Big money

(Update:  Edward Lampert of ESL Investments, the hedge fund manager who was behind the Kmart-Smears merger, took home $1.02bn last year (Financial Times, 28 May).) Last month Institutional Investor's Alpha magazine reported that the average pay for the top 25 hedge-fund managers was $251 million in 2004. Clifford Asness, by contrast, made a mere $50 million in 2003.

The man generally credited with coming up with the first [hedge fund] was a former Fortune magazine writer named Alfred Winslow Jones, who hung out his shingle in 1949 with $100,000 in capital and a new idea about making money in the market. He wanted to invest aggressively while still trying to protect investors' capital. These would seem to be contradictory goals, but here's how he went about it: Instead of simply buying stocks and hoping the wind was at his back, Jones also had a certain percentage of his portfolio on the ''short'' side -- that is, he was betting those stocks would go down. In doing so, he was limiting his fund's exposure the market, or as they say today, he was limiting his ''market risk.'' Since his shorts were likely to make money in a down market, they acted as protection -- a hedge! -- when his ''longs'' weren't doing well. Yet because Jones also borrowed money to buy more shares -- that was the aggressive part of his strategy -- when his stocks went up (as they usually did, for he was a very good stock picker), his returns were much higher than they might otherwise have been, despite having those shorts hedging his portfolio.

Jones was enormously successful; between May 1955 and May 1965, his fund returned 670 percent, according to Fortune magazine, nearly twice as much as the best-performing mutual fund. But Jones was also an innovator in other ways. Because he wanted complete freedom to invest as he pleased -- and didn't want to deal with regulatory restrictions -- he never let more than 100 wealthy investors into any of his funds at any one time; under the rules, this allowed him to avoid registering with the Securities and Exchange Commission, which regulated mutual funds. And he used a fee structure that called for him to get a whopping 20 percent of the profits if he made money. Mutual funds, by contrast, collected fees based on the size of the fund: the more assets under management, the more the fund company made, no matter how well (or poorly) the fund performed.

As hedge funds evolved, Jones's essential structure stuck. Hedge-fund managers made sure their investors were both wealthy and few in number; these days, the rules allow them to have up to 500 ''qualified'' investors and still avoid most S.E.C. regulation. [..] Of course they all adopted performance fees -- usually 20 percent, just like Jones. Hedge funds also became hooked on asset fees, just like their mutual-fund brethren. Today, when a hedge-fund manager says he charges ''2 and 20'' -- and many of them do -- he means he is taking a 2 percent asset fee as well as his 20 percent performance fee.
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What got lost over time was the idea that hedge funds were supposed to hedge.
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In fact, during the bull market, hedge funds became synonymous not with hedging but with the most extreme forms of investment risk-taking. Think for a moment about the hedge-fund giants who captured the public imagination in the 1980's and early 1990's -- George Soros, Julian Robertson, Michael Steinhardt and a handful of others. Those men were all swashbucklers who didn't want to control risk -- they wanted to embrace it.
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Since the end of the bull market, though, the idea of using hedge funds to actually hedge has been making a comeback. Some of the best hedge funds, like Maverick Capital and Lone Pine Capital (the latter is run by the aforementioned Stephen Mandel) use the classic A.W. Jones technique of having a certain percentage of their portfolios on the short side -- betting stocks will go down -- to limit their market risk.
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The computer model [Asness and his team] developed -- and which, after many refinements, they still use today -- grabs a wealth of up-to-the-minute data to identify the cheapest value stocks ( [Eugene Fama and Kenneth French] ), but only value stocks that seemed to have started on an upward swing (Asness). They buy a large block -- about 200 to 300 -- of those stocks. Then the model identifies stocks with the opposite characteristics: growth stocks whose rise is stalling. They sell an equally weighted amount of those stocks short. Unlike A.W. Jones, who had only a percentage of his portfolio on the short side, the Asness portfolio is perfectly balanced between longs and shorts. That is what makes his fund ''market neutral.'' It doesn't matter to him whether the market goes up or down. AQR makes money if its basket of value stocks beats its equally weighted basket of growth stocks -- the way the history suggests it should two-thirds of the time.
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This is not, however, a case in which a big idea eventually filters down to the rest of us. Theoretically, mutual funds could develop market-neutral funds like the one Asness runs; the regulations that limited how much short-selling a mutual fund could engage in were repealed years ago. But the fund industry has historically shied away from shorting stocks.

'The Quantitative, Data-Based, Risk-Massaging Road to Riches', NYT Magazine, 4 Jun (free, if you're quick)