Market neutral investing
Back in the late 1940s, an investment manager called Jones had a hard question: Since 70% of his clients' stocks went up and down with the market, how could he hedge away market risk?
He came up with the novel idea that he could go long with 100% of his clients' money, and at the same time, go short with the same 100% of the clients' money, creating a "market-neutral investment" account. If the movement of the market was called Beta, then the skill that Jones brought to these accounts would be Alpha, and the return to the investor would be "absolute," or not against a benchmark. Thus, if the market went up 10%, he expected his long stock picks to go up at least 10%, and his shorts to lose no more than 10%, and he hoped the longs would go up 15% and the shorts would lose no more than 5%, giving him a 10% real or absolute profit--his Alpha.
Having dreamt up a powerful investing idea, he needed to figure out what to charge clients for his services. He came up with the 1 & 20 formula; that is, he charged the clients 1% of the amount invested per year for the labor of handling the account, and 20% of the profits on an annual basis.
In a stroke he had invented the "hedge fund," both the investing concept and a fair charge for what he provided, and an industry that is now $1.8 trillion was born, even though probably only 10% of the money invested is hedged in this way.