The reputation of Alfred Winslow Jones is unassailable. As a prophet and seer he rests loftily in the hedge fund holy of holies. Coiner of the theory, then in practice he turned $100,000 in 1949 into many millions in the mid 1960s. So far there has been no need to cast a shadow on his achievement or to doubt his role as the first mover. Every article, every book enjoys a prevailing conceit, a half truth enshrined in myth, that he was responsible for conceiving the idea of hedge funds.
However in the background lurks another creator, a writer, academic and investor called Karl Karsten. Unlike Jones he didn't start a public fund, speculating on his own and his colleagues' behalf. His input is conceptual and is described in his epoch-making work: Scientific Forecasting, published by Greenberg in New York in 1931. Previously he had had published in 1923: Charts and Graphs, a magnum opus describing the best possible means of imparting statistical information visually. It has no direct bearing or relevance to Wall Street or the financial markets.
Eight years later he founded the Karsten Statistical Laboratory and turned his attention to the stock market. During this period he has been thinking about the best way to forecast the state of the economy, leading to conclusions about relative sector performance; in his own words, which ones will move "out-of-line." His approach is firmly statistical and objective: "My own snap or curb-stone judgement has never commanded my own respect; I have invariably demurred against venturing opiniative predictions; and the thesis of this book is solely to exalt the importance of impersonal statistics." By statistics, he means business statistics, and has no interest in technical analysis. It would have annoyed and unsettled him, that a discipline so unscientific could command such a great following. In the preface he thanks those who have helped him: Professor Irving Fisher, Professor Wesley C Mitchell and Mr Robert Warshow. All were first rank economists and academicians.
He devotes the first section of his work to ascertaining which various "Barometers" will be necessary to include, providing an accurate forecast of future business conditions. These are listed as follows: Barometer of Volume of Trade, of Building Activity, of Interest Rates, of Wholesale Price-Level, of Indexes of Certain Industries, of Railroad Stocks, of Public Utility Stocks, of Steel Stocks, of Oil Stocks, of Automobile Stocks, of Store Stocks.
Although allowing for statistical success, there were the usual problems translating theory into practice: "Gambling is a science itself, and we made one mistake in undertaking it, privately and incidentally, while we were still occupied with research problems. The result was that we conducted what might be called a fairly thorough investigation of the unprofitable ways of gambling..." Finally, :"On December 17, 1930 a small fund was placed with a New York brokerage house to be managed by one of the officers of this laboratory strictly in accordance with the indications of the six speculative barometers..."
The results were outstanding. By June 3 a $1 value had increased to $1.78, a 250.5% increase compounded annually. In comparison the Dow Jones had commenced at 100, rallied to 115 on March 24, then declined to 79 on June 3. Invariably self-effacing, he writes: "The growth is somewhat in excess of the rate of growth which theoretical studies had led us to anticipate, for those studies had only indicated that the funds would double annually on the average." He concludes: "The system had three characteristics. It did not make large losses, but had long periods (of several weeks) in which it made no substantial movement in the way of either loss or gain. At other times it made large gains which were held permanently and these periods of sidewise and upward movement were entirely INDEPENDENT of the DIRECTION of the stock market averages" (my caps).
Chapter VII reveals all. The magician pulls the rabbit from the hat; the joker appears at the audience's elbow. It is entitled, 'The Hedge Principle'. He writes: "Care must be taken that at no time shall the funds be in a position in which such general market movements can have any effects on the profits or losses. This precaution can be put into effect through several methods, all of which are technically known as "hedge" (his inverted commas) operations." He discusses its modus operandi: "Suppose that motor stocks be the group, and that the prediction for the time is that the average of these stocks will rise out of line from the average of the entire market… we should theoretically sell short an equally great (in dollar value) holding of all the stocks in the market. This short sale exactly counterbalances the long purchase, and, whatever happens, we shall have profit or loss only in accordance with the subsequent out-of-line movement…If the market goes sidewise, and motors rise, our short commitment will be unchanged in value, but our long commitment will rise. If the market rises faster, our short commitment will show a loss, but the long commitment will show a greater profit. If the market falls and motors fall less, our short commitment will show a profit and our long commitment will show a smaller loss, leaving a net profit. In no case will the net profit or net loss be other than in proportion to the net out-of-line movement." Given the difficulties in hedging on this scale, Karsten proposes a system for small funds in which a large amount of diversification is not possible: "Buy the stocks in the group predicted to rise most in comparison with the others, and sell short the leading stocks in the group predicted to fall most. This may be called a "single-hedge" system. If the multiple-hedge system were being followed, one should buy the two best groups out of six and sell short the two worst."
Ironically, having created a perfect long short market neutral strategy using top-down sectoral analysis, having on paper multiplied his capital base twenty times in three years, he dumbfounds us. The money doesn't matter; the money is irrelevant to the greater task, to discover an empirical basis for scientific forecasting, to turn economics into an exact mathematical science. He is adamant: "…From every point it is clear that a gambling system such as will be described has scientific value as it demonstrates the soundness of the scientific method of forecasting, and has practical value which is limited to the few who use it. It is described in this book for its scientific value, and not for its practical value." Unlike Jones, neither leverage nor profit would interest him. His hedge fund was a necessary by-product of his project. He may have laid the foundations; let others inhabit the building.
Remarkably he looked further, predicting the new world of computers, especially in modern finance. If, he reasoned, tide predicting machines like the one at Greenwich could work, why not a machine to predict the various economic tides. Indeed he had built one during the system's implementation: "In the course of the investigation there has already been designed and partially built such a multiple predicting machine. As designed, such a machine would have a great many dials (like radio dials) on its front panel, each labelled for some of the controlling factors Thus there would be one dial labelled "Call Loan Rate," another labelled "Gold Movement," another "Bank Clearings," and so on. These dials would not revolve mechanically all at once, as in the case of the tide-predicting machine, but once each day or week an attendant would set each of these dials with their pointers indicating the latest figures of each series… That not one, but many, such machines will be built in the course of time and put in operation, seems inevitable." He was a visionary, more focussed than Wells, more realistic than Huxley.
Still there are many questions left unanswered. Did he continue to run his fund? We don't know. Unlikely. Compounding at 250% per annum Buffett and Soros would have been left staring at the tape, in which case surely the world would have heard of his extraordinary financial prowess. Had Jones read or heard about Scientific Forecasting? We don't know. Possibly. Both were successful academics. Also there was another proto-hedge fund operator operating at the same time as Karsten. He writes rather mysteriously on page 174: "By chance it happened that another pool was being managed, at the same time, by acquaintances of ours who had very much the same type of market information, opinion, and judgement as we used, and who used the same type of margins and shifting, but who lacked the same confidence in the statistical forecasts." Who was the rival? We don't know.
I feel I have barely scratched the surface, and obviously there remains scope for further investigation. In an obituary I read, no mention was made of either of his two books. Such was his great disappearing act; Scientific Forecasting has the dubious merit of attaining near invisibility whereas it should rank amongst the most influential and stimulating works written on speculation in the twentieth century. I will be pleased if I can help return it and its author to the hedge fund holy of holies, on a plinth alongside that of Alfred Winslow Jones.
The author deals in antiquarian books specialising in works on the stock market and speculation. He has a collection of over four hundred titles on these subjects written between the eighteenth and twentieth centuries. He welcomes any discussion on this article or generally about rare books. He can be contacted at firstname.lastname@example.org.