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As the SEC progresses toward rules to regulate hedge funds, I thought it a good time to talk about their history and development and their current and future role in the world of investment. As these funds become a more and more integral part of the investment process, it is important to understand where the media and other non-sophisticates are misinformed about how they operate and how they affect the financial system. This is A History because it is my history, and my opinion.

I started at Morgan Stanley in 1983 as a trader in derivatives. We made markets in both listed and over the counter options for large institutional clients. As a consequence of facilitating their trades (creating a position on our books opposite the position on their books) we ran a multi-billion dollar portfolio of derivatives, the size of which would make any dealer today chuckle. We did not have the computer power available today either, so our thinking skills were pretty sharp. When we agreed to execute a customer order at a certain price, we took the order down to the floor of one of a number of option exchanges.

There we negotiated the price and quantity of each trade with the floor market makers, ten percent of which were brilliant and ninety percent of which followed the other Ten. The Ten found that they could make a lot more money if they were in many places at once, participating in many such institutional trades. I can remember the conversation I had with Jeff Yass about this. We agreed that he would leave the floor for an upstairs office and I would call him on the phone with a trade we were pricing. He would participate in the trade as normal, but now I would execute his side of the trade as well as the customer’s for a small fee. This worked so well that he expanded his business several fold, growing his firm called Susquahana into one of the premier upstairs market making firms in the country. There were other individuals like Irv Kessler (Irv went on to form Deephaven in Minneapolis, one of the largest and most successful multi-strategy hedge funds in the world), Dan Asher, and Marc Kelner, all brilliant traders that likewise banded together and raised significant amounts of capital to start similar trading firms specializing in options. There were others that were already organized as firms like O’Connor Securities and Chicago Research and Trading that grew exponentially as option volume and liquidity expanded. All these became a blueprint for what I consider to be the first hedge funds.

Before going any further notice that these firms that developed into hedge funds were predicated on providing liquidity: selling derivatives to buyers and buying them from sellers. When you provide liquidity you reduce volatility, not increase it (the more liquid something is, the less volatile it tends to be). One of the primary criticisms of hedge funds (like William Saphire) is that they increase volatility. There are certainly hedge funds that because they use too much leverage and have too concentrated positions increase volatility in certain situations, but in general it is my opinion that at the end of the day it is a wash.

The common element among these trading firms was their understanding of risk. They were mainly concerned with the vagaries of option prices. They all understood one concept: when investors underestimate risk (or potential risk), they sell options too cheaply; when they overestimate risk, they pay too much for them. This concept they used to their advantage by employing proper amounts of leverage to earn spreads between option prices. These firms branched out into other strategies where this concept of estimating and pricing risk (volatility) was tantamount in generating returns: convertible bonds, risk-arbitrage, and even long/short equity.

Dealers like Morgan Stanley also run these same strategies and can themselves be considered a special type of hedge fund (they comparatively use a lot of leverage). Many of today’s hedge fund managers used to work for these dealers and employ the same strategies they used when facilitating customer trades. For example, a long/short equity hedge fund closely resembles block trading at sell side dealers. The first long/short stock hedge fund, Battery March founded by Dean LeBaron, was a huge customer of the block business in the early 1980’s and often took the other side of customer trades that a block desk was facilitating.

And that leads us to try to define what a hedge fund is, or at least what it is supposed to be. A hedge fund eliminates (as far as this can be done) extraneous or superfluous risks, while isolating a set of primary risks. These risks are then analyzed for degree and price and a certain amount of leverage is applied to generate a commensurate amount of return.

A long/short equity hedge fund by selling notionally the same amount of stock as it is buying (adjusted for beta) can be said to hedge away market or systematic risk and isolate stock or unsystematic risk. Because they have little market risk, the manager is theoretically able to increase this amount of unsystematic risk above the level that a straight equity manager would. But the degree to which leverage can then be employed is a function of degree and price.

If the manager is short Motorola (MOT:NYSE) and long The Gap (GPS:NYSE), the degree of that risk is very high because there is not much correlation between the two. If the historical relationship between the two is also low (MOT price is relatively low versus GPS on an historical spread basis), the price is low; because the degree of risk is high and the price of risk is low, applying any leverage may not be wise. Other strategies where there is a high correlation between the long asset and the short asset (degree is low) and when there is a great advantage in the relative price (like when convertible bonds are very cheap theoretically) may allow higher leverage. The bottom line is this: the amount of leverage is a direct function of risk: when risk is low, leverage can be high; when risk is high, leverage should be low.

Because of 1987 investors in general realized that stocks had much more risk than they perceived. Remember there are two subsets of risk: day to day volatility and tail or potential volatility. Investors had been focusing on day to day volatility and had forgotten about the much nastier sister. After 1987 more sophisticated investors began to actively seek out hedge funds (because they control risk) and the industry took off.

The flood of new money didn’t matter much to the Ten, but it mattered a great deal to the other ninety. As the demand for hedge fund managers exceeded supply, in my opinion, a lesser quality of manager was being allowed to set up shop and run money. Most people when comparing a name like John Merriweather (LTCM) and Irv Kessler (Deephaven) before 1998 would pick the former over the latter as a better hedge fund manager. In my mind there is no comparison either—but the other way. You will not find another trader better at analyzing and understanding risk (in a matter of seconds in his head) than Irv Kessler. A trader like Merriweather (who ignored the relationship between risk and leverage) will eventually blow up; it’s just a matter of time.

And here is the most important element in determining a good hedge fund manager from a bad one: their understanding and application of risk.

It is ironic that the hedge fund managers that have destroyed huge amounts of wealth have run risk in the opposite manner than I have described: they have increased leverage with an increase in degree and a reduction in price. If you refer to my piece on LTCM you will see that they used heavy leverage in trades where potential volatility or tail risk was very high, like in risk-arbitrage or even long/short equity. We see even today a very disturbing trend: managers leverage more and more the worse price gets. When convertible bonds are expensive (a bad price to buy), we see managers instead of selling bonds and de-leveraging, buy more and leverage more. To their way of thinking (ignoring risk), a smaller spread (return) can be increased if it is leveraged. And they feel justified in this because that is what they are being paid to do: buy convertible bonds and make a certain return. Irv would say instead that this is a disaster waiting to happen.

And here is my main point. It is not that the concept of a hedge fund is bad, as the media may believe. It is not the concept of a hedge fund that may add volatility to the market or may cause a blow up that dominates the head lines or even puts the financial system at risk. It is the improper execution of hedge fund strategies by inferior managers using detrimental concepts of risk and leverage that cause these things. This is why regulation is absolutely necessary.

Regulation should focus on correcting the problem by requiring full transparency. Experienced analysis then of that transparency is essential in weeding the good hedge fund managers from the bad. This is why the lack of transparency by Fannie Mae (FNM:NYSE) and Freddie Mac (FRE:NYSE), which by my definition are the largest hedge funds in the world [except maybe for General Electric (GE:NYSE)], is so worrisome. The regulators need to bark up the right trees first.