High-Frequency Trading, Quants, Derivatives: Seventy Years After the First Hedge Fund, Finance Has Become Incomprehensibly Complex

"Unfortunately, the more complex the system, the greater the scope for error." — George Soros

In 1949, Alfred Winslow Jones — a former U.S. diplomat in Germany and an editor at Fortune magazine — set up a fund under his own name with $100,000 in assets. Anyone who bought in handed Jones and his team 20% of each year's gains.

On the Wall Street of that time, an investment fund that charged a performance fee at all was an oddity, let alone one that charged 20%.

Most Americans back then traded stocks themselves, much as they do in China's A-share market today. Those who didn't handed their money to asset managers like Fidelity and Prudential, who charged on assets under management rather than on gains, usually around 2%.

Wall Street after the Great Depression and the Roosevelt era was far quieter and simpler than it is now. The job of Fidelity and most of its peers was to preserve a client's principal, not to grow it. Few undergraduates or graduate students studied finance; Harvard scheduled its investment course at noon so the classroom could be freed up for more popular subjects.

The columnist Sebastian Mallaby writes in More Money Than God that Jones explained his cut to outsiders as a descendant of an ancient Phoenician business custom: a ship's captain could keep 20% of the profit from a successful voyage as his reward, and the backers divided the rest. It was a way to motivate investors. Why 20% and not 22% seems to have no particular reason behind it.

Along with the 20% came Jones's investment strategy — hedging.

To hedge is to make several different investments at once so they offset each other's risk. Jones would buy undervalued stocks and short overvalued ones at the same time, hoping for this: when the market rose, the gains on the good stocks would outweigh the losses on the bad ones; when it fell, the profits from shorting the bad stocks would cover the losses on the good ones.

Wall Street at the time did not much like risk. It did not short stocks, and it did not use leverage to multiply returns. Jones's fund did both.

By 1968, Jones's firm had returned a cumulative 5,000% — a little better than Warren Buffett, the "Oracle of Omaha," over the same years.

Over that stretch, the features of the Jones fund — short-selling, margin trading, strategic trading, performance fees — hardened into the standard for a new industry: hedge funds. A 1968 Federal Reserve tally found about 140 hedge funds in the United States.

Seventy years on, there are at least 10,000 hedge funds worldwide, managing close to $3 trillion. The leaders among them include Bridgewater Associates, AQR Capital, Tiger Management, and Renaissance Technologies.

Global financial markets are today worth more than $100 trillion. BlackRock, the largest asset manager, runs more than twice as much money as every hedge fund combined.

But hedge funds can no longer be brushed aside: they use about seven times leverage on average, so the capital they actually put to work exceeds $20 trillion. Some specialize in equity hedging. Some bet on corporate mergers and pocket the premium on the share price. Some wait for companies to go bankrupt and make their money trading the debt. Macro hedge funds run more complicated strategies still, watching interest rate trends, big capital flows, shifts in government policy, and international affairs all at once before they set their trades.

Along the way, the whole financial market took on the complicated trading logic of hedge funds. That became one of the foundations for the elaborate derivatives that followed. Some institutions built financial contracts that had never existed before, meant to make markets more complete; in theory, investors could use these new instruments to allocate assets and manage risk more efficiently — airlines trading crude oil futures, tire makers trading rubber futures, investment banks trading credit default swaps (CDS).

In 2009, after the financial crisis had passed, former Federal Reserve chairman Paul Volcker said "the ATM was the only useful banking innovation of the past 20 years."

A decade on, financial markets are more complex, and more prone to piling up systemic risk.

Seventy Years of Hedge Funds: From $100,000 to $3 Trillion

There is still no legal definition of a hedge fund. According to the minutes of a 2003 hedge fund roundtable published by the U.S. Securities and Exchange Commission, regulators treat "hedge fund" as a manner of speaking: in theory, any partnership that is professionally managed, raises money privately, charges a performance fee, and runs complex investment strategies can be called one.

