE ANTICIPATED THE INSIGHTS OF MODERN portfolio theory, Jones paid a price for ignoring Alfred Cowles’s writings. The verdict that trends in market prices are too faint to be profitable proved all too correct, at least in Jones’s case: His efforts to call the overall direction of the market failed as often as they succeeded. In 1953, 1956, and again in 1957, Jones lost money on his market calls, leveraging him self up when the market did poorly and vice versa. In 1960 Cowles published an update to his earlier research: He reversed his earlier finding of faint trends in monthly prices, concluding that they did not exist after all.44 Oblivious, Jones carried on trying to time the market, but with no better results. In early 1962, he was net long 140 percent of his capital, whereupon the market fell. Then he turned bearish, but the market turned up. At one particularly excruciating moment in August 1965, Jones had a net exposure of minus 18 percent, meaning that his short positions exceeded his longs to the tune of 18 percent of his funds’ capital. Perfectly on cue, the market embarked on a hot rally. Future hedge-fund managers were to prove that trend surfing can be profitable, and future academics were to revise Cowles’s findings. But Jones never turned a profit by following the charts, even though chartism had provided the premise for his hedged fund.45

  Jones’s statistical methods revealed precisely how much money he was losing from bad calls on the market.46 But his funds still performed marvelously. The reason lay in a discovery that he had stumbled upon almost accidentally. He had begun with theories about trends created by investor sentiment, which turned out to be blind alleys. He had invented the hedged strategy, which was conceptually brilliant but not in itself a source of profits. Next, having designed a hedged portfolio, he needed to choose stocks to put inside it. Through skill and a coincidence of temperament, Jones devised a way of assembling stock pickers who beat the pants off Wall Street.

  Jones knew he could not be a great stock picker himself. He was an investment novice, and the details of company balance sheets had never captured his imagination. Instead, he created a system to get the best out of others. Starting in the early 1950s, he invited brokers to run “model portfolios” for his fund: Each man would select his favorite shorts and longs, and phone in changes as though he were running real money. Jones used these paper portfolios as a source of stock-picking ideas. His statistical methods, which separated the fruits of stock selection from the effect of market moves, allowed him to pinpoint each manager’s results precisely. Jones then compensated the brokers according to how well their suggestions worked. It was a marvelous technique for getting brokers to phone in hot ideas before they gave them to others.47

  This system gave Jones an edge over his competitors. In the 1950s, Wall Street was a sleepy, unsophisticated place. At the universities and business schools, practically nobody took courses in finance; the investment course at Harvard was dubbed “Darkness at Noon,” because the university administrators allocated it the unpopular lunchtime slot in order to save classroom space for more popular subjects. The trustees at the old investment institutions were compensated by the volume of assets under management rather than by a performance fee, and they reached decisions by committee. Jones’s method broke the mold. It was each stock picker for himself; it substituted individualism for collectivism and adrenaline for complacency. Even in the 1960s, when Jones’s enterprise had grown big enough to have half a dozen stock pickers on its payroll, he continued to cultivate a Darwinian system. He convened remarkably few investment meetings because he found committees intolerably tedious.48 Instead, he allotted each in-house manager a segment of the partners’ capital, laid down the desired market exposure, and left him to invest the money. At the end of each year, the managers who performed best were also the best rewarded.

  You could see the results in the way the Jones men operated. In the Wall Street of the 1950s and 1960s, information did not reach everyone at once: There were no blast e-mails from brokers, no instant analysis from cable TV squawkers. In this environment, the investment team with the most hustle could beat out sleepier rivals; and the Jones men hustled hardest. The model portfolio managers rushed to call in hot ideas, and the in-house segment managers worked the phones, scrambling for the gossip and insights that would put them ahead of their competitors. Even in the 1960s, when Wall Street finally shrugged off its postcrash stupor, it was surprising how easily sheer diligence could set a man apart. Alan Dresher, one of the Jones stock pickers, had the idea of going over to the Securities and Exchange Commission offices to read company filings the moment they came out. The extraordinary thing was that he was all alone. The rest of the Street was waiting for the filings to arrive in a bundle from the post office.

  The linking of compensation to results was the key to Jones’s formula. When a broker passed a stock tip to a normal mutual fund, there was no certain connection between the quality of the tip and wh
at the broker would be paid for it. For one thing, the mutual funds lacked Jones’s system for tracking how stock recommendations turned out. For another, mutual-fund companies paid out thousands of dollars to salesmen who brought in investors’ capital, leaving little money over to reward excellent research. Jones, on the other hand, was meticulous in paying for good research ideas, and he paid handsomely.49 A young broker could see his salary double if the recommendations in his model portfolio generated profits.50 Meanwhile the funds’ performance fees were divvied up among Jones’s in-house money managers according to whose segment did best, and Jones devised two further ways of sharpening incentives. Each year successful segment managers were given extra capital to manage, which increased their chances of generating profits in the coming year and so earning a large bonus; unsuccessful managers received less capital to play with. And in another innovation that anticipated the hedge funds of later times, Jones required his partners to have their own capital in the funds, so that their wealth as well as their income was riding on their performance.51

  Without realizing the significance of what he was doing, Jones had created the competitive multimanager structure that has been used to great effect by later generations of hedge funds. As we shall see in chapter three, the same structure was reinvented in the 1970s by a firm in Princeton, New Jersey, and later dozens of hedge funds came to use it. But in the 1950s and 1960s, the combination of Darwinist individualism and top-down risk control was almost unique to Jones, and this gave him a powerful advantage. The market may be efficient, in the sense that information is reflected in prices to the extent that existing institutional arrangements allow. But Jones blew up those institutional arrangements, scrapping staid committee meetings and paying people to perform. Thus did he create the edge that brought in serious money.