Wall Streeters: The Creators and Corruptors of American Finance

Little in the first half of Alfred Winslow Jones’s life suggested that, over the second half, he would become the acknowledged father of the hedge fund. After following the family tradition of attending Harvard College, he set off not for a career in finance but instead hired on in 1923 as a purser on a tramp steamer. For the remainder of the 1920s, he hopped from job to job, living the life of a vagabond intellectual and—like many of the idealistic young men and women of his time—flirting with various socialist and communist ideologies.

By 1930, Jones had joined the U.S. Foreign Service and was dispatched to Berlin, where he observed the early rise of Adolf Hitler and the Nazi Party. His task was to write reports for the State Department on the condition of German workers, but Jones—slim and pleasant-faced if not remarkably handsome—was also living an adventurous second life as a result of his brief marriage to Anna Block, a German citizen and a social activist who introduced him to a group called the Leninist Organization. Since Block was a Jew, her well-being was of growing concern with the rise of Nazi political power, and she and Jones operated largely underground. After his marriage was discovered in 1932, he was forced to resign from the Foreign Service. But he remained in Germany and continued working sub rosa with leftist organizations, including the communist-inspired Marxist Workers School.1 His German experiences, along with his marriage, drew to a close in 1934, and he returned to the United States and enrolled as a graduate student in sociology at Columbia University. Yet his interest in European affairs and antifascism remained strong, and in 1937 he and his second wife—the former Mary Elizabeth Carter, who would remain his lifelong partner—spent their honeymoon in Spain as observers during that country’s civil war, meeting Ernest Hemingway and hitchhiking through the country with the great literary figure and social activist Dorothy Parker.

Soon after Jones returned to New York to continue graduate work at Columbia, he and Mary found another venue for their social justice instincts, this one in Akron, Ohio, the industrial heartland of America. After many months gathering data from the city’s workers and citizens, Jones produced a PhD dissertation dealing with social class and attitudes. Reworked in 1941 into a book titled Life, Liberty and Property, the text was for a time a standard part of the sociology curriculum and also led to his employment as a writer for the affiliated Time and Fortune magazines, where his first assignment was the creation of an abridged version of his dissertation for an article in Fortune. His assignments for the two magazines covered a wide variety of subjects, from Franklin Roosevelt’s economic policies to life at boys’ prep schools. His writing stints with the establishment magazines seemed to temper his left-leaning outlook; a statement attributed to him in Fortune called for “being as conservative as possible in protecting the free market and as radical as necessary in securing the welfare of the people.”²

Although his political views became more nuanced and encompassing over the years, as late as 1949 there was still little in Jones’s life or writing that would hint at his future as an investment mogul. The turning point came with a Fortune assignment to write a piece on “technical” investing. The article that appeared in the magazine’s March 1949 edition, “Fashions in Forecasting,” was a departure for him, since his previous articles focused on social and political topics rather than financial issues. But well over a half century later, the article still serves as a comprehensive survey of a style of investing that looks not at the fundamentals of stock market investing, as advocated by Benjamin Graham, but rather at movements in a company’s stock that have little to do with its underlying business or prospects. Most professional investors and academics view technical analysis as a form of investment voodoo, and in the article Jones refers to more sophisticated analysts who are fond of “directing a steady fine spray of ridicule at the technicians and lumping them together with spiritualists, Ouija-board operators, astrologers, sunspot followers, and cycle theorists.”3 Though Jones disavowed the usefulness of technical analysis, the research he conducted in putting the article together sparked his interest and also put him in touch with important contacts on Wall Street. The ultimate result, and the beginning of Jones’s life as an investor, was the creation of A. W. Jones and Company—an operation he called a “hedged” fund.

At the heart of Jones’s investing philosophy was the idea that one could reduce investment risk by combining two otherwise speculative strategies: selling stock short and purchasing stocks on margin. Short sales are inherently speculative, because the long-term trend of the stock market has always been upward, so over the long run, someone consistently bucking that trend by selling stock short is likely to be a loser. But in the short term, the technique can be quite lucrative. If Jones thought one of the stocks of the day, say International Nickel, was overvalued at $30 per share, he could borrow shares of that stock from an investment firm and immediately sell them on the New York Stock Exchange at that price. Then later, if he was right and the price of International Nickel fell to $25, he could buy the shares back on the exchange and return them to the investment firm from which he had earlier borrowed them—and pocket the $5 difference as his profit.

