More Money Than God_Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

  Jones was born in the ninth hour of the ninth day of the ninth month of 1900—a fact with which he would bore his family years later.6 He was the son of an expatriate American who ran the Australian operations of General Electric; according to Jones family lore, they owned the first car in Australia. A formal photograph from the time shows the three-year-old Alfred wearing a white sailor cap with a white jacket; on one side of him sits his father in a stiff, winged collar, on the other side is his mother in an elaborate feathered hat. After the family returned to GE’s company headquarters in Schenectady, New York, Alfred went to school there and followed in the family tradition by attending Harvard. But when he graduated in 1923, he was at a loss for what to do; none of the obvious career paths for a gifted scion of the Ivy League appealed to him. The Jazz Age was beginning its ascent; F. Scott Fitzgerald was conjuring the dissolute antiheroes of The Great Gatsby; slim, tall, with soft features and thick hair, Jones would have fitted into Fitzgerald’s world with little difficulty. But Jones had other ideas about his life. Having inherited the wanderlust of his father, he signed on as a purser on a tramp steamer and spent a year touring the world. He took a job as an export buyer and another as a statistician for an investment counselor. And then, after drifting aimlessly some more, he took the foreign-service exam and joined the State Department.7

  Jones was immediately posted to Berlin, arriving as America’s vice-consul in December 1930. Germany’s economy was in free fall: Output had shrunk 8 percent that year, and unemployment stood at 4.5 million. In the elections three months earlier, the little-known National Socialist Party had capitalized on popular fury, winning 107 seats in the Reichstag.8 Jones’s work brought him face to face with Germany’s troubles: He wrote two studies on the conditions of Germany’s workers, one dealing with their access to food and a second with housing. But his engagement with Germany became intense when he met Anna Block, a socialite and left-wing anti-Nazi activist. The daughter of a Jewish banking family, Anna was attractive, flirtatious, and resourceful: For a while she escaped Nazi detection by operating out of the maternity wing of a Berlin hospital; and years later, when she was involved in the Paris underground, she bet that she could bluff her way into the finest London hotel, equipped only with a cardboard box as her luggage. When Jones met Anna in 1931, she was working for a group called the Leninist Organization and bent on finding a third husband. Captivated by Anna’s heady mix of socialist engagement and bourgeois charm, Jones became the servant of her purposes, political and personal.9

  Jones married Anna in secret, but the union was soon discovered by his embassy colleagues. The breach forced his resignation from the State Department in May 1932, just a year and a half after joining. But his involvement with Germany did not end there. He returned to Berlin in the fall of 1932, operating under the pseudonym “Richard Frost” and working secretly for the Leninist Organization.10 The next year he represented the group in London, assuming the cover name “H. B. Wood” and seeking to persuade the British Labour Party, which was tinged with pacifism, to wake up to the need for military action against Hitler. The British authorities grew suspicious of Jones’s activities, all the more so when they discovered that he had attended the Marxist Workers School in Berlin, which was organized by the German Communist Party. “It is understood that Mr. Jones expressed an interest in communism while connected with the Foreign Service,” a State Department official wrote in response to an urgent query from London.11

  The German resistance to Hitler proved more romantic than practical. The same could also have been said of Jones’s relationship with Anna. The couple divorced after a few months, and Jones left London for New York in 1934, enrolling as a graduate student in sociology at Columbia University and marrying Mary Elizabeth Carter, a middle-class plantation girl from Virginia.12 But if Jones’s life seemed to be shifting into conventional channels, the shift was not complete. He maintained his connections to the German Left through the 1930s and early 1940s and may have been involved in U.S. intelligence operations.13 After his marriage to Mary, he set off in 1937 for a honeymoon in war-torn Spain.14 The newlyweds hitchhiked to the front lines with the writer Dorothy Parker. They encountered Ernest Hemingway, who treated them to a bottle of Scotch whiskey.

  THE DISINTEGRATION OF EUROPE THAT JONES HAD WITNESSED, first in Germany and then in Spain, was an extreme version of the turmoil in his own country. The America of The Great Gatsby had given way to the America of John Steinbeck’s The Grapes of Wrath; the Jazz Age had given way to the Depression. On Wall Street, the crash of October 1929 was followed by a series of collapses in the early 1930s. Investors fled the market in droves, and the bustling brokerages fell quiet; it was said that you could walk the famous canyons near the stock exchange and hear only the rattle of backgammon dice through the open windows.15 But what is striking about Jones, given his youthful adventures with the undercover Left, is that he emerged from this turmoil more levelheaded than before. He grappled ambitiously with the biggest questions of his age, but his conclusions tended to be moderate.

