Chapter 3

Hedge Funds

An Absolute Return Answer?

In 1947, A.W. Jones began trading what is known today as a long/short equity fund. In the decades that followed, hedge funds continued to grow but were not a major part of the financial system. However, in the late 1980s, the interaction of advances in technology, the growth of derivative markets, and regulatory changes encouraged many financial trading firms and banks to sell all or part of their proprietary trading operations to outside legal entities. Banks and many trading houses simply found it more profitable to charge certain services (e.g., brokerage, lending, and back-office support) than to have to cover the new capital charges required by changing regulations.

Although many investors see hedge funds as unique animals, hedge funds are actually just one example of the privatization of the trading floor. Over the course of the 1990s, the growth of financial markets, both in the United States and globally, increased the availability of new security forms (e.g., mortgages), new markets (Europe and emerging), and new strategies (convertible arbitrage and fixed-income arbitrage). Hedge funds had matured, but unfortunately, the public perception of the industry had not. Even within the hedge fund industry, many managers continued to portray themselves, inaccurately, as absolute return managers—managers who could make money in every market. Academics and others, of course, were well aware that most hedge fund strategies provided ...

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