But short sales are also risky, because short sellers can lose an unlimited amount of money if the price moves up instead of down. If Jones had been “long” International Nickel—that is, if he purchased the company’s shares rather than selling them short—his potential loss would be limited to the $30 price he paid for them. In other words, if the company went bankrupt and the shares became worthless, he would lose his $30 investment, but no more. With a short sale, however, there is no limit to the loss. If International Nickel moved up to $100 following a short sale at $30, Jones would eventually have had to “cover” his short sale, and if he did so by buying stock at $100, his loss would be $70. If the stock price moved up even more, the short sale loss would only grow larger.

Short sales also carried a stigma held over from the bear raids of the 1920s and 1930s. In those notorious transactions, a group of so-called operators established their short positions by creating downward pressure on common stock through coordinated sales. They then spread negative rumors about the company to encourage panic selling, which caused the price of the stock to fall even further and ensured that the short sellers would profit when they closed out their positions at lower prices. The stigma of short selling was made worse, perhaps unduly so, by Herbert Hoover’s allegations during his presidency that bear raiders were behind the stock market’s relentless downward slide in those years. As a result of the fears of market manipulation by short sellers, an “uptick rule” was made part of the Securities Exchange Act of 1934, requiring that stocks could be sold short only at a price higher than the previous trade in the stock; that is, on an “uptick.” The idea, of course, was to halt the downward momentum of a falling market and to make bear raids and other market manipulations more difficult. (The SEC removed its uptick rule in 2007 as one of the deregulatory movements of the time, only to reestablish the rule in a modified form in 2010 following the financial crisis that occurred in the interim.)

Jones’s key insight was to recognize that because short sellers benefit from falling stock prices and margin buyers benefit from rising stock prices, the two practices can be combined to effectively hedge against the normal ups and downs in the market. The investment strategy that Jones conceived called for assembling a portfolio of stocks that were judged to be undervalued and attractive for purchase, along with other stocks that were judged to be overvalued and sold short. The relative size of the two portfolios would vary depending on the extent to which Jones held a bullish or bearish view of the overall market. But Jones’s investment strategy called for a leveraged long position that was consistently greater than the short position, so the “net hedged” position of the fund was almost always net long.

Operating a fund that hedged its long and short positions—Jones would always refer to a “hedged” fund rather than the generally accepted “hedge” fund designation—was the central idea that led to the founding, in 1949, of A. W. Jones & Company. The initial contributions to the fund, all from individual investors, totaled $100,000. Jones, who was then just a year shy of his fiftieth birthday and not a rich man, contributed $40,000 of the founders’ equity, with friends and academic colleagues providing the remaining $60,000. Most of his coinvestors were intellectuals—including individuals he met during his Spanish Civil War efforts, during his flirtation with Leninism, and in connection with settlement house work4—and by no means financial sophisticates. But they were very lucky. Using Jones’s long-short strategy, their investments grew nearly fiftyfold in seventeen years, turning this fortunate group into wealthy individuals in less than a generation.

Meanwhile, very few people, even those working on Wall Street, had ever heard of a hedge fund. But that changed after an article titled “The Jones Nobody Keeps Up With” appeared in the April 1966 issue of Fortune. Chronicling the success of Jones and his initial partners, Carol Loomis wrote what became one of the most influential sentences in the history of financial journalism: “Not quite all of the original $100,000 has been left in the partnership, but if it had been it would today be worth $4,920,789 (before any allowance for the partners’ taxes).”⁵ The Fortune article led to a spate of follow-up pieces in other journals that trumpeted the success of the A. W. Jones funds—A. W. Jones & Company was joined by A. W. Jones Associates in 1961—and also made prominent mention of Jones’s unlikely social service background and liberal philosophies. He became known as a financial hippie.⁶

With the news of Jones’s success out, the floodgates of the hedge fund business opened. With the extraordinarily enticing prospects for investors and the equally enticing 20 percent performance fee that had become standard for running the funds, there was no shortage of organizers ready to bring the hedge fund concept to wealthy investors clamoring for the product. New funds sprang up right and left to soak up the demand. In addition to the “Jones children”—funds founded by former associates of A. W. Jones—many new funds were created in the Jones image.

