A hedge fund is a private investment fund that charges a performance fee and is typically open to only a limited range of qualified investors. Hedge fund activity in the public securities markets has grown substantially as it constitutes approximately 30% of all U.S. fixed-income security transactions, 55% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, as well as 30% of equity trades. Hedge Funds dominate certain specialty markets such as trading in derivatives with high-yield ratings, and distressed debt.
Alfred Winslow Jones is credited with inventing Hedge Funds in 1949.
In the United States, in order for an investment fund to be exempt from direct regulation, it must be open to accredited investors only and only a limited number of investors can belong to it. While there is no legal definition of "Hedge Fund" under U.S. securities laws and regulations, typically they include any investment fund that, because of an exemption from the types of regulation that otherwise apply to mutual funds, brokerage firms or investment advisers can invest in more complex and more risky investments than a public fund might. As a hedge fund's investment activities are limited only by the contracts governing the particular fund, it can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.
As their name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging via any number of methods. However, the term "hedge fund" has come in modern parlance to be overused and inappropriately applied to any absolute-return fund – many of these so-called "hedge funds" do not actually hedge their investments.
Hedge funds have acquired a reputation for secrecy. Unlike open-to-the-public "retail" funds (e.g., U.S. mutual funds) which market freely to the public, in most countries, hedge funds are specifically prohibited from marketing to investors who are not professional investors or individuals with sufficient private wealth. This limits the information a hedge fund is legally required to release. Additionally, divulging a hedge fund's methods could unreasonably compromise their business interests; this limits the information a hedge fund would want to release. Since hedge fund assets can run into many billions of dollars and will usually be multiplied by leverage, their sway over markets, whether they succeed or fail, is potentially substantial and there is a continuing debate over whether they should be more thoroughly regulated.
Industry - In 2005, Absolute Return magazine found there were 196 hedge funds with $1 billion or more in assets, with a combined $743 billion under management - the vast majority of the industry's estimated $1 trillion in assets. However, according to hedge fund advisory group Hennessee, total hedge fund industry assets increased by $215 billion in 2006 to $1.442 trillion, up 17.5% on a year earlier, an estimate for 2005 seemingly at odds with Absolute Return.
As large institutional investors have entered the hedge fund industry the total asset levels continue to rise. The 2008 Hedge Fund Asset Flows & Trends Report [5] published by HedgeFund.net and Institutional Investor News estimates total industry assets reached $2.68 trillion in Q3 2007. According to the Barclay Hedge Monthly Asset Flow Report, hedge funds received only $16 billion in October, the second-lowest inflow in 2007. Year-to-date hedge funds attracted $278.5 billion, three times year-to-date inflow into equity mutual funds.
A major trend in the hedge fund industry is the increasing amount of capital being poured in to the asset class through institutional investments. Single digit returns and underfunded pension plans has led to institutional investors looking beyond traditional investments in stocks and bonds in order to generate the absolute returns needed to close their funding gaps or maintain capital levels. Data taken from the 2008 Preqin Hedge Institutional Investor Directory indicates that throughout 2008 up to $80-90 billion will be invested in hedge funds through institutional commitments alone. The most prolific institutional investors, as identified by Preqin Hedge, are public pension plans, endowments and family offices and foundations.
Fees - Usually the hedge fund manager will receive both a management fee and a performance fee (also known as an incentive fee). Performance fees are closely associated with hedge funds, and are intended to incentivize the investment manager to produce the largest returns they can.
Management Fees - As with other investment funds, the management fee is calculated as a percentage of NAV of the fund at the time when the fee becomes payable. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. Therefore, if a fund has $1 billion of assets at the year end and charges a 2% management fee, the management fee will be $20 million in total. Management fees are usually calculated annually and paid monthly.
Performance Fees - Performance fees, which give a share of positive returns to the manager, are one of the defining characteristics of hedge funds. In contrast to retail investment firms, performance fees are prohibited in the U.S. for stock brokers. A hedge fund's performance fee is calculated as a percentage of the fund's profits, counting both unrealized profits and actual realized trading profits. Performance fees exist because investors are usually willing to pay managers more generously when the investors have themselves made money. For managers who perform well the performance fee is extremely lucrative.
Typically, hedge funds charge 20% of gross returns as a performance fee, but again the range is wide, with highly regarded managers demanding higher fees. In particular, Steven Cohen's SAC Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons' Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its flagship Medallion Fund before returning all investors' capital and running solely on its employees' money.
Managers argue that performance fees help to align the interests of manager and investor better than flat fees that are payable even when performance is poor. However, performance fees have been criticized by many people, including notable investor Warren Buffett, for giving managers an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark and sometimes by a hurdle rate. Alternatively, the investment manager might be required to return performance fees when the value of the fund drops. This provision is sometimes called a ‘claw-back.’
High water marks - A "High water mark" is often applied to a performance fee calculation. This means that the manager does not receive performance fees unless the value of the fund exceeds the highest net asset value it has previously achieved. For example, if a fund was launched at a net asset value (NAV) per share of $100, which then rose to $130 in its first year, a performance fee would be payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If in the third year the NAV per share rises to $143, a performance fee will be payable only on the extra $13 return from $130 to $143 rather than on the full return from $120 to $143.
This measure is intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. If a high water mark is not used, a fund that ends alternate years at $100 and $110 would generate performance fee every other year, enriching the manager but not the investors. However, this mechanism does not provide complete protection to investors: a manager who has lost money may simply decide to close the fund and start again with a clean slate -- provided that he can persuade investors to trust him with their money. A high water mark is sometimes referred to as a "Loss Carry forward Provision." Poorly performing funds frequently close down rather than work without fees, as would be required by their high water mark policies.
Hurdle Rates - Some funds also specify a hurdle rate, which signifies that the fund will not charge a performance fee until its annualized performance exceeds a benchmark rate, such as T-bills or a fixed percentage, over a certain period. This links performance fees to the ability of the manager to do better than the investor would have done if invested money elsewhere.
Funds which specify a soft hurdle rate charge a performance fee based on the entire annualized return. Funds which use a hard hurdle rate only charge a performance fee on returns above the hurdle rate. Though logically appealing, this practice has diminished as demand for hedge funds has outstripped supply and hurdles are now rare.
Strategies - Hedge funds are no longer a homogeneous class. Under certain circumstances, an investor or hedge fund can completely hedge the risks of an investment, leaving pure profit.[citation needed] For example, at one time it was possible for exchange traders to buy shares of, say, IBM on one exchange and simultaneously sell them on another exchange, leaving pure profit.[citation needed] Competition among investors has leached away such profits, leaving hedge fund managers with trades that are partially hedged, at best. These trades still contain residual risks which can be considerable. Some styles of hedge fund investing, such as global macro investing, may involve no hedging at all. Strictly speaking, it is not accurate to call such funds hedge funds, but that is current usage.
The bulk of hedge funds describe themselves as long / short equity, but many different approaches are used taking different exposures, exploiting different market opportunities, using different techniques and different instruments:
* Global macro – seeking related assets that have deviated from some anticipated relationship.
* Arbitrage – seeking assets that are mispriced relative to related assets.
o Convertible arbitrage – between a convertible bond and the same company's equity.
o Fixed income arbitrage – between related bonds.
o Risk arbitrage – between securities whose prices appear to imply different probabilities 1 event.
o Statistical arbitrage between securities that have deviated from statistically estimated relationship.
o Derivative arbitrage – between a derivative and its security.
* Long / short equity – generic term covering all hedged investment in equities.
o Short bias – emphasizing or solely using short positions.
o Equity market neutral – maintaining a close balance between long and short positions.
