Rule No. 1 of investing, as Berkshire Hathaway Chairman and CEO Warren Buffett famously put it, is to never lose money; rule No.2 is never forget rule No. 1.
As intuitive as this rule is, it’s not actually straightforward in practice. The market moves in mysterious ways, and almost without exception investment involves the risk of partial or total loss. Equity investors are perhaps the most exposed, but as the financial crisis reminded us, even high-quality debt investments can go bad. Add to this human error and bad judgement, and you have an investment environment where losses are not just common but are expected to occur for almost everyone, at least some of the time. This is particularly true in the risk-on world of equity investing.
While savvy investors have always aimed to maximize returns while minimizing risk, it wasn’t until 1949 that the idea of a hedge fund really emerged. Alfred Jones, a doctor of sociology, cooked up the idea as a member of the Fortune editorial team. Raising some funds and putting up a lot of his own money, Jones experimented with a strategy of hedging long positions in equity with short positions, giving birth to the now classic long-short equity model. By combining this model with leverage — the use of borrowed capital to increase potential ROI — Jones was able to deliver outsize returns with minimal risk. Taken at its purest, a hedge fund promises to deliver a target return no matter what the market does.
Today, the term “hedge fund” conjures up a large number of images, some of which are contradictory and all of which are vague. As initially conceived, hedge funds were relatively small investment pools with an eye toward mitigating risk. However, come 2006, the Congressional Research Service was describing hedge funds as “private, high-risk, unregulated investment pools for wealthy individuals and institutions.”
The reason is this: There is no common definition of what a hedge fund is. Hedge funds are unregulated, and little was known about them until a provision of the Dodd-Frank Act gave the U.S. Securities and Exchange Commission the authority to collect data from registered investment advisers. The first report by the SEC of this type was published in July 2013. The provision was established in light of the 2008 financial crisis, which drove many hedge funds into the ground and saw the bailout of many more.
Here are some of the biggest failures in hedge funds in history, all of which helped bring the funds into focus for both regulators and the public.