History of the Hedge Fund Industry

Alfred Winslow Jones is cited as creating the first hedge fund strategy in 1949. His thesis was simple but groundbreaking: he sought to separate two risks involved in investing in stocks by creating a market-neutral portfolio. The first, market risk, is caused by changing stock prices as a result of market influences. The second, the risk in specific equities, is created by factors individual to that stock.

Jones achieved market neutrality by buying assets he believed would rise in value relative to the overall performance of the market, and selling short assets whose price he expected to decrease. The performance of his portfolio depended on picking the correct stock, and not on the direction of the market, hence his portfolio was market neutral, or ‘hedged’ against market movements.

Jones created the first hedge fund product in 1952 when he added an incentive fee and converted his fund into a limited partnership. This was the first pooled investment vehicle combining a hedged strategy with leverage and a 20% fee.

Interest in hedge funds began to take off in the 1960s, following a 1966 article in Fortune magazine that highlighted the outperformance of Jones’s investment vehicle. The article revealed that Jones had outperformed the best mutual fund over the prior five years by 44%, even when fees were taken into account. After this, many new hedge funds were established, including Quantum Fund (advised by George Soros), which caused a stir in the 1990s when Soros was rumored to have earned $1bn and “broke the Bank of England” betting against the British pound.

In 1969, the first fund of hedge funds was created to allow investors access to a group of hedge funds through one investment vehicle.

The recession of 1969-1970 and the stock market crashes of 1973-1974 resulted in many hedge fund closures as the industry struggled against market risks. Jones’s fund itself lost over 10% more than the S&P in the 12-month period ending 31 May 1970. However, over the 34-year life span of his fund, Jones made losses in only three years. 

In 1975, Ray Dalio established Bridgewater Associates as a currency and bond advisory service for institutional investors. It was not until the 1990s that Bridgewater launched Pure Alpha and All Weather, the portable alpha strategies that are the largest hedge funds globally today. 

The hedge fund sector continued to evolve over the 1980s, with many funds experiencing extraordinary growth due to strong performance and increased interest from wealthy individuals and families. At the start of the decade, assets under management (AUM) were in the hundreds of millions; by the end, the largest funds were commanding upwards of $1bn each.

The changing markets of the 1980s provided many opportunities for hedge funds. The combination of an unconstrained investment style, the use of instruments to enhance leverage, and large movements in the currency and commodity markets generated huge returns for investors on the right side of the trade. The hedge funds of the 1980s could be characterized as small (with few employees) but generating immense returns; an image that still persists, even if the reality is not the case.

In 1980 Julian Robertson started Tiger Fund, a hedge fund which generated a large amount of attention. The fund launched with $8mn and at its peak was worth over £22bn, making it the largest hedge fund at that time (although the fund later collapsed in early 2000). The legacy of Tiger Fund has lived on, as a number of those employed by Robertson went out on their own, launching some of the top performing funds in the industry today; this group is nicknamed the ‘Tiger Cubs.’

Hedge funds grew and performed spectacularly in the 1980s, but it was in the 1990s that the sector really boomed. In this decade many dominant funds were launched, including Bridgewater Associates’ first hedge funds, Steve Cohen’s SAC Capital Advisors (today called Point72 Asset Management) John Paulson’s Paulson & Co., David Tepper and Jack Walton’s Appaloosa Management, and Daniel Och’s Och-Ziff Capital Management (now OZ Management). 

This era was defined not only by the emergence of superstar managers, but also by an explosion of new strategies within the hedge fund sector. The hedge fund universe evolved from products holding buckets of long and short equity positions to cover a broad group of asset classes and styles of investments. Arbitrage, macro, distressed investments, activism, and multi-strategy all became a key part of the hedge fund landscape in the decade. Explore the strategies in more depth here: Hedge Fund Strategies. 

Perhaps the biggest event of the 1990s was the near collapse of Long Term Capital Management (LTCM), which would likely have led to a global financial crisis had it not been bailed out by Wall Street and the Fed.

Hedge funds moved even further into the mainstream in the 2000s. After the dotcom bubble burst, institutional investors such as pension funds, insurance companies, and sovereign wealth funds made their first investments in hedge fund products. AUM rapidly expanded, reaching almost $2tn by 2008.

However, the GFC in 2008 proved challenging for hedge funds. Many funds closed following heavy losses, investors withdrew assets and, subsequently, AUM declined significantly.

One of the most significant events of the decade was the discovery and subsequent collapse of the giant Ponzi scheme run by Bernie Madoff. Although not strictly a hedge fund, the $65bn fraud led to fundamental changes in the way that hedge funds and other alternatives were monitored and controlled.

55% of the institutions tracked by Preqin made their first allocations to hedge funds between 2000 and 2010.

The 2010s brought about major changes in how the hedge fund industry was regulated. Previously, the sector had largely avoided regulation; for example, Jones avoided the requirements of the Investment Company Act of 1940 by restricting the number of investors in his limited partnership to 99 or fewer.

The Dodd-Frank Wall Street Reform and Consumer Protection Act came into effect in the early part of the decade in direct response to the GFC, leading to greater requirements for registering and reporting to the SEC. In Europe, the Alternative Investment Fund Manager Directive (AIFMD) forced hedge funds to upgrade their compliance and operational frameworks. The Volcker Rule, which prohibited banks from certain investment activities and their ownership of certain alternative asset funds, led to an influx of new funds as prop-traders (traders using the firm’s money instead of external funding) spun out of hedge funds. The net result of these and other regulations (e.g. MIFID II) was that barriers to entry and competition grew as the hedge fund sector professionalized and institutionalized.

Despite increased scrutiny from regulators, hedge funds rebounded well from the GFC, with industry assets exceeding $2tn again in 2011 and exceeding $3tn as of 2019. Even so, the sector was affected by negative perceptions of performance and fees over the latter half of the 2010s, and several high-profile investors (notably CalPERS – the US pension fund) pulled their investment.

The industry is still responding to regulation and an evolving investor client base. Gone are the days of the 1980s and 1990s when funds could operate in spare rooms with a laptop and phone. Today, hedge funds focus on providing a solution rather than a product, as managers work with increasingly sophisticated and discerning clients. To discover the assets under management in hedge funds by region in 2022, explore the map below.