* Event driven – specialized in the analysis of a particular kind of event.
o Distressed securities – companies that are or may become bankrupt.
o Regulation D – distressed companies issuing securities.
o Merger arbitrage - arbitrage between an acquiring public company and a target public company.
* Other – the strategies below are sometimes considered hedge strategies, although in several cases usage of the term is debatable.
o Emerging markets- this usually means unhedged, long positions in small overseas markets.
o Fund of hedge funds - unhedged, long only positions in hedge funds (though the underlying funds, of course, may be hedged). Additional leverage is sometimes used.
o Quantitative
o 130-30 funds - Through leveraging, 130% of the money invested in the fund is used to buy stocks. 30% of the money invested in the fund is used to short stock.
Hedge Fund Risk - Investing in a hedge fund is considered to be a riskier proposition than investing in a regulated fund, despite the traditional notion of a "hedge" being a means of reducing the risk of a bet or investment. The following are some of the primary reasons for the increased risk:
Leverage - in addition to putting money into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing sums many times greater than the initial investment. Where a hedge fund has borrowed $9 for every $1 invested, a loss of only 10% of the value of the investments of the hedge fund will wipe out 100% of the value of the investor's stake in the fund, once the creditors have called in their loans. At the beginning of 1998, shortly before its collapse, Long Term Capital Management had borrowed over $26 for each $1 invested.
Short Selling - due to the nature of short selling, the losses that can be incurred on a losing bet are theoretically limitless, unless the short position directly hedges a corresponding long position. Therefore, where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns against it.
Appetite for Risk - hedge funds are culturally more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities and collateralised debt obligations based on sub-prime mortgages.
Lack of Transparency - hedge funds are secretive entities. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision.
Lack of Regulation - hedge funds are not subject to as much oversight from financial regulators, and therefore some may carry undisclosed structural risks. Investors in hedge funds are willing to take these risks because of the corresponding rewards. Leverage amplifies profits as well as losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns; secrecy helps to prevent imitation by competitors; and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis.
Legal Structure - A hedge fund is a vehicle for holding and investing the funds of its investors. The fund itself is not a genuine business, having no employees and no assets other than its investment portfolio and a small amount of cash, and its investors being its clients. The portfolio is managed by the investment manager, which has employees and property and which is the actual business. An investment manager is commonly termed a “hedge fund” (e.g. a person may be said to “work at a hedge fund”) but this is not technically correct. An investment manager may have a large number of hedge funds under its management.
Domicile – The specific legal structure of a hedge fund – in particular its domicile and the type of entity used – is usually determined by the tax environment of the fund’s expected investors. Regulatory considerations will also play a role. Many hedge funds are established in offshore tax havens so that the fund can avoid paying tax on the increase in the value of its portfolio. An investor will still pay tax on any profit it makes when it realizes its investment, and the investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund.
At the end of 2004 55% of the world’s hedge funds, accounting for nearly two-thirds of total hedge fund assets, were established offshore. The most popular offshore location was the Cayman Islands, followed by the British Virgin Islands, Bermuda and the Bahamas. The US was the most popular onshore location, accounting for 34% of funds and 24% of assets. EU countries were the next most popular location with 9% of funds and 11% of assets. Asia accounted for the majority of the remaining assets.
The legal entity - Limited partnerships are principally used for hedge funds aimed at US-based investors who pay tax, as the investors will receive relatively favorable tax treatment in the US. The general partner of the limited partnership is typically the investment manager (though is sometimes an offshore corporation) and the investors are the limited partners. Offshore corporate funds are used for non-US investors and US entities that do not pay tax (such as pension funds), as such investors do not receive the same tax benefits from investing in a limited partnership. Unit trusts are typically marketed to Japanese investors. Other than taxation, the type of entity used does not have a significant bearing on the nature of the fund.
Many hedge funds are structured as master/feeder funds. In such a structure the investors will invest into a feeder fund which will in turn invest all of its assets into the master fund. The assets of the master fund will then be managed by the investment manager in the usual way. This allows several feeder funds (e.g. an offshore corporate fund, a US limited partnership and a unit trust) to invest into the same master fund, allowing an investment manager the benefit of managing the assets of a single entity while giving all investors the best possible tax treatment.
The investment manager, which will have organized the establishment of the hedge fund, may retain an interest in the hedge fund, either as the general partner of a limited partnership or as the holder of “founder shares” in a corporate fund. Founder shares typically have no economic rights, and voting rights over only a limited range of issues, such as selection of the investment manager – most of the fund’s decisions are taken by the board of directors of the fund, which is self-appointing and independent but invariably loyal to the investment manager.
Open-ended Nature - Hedge funds are typically open-ended, in that the fund will periodically issue additional partnership interests or shares directly to new investors, the price of each being the NAV per interest/share. To realise the investment, the investor will redeem the interests or shares at the NAV per interest/share prevailing at that time. Therefore, if the value of the underlying investments has increased (and the NAV per interest/share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Investors do not typically trade shares among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund, which has a limited number of shares which are traded among investors, and which distributes its profits.
Listed funds - Corporate hedge funds often list their shares on smaller stock exchanges, such as the Irish Stock Exchange, in the hope that the low level of quasi-regulatory oversight will give comfort to investors and to attract certain funds, such as some pension funds, that have bars or caps on investing in unlisted shares. Shares in the listed hedge fund are not traded on the exchange, but the fund’s monthly net asset value and certain other events must be publicly announced there.
A fund listing is distinct from the listing of an IPO of shares in an investment manager. Although widely reported as a "hedge-fund IPO"[, the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.
In contrast to the funds themselves, hedge fund managers are primarily located onshore in order to draw on larger pools of financial talent. The US East coast – principally New York City and the Gold Coast area of Connecticut (particularly Stamford and Greenwich) – is the world's leading location for hedge fund managers with approximately double the hedge fund managers of the next largest centre, London. With the bulk of hedge fund investment coming from the US, this distribution is natural.
London is Europe’s leading centre for the management of hedge funds. At the end of 2006, three-quarters of European hedge fund investments, totaling $400bn (£200bn), were managed from London, having grown from $61bn in 2002. Australia was the most important centre for the management of Asia-Pacific hedge funds, with managers located there accounting for approximately a quarter of the $140bn of hedge fund assets managed in the Asia-Pacific region in 2006. Part of what gives hedge funds their competitive edge, and their cachet in the public imagination, is that they straddle multiple definitions and categories; some aspects of their dealings are well-regulated, others are unregulated or at best quasi-regulated.
US Regulation - The typical public investment company in the United States is required to be registered with the U.S. Securities and Exchange Commission (SEC). Mutual funds are the most common type of registered investment companies. Aside from registration and reporting requirements, investment companies are subject to strict limitations on short-selling and the use of leverage. There are other limitations and restrictions placed on public investment company managers, including the prohibition on charging incentive or performance fees.
Although hedge funds fall within the statutory definition of an investment company, the limited-access, private nature of hedge funds permits them to operate pursuant to exemptions from the registration requirements. The two major exemptions are set forth in Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940. Those exemptions are for funds with 100 or fewer investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7 Fund"). A qualified purchaser is an individual with over US$5,000,000 in investment assets. (Some institutional investors also qualify as accredited investors or qualified purchasers.) A 3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited number of investors. Both types of funds can charge performance or incentive fees.
