When Alfred Winslow Jones first invented the “hedge fund” in 1966, it was designed to be a true “hedge.” There were two key features of the new investment structure: the strategy and performance fee. The alternative strategy upon which Jones based the hedge fund featured a 50% / 50% Long / Short ratio in the stock market with the goal to profit during up and down market environments. For this feat, Jones wanted a percentage of his ability to deliver performance different from that of stock market beta, particularly during when the market was down. This basic concept led to legendary hedge fund managers such as George Soros and Jim Rogers and their Quantum Fund delivering investors 4,200% during down markets at a time when the S&P 500 only returned 47% over a similar period. This outperformance during down stock markets defined the industry. Fast forward nearly fifty years later and what Baupost Group’s Seth Klarman sees is an industry that is, in part, not changed much but also very different from the initial vision of Jones.

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Klarman: Investments Can “only be as sound as the integrity and stability of the system”

Seth Klarman
By Hedge Funds [CC BY 3.0], via Wikimedia Commons

Baupost Group says “competitors play like they can never get hurt”

Klarman isn’t exactly sure he self-identifies with this “hedge fund” community, “a category we sometimes get lumped into,” he warily says. The man who reportedly has delivered $22.6 billion in net profit to investors from inception to 2015, delivering a 16.4% annual return, has a different perspective. In a letter to investors, Klarman said the hedge fund industry is “starting to look more alike” and appear “as a monolithic asset class” with one commonality: “charging an annual performance-based fee.”

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In other words, of the two factors upon which the hedge fund industry was initially founded, actual “hedging” and a performance fee, it is the performance fee that Wall Street has decided would stand the test of time, fellow hedge fund manager Erik Townsend noted in a recent podcast.

Klarman, for his part, considers the panoply of hedge fund strategies – “absolute return, long-short, growth, quant, country or industry specific, etc.” – and notes they are all in “Wall Street’s ubiquitous short-term performance derby.”


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