Alternative Investments: Fundamentals

The first alternative investment fund was established in 1949 by the Alfred Winslow Jones, a Harvard-educated sociologist.

Jones is credited with developing the technique of short selling, which enables investors to make money if the price of a stock falls. In essence, short selling means selling stocks that you do not own with the aim of buying them back at a lower price. In practice, you borrow stocks that you believe to be overvalued and likely to fall in value. By selling them at a high price and buying back at a low price, you make money on the differential—minus the cost of borrowing the stocks in the first place, of course.

Taking a short position, in this way, is the opposite of what happens in a traditional portfolio.

In a traditional portfolio an investment manager will take a long position, that is, buying stocks that he believes are undervalued at a low price with the aim of selling them at a higher price.

Long managers may also borrow money to improve their performance. By borrowing money and putting more into stocks that you expect to perform well you can achieve an enhanced return-minus the cost of borrowing. In investment terms, this is called leverage or gearing.

Jones’s investment fund combined both long and short positions. He believed that good long stock selection would ensure above average profit in a rising market and he would also leverage his portfolio to enhance the return. Good stock selection should also ensure that his long positions would fall less than the rest of the market when the market reversed.

At the same time, good short stock selections might make less money in a rising market, but when the market reversed, these would fall more than the market, yielding a profit that would cover any losses on his long positions.

The intervening half century has seen a proliferation in techniques, financial instruments and technology, but the principles behind Jones’s portfolio still hold true for the modern alternative investor. In particular, Jones’s skill in selecting stocks was critical to the overall performance of the fund, on both the long and short side of the portfolio. Indeed, some alternative investment managers prefer the term "skill-based investing" to describe what they do.