In order to comply with 3(c)(1) or 3(c)(7), hedge funds are sold via private placement under the Securities Act of 1933. Thus interests in a hedge fund cannot be offered or advertised to the general public, and are normally offered under Regulation D. Although it is possible to have non-accredited investors in a hedge fund, the exemptions under the Investment Company Act, combined with the restrictions contained in Regulation D, effectively require hedge funds to be offered solely to accredited investors. An accredited investor is an individual with a minimum net worth of US $5,000,000 or, alternatively, a minimum income of US$200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year.
The regulatory landscape for Investment Advisors is changing, and there have been attempts to register hedge fund investment managers. There are numerous issues surrounding these proposed requirements. One issue of importance to hedge fund managers is the requirement that a client who is charged an incentive fee must be a "qualified client" under Advisers Act Rule 205-3. To be a qualified client, an individual must have US$750,000 in assets invested with the adviser or a net worth in excess of US$1.5 million, or be one of certain high-level employees of the investment adviser.
For the funds, the tradeoff of operating under these exemptions is that they have fewer investors to sell to, but they have few government-imposed restrictions on their investment strategies. The presumption is that hedge funds are pursuing more risky strategies, which may or may not be true depending on the fund, and that the ability to invest in these funds should be restricted to wealthier investors who are presumed to be more sophisticated and who have the financial reserves to absorb a possible loss.
In December 2004, the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers Act.[10] The requirement, with minor exceptions, applied to firms managing in excess of US$25,000,000 with over 15 investors. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry. The rule change was challenged in court by a hedge fund manager, and in June 2006, the U.S. Court of Appeals for the District of Columbia overturned it and sent it back to the agency to be reviewed. See Goldstein v. SEC.
Although the SEC is currently examining how it can address the Goldstein decision, commentators have stated that the SEC currently has neither the staff nor expertise to comprehensively monitor the estimated 8,000 U.S. and international hedge funds. See New Hedge Fund Advisor Rule. One of the Commissioners, Roel Campos, has said that the SEC is forming internal teams that will identify and evaluate irregular trading patterns or other phenomena that may threaten individual investors, the stability of the industry, or the financial world. "It's pretty clear that we will not be knocking on [hedge fund] doors very often," Campos told several hundred hedge fund managers, industry lawyers and others. And even if it did, "the SEC will never have the degree of knowledge or background that you do." In February 2007, the President's Working Group on Financial Markets rejected further regulation of hedge funds and said that the industry should instead follow voluntary guidelines.
Comparison to Private Equity Funds - Hedge funds are similar to private equity funds in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in relatively liquid assets, and permit investors to enter or leave the fund, perhaps requiring some months notice. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition funds. Between 2004 and February 2006 some hedge funds adopted 25 month lock-up rules expressly to exempt themselves from the SEC's new registration requirements and cause them to fall under the registration exemption that had been intended to exempt private equity funds.[citations needed]
Comparison to U.S. Mutual Funds - Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to invest). However, there are many differences between the two, including:
• Mutual funds are regulated by the SEC, while hedge funds are not
• A hedge fund investor must be an accredited investor with certain exceptions (employees, etc.)
• Mutual funds must price and be liquid on a daily basis
Some hedge funds that are based offshore report their prices to the Financial Times, but for most there is no method of ascertaining pricing on a regular basis. Additionally, mutual funds must have a prospectus available to anyone that requests one (either electronically or via US postal mail), and must disclose their asset allocation quarterly, while hedge funds do not have to abide by these terms.
Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time where the total returns are generated (net of fees) for their investors and then returned when the term ends, through a pass through requiring CPAs and US Tax W-forms. Hedge fund investors tolerate these policies because hedge funds are expected to generate higher total returns for their investors versus mutual funds. Recently, however, the mutual fund industry has created products with features that have traditionally only been found in hedge funds.
Mutual funds have appeared which utilize some of the trading strategies noted above. Grizzly Short Fund for example, is always net short, while Arbitrage Fund (ARBFX) specializes in merger arbitrage. Such funds are SEC regulated, but they offer hedge fund strategies and protection for mutual fund investors.
Also, a few mutual funds have introduced performance-based fees, where the compensation to the manager is based on the performance of the fund. However, under Section 205(b) of the Investment Advisers Act of 1940, such compensation is limited to so-called "fulcrum fees". Under these arrangements, fees can be performance-based so long as they increase and decrease symmetrically. For example, the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves, within limits and symmetrically, similarly to a hedge fund "0 and 50" fee: A 0% management fee coupled with a 50% performance fee if the fund outperforms its benchmark index. However, the 125 bp base fee is reduced (but not below zero) by 50% of underperformance and increased (but not to more than 250 bp) by 50% of outperformance.
Many offshore centers are keen to encourage the establishment of hedge funds. To do this they offer some combination of professional services, a favorable tax environment, and business-friendly regulation. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin Islands and Bermuda. The Cayman Islands have been estimated to be home to about 75% of world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM.
Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centers. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager Many offshore hedge funds, such as the Soros funds, are structured as mutual funds rather than as limited partnerships.
Hedge Fund Indices - here are a number of indices that track the hedge fund industry. These indices come in two types, Investable and Non-investable, both with substantial problems. There are also new types of tracking product launched by Goldman Sachs and Merrill Lynch, "clone indices" that aim to replicate the returns of hedge fund indices without actually holding hedge funds at all.
Investable indices are created from funds that can be bought and sold, and only Hedge Funds that agree to accept investments on terms acceptable to the constructor of the index are included. Investability is an attractive property for an index because it makes the index more relevant to the choices available to investors in practice, and is taken for granted in traditional equity indices such as the S&P500 or FTSE100. However, such indices do not represent the total universe of hedge funds and may under-represent the more successful managers, who may not find the index terms attractive. Fund indexes include Barclay Hedge, Hedge Fund Research, Eurekaa edge Indices, Credit Suisse Tremont and FTSE Hedge.
The index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index, making investable indices similar in some ways to fund of hedge funds portfolios. Non-investable benchmarks are indicative in nature, and aim to represent the performance of the universe of hedge funds using some measure such as mean, median or weighted mean from a hedge fund database. There are diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different databases.
Non-investable indices inherit the databases' shortcomings, or strengths, in terms of scope and quality of data. Funds’ participation in a database is voluntary, leading to “self reporting bias” because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money. This tends to lead to a clustering of returns around the mean rather than representing the full diversity existing in the hedge fund universe. Examples of non-investable indices include an equal weighted benchmark series known as the HFN Averages, and revolutionary rules based set known as the Lehman Brothers/HFN Global Index Series which leverages an Enhanced Strategy Classification System.
The short lifetimes of many hedge funds means that there are many new entrants and many departures each year, which raises the problem of “survivorship bias”. If we examine only funds that have survived to the present, we will overestimate past returns because many of the worst-performing funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial. As the HFR and CISDM databases began in 1994, it is likely that they will be more accurate over the period 1994/2000 than the Credit Suisse database, which only began in 2000.
When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favourable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias” or “backfill bias”.
In traditional equity investment, indices play a central and unambiguous role. They are widely accepted as representative, and products such as futures and ETFs provide liquid access to them in most developed markets. However, among hedge funds no index combines these characteristics. Investable indices achieve liquidity at the expense of representativeness. Non-investable indices are representative, but their quoted returns may not be available in practice. Neither is wholly satisfactory.
Systemic Risk - Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital Management (LTCM) in 1998, which necessitated a bailout coordinated by the U.S. Federal Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster. The excessive leverage (through derivatives) that can be used by hedge funds to achieve their return is outlined as one of the main factors of the hedge funds contribution to systematic risk.
