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, thechair 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.
