In literature, great speculators are colourful characters, as large—and imperfect—as life itself: Trollope’s Augustus Melmotte, in The Way We Live Now, or F Scott Fitzgerald’s Jay Gatsby. The real world of banking and finance is, sadly, not always populated by such personalities. Yet speculation is again a roaring business. Less conspicuous than in Victorian London or 1920s New York, nowadays it emanates from hushed computer-driven dealing rooms on Park Avenue, New York, or behind brass plates in and around Curzon Street in London’s Mayfair. Its practitioners tend to shun the limelight, and have little in common with the flashier crowd of a more recent speculative era, the 1990s; their mystique is bound up with mysterious algorithmic trading models and offshore tax havens. Even the term used to describe them—”hedge funds”—conceals more than it reveals.

Twenty years after London’s “big bang” blew away the last of the bowler hats in the square mile and gave further impetus to the globalisation of international finance, it is worth asking who these postmodern masters of capital are. Are they, as the Guardian recently put it, proponents of “casino capitalism,” a shadowy and unstable force which should be far more tightly regulated? Or would such a response be “regulatory McCarthyism,” as Jonathan Macey, a professor at Yale Law School, put it in the Wall Street Journal? Are the 10,000 hedge funds in existence so diverse that they cannot pose a threat to the global financial system—for when some do badly, others do well? To answer these questions, it is necessary first to try to understand what a hedge fund is.

What is a hedge fund?

The term “hedge fund” was first inspired by Alfred Winslow Jones, a former editor of America’s Fortune, who in 1949 acted on his idea to take offsetting positions on pairs of stocks. His rationale was simple, and persists to this day: he thought himself good at picking stocks likely to outperform the market, but not so good at predicting more general market trends. If, for instance, you buy General Motors shares, you expose yourself to several risks which have little or nothing to do with the performance of the company itself. Among them are the chance that the dollar might collapse, or that a sudden rise in the price of oil will depress car sales. Today you can hedge against such risks by selling or buying options in futures markets. In Jones’s case, he took bets that undervalued stocks would go up, and then cushioned investors from the risk that markets would fall by “short-selling” overvalued stocks (to short-sell is to sell assets you do not yet own on the expectation that the price will fall; if the price does fall, you pocket the difference between the lower price and the earlier, higher price). This “hedged” strategy is, by definition, low-risk, so to spice up returns, Jones moved his funds offshore, enabling him to borrow money to invest with—something that fund management companies in the US are not allowed to do to this day. He collected no fee for managing his clients’ money, but claimed 20 per cent of all profits made. For 20 years the returns to investors, and to himself, were impressive.

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