However, the ECB statement itself has been criticized by a part of the financial research community. These arguments are developed by the EDHEC Risk and Asset Management Research Centre: The main conclusions of the study are that “the ECB article’s conclusion of a risk of “disorderly exits from crowded trades” is based on mere speculation. While the question of systemic risk is of importance, we do not dispose of enough data to reliably address this question at this stage”, “ it would be worthwhile for financial regulators to work towards obtaining data on hedge fund leverage and counterparty credit risk. Such data would allow a reliable assessment of the question of systemic risk”, and “besides evaluating potential systemic risk, it should be recognised that hedge funds play an important role as “providers of liquidity and diversification”.
The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge funds in June 2007. The funds invested in mortgage-backed securities. The funds' financial problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside assistance. It was the largest fund bailout since Long Term Capital Management's collapse in 1998. The U.S. Securities and Exchange commission is investigating.
Transparency - As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to third parties. This is in contrast to a fully regulated mutual fund (or unit trust) which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment advisor of the fund, and may enjoy more personalised reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy. Several hedge funds are completely "black box", meaning that their returns are uncertain to the investor.
Restrictions on marketing and the lack of regulation is that there are no official hedge fund statistics. An industry consulting group, HFR (hfr.com), reported at the end of the second quarter 2003 that there are 5,660 hedge funds world wide managing $665 billion. For comparison, at the same time the US mutual fund sector held assets of $7.818 trillion
Some hedge funds, mainly American, do not use third parties either as the custodian of their assets or as their administrator. This can lead to conflicts of interest, and in extreme cases can assist fraud. In a recent example, Kirk Wright of International Management Associates has been accused of mail fraud and other securities violations which allegedly defrauded clients of close to $180 million.
Market Capacity - Analysis of the rather disappointing hedge fund performance in 2004 and 2005 called into question the alternative investment industry's value proposition. Alpha may have been becoming rarer for two related reasons. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more and more managers, which may dilute the talent available in the industry.
However, the market capacity effect has been questioned by the EDHEC Risk and Asset Management Research Centre through a decomposition of hedge fund returns between pure alpha, dynamic betas, and static betas. While pure alpha is generated by exploiting market opportunities, the dynamic betas depend on the manager’s skill in adapting the exposures to different factors, and these authors claim that these two sources of return do not exhibit any erosion. This suggests that the market environment (static betas) explains a large part of the poor performance of hedge funds in 2004 and 2005.
Investigations of Illegal Conduct - In the U.S., the SEC is focusing more resources on investigating violations and illegal conduct on the part of hedge funds in the public securities markets. Linda C. Thomsen, enforcement director of the SEC, said in November 2007 that federal regulators were concerned about illegal trading and the potential for harm to hedge fund investors. She said, “These days, the money is in hedge funds, so the potential for abuse, the potential for securities law violations is there because there is so much money there.” Outside firms offering services to the hedge funds such as Prime Brokerage may be held accountable for failing to report illegal conduct on account of their client hedge funds
Performance Measurement - The issue of performance measurement in the hedge fund industry has led to literature that is both abundant and controversial. Traditional indicators (Sharpe, Treynor, Jensen) work best when returns follow a symmetrical distribution. In that case, risk is represented by the standard deviation. Unfortunately, hedge fund returns are not normally distributed, and hedge fund return series are auto correlated. Consequently, traditional performance measures suffer from theoretical problems when they are applied to hedge funds, making them even less reliable than is suggested by the shortness of the available return series.
Innovative performance measures have been introduced in an attempt to deal with this problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003), Omega by Keating and Shadwick (2002), Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004), and Kappa by Kaplan and Knowles (2004). An overview of these performance measures is available in Géhin, W., 2006, The Challenge of Hedge Fund Performance Measurement: a Toolbox rather than a Pandora’s Box, EDHEC Risk and Asset Management Research Center, Position Paper, December. However, there is no consensus on the most appropriate absolute performance measure, and traditional performance measures are still widely used in the industry.
Relationships with Analysts - In June 2006. the U.S. Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts, and other issues related to the funds. Connecticut Attorney General Richard Blumenthal testified that an appeals court ruling striking down oversight of the funds by federal regulators left investors "in a regulatory void, without any disclosure or accountability." The hearings heard testimony from, among others, Gary Aguirre, a staff attorney who was recently fired by the SEC.
The top 10 are as follows:
• RAB Special Situations Fund (RAB Capital, London) - 47.69%
• The Children's Investment Fund (The Children's Investment Fund Mgmt. London) - 44.27%
• Highland CDO Opportunity Fund (Highland Capital Management, Dallas) - 43.98%
• BTR Global Opportunity Fund, Class D (Salida Capital, Toronto) - 43.42%
• SR Phoenicia Fund (Sloane Robinson, London) - 43.10%
• Atticus European Fund (Atticus Management, New York) - 40.76%
• Gradient European Fund A (Gradient Capital Partners, London) - 39.18%
• Polar Capital Paragon Absolute Return Fund (Polar Capital Partners, London) - 38.00%
• Paulson Enhanced Partners Fund (Paulson & Co., New York) - 37.97%
• Firebird Global Fund (Firebird Management, New York) - 37.18%
The full top 10 list of hedge fund earners according to Trader Monthly includes:
T. Boone Pickens - estimated 2005 earnings $1.5bn +
Steven A. Cohen, SAC Capital Advisers - $1bn +
James H. Simons, Renaissance Technologies Corp. - $900m - $1bn
Paul Tudor Jones, Tudor Investment Corp. - $800m - $900m
Stephen Feinberg, Cerberus Capital Management - $500 - $600m
Bruce Kovner, Caxton Associates - $500m - $600m
Eddie Lampert, ESL Investments - $500m - $600m
David E. Shaw, D. E. Shaw & Co. - $400m - $500m
Jeffrey Gendell, Tontine Partners - $300m - $400m
Louis Bacon, Moore Capital Management - $300m - $350m
[Notable Hedge Fund Management Companies Sometimes also known as Alternative Investment Management Companies.
Amaranth Advisors
Bridgewater Associates
Caxton Associates
Centaurs Energy
Citadel Investment Group
D. E. Shaw & Co.
Fortress Investment Group
Goldman Sachs Asset Management
Long Term Capital Management
Man Group
Pirate Capital LLC
Renaissance Technologies
SAC Capital Advisors
Soros Fund Management
Marshall Wace
In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities. Thus the hedger is indifferent to the movements of the market as a whole, and is interested only in the performance of the 'under-priced' security relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis," where the basis is the difference between the hedge's theoretical value and its actual value (or between spot and futures prices in Working's time).
Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, expects to face natural risks such as the risk of competition, of poor or unpopular products, and so on.
The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency. Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits.
Example Hedge - A stock trader believes that the stock price of Company A will rise over the next month, due to this company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.
Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of Company A's direct competitor, Company B. If the trader were able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a call option on Company A shares) the trade might be essentially riskless and be called an arbitrage. But since some risk remains in the trade, it is said to be "hedged."
The first day the trader's portfolio is:
• Long 1000 shares of Company A at $1 each
• Short 500 shares of Company B at $2 each
(Notice that the trader has sold short the same value of shares.)
On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, goes up by 10%, while Company B goes up by just 5%:
• Long 1000 shares of Company A at $1.10 each — $100 profit
• Short 500 shares of Company B at $2.10 each — $50 loss
(In a short position, the investor loses money when the price goes up.)
The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash -- 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:
Value of long position (Company A):
• Day 1 — $1000
• Day 2 — $1100
• Day 3 — $550 => $450 loss
Value of short position (Company B):
• Day 1 — $1000
• Day 2 — $1050
• Day 3 — $525
Without the hedge, the trader would have lost $450. But the hedge - the short sale of Company B - gives a profit of $475, for a net profit of $25 during a dramatic market collapse.