Because hedge funds are private by design, and because there was no official scorekeeper in the early years, the number of Jones-style hedge funds that cropped up in the 1960s is notoriously difficult to calculate. In a follow-up article written for the January 1970 issue of Fortune, Loomis reported that the number of funds following a Jones structure had grown from just a handful in 1966 to an estimated 150 four years later. By 1970, the two Jones funds had grown to approximately $80 million and remained the country’s largest hedge fund organization—but Loomis estimated that another $1 billion was under management in the various copycat funds.7

The success of hedge funds depended not so much on the long-short structure they shared, but rather on the ability of managers to select the appropriate stocks to buy long or sell short. On that score, Jones seemed nonpareil, providing jaw-dropping investment performance during the first two decades of his funds’ existence. With the advantage of hindsight, however, Jones’s phenomenal success seemed to rely on a mix of factors—a bull market, a generous use of leverage, loose regulations on commissions, and lax enforcement of certain insider practices—that would make his performance almost impossible to replicate today.

There is a well-known adage on Wall Street that counsels against “confusing genius with a bull market.” At the time Jones opened his initial hedge fund, the Dow Jones Industrial Average was around 200; by the end of the Soaring Sixties it was flirting with the 1,000 mark. But while Jones clearly entered the business at a propitious time, a fivefold appreciation in the Dow is far short of the nearly fiftyfold increase the Jones funds enjoyed. More explanation is needed.

While Jones referred to his new investment concept as a hedged fund, “partially hedged” is a more apt description. Far from an absolute hedge, in which an investment position is totally protected from both gain or loss in order to avoid risk, Jones consistently maintained a net long position, with the extent of that position dependent on how sanguine he felt about the prospects for the market. In the 1960s, common stock prices were moving upward, and Jones, like most investors, was bullish on the prospects for additional gains. Given that frame of mind, he offset the funds’ long positions with only a modest amount of short selling. Furthermore, he added to his long positions by borrowing—sometimes to the 50 percent maximum allowed under margin account rules—for the purpose of increasing his investors’ gains through financial leverage. In a rueful moment during the heady years of the 1960s, Jones second-guessed the very essence of his hedge strategy, suggesting that he could have done better for himself and his investors by just leveraging up his long positions and forgoing the short positions altogether.

The research analysts that Jones brought on board were among the stars of Wall Street, and one might wonder why they subjected themselves to a somewhat demeaning approach to their hiring and retention. The answer, of course, is compensation. With their frequency of trading, the Jones funds (like all of the new hedge funds that were springing up) generated a prodigious amount of commissions. Short positions in particular require constant tending, resulting in frequent adjustments and commission-generating trades from hedge fund operators. In addition, the adjustments to short positions were often balanced by offsetting adjustments to the fund’s long positions, with all the resultant trading leading to commissions for the fortunate brokerage firms that had an operation like A. W. Jones as a customer.

Jones appeared to concentrate on big picture matters such as the total mix of long and short positions and the degree of financial leverage used, with less of his time spent on the details of stock selection. And in fact, the funds’ business was not necessarily his top concern. He maintained an office at the A. W. Jones location near Wall Street, but he also had an office in midtown Manhattan where he oversaw his several not-for-profit social ventures, and he increasingly spent more time there than downtown.