The A.W. Jones & Co. partnership that Alfred Jones set up in 1949 is generally counted as the first hedge fund. It started with $100,000 and at its peak managed more than $100 million.

Unlike most people in finance, Jones never went to business school and never took a degree in finance or mathematics. He had not spent a single day working in the Wall Street financial industry.

His Harvard doctoral dissertation, Life, Liberty and Property, surveyed how different social classes thought about property. After graduating he served as a U.S. diplomat and ran secret errands for anti-Nazi groups. For a while he worked on a tramp freighter with no fixed route and no fixed schedule.

From the 1940s on, Jones wrote for Fortune. Drawing on his years of empirical sociological research, he published a series of articles on how to forecast swings in the stock market. Jones believed investor sentiment showed up in trading volume, and that when picking stocks this data supplemented a listed company's operating results. In the end, he thought, all of these factors turned up on the stock chart.

None of these ideas was new. But the 1929 Depression still had a grip on American financial markets: regulators restricted the movement of capital and levied a steep capital gains tax, and investors treated risk control as the first thing that mattered. Most professional investors before Jones bought a stock when it was undervalued, sold it before they expected it to fall, and held a lot of cash.

Jones instead bought undervalued stocks and sold overvalued ones, the two often in the same industry or otherwise correlated. He did this because he thought he could pick good stocks but could not time his entry. If the market fell after he bought a good stock, the profit on shorting a bad one might cover the loss, leaving him ahead overall.

To stay out of reach of the SEC and of a 91% capital gains tax, and to keep the fund's portfolio as free and flexible as possible, Jones's firm took the form of a general partnership. To draw investors in and keep his staff motivated, Jones also decided against a management fee and took a 20% cut of performance instead. Later hedge funds added a 2% management fee on assets. This "2-and-20" pairing became the convention of today's hedge fund industry.

Mallaby writes in More Money Than God that where Jones got these ideas is unknown; they may go back to Benjamin Graham, Buffett's teacher. Graham's investment partnership looked like a hedge fund in many ways: it shorted stocks, used leverage, and charged performance fees. Leverage and short-selling, it is worth noting, are also blamed for the 1929 crash.

Besides beating Buffett between 1949 and 1968, the Jones partnership returned a cumulative 670% from 1955 to 1965, another tally shows, while the second-place fund managed "only" 350%.

By early 1968 about 140 hedge funds in the United States were copying Jones. A year later the estimate ran between 200 and 500, and nearly all the best performers were run by people who had once been stockbrokers at Jones's firm. This, The Economist noted, was when "hedge fund" finally entered Wall Street's dictionary; everyone wanted to work at one.

Fortune described Jones this way in 1966: we have reason to believe that the best-performing professional investment manager of recent years is a man who says little and shows himself rarely, named Alfred Winslow. New York magazine went further, calling hedge funds the embodiment of the spirit of the age and Jones their forefather.

But as Mallaby put it, "every great investor's edge is destined to disappear." Jones's firm lost its clients 35% of their money in the 1969-1970 crash, and the assets it managed shrank from more than $100 million in the 1960s to $35 million by 1973.

New hedge funds took up where he left off — George Soros's Double Eagle Fund, later renamed the Quantum Fund, and Julian Robertson's Tiger Management. They invested nothing like Jones's original idea of hedging away risk. Soros was good at reading the direction of the economy and made huge one-way bets with no hedging strategy at all.

The meaning of hedging had in fact changed. Making two related trades at once was no longer about avoiding risk but about using margin leverage to double the bet in one direction. Get the direction wrong and the loss doubled too.

Robertson's Tiger Management was far more old-fashioned by comparison. Wall Street then judged how long to hold a company on a 12-to-18-month horizon; Robertson's was three years. He called himself a committed long-term investor. In 1994 the S&P 500 rose 6.3%; Tiger rose 20.2%.

Then a mathematician and a computer scientist carried hedge funds into the age of computer algorithms.