Types of hedging –
The example above is a "classic" sort of hedge, known in the industry as a "pairs trade" due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values, known as models, the types of hedges have increased greatly.
Natural Hedges
Many hedges do not involve exotic financial instruments or derivatives. A natural hedge is an investment that reduces the undesired risk by matching cash flows, i.e. revenues and expenses. For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure. Another example is a company that opens a subsidiary in another country and borrows in the local currency to finance its operations, even though the local interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the local currency, the parent company has reduced its foreign currency exposure.
Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars. One of the oldest means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life. Categories of hedgeable risk
For the following categories of the risk, for exporters, that the value of their accounting currency will fall against the value of the importers, also known as volatility risk.
• Interest rate risk – is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed income instruments or interest rate swaps.
• Equity – the risk, for those whose assets are equity holdings, that the value of the equity falls
Futures contracts and forward contracts are a means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the nineteenth century, but over the last fifty years a huge global market developed in products to hedge financial market risk.
Hedging Credit Risk - Credit risk is the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, naturally an early market developed between banks and traders: that involving selling obligations at a discounted rate. See for example forfeiting, bill of lading, or discounted bill.
Hedging Currency Risk - Currency hedging (also known as Foreign Exchange Risk hedging) is used both by financial investors to parse out the risks they encounter when investing abroad, as well as by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.
For example, labor costs are such that much of the simple commoditized manufacturing in the global economy today goes on in China and South-East Asia (Philippines, Vietnam, Indonesia, etc.). The cost benefit of moving manufacturing to outsource providers outweighs the uncertainties of doing business in foreign countries, so many businesses are moving manufacturing operations overseas. But the benefits of doing this have to be weighted also against currency risk.
If the cost of manufacturing goods in another country is denominated in a currency other than the one that the finished goods will be sold for, there is the risk that changes in the values of each currency will reduce profit or produce a loss. Currency hedging is akin to insurance that limits the impact of foreign exchange risk.
Currency hedging is not always available, but is readily found at least in the major currencies of
the world economy, the growing list of which qualify as major liquid markets beginning with the Major 8 Currency as USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD which are also called the "Benchmark Currencies", and expands to include several others by virtue of liquidity.
Currency hedging, like many other forms of financial hedging, can be done in two primary ways: with standardized contracts, or with customized contracts (also known as over-the-counter or OTC). The financial investor may be a hedge fund that decides to invest in a company in, for example, Brazil, but does not want to necessarily invest in the Brazilian currency. The hedge fund can separate out the credit risk (i.e. the risk of the company defaulting), from the currency risk of the Brazilian Real by "hedging" out the currency risk. In effect, this means that the investment is effectively a USD investment, in Brazil. Hedging allows the investor to transfer the currency risk to someone else, who wants to take up a position in the currency. The hedge fund has to pay this other investor to take on the currency exposure, similar to insuring against other types of events. As with other types of financial products, hedging may allow economic activity to take place that would otherwise not have been possible (as a loan, for example, may allow an individual to purchase a home that would be "too expensive" if the individual had to pay cash). The increased investment is assumed in this way to raise economic efficiency.
Related concepts
Forwards
A contracted agreement specifying an amount of currency to be delivered, at an exchange rate decided on the date of contract.
Forward Rate Agreement
A contract agreement specifying an interest rate amount to be settled, at a pre-determined interest rate on the date of the contract. This is also known as FRAs.
Currency option
A contract that gives the owner the right but not the obligation to take (call option) or deliver (put option) a specified amount of currency, at an exchange rate decided at the date of purchase.
Non-Deliverable Forwards (NDF)
A strictly risk-transfer financial product similar to a Forward Rate Agreement, but only used where monetary policy restrictions on the currency in question limit the free flow and conversion of capital. NDFs are, as the name suggests, not delivered, but rather, these are settled in a reference currency, usually USD or EUR, where the parties exchange the gain or loss that the NDF instrument yields, and if the buyer of the controlled currency truly needs that hard currency, he can take the reference payout and go to the government in question and convert the USD or EUR payout. The insurance effect is the same, it's just that the supply of insured currency is restricted and controlled by government.
Interest rate parity and Covered Interest Arbitrage
The simple concept that two similar investments in two different currencies ought to yield the same return. If the two similar investments are not at face value offering the same interest rate return, the difference should conceptually be made up by changes in the exchange rate over the life of the investment. IRP basically gives you the math to calculate a projected or implied forward rate of exchange. This calculated rate is not and cannot be considered a prediction or forecast, but rather is the arbitrage-free calculation for what the exchange rate is implied to be in order for it to be impossible to make a free profit by converting money to one currency, investing it for a period, then converting back and making more money than if you had invested in the same opportunity in the original currency.
Distributed Funds Transfer Hedge (DFT-hedge)
Hedging Equity & Equity Futures
Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, you short futures when you buy equity. Or long futures when you short stock.
There are many ways to hedge, and one is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures. Buy 10000 GBP worth of Vodafone and short 10000 worth of FTSE futures.
Another method to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone is 2, then for a 10000 GBP long position in Vodafone you will hedge with a 20000 GBP equivalent short position in the FTSE futures (the Index that Vodafone trades in).
Futures hedging - If you primarily trade in futures, you hedge your futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. So if you are long futures in your trade you can hedge by shorting synthetics, and vice versa.
Contract for differences - A Contract for Differences (CfD) is a two way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. For instance, consider a deal between an electricity producer and an electricity retailer who both trade through an electricity market pool. If the producer and the retailer agree to a strike price of $50 per MWh, for 1 MWh in a trading period, and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer. Conversely, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price.
In effect, the pool volatility is nullified and the parties pay and receive $50 per MWh. However, the party who pays the difference is "out of the money" because without the hedge they would have received the benefit of the pool price.
Origins
The term is derived from the phrase "hedging your bets" used in gambling games such as roulette. The hedges on a roulette table are the lines between numbers or number groups. Placing a hedged bet is one where the chips lie across one or more hedges (i.e. on a line between two numbers or on a corner between three or four numbers). The bet then covers all the numbers involved at an appropriately reduced stake (e.g. 1/2, 1/3, 1/4).
An aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).
Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.
It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.
The Differences Between Mutual Funds and Hedge Funds
Mutual funds and hedge funds differ in many ways, particularly the fees charged; leveraging, pricing, and liquidity practices employed; the degree of regulatory oversight to which each is subject; and the characteristics of the typical investors who use each investment vehicle.
U.S. mutual funds are among the most strictly regulated financial products. They are subject to numerous requirements designed to ensure they operate in the best interests of their shareholders. Hedge funds are private investment pools subject to far less regulatory oversight.
Regulatory Requirements
Mutual Funds
Mutual funds are investment companies that must register with the U.S. Securities and Exchange Commission (SEC) and, as such, are subject to rigorous regulatory oversight. Virtually every aspect of a mutual fund's structure and operation is subject to strict regulation under four federal laws: the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisers Act. The SEC is charged with overseeing the mutual fund industry's compliance with these regulations. The Internal Revenue Code sets additional requirements regarding a fund's portfolio diversification and its distribution of earnings, and the National Association of Securities Dealers, Inc. (NASD) oversees most mutual fund advertisements and other sales materials. In addition, mutual funds must have directors who are responsible for extensive oversight of the fund's policies and procedures. For virtually all funds, at least a majority of their directors must be independent from the fund's management.
