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Sometimes, different parts of language evolve at different paces and we end up with strange archaisms embedded in regular speech. Nobody's surprised to hear an atheist end a phone call with "goodbye," even though it's a contraction of "God be with ye," and there's a pretty big gap in meaning between the word "housewife" and "hussy," even though the second is a contraction of the first.

"Hedge fund" was born as a slight contraction of the original term, "hedged fund." This drove A.W. Jones, who coined the term and invented the model, crazy—he grew up wealthy, went to Harvard, worked as a diplomat, got a PhD from Columbia, and worked as a journalist before founding his fund. And then he had to deal with the twin irritations that brutish traders were copying his model and butchering his grammar. Outrageous!

Jones' approach is surprisingly modern considering that it dates back to a time when the Dow was calculated six times a day by a 76-year-old using a mechanical calculator. (On one busy day, the ticker tape moved so fast he got a papercut.) First, Jones hedged against broad market moves, by going long and short. And second, he engineered a system that tried to get the best stock tips per dollar of commissions spent. He'd find good sell-side analysts, and give them bonuses based on how well their ideas helped him. At a time of scarce bandwidth, that meant they could give him insightful fundamental analysis like "I'm downgrading US Steel next week" and get away with it, though the market was inefficient enough that a straight-shooting analyst who actually did the research could also probably do well.

Jones popularized structuring an investment vehicle as a limited partnership that paid the manager a percentage of profits, set at 20% (Benjamin Graham had done this before, under various legal structures, and also charged a 20% performance fee).¹ Graham himself was a pretty erudite character; he, too, went to Columbia, and before he finished undergrad they were asking him whether he'd prefer to teach math, English, or philosophy; he needed money, so he went into finance instead.

So if you happened to be insanely ahead of the curve in asset management in the early 1950s, your stereotype of hedge funds was that they were a niche variety of risk-averse investment vehicle, run by someone who would throw in a quote from Horace while explaining the virtues of a particular wine.

But it's very hard to keep a lucrative compensation structure secret, and people who want to manage money already have a high assessment of their own abilities, so hedge funds started to proliferate in the 1960s, especially after Carol Loomis published a story about the Jones nobody keeps up with. Even by then, the model had proliferated, and, as one might expect during a roaring bull market, the part fund managers liked was that they could use leverage and earn 20% of the profits, and the part that struck them as a little old-fashioned was the bit where they'd hedge.

It's mostly forgotten today, but the hedge fund collapse of the late 60s and early 70s was brutal: there were around 150 funds managing a collective $1bn in 1969, and by 1971 there were around 30 left. This is around when people started asking why they're called "hedge funds" in the first place.

But as it turns out, it's a lot easier to justify taking a big cut of returns if you have some way to prove that you're responsible for those returns. If you're up 50% for the year, and the reasons for that are that 1) you bought Ling-Temco-Vought, Polaroid, and Xerox, just like all of your peers, and 2) you were levered 2:1, your investors will have some probing questions for you (at least when they go down).

And, in a way, that describes the modern evolution of the hedge fund model: over time, limited partners got better at asking tough questions about where returns came from before they turned negative and rendered the answer obvious. Investors in the aggregate relearn certain lessons about leverage, concentration, and crowding, but they tend to learn them in more elaborate ways. Within funds, there was internal pressure to benchmark returns against the easily-replicated parts of the strategy, not just in absolute terms, and one of the ways to avoid benchmarking problems is to keep portfolio managers from taking easy risks in the first place, or to charge them for it. (So, for example, a commodity strategy might make some of its money betting on the correlations between different commodities, and be allowed to lever that up a bit so long as a bullish-on-growth bet like long oil was offset by a bearish-on-growth bet like shorting copper. But if they had some specific reason to have an unhedged directional view, they could trade it, but not get the same cut of the upside.)

This coevolved with the process of giving investors easier access to those more passive bets. There are funds you can invest in if you want exposure to growth offset by some short positions in companies whose growth is slowing, or whose business is being disrupted by growth elsewhere, and if you want just the long side of that trade, something like ARKK is a cheaper way to get it. However, factors and correlations rear their head again. There have been many days where all the AI plays sold off, and software rallied, because long AI and short software were, at least earlier this year, the same bet expressed two different ways. Part of what hedge funds try to do is to figure out which of those correlations are some newly-discovered or newly-created but basically permanent feature of the market, and which are temporary. For a while, stocks exposed to streaming entertainment and stocks exposed to office real estate reliably moved in opposite directions, but that was mostly true in a post-outbreak, pre-vaccine world. But if you decided to bet that the "volatility smirk," the extra option premium you pay to buy insurance against big crashes as opposed to betting on big rallies, showed up after 1987 and never went away; market participants realized that there are more ways for the market to drop 20% in a day than to rally that much.

The hedge fund industry has been on a long odyssey, starting with the observation that people will pay a lot for an investment that goes up more than average and almost never goes down, then getting lost and bewitched by various appealing riffs on some but not all of that thesis, before finally converging on a model where different mixes of security selection, industry selection, and systematic factors all have some fair market value.

Hedge funds are a running theme in The Diff, both because they have a big impact on the market and because they're an interesting business in their own right. For example:

• Advanced Portfolio Management explains many otherwise mysterious traits of factor-neutral funds ($).

• We've looked at specialized funds as hedges rather than a pure source of returns.

• And here's a breakdown of Situational Awareness ($).

• During the GameStop excitement, we covered funds' role in market structure, and what changes when they pull back ($).

• And, for fun: why the strategies hedge funds pursue are almost perfectly designed to make people at funds sound very smart ($).

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1  Graham didn't do a lot on the short side, other than as a leg of arbitrage trades. Oddly enough, spot-checking their old portfolio reveals that at one point, they owned a little of American Research & Development, generally considered the first venture capital firm. Crossover investing: older than we knew.