While the stellar performance of the early Jones funds may have occurred while the boss was conveniently looking the other way, in today’s regulatory environment a hands-off management style would not excuse a laxity in complying with securities laws. The late Barton Biggs, a longtime fixture in Wall Street’s research community, credited his early success in the investment business, including the partnership he was awarded in E. F. Hutton as a young man, to the large amount of commissions he generated from A. W. Jones portfolios. Yet in later years Biggs would gratuitously defame his onetime employer, saying, “Basically Jones used commissions to develop an informational advantage and hired smart young guys to exploit it.” Hinting at a fundamental illegality in Jones’s methods, he continued with a reference to a future New York attorney general and an inveterate Wall Street foe: “Fortunately, Eliot Spitzer was still in diapers.”8

Whatever Biggs’s later criticisms of the Jones approach (and presumably his own profitable embrace of its purported front-running modus operandus), he was one of the first to break away and create his own Jones-style fund—one of the so-called Jones children. In 1965, he and another Jones acolyte, Dick Radcliffe, left E. F. Hutton and A. W. Jones to form Fairfield Partners. They also left the confines of Wall Street, locating Fairfield Partners in Greenwich, Connecticut, where they both lived. Other funds soon followed, settling in Greenwich partly for the lifestyle and partly because Connecticut had fewer reporting requirements for financial firms than did New York. The city would soon become the capital of an emerging hedge fund industry.

Fairfield Partners was just the second breakaway hedge fund formed by former employees of A. W. Jones, with City Associates being the first. And there would be more defections to follow as the hedge fund business exploded. Some managers were simply bitten by the entrepreneurial bug and wanted to go it alone and capture more of the lucrative fees for themselves; others were essentially forced out through Jones’s policy of reducing or eliminating the allocation of funds to low-performing managers. Still others left due to personal differences with Jones—and no wonder. Intellectual by inclination, politically to the left, and at least ostensibly more passionate about social justice than money, he had a different mind-set from the typical Wall Street analyst. He was also aloof in attitude and physically removed from the day-to-day matters of his fund. Rather than socializing with his portfolio managers and traders, he was more likely to be found at his midtown office, or on a social mission to a third world country, or at work with one of his several philanthropic projects. His high-mindedness was resented as much as it was admired, with Biggs for one writing him off as a “wealthy, snobbish, pretentious man.”9

However, any exodus of talent from the A. W. Jones funds in the late 1960s was not cause for great alarm. There were few rules on conflicts of interests between research analysts and their customers, and there was no shortage of analysts who were willing to swap their proprietary investment ideas for hedge fund–generated commissions. Neither was the explosion of rival funds a problem. After the news of the concept began to spread, whether through articles such as those in Fortune and the Institutional Investor or just through conversations among well-heeled investors, the demand from willing new limited partner investors far outstripped the supply of hedge funds for them to invest in.

The exponential growth in the number of Jones-like funds legitimizes Jones’s fatherhood of the hedge fund concept. Some have suggested that other fund managers who took simultaneous long and short positions, including John Maynard Keynes, were the true hedge fund progenitors. Warren Buffett, in fact, maintains that Benjamin Graham, whose Graham-Newman fund predated that of Jones by about twenty years, has the rightful claim to hedge fund fatherhood. Graham, before Jones, made liberal use of both short selling and leveraged long buying and, just as important, may have pioneered the 20 percent performance fee for hedge fund management. (Jones justified the 20 percent fee to his investors based on the rather belabored explanation that it mirrored what Phoenician seafaring captains received from their investors upon arriving home from a profitable voyage.) Whether pioneered by Graham or not, it seems likely that the performance fee—now standard for private equity and venture capital funds as well as hedge funds—had been the arrangement well before the A. W. Jones funds came on the scene. All that acknowledged, Jones’s 1949 conception of a hedge fund was the kernel from which the many look-alike funds emerged.

For Jones, who was turning seventy at the time, the monumental losses caused him to rethink the fundamental operating philosophy of hedging and to castigate himself for his lack of proper stewardship on behalf of his investors. Caught up in the euphoria of the 1960s, he had occasionally let his funds operate, through financial leverage, with a long position in excess of 100 percent; that meant that the leveraged long positions had overwhelmed a sparse use of short-sale hedges.¹¹ And since leverage is a double-edged sword, when the lofty stock prices of the 1960s fell to earth in the 1970s, the Jones investments suffered even more than the market averages.