The Investment Company Act is the cornerstone of mutual fund regulation. It regulates the structure and operation of mutual funds and requires funds to safeguard their portfolio securities, forward price their securities, and keep detailed books and records. In addition, the 1933 Act requires all prospective fund investors to receive a prospectus containing specific information about the fund's management, holdings, fees and expenses, and performance.
Hedge Funds
Hedge funds-unlike mutual funds-are not required to register with the SEC. They issue securities in "private offerings" not registered with the SEC under the Securities Act of 1933. Furthermore, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934.
Like mutual funds and other securities market participants, hedge funds are subject to prohibitions against fraud, and their managers have the same fiduciary duties as other investment advisers.
Fees
Mutual Funds
Federal law imposes a fiduciary duty on a mutual fund's investment adviser regarding the compensation it receives from the fund. In addition, mutual fund sales charges and other distribution fees are subject to specific regulatory limits under NASD rules. Mutual fund fees and expenses are disclosed in detail, as required by law, in a fee table at the front of every prospectus. They are presented in a standardized format, so that an investor can easily understand them and can compare expense ratios among different funds.
Hedge Funds
There are no limits on the fees a hedge fund adviser can charge its investors. Typically, the hedge fund manager charges an asset-based fee and a performance fee. Some have front-end sales charges, as well.
Leveraging Practices
Mutual Funds
The Investment Company Act severely restricts a mutual fund's ability to leverage or borrow against the value of securities in its portfolio. The SEC requires that funds engaging in certain investment techniques, including the use of options, futures, forward contracts and short selling, "cover" their positions. The effect of these constraints has been to strictly limit leveraging by mutual fund portfolio managers.
Hedge Funds
Leveraging and other higher-risk investment strategies are a hallmark of hedge fund management. Hedge funds were originally designed to invest in equity securities and use leverage and short selling to "hedge" the portfolio's exposure to movements of the equity markets. Today, however, advisers to hedge funds utilize a wide variety of investment strategies and techniques. Many are very active traders of securities.
Pricing and Liquidity
Mutual Funds
Mutual funds are required to value their portfolios and price their securities daily based on market quotations that are readily available at market value and others at fair value, as determined in good faith by the board of directors. In addition to providing investors with timely information regarding the value of their investments, daily pricing is designed to ensure that both new investments and redemptions are made at accurate prices. Moreover, mutual funds are required by law to allow shareholders to redeem their shares at any time.
Hedge Funds
There are no specific rules governing hedge fund pricing. Hedge fund investors may be unable to determine the value of their investment at any given time
Investor Characteristics
Mutual Funds
The only qualification for investing in a mutual fund is having the minimum investment to open an account with a fund company, which is typically around $1,000, but can be lower. After the account has been opened, there is generally no minimum additional investment required, and many fund investors contribute relatively small amounts to their mutual funds on a regular basis as part of a long-term investment strategy.
Hedge Funds
A significantly higher minimum investment is required from hedge fund investors. Under the Investment Company Act of 1940, certain hedge funds only may accept investments from individuals who hold at least $5 million in investments. This measure is intended to help limit participation in hedge funds and other types of unregulated pools to highly sophisticated individuals. Hedge funds can also accept other types of investors if they rely on other exemptions under the Investment Company Act or are operated outside the United States.
Visit the SEC website for more complete information on hedge funds edging Your Bets:
What are hedge funds?
Like mutual funds, hedge funds pool investors' money and invest those funds in financial instruments in an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.
Unlike mutual funds, however, hedge funds are not required to register with the SEC. Hedge funds typically issue securities in “private offerings” that are not registered with the SEC under the Securities Act of 1933. In addition, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934. But hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary duties as other investment advisers.
What are "Funds of Hedge Funds?"
A fund of hedge funds is an investment company that invests in hedge funds -- rather than investing in individual securities. Some funds of hedge funds register their securities with the SEC. These funds of hedge funds must provide investors with a prospectus and must file certain reports quarterly with the SEC.
Note: Not all funds of hedge funds register with the SEC.
Many registered funds of hedge funds have much lower investment minimums (e.g., $25,000) than individual hedge funds. Thus, some investors that would be unable to invest in a hedge fund directly may be able to purchase shares of registered funds of hedge funds.
What information should I seek if I am considering investing in a hedge fund or a fund of hedge funds?
• Read a fund's prospectus or offering memorandum and related materials. Make sure you understand the level of risk involved in the fund's investment strategies and ensure that they are suitable to your personal investing goals, time horizons, and risk tolerance. As with any investment, the higher the potential returns, the higher the risks you must assume.
• Understand how a fund's assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources.
• Ask questions about fees. Fees impact your return on investment. Hedge funds typically charge an asset management fee of 1-2% of assets, plus a "performance fee" of 20% of a hedge fund's profits. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return. Funds of hedge funds typically charge a fee for managing your assets, and some may also include a performance fee based on profits. These fees are charged in addition to any fees paid to the underlying hedge funds.
Tip: If you invest in hedge funds through a fund of hedge funds, you will pay two layers of fees: the fees of the fund of hedge funds and the fees charged by the underlying hedge funds.
• Understand any limitations on your right to redeem your shares. Hedge funds typically limit opportunities to redeem, or cash in, your shares (e.g., to four times a year), and often impose a "lock-up" period of one year or more, during which you cannot cash in your shares.
• Research the backgrounds of hedge fund managers. Know with whom you are investing. Make sure hedge fund managers are qualified to manage your money, and find out whether they have a disciplinary history within the securities industry. You can get this information (and more) by reviewing the adviser’s Form ADV. You can search for and view a firm’s Form ADV using the SEC’s Investment Adviser Public Disclosure (IAPD) website. You also can get copies of Form ADV for individual advisers and firms from the investment adviser, the SEC’s Public Reference Room, or (for advisers with less than $25 million in assets under management) the state securities regulator where the adviser's principal place of business is located. If you don’t find the investment adviser firm in the SEC’s IAPD database, be sure to call your state securities regulator or search the NASD's Broke rCheck database for any information they may have.
• Don't be afraid to ask questions. You are entrusting your money to someone else. You should know where your money is going, who is managing it, how it is being invested, how you can get it back, what protections are placed on your investment and what your rights are as an investor. In addition, you may wish to read NASD’s investor alert, which describes some of the high costs and risks of investing in funds of hedge funds.
What protections do I have if I purchase a hedge fund?
Hedge fund investors do not receive all of the federal and state law protections that commonly apply to most registered investments. For example, you won't get the same level of disclosures from a hedge fund that you'll get from registered investments. Without the disclosures that the securities laws require for most registered investments, it can be quite difficult to verify representations you may receive from a hedge fund. You should also be aware that, while the SEC may conduct examinations of any hedge fund manager that is registered as an investment adviser under the Investment Advisers Act, the SEC and other securities regulators generally have limited ability to check routinely on hedge fund activities.
The SEC can take action against a hedge fund that defrauds investors, and we have brought a number of fraud cases involving hedge funds. Commonly in these cases, hedge fund advisers misrepresented their experience and the fund's track record. Other cases were classic "Ponzi schemes," where early investors were paid off to make the scheme look legitimate. In some of the cases we have brought, the hedge funds sent phony account statements to investors to camouflage the fact that their money had been stolen. That's why it is extremely important to thoroughly check out every aspect of any hedge fund you might consider as an investment
What should I do if I have a complaint about a hedge fund or a fund of hedge funds?