David Shaw, a former Columbia University computer science professor, had worked at Morgan Stanley, where he helped build its automated trading operation. In 1988 Shaw set out on his own and went to Goldman Sachs for money, but did not get the number he wanted. Only after Paloma Partners put in $30 million did his fund begin operating, under the name D.E. Shaw.

Shaw and his team were good at using mathematical formulas to catch price gaps between derivatives. The gap on each trade was tiny, but the volumes were large, the borrowing was heavy, and the trades ran in milliseconds. One young man who worked for him became a D.E. Shaw vice president at 30, then moved to Seattle with a wife he had met at the firm and opened a website that sold books, called Amazon.

Jim Simons was a mathematician and code-breaker; his partner was a cryptographer too. They hired more physicists, computer scientists, and astronomers — but no economists — to find what drove volatility in a market that looked random on its surface. From 1989 to the middle of 2014, Renaissance Technologies averaged more than 70% a year, and in 2008 it came close to 100%.

Ray Dalio, the semi-retired founder of Bridgewater Associates, is now something of a celebrity. He writes books and blogs, and Principles has become a bible in investing circles. The reverence is no surprise: Bridgewater manages more money than any other hedge fund firm in the world, and its flagship All Weather fund rose 14.6% last year, beating all three major U.S. stock indices, and Buffett too.

When he was working flat out, Dalio often called his staff into a meeting titled "What's Going On in the World." He would cut an employee off the moment a judgment was not precise enough, then explain at length why. Dalio and Bridgewater run a macro hedging strategy; their traders buy and sell more than 100 different financial instruments a day, from Japanese bonds to London copper to North Sea oil.

The strong showing of these star funds cannot hide one fact: hedge fund returns as a whole have trailed the broad indices in recent years, and for three years running more hedge funds have closed than opened. The industry manages $3 trillion, but the 100 largest funds account for $1.6 trillion of it. Investors are also paying more attention to excessive management fees, secretive investment arrangements, and undisclosed cash positions.

Buffett and Bogle Already Showed That Hedge Funds, on Average, Trail the Market

Buffett has looked down on hedge funds and finance's complicated trading logic for a long time.

In the capital markets' famous ten-year wager, Buffett bet a hedge fund called Protégé Partners that from January 2008 to the end of December 2017 the S&P 500 would beat a portfolio of any five hedge funds it picked.

The S&P 500 ended up rising an average of 7.1% a year; the five funds Protégé Partners chose returned 2.2% a year. The fees those funds charged were far higher than those of passive index funds.

Buffett announced the "result" at Berkshire Hathaway's 2017 annual meeting. He also teased his opponent with a story about a monkey picking stocks.

There will always be professional investors, Buffett said, who post big short-term returns out of pure luck. If 1,000 fund managers had forecast the market at the start of 2007, at least one would have called the next nine years right. Among 1,000 monkeys, one might likewise look like an all-knowing prophet. But there is still a difference: nobody lines up to hand a monkey their money.

Jack Bogle, the recently deceased founder of Vanguard and the inventor of the index fund, saw the market much the same way. As far back as a college thesis he wrote in 1951, before hedge funds took off, he argued that the mutual funds of the day, once fees were deducted, did not beat the market average the way they had promised.

That was the principle he founded Vanguard on, though most mutual fund companies at the time found the idea repugnant. Bogle popularized index funds and pushed them hard, charging less than 1% a year.

In 2012 he told Jeff Sommer, the New York Times financial columnist: "My idea is simple. In investing, the return should be greater than the cost. Cost matters. So a smart investor uses low-cost index funds to build a diversified stock and bond portfolio, and sticks with it. They aren't foolish enough to think they can always beat the market."

On hedge funds, Bogle saw an industry of comings and goings, run by managers far smarter than himself — "but on average, they will eventually revert to the average." Like Buffett, Bogle believed these managers as a group could not beat the market forever; their performance would return to the mean in the end.

