https://www.newyorker.com/culture/culture-desk/a-brief-history-of-the-hedge-fund
The French dissertation that inspired the strategies that guide many modern investors.
The researcher Louis Bachelier observed that the best traders in the Paris Bourse tended to take an array of diverse and even contradictory positions.Photograph from Getty
In the midst of a global crisis, the hedge fund has prospered. The top fifteen hedge-fund managers earned an estimated $23.2 billion last year, according to Bloomberg. Chase Coleman, the forty-five-year-old founder of Tiger Global Management, led the way, hauling in more than three billion for himself. The Financial Times took a more democratic view of the phenomenon, noting that the top twenty “best-performing hedge fund managers of all time” had provided more than sixty-three billion dollars for their investors during the coronavirus-driven market turmoil, “making it the industry’s best year of gains in a decade.”
Given the supremacy of hedge funds, it was both satisfying and terrifying to observe the recent boom and bust in the value of GameStop, a run driven by small-time speculators. Several hedge funds lost extraordinary amounts of cash—as in billions and billions of dollars—on financial derivatives called options. Of course, “loss” is a relative term in the world of élite finance. The hedge fund Melvin Capital saw more than half its assets vanish in the GameStop turmoil, but its founder made nearly eight hundred and fifty million dollars last year.
The GameStop mess called attention to the hedgies in a way that they have carefully avoided for the past decade. Maxine Waters, the chair of the House Committee on Financial Services, immediately called for hearings on these “abusive practices.” “This recent market volatility has put a national spotlight on institutional practices of Wall Street firms,” the congresswoman declared during the first committee hearing, before noting the widespread sentiment that “market participants, like our witnesses, hide the ball.” Indeed, those who work at hedge funds are diligent about keeping who they are and what they do obscured behind a wall. Secrecy is intrinsic to the job description—for a hedge is a wall. A recorded reference to a “hedge” appeared in Old English in 785, around the time the Vikings began to ransack northern England. Back then, a hedge was a boundary planted by man. It was the basic demarcation of property and of ownership, the line between what is mine and what is yours.
The definition of hedge has expanded since then, but not our general understanding of hedge funds. The wall that separates the rest of us from those who buy and sell billions on a daily basis has, if anything, become increasingly fortified—and for good reason. By the time the word had migrated into the lexicon of modern English, the line between “mine” and “not mine” had waxed militaristic, and the definition of hedge came to include arsenals of physical defense, like hedges of archers. At this point in linguistic history, one man’s hedge became another man’s extreme bad luck.
Another half a millennium would pass before hedging merged with gambling. In 1672, the phrase “to hedge a bet” first appears, with an implication of shaky moral standing. The hedged bet was for rooks, and Shakespearean English abounds with hedge wenches, hedge cavaliers, hedge doctors, hedge lawyers, hedge writers, hedge priests, and hedge wine. Some of the earliest examples of investor hedging appear a few decades later in the coffeehouses of London’s Exchange Alley, where caffeine-addled proto-brokers bet on the movement of equity stakes in the Bank of England, the South Sea Company, and the British East India Company. Investors who owned shares could offset the possibility of future losses by hedging, for example by betting in advance on the stock’s downward movement, a strategy recently duplicated by hedge funds unfortunate enough to have “sold short”—that is, to bet against the price—of GameStop.
Hedging, originally a matter of defense, could also be an aggressive maneuver—the bet that the thing you were betting on would lose. This contrarian take on speculation reflected the eighteenth century’s ever-increasing interest in betting strategies, typified by the activity at the Ridotto casino, in Venice, the world’s first government-sanctioned gambling venue.
In 1754, the infamous scam artist, diarist, and womanizer Giacomo Girolamo Casanova reported that a certain type of high-stakes wager had come into vogue at the Ridotto. The bet was known as a martingale, which we would immediately recognize as a rather basic coin toss. In a matter of seconds, the martingale could deliver dizzying jackpots or, equally as often, ruination. In terms of duration, it was the equivalent of today’s high-speed trade. The only extraordinary fact about the otherwise simple martingale was that everybody knew the infallible strategy for winning: if a player were to put money on the same outcome every time, again and again ad infinitum, the laws of probability dictated that not only would he win back all he may have previously lost, he would double his money. The only catch was that he would have to double down each time, a strategy that could be sustained only as long as the gambler remained solvent. On numerous occasions, martingales left Casanova bankrupt.
In modern finance, the coin toss has come to represent a great deal more than heads or tails. The concept of the martingale is a bulwark of what economists call the efficient-market hypothesis, the meaning of which can be grasped by an oft-repeated saying on Wall Street: for every person who believes a stock will rise—the buyer—there will be some other equal and opposite person who believes the stock will fall—the seller. Even as markets go haywire, brokers and traders repeat the mantra: for every buyer, there is a seller. But the avowed aim of the hedge fund, like the fantasy of a coin-tosser on the brink of bankruptcy, was to evade the rigid fifty-fifty chances of the martingale. The dream was heads I win, tails you lose.
One premonition as to how such hedged bets could be constructed appeared in print around the time when gambling reached an apex at the Ridotto casino, when an eighteenth-century financial writer named Nicolas Magens published “An Essay on Insurances.” Magens was the first to specify the word “option” as a contractual term: “The Sum given is called Premium, and the Liberty that the Giver of the Premium has to have the Contract fulfilled or not, is called Option . . .” The option is presented as a defense against financial loss, a structure that would eventually make it an indispensable tool for hedge funds.