In response to the funds’ large losses, Jones cut back on his outside pursuits and became fully engaged in overseeing the funds’ business. That closer oversight included a return to more balanced long-short positions, but by the time Jones and his managers stepped in to correct matters, short positions were hard to find, and the damage could not be undone. Many of his limited partners were friends and academics with modest wealth, and in his 1970 annual report to the funds’ investors he sought to reassure and apologize to them, writing, “Each money manager is now fully aware of the necessity of running his segment as though the typical Limited Partner were retired and had all of his capital, say $500,000, invested in our business.”¹²

Throughout the sagging stock market of the 1970s—the Dow Jones Industrial Average, which briefly closed above 1,000 in 1972, finished the decade below 800—the hedge fund business languished. The A. W. Jones funds managed to limp along during those lackluster years, along with a diminished group of other surviving funds, but their total assets under management fell toward a vanishing point. The various multi-billion-dollar estimates of the combined hedge fund assets in the 1960s were reduced to a fraction of that amount in the 1970s. One 1977 estimate put the total at just $250 million, and Jones said of the hedge fund industry, “I don’t think it is going to be a big part of the investment scene as it was in the late 1960s.” And, in an opinion that would prove to be highly inaccurate, he offered that “the hedge fund doesn’t have a terrific future.”13

But Jones’s gloomy outlook for his business did prove correct for the short term. His funds continued to struggle during the desultory years of the late 1970s and early 1980s, a time when many of his erstwhile competitors folded their operations altogether. By 1984, when Jones was well into his octogenarian years and devoting more of his remaining energy and time to social causes, A. W. Jones converted into one of the hedge fund industry’s early “fund of funds.” Rather than hiring research analysts to evaluate companies and pick stocks for long or short positions, the firm sized up other hedge funds and picked a handful considered to be run the most profitably and prudently.

At the time of its movement out of the stock-picking business and into the fund advisory business, A. W. Jones was under the management of Jones’s son-in-law, Robert Burch III. Earlier in his career, Burch had been at the old-line investment firm of Kidder, Peabody & Company, and, while there, developed a close relationship with future hedge fund manager Julian Robertson. It proved to be a fortunate relationship for both men. For Robertson, it led to highly enlightening meetings with the elderly Jones, who was happy to tutor him on the hedge fund business; for Burch, it led to one of the best decisions A. W. Jones company would ever make: a $5 million allocation of A. W. Jones’s remaining assets under management to Robertson’s newly formed Tiger Management. The Tiger hedge funds would be as celebrated in the 1980s and most of the 1990s as the A. W. Jones funds had been in the 1950s and most of the 1960s—and as a result, Tiger’s success revived the fortunes of many of Jones’s investors.¹⁴

Like Jones, Robertson went into the hedge fund business late in his career and presided over two decades of extraordinary investment success. In running Tiger Management, he adhered to the long-short investment approach that Jones had pioneered, but with a vastly different management style and personality. Where Jones was a reserved intellectual who rarely fraternized with his portfolio managers and analysts, North Carolina–born Robertson cast a Southern charm over everyone he met. He socialized easily with his employees and projected a swashbuckling approach to investment selection that masked a well-reasoned investment philosophy and thorough research.

Whatever their differences, Robertson, like Jones, produced spectacular results for his early investors. Tiger Management’s initial limited partners enjoyed investment returns from the start of the fund in 1980 through its peak in 1998 that averaged almost 32 percent per year. In all but a few years, Tiger Management far outperformed the S&P 500, which was growing at a rate of “just” 12.7 percent during that happy era for stock market investors.15 In dollars, that meant that an initial limited partner who contributed $100,000 to Tiger Management in 1980 would have seen his investment grow to about $14 million eighteen years later.

And just as the Jones children accounted for much of the growth of the hedge fund business in the 1960s, scores of “Tiger cub” funds sprang up in the 1990s. Some of the cubs were formed by defectors from Tiger Management, but just as many were formed with the blessing—and sometimes financial seeding—of Robertson himself. In addition to the direct descendant cubs, Tiger Management’s success spawned a second wave of imitator hedge funds. By the turn of the millennium, hedge funds had become a powerful new “asset class.” With hundreds of new entrants, assets under management in hedge funds soared past the half-trillion-dollar mark, invalidating Jones’s pronouncement twenty-some years earlier that the time had come and gone for hedge funds.

