While hedge funds have been in the limelight in the last two decades, their origins can be traced back much further to early 1930s. Karl Karsten, an academic, first summarized the key principles of running a hedge fund in his book Scientific Forecasting in 1931. He also created a small fund and invested his own savings and money from his colleagues to test his hypothesis; though this fund delivered huge positive returns, it was not open to public for investment.
The credit for creating the first hedge fund open for investment goes to Alfred Winslow. Back in 1949, Alfred set up A.W. Jones & Co. (the fund) as a general partnership. While majority of the money ($60,000) came from public, he invested $40,000 of his own money also in the fund.
The fund followed what is now known as the long-short equities strategy. Essentially, he hedged his long investments in supposedly undervalued stocks by short selling stocks believed to be overvalued. Through this combination of going long on some stocks and short on others, he tried to minimise market risk. He also used leverage to maximise returns. In 1952, he altered the structure of his fund from general partnership into a limited partnership and added 20% performance fees on realised profits. However, he did not charge any asset management fees. In short, back in 1952, Alfred developed a template for hedge funds, used even today.
While Alfred’s fund delivered staggering returns to its investors, it operated in relative obscurity till Fortune Magazine published an article on the fund titled "The Jones' That Nobody Can Keep Up With". The article highlighted Alfred’s investment strategy and outperformance vis-à-vis all other mutual funds.
By 1968, there were around 140 hedge funds in USA. Many prominent fund managers also launched their hedge funds including Michael Steinhardt (1967) and George Soros (1969)) during this period. As the hedge funds grew, they started deviating from Alfred’s strategy. Instead of hedging their positions through short-selling, they took more long positions with leverage. This led to heavy losses in 1969-70. In the following bear markets of 1973-74, many hedge fund houses shut shop.
Over the next two decades, the hedge fund management industry grew albeit slowly. From 1975 to 1982, as the stock market moved sideways, the number of hedge funds started increasing gradually. The industry came again in limelight in late 1980s as Julian Robertson's Tiger Fund made headlines for his stellar performance and George Soros (Quantum Fund) made his big killing by shorting British Pound. However, these fund managers used techniques and strategies different from Alfred - while Julian’s fund used derivatives, George employed currency trading.
Over the next two decades, hedge funds grew in number. While there were some hiccups along the way such as bankruptcy of Long Term Capital Management (1998) and dotcom bubble and the 2008 financial crisis, there were 9754 hedge funds by 2017 according to research firm Hedge Fund Research (source: Investopedia).
While globally, hedge funds typically represent around 10% of investor portfolio, they are still at a nascent stage in India. Classified as category 3 AIF, the hedge fund regulations were formulated by SEBI in 2012. In the seven years since then, category 3 AIFs grew at a fast pace to reach investments of Rs. 30,802 crore (as on March 2019, source: SEBI).
From their humble beginnings in 1949, hedge funds have grown to become a massive industry with US $3011.3 billion in assets till March 2019 (Source: Barclay’s Hedge). The flexibility to employ exotic investment strategies, low regulations and ability to take concentrated bets have helped hedge funds generate strong performance and attract investors.