By the middle of the next century, large-scale betting on stocks and bonds was under way on the Paris Bourse. The exchange, located behind a panoply of Corinthian columns, along with its unofficial partner market, called the Coulisse, was clearing more than a hundred billion francs that could change volume, speed, and direction. One of the most widely traded financial instruments on the Bourse was a debt vehicle known as a rente, which usually guaranteed a three-per-cent return in annual interest. As the offering dates and interest rates of these rentes shifted, their prices fluctuated in relationship to one another.
Somewhere among the traders lurked a young man named Louis Bachelier. Although he was born into a well-to-do family—his father was a wine merchant and his maternal grandfather a banker—his parents died when he was a teen-ager, and he had to put his academic ambitions on hold until his adulthood. Though no one knows exactly where he worked, everyone agrees that Bachelier was well acquainted with the workings of the Bourse. His subsequent research suggests that he had noted the propensity of the best traders to take an array of diverse and even contradictory positions. Though one might expect that placing so many bets in so many different directions on so many due dates would guarantee chaos, these expert traders did it in such a way as to decrease their risk. At twenty-two, after his obligatory military service, Bachelier was able to enroll at the Sorbonne. In 1900, he submitted his doctoral dissertation on a subject that few had ever researched before: a mathematical analysis of option trading on rentes.
Bachelier’s dissertation, “The Theory of Speculation,” is recognized as the first to use calculus to analyze trading on the floor of an exchange, and it contained a startling claim: “I have in fact known for several years that it would be possible . . . to imagine transactions where one of the parties makes a profit at all prices.” The best traders on the Bourse knew how to establish an intricate set of positions designed to protect themselves no matter which way or at what speed the market might move. Bachelier’s process was to separate out each element that had gone into the complex of bets at different prices, and write equations for them. His committee, supervised by the renowned mathematician and theoretical physicist Henri Poincaré, was impressed, but it was an unusual thesis. “The subject chosen by M. Bachelier is rather far away from those usually treated by our candidates,” the report noted. For work that would unleash billion-dollar torrents into the capital pools of future hedge funds, Bachelier received a grade of honorable instead of très honorable. It was a B.
Needless to say, Bachelier’s views of math’s application to finance were ahead of his time. The implications of his work were not appreciated, much less exploited, by Wall Street until the nineteen-seventies, after his dissertation was discovered by the Nobel Prize winner Paul Samuelson, the author of one of the best-selling economics textbooks of all time, who pushed for its translation into English. Two economists, Fischer Black and Myron Scholes, read the work and, in a 1973 issue of the Journal of Political Economy, published one of the most famous articles in the history of quantitative finance.
Based on Bachelier’s dissertation, the economists developed the eponymous Black-Scholes model for option pricing. They established that an option could be priced from a set-in-stone mathematical equation, which allowed the Chicago Board Options Exchange (C.B.O.E.), a new organization, to expand their business to a new universe of financial derivatives. Within a year, more than twenty thousand option contracts were changing hands each day. Four years after that, the C.B.O.E. introduced the “put” option—thus institutionalizing the bet that the thing you were betting on would lose. “Profit at all prices” had joined the mainstream of both economic theory and practice.
In 1994, Scholes became a partner at Long-Term Capital Management, a hedge fund based in Greenwich, Connecticut, that at its height held more than a hundred billion dollars in assets. By deploying the theories of quantitative finance, L.T.C.M. brought in annual returns estimated at twenty per cent in 1994 and forty per cent in 1995 and 1996.
Unfortunately, his equation was not foolproof. Like the finest traders on the Paris Bourse, Scholes seems to have understood that sudden changes in price depended on human emotions—such as fear and greed—that could increase or decrease the speed at which an asset was bought or sold. At the heart of option pricing lay an ingenious calculation of sensitivity to that volatility, known throughout quantitative finance by the pseudo-Greek sobriquet “Vega.” But there were volatilities of human history that even M.I.T. professors and Louis Bachelier could not anticipate. The financial collapses in Asia and Russia in 1998 were not part of the Black-Scholes equation, and Long-Term Capital Management lost more than four billion dollars in less than four months. But that setback did not stop generations of mathematically minded would-be billionaires from working day and night to forge next-generation formulae for profit at all prices, skewing Vega into ever more baroque derivatives, creating a new alphabet of financial Greek—including Vomma and Zomma—in the process.
Much in the world has changed since nineteenth-century Parisian traders bet on the prices of canals, railroads, and rentes, but not the dream that we might devise a foolproof barrier against financial risk. For a while, it appeared as though the hedge funds, faced with yearlong global crises, might have achieved a new level of defense against unpredictable volatility. Then came a few days in February of 2021, when a hoard of subreddit barbarians breached the walls and it was clear that the hedgies, for all their brainpower and hype, had still not progressed much beyond Casanova flipping coins at the Ridotto. The hedge fund, created to safeguard property and mitigate risk, formulated to destroy the downside of a binary buy or sell, dedicated to the proposition of profit at all prices, had again proved to be fallible. We all marvelled at the story, and then it was back to business as usual in Washington, D.C., and on Wall Street. Tiger Global Management looked forward to another record-setting year, while Maxine Waters, determined to “get the facts” about “dark pools” of hidden capital, promised more hearings.
Frederick Kaufman is the author of the forthcoming book “The Money Plot: A History of Currency’s Power to Enchant, Control, and Manipulate.”