If you encounter a problem with your hedge fund or fund of hedge funds, please contact
Securities and Exchange Commission,
Office of Investor Education and Advocacy
100 F Street, North East Avenue
Washington, D.C. 20549-0213
United States of America.
www.sec.gov
Securities and Exchange Board of India,
SEBI Bhavan, Plot No. G – 5, G Block,
Bandra – Kurla Complex,
Bandra ( East ), Mumbai – 400 051
Maharashtra State, India.
www.sebi.gov.in
Alfred Winslow Jones is credited with inventing Hedge Funds in 1949.
In the United States, in order for an investment fund to be exempt from direct regulation, it must be open to accredited investors only and only a limited number of investors can belong to it. While there is no legal definition of "Hedge Fund" under U.S. securities laws and regulations, typically they include any investment fund that, because of an exemption from the types of regulation that otherwise apply to mutual funds, brokerage firms or investment advisers can invest in more complex and more risky investments than a public fund might. As a hedge fund's investment activities are limited only by the contracts governing the particular fund, it can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.
As their name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging via any number of methods. However, the term "hedge fund" has come in modern parlance to be overused and inappropriately applied to any absolute-return fund – many of these so-called "hedge funds" do not actually hedge their investments.
Hedge funds have acquired a reputation for secrecy. Unlike open-to-the-public "retail" funds (e.g., U.S. mutual funds) which market freely to the public, in most countries, hedge funds are specifically prohibited from marketing to investors who are not professional investors or individuals with sufficient private wealth. This limits the information a hedge fund is legally required to release. Additionally, divulging a hedge fund's methods could unreasonably compromise their business interests; this limits the information a hedge fund would want to release. Since hedge fund assets can run into many billions of dollars and will usually be multiplied by leverage, their sway over markets, whether they succeed or fail, is potentially substantial and there is a continuing debate over whether they should be more thoroughly regulated.
Industry - In 2005, Absolute Return magazine found there were 196 hedge funds with $1 billion or more in assets, with a combined $743 billion under management - the vast majority of the industry's estimated $1 trillion in assets. However, according to hedge fund advisory group Hennessee, total hedge fund industry assets increased by $215 billion in 2006 to $1.442 trillion, up 17.5% on a year earlier, an estimate for 2005 seemingly at odds with Absolute Return.
As large institutional investors have entered the hedge fund industry the total asset levels continue to rise. The 2008 Hedge Fund Asset Flows & Trends Report [5] published by HedgeFund.net and Institutional Investor News estimates total industry assets reached $2.68 trillion in Q3 2007. According to the Barclay Hedge Monthly Asset Flow Report, hedge funds received only $16 billion in October, the second-lowest inflow in 2007. Year-to-date hedge funds attracted $278.5 billion, three times year-to-date inflow into equity mutual funds.
A major trend in the hedge fund industry is the increasing amount of capital being poured in to the asset class through institutional investments. Single digit returns and underfunded pension plans has led to institutional investors looking beyond traditional investments in stocks and bonds in order to generate the absolute returns needed to close their funding gaps or maintain capital levels. Data taken from the 2008 Preqin Hedge Institutional Investor Directory indicates that throughout 2008 up to $80-90 billion will be invested in hedge funds through institutional commitments alone. The most prolific institutional investors, as identified by Preqin Hedge, are public pension plans, endowments and family offices and foundations.
Fees - Usually the hedge fund manager will receive both a management fee and a performance fee (also known as an incentive fee). Performance fees are closely associated with hedge funds, and are intended to incentivize the investment manager to produce the largest returns they can.
Management Fees - As with other investment funds, the management fee is calculated as a percentage of NAV of the fund at the time when the fee becomes payable. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. Therefore, if a fund has $1 billion of assets at the year end and charges a 2% management fee, the management fee will be $20 million in total. Management fees are usually calculated annually and paid monthly.
Performance Fees - Performance fees, which give a share of positive returns to the manager, are one of the defining characteristics of hedge funds. In contrast to retail investment firms, performance fees are prohibited in the U.S. for stock brokers. A hedge fund's performance fee is calculated as a percentage of the fund's profits, counting both unrealized profits and actual realized trading profits. Performance fees exist because investors are usually willing to pay managers more generously when the investors have themselves made money. For managers who perform well the performance fee is extremely lucrative.
Typically, hedge funds charge 20% of gross returns as a performance fee, but again the range is wide, with highly regarded managers demanding higher fees. In particular, Steven Cohen's SAC Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons' Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its flagship Medallion Fund before returning all investors' capital and running solely on its employees' money.
Managers argue that performance fees help to align the interests of manager and investor better than flat fees that are payable even when performance is poor. However, performance fees have been criticized by many people, including notable investor Warren Buffett, for giving managers an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark and sometimes by a hurdle rate. Alternatively, the investment manager might be required to return performance fees when the value of the fund drops. This provision is sometimes called a ‘claw-back.’
High water marks - A "High water mark" is often applied to a performance fee calculation. This means that the manager does not receive performance fees unless the value of the fund exceeds the highest net asset value it has previously achieved. For example, if a fund was launched at a net asset value (NAV) per share of $100, which then rose to $130 in its first year, a performance fee would be payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If in the third year the NAV per share rises to $143, a performance fee will be payable only on the extra $13 return from $130 to $143 rather than on the full return from $120 to $143.
This measure is intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. If a high water mark is not used, a fund that ends alternate years at $100 and $110 would generate performance fee every other year, enriching the manager but not the investors. However, this mechanism does not provide complete protection to investors: a manager who has lost money may simply decide to close the fund and start again with a clean slate -- provided that he can persuade investors to trust him with their money. A high water mark is sometimes referred to as a "Loss Carry forward Provision." Poorly performing funds frequently close down rather than work without fees, as would be required by their high water mark policies.
Hurdle Rates - Some funds also specify a hurdle rate, which signifies that the fund will not charge a performance fee until its annualized performance exceeds a benchmark rate, such as T-bills or a fixed percentage, over a certain period. This links performance fees to the ability of the manager to do better than the investor would have done if invested money elsewhere.
Funds which specify a soft hurdle rate charge a performance fee based on the entire annualized return. Funds which use a hard hurdle rate only charge a performance fee on returns above the hurdle rate. Though logically appealing, this practice has diminished as demand for hedge funds has outstripped supply and hurdles are now rare.
Strategies - Hedge funds are no longer a homogeneous class. Under certain circumstances, an investor or hedge fund can completely hedge the risks of an investment, leaving pure profit.[citation needed] For example, at one time it was possible for exchange traders to buy shares of, say, IBM on one exchange and simultaneously sell them on another exchange, leaving pure profit.[citation needed] Competition among investors has leached away such profits, leaving hedge fund managers with trades that are partially hedged, at best. These trades still contain residual risks which can be considerable. Some styles of hedge fund investing, such as global macro investing, may involve no hedging at all. Strictly speaking, it is not accurate to call such funds hedge funds, but that is current usage.
The bulk of hedge funds describe themselves as long / short equity, but many different approaches are used taking different exposures, exploiting different market opportunities, using different techniques and different instruments:
* Global macro – seeking related assets that have deviated from some anticipated relationship.
* Arbitrage – seeking assets that are mispriced relative to related assets.
o Convertible arbitrage – between a convertible bond and the same company's equity.
o Fixed income arbitrage – between related bonds.
o Risk arbitrage – between securities whose prices appear to imply different probabilities 1 event.
o Statistical arbitrage between securities that have deviated from statistically estimated relationship.
o Derivative arbitrage – between a derivative and its security.
* Long / short equity – generic term covering all hedged investment in equities.
o Short bias – emphasizing or solely using short positions.
o Equity market neutral – maintaining a close balance between long and short positions.