  Jones’s politics emerged from his writings as a sociologist and journalist. In the late 1930s, as the Nazi menace spread across Europe, Jones plunged into the research for his doctoral thesis, motivated by a desire to understand whether the same calamity could befall his own country.16 His thesis topic reflected the preoccupation of the political Left with class structure. He was bent on teasing out the links between Americans’ economic conditions and their attitudes toward property; his purpose was “to help find out to what extent, in our basic ideas, we are a united people, and to what extent we are a house divided.”17 In late 1938 and early 1939, Jones decamped with Mary to a hotbed of industrial conflict, Akron, Ohio, and organized a team of assistants to conduct 1,700 field interviews. Subjecting his interview results to a series of statistical tests, he concluded that acute economic divisions did not actually carry over into polarized world-views. It was a repudiation of the socialist assumptions of his youth and a testimony to the vitality of American democracy.

  Jones’s thesis, which appeared as a book titled Life, Liberty and Property in 1941, became a standard sociology textbook. Meanwhile it served to launch Jones on yet another career—this time as a journalist. Fortune magazine published the thesis in condensed form and also offered Jones a job; he signed on happily, even though he found writing a hard process. In an essay published in 1942, Jones gave warning that Roosevelt’s economic statism would need to be dismantled once the war ended.18 His respect for the market, which confirmed his retreat from socialism toward the political center, was mixed with continued interest in redistributive programs. “The ideal,” he wrote in Fortune, was a sort of left-right blend: “As conservative as possible in protecting the free market and as radical as necessary in securing the welfare of the people.”

  In 1948 a writing assignment for Fortune gave Jones the opportunity to turn his mind to finance, a subject he had largely ignored since his stint with an investment counselor two decades earlier. The resulting essay, which appeared in March 1949 under the title “Fashions in Forecasting,” anticipated many of the hedge funds that came after him. The essay started out by attacking the “standard, old-fashioned method of predicting the course of the stock market,” which was to examine freight-car loadings, commodity prices, and other economic data to determine how stocks ought to be priced. This approach to market valuation failed to capture much of what was going on: Jones cited moments when stocks had shifted sharply in the absence of changed economic data. Having dismissed fundamental analysis, Jones turned his attention to what he believed was a more profitable premise: the notion that stock prices were driven by predictable patterns in investor psychology. Money might be an abstraction, a series of numerical symbols, but it was also a medium through which greed and fear and jealousy expressed themselves; it was a barometer of crowd psychology.19 Perhaps it was natural that a sociologist should find this hypothesis attractive.

  Jones believed that investor
emotions created trends in stock prices. A rise in the stock market generates investor optimism, which in turn generates a further rise in the market, which generates further optimism, and so on; and this feedback loop drives stock prices up, creating a trend that can be followed profitably. The trick is to bail out at the moment when the psychology turns around—when the feedback loop has driven prices to an unsustainable level, and greed turns to fear, and there is a reversal of the pendulum. The forecasters whom Jones profiled in Fortune offered fresh methods for catching these tipping points. Some believed that if the Dow Jones index was rising while most individual stocks were falling, the rally was about to peter out. Others argued that if stock prices were rising but trading volume was falling, the bull market was running out of buyers and the tide would soon reverse. All shared the view that stock charts held the secret to financial success, because the patterns in the charts repeated themselves.

  In his deference to chart-watching forecasters, Jones seemed oddly ignorant of academic economics. In 1933 and 1944, Alfred Cowles, one of the fathers of statistical economics, had published two studies reviewing thousands of investment recommendations issued by financial practitioners. The first of these two articles was titled “Can Stock Market Forecasters Forecast?” The three-word abstract answered the question: “It is doubtful.” Jones cited Cowles’s work selectively in Fortune, mentioning in passing that the master had found evidence of trends in monthly prices. He neglected to mention that Cowles had found no trends when he examined prices reported at three-week intervals, nor did he say that Cowles had concluded that any appearance of patterns in markets was too faint and unreliable to be traded upon profitably.20 Yet despite Jones’s superficial reading of Cowles, there was at least one point on which the two saw eye to eye: Both believed that successful market forecasters could not sustain their performance. The very act of forecasting a trend was likely to destroy it. Suppose, for example, that a financial seer could tell when an upward trend was going to be sustained for several days until the market hit a certain level. Money would follow this advice, pushing up prices to the predicted level straight away and cutting the trend off in its infancy. In this way, the forecasters would speed up the workings of the market while working themselves out of a job. As Jones concluded in his Fortune piece, the price trends would cease. The market would be left to “fluctuate in a relatively gentle, orderly way to accommodate itself to fundamental economic changes only.”

  To an extent that he could not possibly have foreseen, Jones was anticipating the history of hedge funds. Over the succeeding decades, wave upon wave of financial innovators spotted opportunities to profit from markets, and many of them found that once their insight had been understood by a sufficient number of investors, the profit opportunity faded because the markets had grown more efficient. In the 1950s and 1960s, Jones himself was destined to impose a new efficiency upon markets. But the nature of that change was not at all what he expected.

  BY THE TIME THE FORTUNE ESSAY APPEARED IN MARCH 1949, Jones had launched the world’s first hedge fund. It was not that he had suddenly turned passionate about finance; on the contrary, he was more preoccupied with his political migration from liberalism to socialism and back, and with the pleasures of gardening at his new country home in Connecticut.21 But, now in his late forties, with two children and expensive New York tastes, he decided that he needed money.22 His efforts to earn more in journalism had fizzled: He had left the staff of Fortune hoping to launch a new magazine, but two blueprints had failed to attract financial backing. Stymied in these publishing ventures, Jones moved to plan B. He raised $60,000 from four friends and put up $40,000 of his own to try his hand at investing.

  Jones’s investment record over the next twenty years was one of the most remarkable in history. By 1968 he had racked up a cumulative return of just under 5,000 percent, meaning that the investor who had given him $10,000 in 1949 was now worth a tidy $480,000.23 He left his competitors in the dust: For instance, in the five years to 1965 he returned 325 percent, dwarfing the 225 percent return on the hottest mutual fund for that period. In the ten years to 1965 Jones earned almost two times as much as his nearest competitor.24 By some measures, Jones’s performance in these years rivaled even that of Warren Buffett.25

  Jones’s investment venture started out in a shabby one-and-a-half-room office on Broad Street. He rented space from an insurance business owned by one of his investors, Winslow Carlton, a dapper man who favored blue shirts with white collars and tightly knotted ties and who drove a magnificent Packard convertible. Some mornings in those early years, Carlton would have his resplendent vehicle brought out of its garage, and he would drive over to Jones’s apartment at 30 Sutton Place, and the two of them would proceed down the East Side with the roof off, trading predictions about the market. Jones kept a Royal typewriter on his desk and a dictionary mounted on a stand. There was a stock-exchange ticker with a glass dome over it, an electromechanical calculating machine that you cranked by hand, and a couch on which Jones liked to nap after his lunches. 26

  Jones set out to see whether he could translate the chart watchers’ advice into investment profits. But it was the structure of his fund that was truly innovative. The standard practice for professional investors was to load up with stocks when the market was expected to go up and to hold a lot of cash when it was expected to topple. But Jones improved on these options. When the charts signaled a bull market, he did not merely put 100 percent of his fund into stocks; he borrowed in order to be, say, 150 percent “long”—meaning that he owned stocks worth one and a half times the value of his capital. When the charts signaled trouble, on the other hand, Jones did not merely retreat to cash. He reduced his exposure by selling stocks “short”—borrowing them from other investors and selling them in the expectation that their price would fall, at which point they could be repurchased at a profit.

  Both leverage and short selling had been used in the 1920s, mostly by operators speculating with their own money.27 But the trauma of 1929 had given both techniques a bad name, and they were considered too racy for professionals entrusted with other people’s savings. Jones’s innovation was to see how these methods could be combined without any raciness at all—he used “speculative means for conservative ends,” as he said frequently. By selling a portion of his fund short as a routine precaution, even when the charts weren’t signaling a fall, Jones could insure his portfolio against market risk. That freed him to load up on promising stocks without worrying about a collapse in the Dow Jones index: “You could buy more good stocks without taking as much risk as someone who merely bought,” as Jones put it.28 Whereas traditional investors had to sell hot companies like Xerox or Polaroid if the market looked wobbly, a hedged fund could profit from smart stock picking even at times when the market seemed overvalued.

  In a prospectus distributed privately to his outside partners in 1961, Jones explained the magic of hedging with an example.29 Suppose there are two investors, each endowed with $100,000. Suppose that each is equally skilled in stock selection and is optimistic about the market. The first investor, operating on conventional fund-management principles, puts $80,000 into the best stocks he can find while keeping the balance of $20,000 in safe bonds. The second investor, operating on Jones’s principles, borrows $100,000 to give himself a war chest totaling $200,000, then buys $130,000 worth of good stocks and shorts $70,000 worth of bad ones. This gives the second investor superior diversification in his long positions: Having $130,000 to play with, he can buy a broader range of stocks. It also gives him less exposure to the market: His $70,000 worth of shorts offsets $70,000 worth of longs, so his “net exposure” to the market is $60,000, whereas the first investor has a net exposure of $80,000. In this way, the hedge-fund investor incurs less stock-selection risk (because of diversification) and less market risk (because of hedging).

  It gets better. Consider the effect on Jones’s profits. Suppose the stock market index rises by 20 percent, and, because th
ey are good at stock selection, the investors in Jones’s example see their longs beat the market by ten points, yielding a rise of 30 percent. The short bets of the hedged investor also turn out well: If the index rises by 20 percent, his shorts rise by just 10 percent because he has successfully chosen companies that perform less well than the average. The two investors’ performance will look like this:

  The result appears to defy a basic rule of investing, which is that you can only earn higher returns by assuming higher risk. The hedged investor earns a third more, even though he has assumed less market risk and less stock-selection risk.

  Now consider a down market: The magic works even better. If the market falls by 20 percent, and if the stocks selected by the two investors beat the market average by the same ten-point margin, the returns come out like this:

  In sum, the hedged fund does better in a bull market despite the lesser risk it has assumed; and the hedged fund does better in a bear market because of the lesser risk it has assumed. Of course, the calculations work only if the investors pick good stocks; a poor stock picker could have his incompetence magnified under Jones’s arrangement. Still, given the advantages of the hedged format, the question was why other fund managers failed to emulate it.