Hedge Funds: More Money than God (Sebastian Mallaby)

Chapter 1: Big Daddy

Hedging is not a new concept. The first hedge fund, A.W. Jones & Co., was founded in 1949 by Alfred
Winslow Jones. AW Jones, a sociologist and financial journalist, was describes as the big daddy of
the hedge-fund era by New York magazines 1968 essay.

Indeed, in terms of fund management strategy, Jones was far ahead of his contemporaries.

In 1949, Jones wrote an essay titled Fashions in Forecasting attacking then traditional standard,
old-fashioned method of predicting the course of the stock market. He argued that traditional
forecasting methods failed to properly capture much of what was going on. There were instances
when stocks had shifted sharply in the absence of changed economic data.

Instead, he believes that stock prices were driven by predictable patterns in investor psychology.
Money might be an abstraction but it was also a medium through which greed, fear and jealously
expressed themselves. Money was a barometer of crowd psychology. Hence, a rise in the stock
market will generate investor optimism, which in turn generates a further rise in the market, which
creates a feedback loop that drives stock prices up. The trick then is to bail out at the moment when
the psychology turns around, when prices reach unsustainable levels. Given this, there will then be
instances where some stocks may end up overvalued while some may be undervalued.

Long and Short

Joness method involves a combination of long and short strategies. In a bullish market, Jones did
not merely put 100% of his capital into stocks. Instead, he borrowed so that he could put 150% of his
capital into stocks. This is his long position. At the same time, to reduce his market exposure, he sold
stocks short borrowing shares from other investors and selling them in the expectation that their
price would fall, at which point they could be repurchased for a profit.

Jones provided an example demonstrating the magic of his method in a prospectus inviting
investors. Suppose there are two investors, each with $100,000. Suppose that each is equally skilled
in stock selection and are both equally optimistic about the market. The first investor, operating on
conventional fund-management principles, puts $80,000 into the best stocks he can find while
putting the remaining $20,000 into safe bonds.

The second investor, operating on Joness strategy, borrows another $100,000, giving him a total of
$200,000. He invests $130,000 into good stocks and $70,000 into bad ones. This means that his long
position is $130,000 while his short position is $70,000. His net market exposure is then $60,000. In
comparison, the first investor has a net exposure of $80,000.

At the starting point then, Joness strategy gives the second investor a larger capital to play with,
with a lower market exposure.

Suppose then the stock market index rises by 20%. Since both investors are good at stock selection,
their stocks beat the market by 10 points, resulting in a 30% rise. The shorts turn out well as well,
and only rises by 10%. The result will be as follows.

Traditional Investor Hedged Investor

30% gain on $80,000 = $24,000 30% gain on $130,000 = $39,000
10% loss on $70,000 = $7,000
Net gain = $24,000 Net gain = $32,000
Suppose the stock market index falls by 20%. Since both investors are good at stock selection, their
stocks beat the market my 10 points. The long position then only falls by 10%. The short position
however, results in a 30% gain.

Traditional Investor Hedged Investor

10% loss on $80,000 = $8,000 10% loss on $130,000 = $13,000
30% gain on $70,000 = $21,000
Net gain = - $8,000 Net gain = $8,000

In sum, the hedged fund does better in a bull market despite the lesser risk it had assumed. And in a
bear market, the hedged fund does better because of the lesser risk it had assumed.

Stock volatility

Shorting on its own does not necessarily provide a hedge. Buying $1,000 worth of inert stock and
shorting $1,000 worth of volatile stocks is not a proper hedge. If the market index rises by 20%, the
inert stock might only rise by 10% while the short position might rise by 30%, resulting in a net loss.

Jones recognised the significance of stock volatility and incorporated the values into his strategy.
However, the velocity of a stock does not indicate whether it is a good investment. Rather, the
overall portfolio needs to be adjusted to accommodate the volatilities so as to create a proper
hedge.

Jones called the volatility of the stocks velocity. He measured the price swings against the
movement of the Standard & Poors Index. Suppose Company As swing is 80% of the market
average. The velocity of Company As stock would be 0.8. Assuming Company B has a velocity of
1.96, a fund with a neutral exposure position will be as such.

We buy We sell short

245 shares in Company A at $50 = $12,250 100 shares in Company B at $50 = $5,000
$12,250 x 0.8 = $9,800 $5,000 x 1.96 = $9,800

By paying attention to the velocity of the stocks, Jones was controlling risk. By balancing the
volatility of his long and short positions, Jones reflected his insight that the risk of a portfolio
depends on the relationship of its components.

Alpha and Beta returns

Skill-driven stock picking returns are known as alpha, whereas passive market exposure returns
are known as beta. Jones further refined his strategy by incorporating this differentiation. For
instance, suppose the long position of $130,000 went up by $2,500 when the stock market index
rose by 1%. This would mean that the beta is $1,300 and the alpha is $1,200.

In defence of shorting

Before Jones, shorting was a frowned upon. This was something Jones found irrational. Indeed, the
successful short seller performs a socially useful regulatory function. By selling overvalued stocks
(shorting), the seller dampen bubbles as they emerge. By later repurchasing the same stocks as the
price falls, he can provide a soft landing. The short seller is then moderating market gyrations.

The hedge fund manager, who goes long and short for undervalued and overvalued stocks
respectively, contributes to correcting market inefficiencies.