* Event driven – specialized in the analysis of a particular kind of event.
o Distressed securities – companies that are or may become bankrupt.
o Regulation D – distressed companies issuing securities.
o Merger arbitrage - arbitrage between an acquiring public company and a target public company.
* Other – the strategies below are sometimes considered hedge strategies, although in several cases usage of the term is debatable.
o Emerging markets- this usually means unhedged, long positions in small overseas markets.
o Fund of hedge funds - unhedged, long only positions in hedge funds (though the underlying funds, of course, may be hedged). Additional leverage is sometimes used.
o Quantitative
o 130-30 funds - Through leveraging, 130% of the money invested in the fund is used to buy stocks. 30% of the money invested in the fund is used to short stock.
Hedge Fund Risk - Investing in a hedge fund is considered to be a riskier proposition than investing in a regulated fund, despite the traditional notion of a "hedge" being a means of reducing the risk of a bet or investment. The following are some of the primary reasons for the increased risk:
Leverage - in addition to putting money into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing sums many times greater than the initial investment. Where a hedge fund has borrowed $9 for every $1 invested, a loss of only 10% of the value of the investments of the hedge fund will wipe out 100% of the value of the investor's stake in the fund, once the creditors have called in their loans. At the beginning of 1998, shortly before its collapse, Long Term Capital Management had borrowed over $26 for each $1 invested.
Short Selling - due to the nature of short selling, the losses that can be incurred on a losing bet are theoretically limitless, unless the short position directly hedges a corresponding long position. Therefore, where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns against it.
Appetite for Risk - hedge funds are culturally more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities and collateralised debt obligations based on sub-prime mortgages.
Lack of Transparency - hedge funds are secretive entities. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision.
Lack of Regulation - hedge funds are not subject to as much oversight from financial regulators, and therefore some may carry undisclosed structural risks. Investors in hedge funds are willing to take these risks because of the corresponding rewards. Leverage amplifies profits as well as losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns; secrecy helps to prevent imitation by competitors; and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis.
Legal Structure - A hedge fund is a vehicle for holding and investing the funds of its investors. The fund itself is not a genuine business, having no employees and no assets other than its investment portfolio and a small amount of cash, and its investors being its clients. The portfolio is managed by the investment manager, which has employees and property and which is the actual business. An investment manager is commonly termed a “hedge fund” (e.g. a person may be said to “work at a hedge fund”) but this is not technically correct. An investment manager may have a large number of hedge funds under its management.
Domicile – The specific legal structure of a hedge fund – in particular its domicile and the type of entity used – is usually determined by the tax environment of the fund’s expected investors. Regulatory considerations will also play a role. Many hedge funds are established in offshore tax havens so that the fund can avoid paying tax on the increase in the value of its portfolio. An investor will still pay tax on any profit it makes when it realizes its investment, and the investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund.
At the end of 2004 55% of the world’s hedge funds, accounting for nearly two-thirds of total hedge fund assets, were established offshore. The most popular offshore location was the Cayman Islands, followed by the British Virgin Islands, Bermuda and the Bahamas. The US was the most popular onshore location, accounting for 34% of funds and 24% of assets. EU countries were the next most popular location with 9% of funds and 11% of assets. Asia accounted for the majority of the remaining assets.
The legal entity - Limited partnerships are principally used for hedge funds aimed at US-based investors who pay tax, as the investors will receive relatively favorable tax treatment in the US. The general partner of the limited partnership is typically the investment manager (though is sometimes an offshore corporation) and the investors are the limited partners. Offshore corporate funds are used for non-US investors and US entities that do not pay tax (such as pension funds), as such investors do not receive the same tax benefits from investing in a limited partnership. Unit trusts are typically marketed to Japanese investors. Other than taxation, the type of entity used does not have a significant bearing on the nature of the fund.
Many hedge funds are structured as master/feeder funds. In such a structure the investors will invest into a feeder fund which will in turn invest all of its assets into the master fund. The assets of the master fund will then be managed by the investment manager in the usual way. This allows several feeder funds (e.g. an offshore corporate fund, a US limited partnership and a unit trust) to invest into the same master fund, allowing an investment manager the benefit of managing the assets of a single entity while giving all investors the best possible tax treatment.
The investment manager, which will have organized the establishment of the hedge fund, may retain an interest in the hedge fund, either as the general partner of a limited partnership or as the holder of “founder shares” in a corporate fund. Founder shares typically have no economic rights, and voting rights over only a limited range of issues, such as selection of the investment manager – most of the fund’s decisions are taken by the board of directors of the fund, which is self-appointing and independent but invariably loyal to the investment manager.
Open-ended Nature - Hedge funds are typically open-ended, in that the fund will periodically issue additional partnership interests or shares directly to new investors, the price of each being the NAV per interest/share. To realise the investment, the investor will redeem the interests or shares at the NAV per interest/share prevailing at that time. Therefore, if the value of the underlying investments has increased (and the NAV per interest/share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Investors do not typically trade shares among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund, which has a limited number of shares which are traded among investors, and which distributes its profits.
Listed funds - Corporate hedge funds often list their shares on smaller stock exchanges, such as the Irish Stock Exchange, in the hope that the low level of quasi-regulatory oversight will give comfort to investors and to attract certain funds, such as some pension funds, that have bars or caps on investing in unlisted shares. Shares in the listed hedge fund are not traded on the exchange, but the fund’s monthly net asset value and certain other events must be publicly announced there.
A fund listing is distinct from the listing of an IPO of shares in an investment manager. Although widely reported as a "hedge-fund IPO"[, the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.
In contrast to the funds themselves, hedge fund managers are primarily located onshore in order to draw on larger pools of financial talent. The US East coast – principally New York City and the Gold Coast area of Connecticut (particularly Stamford and Greenwich) – is the world's leading location for hedge fund managers with approximately double the hedge fund managers of the next largest centre, London. With the bulk of hedge fund investment coming from the US, this distribution is natural.
London is Europe’s leading centre for the management of hedge funds. At the end of 2006, three-quarters of European hedge fund investments, totaling $400bn (£200bn), were managed from London, having grown from $61bn in 2002. Australia was the most important centre for the management of Asia-Pacific hedge funds, with managers located there accounting for approximately a quarter of the $140bn of hedge fund assets managed in the Asia-Pacific region in 2006. Part of what gives hedge funds their competitive edge, and their cachet in the public imagination, is that they straddle multiple definitions and categories; some aspects of their dealings are well-regulated, others are unregulated or at best quasi-regulated.
US Regulation - The typical public investment company in the United States is required to be registered with the U.S. Securities and Exchange Commission (SEC). Mutual funds are the most common type of registered investment companies. Aside from registration and reporting requirements, investment companies are subject to strict limitations on short-selling and the use of leverage. There are other limitations and restrictions placed on public investment company managers, including the prohibition on charging incentive or performance fees.
Although hedge funds fall within the statutory definition of an investment company, the limited-access, private nature of hedge funds permits them to operate pursuant to exemptions from the registration requirements. The two major exemptions are set forth in Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940. Those exemptions are for funds with 100 or fewer investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7 Fund"). A qualified purchaser is an individual with over US$5,000,000 in investment assets. (Some institutional investors also qualify as accredited investors or qualified purchasers.) A 3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited number of investors. Both types of funds can charge performance or incentive fees.
In order to comply with 3(c)(1) or 3(c)(7), hedge funds are sold via private placement under the Securities Act of 1933. Thus interests in a hedge fund cannot be offered or advertised to the general public, and are normally offered under Regulation D. