Hedge Funds Explained: Alfred W. Jones, the 2 and 20 Fee and Form PF Rules

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Hedge funds manage roughly $3.8 trillion, as of 2021, yet the name comes from a defensive idea. They are private pooled investment vehicles open in the U.S. mainly to wealthy individuals and institutions, which lets them use short selling, derivatives, heavy borrowing and credit arbitrage that mutual funds cannot. Warren Buffett cited the 1920s Graham-Newman partnership as an early precursor, but the industry's founder was Alfred W. Jones, a sociologist who wrote for Fortune and launched his fund in 1949. Jones paired long positions with short sales so his portfolio was protected whichever way the overall market moved.

After losses in the early 1970s recessions, the 1990s turned Jones's defensive tools into offensive ones, with pension funds and endowments pouring in. Modern funds chase absolute return through global macro bets, either discretionary or systematic, and directional strategies such as short bias funds that hunt for overvalued or fraudulent companies. The 2 and 20 fee, a 2 percent management fee and 20 percent of gains, created many billionaires, and Buffett criticized it for sharing upside but none of the downside. Funds long relied on exemptions in the Investment Company Act of 1940, until the 2010 Dodd-Frank Act required advisors managing over $150 million to register with the SEC and file Form PF.

• Systematic funds may use satellite images of retail parking lots to predict weak earnings before companies report them.
• On a $1 billion fund, the 2 percent fee alone yields $20 million a year regardless of performance.
• The high-water mark means managers earn performance fees only on new profits, so some close losing funds and start fresh.
• The industry is consolidating around giants such as Citadel, Bridgewater and Millennium as closures outpace launches.
• In 2009 Fed Chairman Ben Bernanke testified that no single hedge fund was large enough to be systemically critical.