What fueled this growth and reenergized the hedge fund business? Much was due to the entrance of institutional investors into the market, most notably large pension funds whose managers were failing to produce sufficient investment returns to adequately fund their plans and were seeking outsized returns from hedge funds to catch up. Once the province of wealthy individuals, by 2000, pension plans—along with university endowments, foundations, and other adventurous institutional investors—made up close to half of the hedge fund investor base.¹⁶

At the same time, the nature of hedge fund investing had strayed far from the relatively simple long-short operation that Jones conceived. Today, hedge funds embark upon an ever-widening variety of strategies, including: macro, investing in bonds and currencies in anticipation of profit from global trends; directional, taking “opportunistic” positions, with or without a hedge, in what are considered to be incorrectly valued securities or special situations (a Graham-Newman approach); and convergence trading, acting on the perceived misalignment of securities with the expectation of a profitable self-correction of the prices (Long-Term Capital Management’s ill-fated strategy).

And, of course, the ultimate test of the advertised market neutrality of hedge funds—their ability to avoid market risk through hedging—occurred during and after the financial crisis of 2008, when the average hedge fund did little to fulfill a risk-avoidance mission or justify its lofty fee schedule. Hedge funds, in the aggregate, performed marginally better than the overall stock market during the depth of the 2008 market swoon. But a review of their performance that includes the years immediately leading up to and following the financial crisis shows that the hedge fund industry fared poorly. An ordinary investor who purchased the Bogle-conceived Vanguard Balanced Index Fund, with a 60–40 equities and bonds split—the kind of stodgy portfolio long favored by conservative advisors—would have incurred a miniscule management fee and netted a 3.5 percent annual return between 2007 and 2012. By contrast, the widely used HFRX Global Hedge Fund Index, which tracks 2,697 funds of all varieties, fell by an average of 2.2 percent during the same period.17

With their mediocre performance, the question persists as to why hedge funds, now managing over $2 trillion in assets, continue to play such an important role in the financial markets. The answer might be hope triumphing over experience. It is true that some hedge fund managers have been able to compile impressive, index-beating records. But there are few that stand the test of time—or a bear market. And those that do often become, like Julian Robertson, victims of their own success. In his case, he put together a string of impressive investment returns by finding smaller and less well-known companies to invest in, but as investors flocked to the Tiger funds there were simply not enough small, special situation opportunities into which he could funnel all of the money being thrown his way. As a result he moved away from his competency and experience and began to deploy vast amounts of money to “macro” plays involving ill-conceived and poorly executed bets on interest rates and currencies.

Just as individual funds can be victims of their own success, today’s hedge fund business may be suffering from its size and growth. With vast amounts of money searching for the elusive investment edge, it’s increasingly difficult to latch on to a piece of information or market phenomenon that has somehow eluded everyone else’s notice. That, coupled with the increasing strictures and controls on the use of privileged information, makes it highly unlikely that any one fund will come upon profitable trading schemes. Vanguard’s Bogle, who has observed some sixty years of futility in attempting to beat the market, sums it up well: “Reversion to the mean is a very powerful force. These hedge fund products might work in the short term, but I can absolutely guarantee that they won’t work forever.”18 And, in fact, the days of hedge fund products working for any period of time may be long gone, and there is little in the record to support the notion that hedge funds in the aggregate have ever provided a competitive return for their investors. A J. P. Morgan executive with a close view on the hedge fund industry calculates that “if all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good.”¹⁹

But for an investor who remains intent on participating in the hedge fund asset class, diversification through a fund of funds approach is a prudent strategy. It is also expensive, with most fund-of-funds managers layering another 1 percent fee for assets under management on top of the 2 percent management fee charged by the hedge funds they select—and a separate negotiated performance fee atop the underlying funds’ 20 percent performance fees. A knowledgeable fund-of-funds advisor, however, is able to steer around some of the pitfalls of hedge fund investing. And that circles back to the current version of A. W. Jones, a fund of funds that manages more than $300 million in assets and today operates under the direction of Jones’s grandson, Robert Burch IV.