The hedge fund industry has proved both these long-term value investors right with its own record. From the 1990s until just before the 2008 crisis, hedge funds returned a cumulative 1,000%, against roughly 600% for the S&P 500. Since then hedge funds have gained about 70% in total, while the S&P 500 has risen 250%.

2018 was especially bad, the industry's worst year since 2008. Bloomberg's hedge fund database puts the average loss at 6%, behind the S&P 500.

Combining figures from Hedge Fund Research (HFR) and BarclayHedge, global hedge funds managed $2.87 trillion in 2018, down $186.7 billion from the third quarter. Over the year 552 funds opened and 580 closed — the third year in a row that closures outnumbered launches.

Several well-known funds — Pershing Square, Tudor Investment Corporation, Discovery Capital Management, Greenlight Capital and others — once held more than $10 billion each at their peak and have since shrunk to somewhere between $2.5 billion and $7.5 billion. John Paulson, who made more than $20 billion by betting correctly that the U.S. property bubble would burst, is now considering liquidating the fund that carries his name.

But the Whole Financial Industry Swelled — and Took Up the Hedge Fund Method

More and more people believe Jones's success owed a great deal to a long American bull market, and to a set of inequalities that worked in his favor and that he exploited legally and fully. After him, the frequency and complexity of financial activity and the number, size, and strategic variety of hedge funds fed on each other.

Jones started trading on borrowed money just as the aftereffects of the Depression were wearing off. In 1950, one American in 25 owned stock. Only 100,000 Americans had opened a pension account, and the country's mutual funds held $20 billion in all.

The shadow of the Depression was lifting. By 1960 one American in eight owned stock, and mutual fund assets had swelled to $50 billion. Wall Street was becoming New York's main street, and finance was no longer the course nobody wanted to take, shunted off to the noon slot. In the markets, trust banks known for savings and cautious investment had given way to investment banks. For that generation the Depression was distant history.

As Mallaby put it, "people believed that under the watch of the Federal Reserve and the SEC, financial storms would not return."

Yet in the bear market of 1970 the mutual funds were helpless, and so were the hedge funds. Most managers had copied the Jones partnership's performance fee and its leverage, but few used short-selling. The recession and oil crisis of the mid-1970s cost many hedge funds dearly; investors pulled their money out, and the industry's first two decades of prosperity ended.

The boom in finance itself did not stop. Since modern capitalism rose in the middle and later 19th century, finance has always grown faster than the real economy. But how much faster has varied greatly from period to period, and the rapid growth is really a post-1970s phenomenon. In the United States, it took 120 years, from 1850 to 1970, for finance to go from 2% of the economy to 3%. Between 1970 and 2009 it went to 6%.

One sign of that boom was governments, companies, and individuals taking on more debt. In developed countries, corporate and household debt went from under 50% of GDP to more than 100%. Financial institutions turned the deposits they took in into some multiple of that in loans, which flowed to businesses and households to fund spending or expansion.

Asset managers of every kind — hedge funds, pension funds, mutual funds — were expanding as well. Options, swaps, total return swaps: derivatives that not even every Wall Street banker understood began showing up on the exchanges of London, Frankfurt, New York, Hong Kong, and elsewhere.

The spread of financial engineering and computers in the 1980s suddenly gave a mass of derivatives, commodities, and securities a relatively common way of being priced. Gold, silver, and copper futures in London and Chicago, for instance, trade at different hours, in different currencies, in different units — and still their prices move together. So investors ran high-frequency trades by computer, chasing gaps out to the second and third decimal place. Almost every trade carried leverage, which meant $10,000 could become $1 million, or drop to zero in milliseconds.

These tools were no longer the property of hedge funds either. The financial industry had adopted the method hedge funds set out, completely.

By the time the subprime crisis broke, more than half the financial assets of banks such as JPMorgan Chase, Citigroup, Barclays, and Société Générale consisted of interbank lending contracts or derivatives, with counterparties that ran from bank to bank, and from banks to money market funds, hedge funds, and other financial institutions.

A Complex Financial Market Carries Risks No One Can Quite Name

In 1987, Tom Wolfe wrote a scene into his Wall Street novel The Bonfire of the Vanities in which a wife has nothing but scorn for the social value of her husband's bond trading. She tells her daughter that trading bonds is like passing around a cake that does not exist, over and over, picking up a few crumbs with each pass in the form of trading profits and fees. For most ordinary people, the idea that a great deal of financial trading is worthless is "almost self-evident."

Many economists say that active investors, hedge funds included, make markets more efficient. By buying what is undervalued and selling what is overvalued, they pull prices back toward reason until the mispricing is gone, and capital markets work better for it. In this telling, markets keep improving through a loop that reinforces itself.

The trouble is that in the real world markets are imperfect, information is incomplete, and people behave rationally some of the time and not at other times.

In a market this complex — so complex that its participants often cannot explain why a swing happened — risk becomes impossible to predict as well.

In April 2006, fifteen months before the crisis broke, the International Monetary Fund wrote in its annual Global Financial Stability Report that banks were dispersing credit risk to a broader and more diverse group of investors, "this has helped to make the banking system, as well as the overall financial system, more resilient... commercial banks today are less vulnerable to credit or economic shocks."

Around the same time, former Fed chairman Alan Greenspan pointed to the growing variety of derivatives as one of the things that made the banking system so resilient. Raghuram Rajan, the former governor of India's central bank, said of the previous four decades that the sharp transformation of the global financial system amounted to a revolution and had brought a great deal of progress: "we are moving toward a utopia where finance can accomplish anything."

Two years later, in 2008, the more resilient system and the healthier market collapsed. Governments spent taxpayers' money to rescue the markets, and the decade that followed brought a sharper split in wealth.

In the words of Adair Turner, former chairman of Britain's Financial Services Authority, these new financial technologies, compared with a plain banking system, wasted more credit and swelled the debt inside the financial system itself; once confidence in the market slips, those risks compound and finally set off a chain reaction.

A great deal of empirical work shows that the bigger and more complex the financial system, the higher the industry's income. Critics say finance has drawn off a huge share of the best talent: the world's trading floors are full of mathematicians, physicists, meteorologists, and engineers, giving their knowledge and skill to financial innovation and trading strategy instead of to scientific research and industrial innovation.

By the founding logic of hedge funds — a long-short combination that screens out risk — a market full of volatility should be a fund manager's dream. It is a chance for these financial geniuses to "catch the market's fleeting signals and earn returns far above average."

Swinging global stock and commodity prices in 2018, uncertainty about politics and monetary policy, trade friction between major economies: in theory these are exactly the conditions hedge funds need to make money.

What hedge funds turned in instead was their worst performance in a decade, because managers found that "when the swings are too violent, you can't make money off them either." Nor was it the first time volatility had hurt the industry. When the European sovereign debt crisis began spreading through global markets in 2011, hedge funds lost 2.1% on average.

Even the traders considered the most rational — machines — can shake a market violently through that very rationality. Trading models can tip billions of dollars of sell orders out in a few hundred milliseconds, and within seconds this purely machine-made panic spreads around the world. In February 2018, that is how global stock markets lost $1.2 trillion in a single day.

The machines are only executing, faithfully, the trading programs people wrote for them — and carrying a systemic risk that almost no one can get out of the way of.

On the subject of risk: every investor loves to talk about returns. Ask how much risk they took to get them, and most — including pension funds, which are widely regarded as the steadiest investors of all — would struggle to say.

Adair Turner said the new instruments do make markets more complete, but their effect on society is negative: "any tool that can hedge risk can also be used to gamble, which in turn deepens the market's complexity, its speculation, and its interconnection — and in the end some instrument or other will become the detonator of a financial market."

Cover image/M. B. M. on Unsplash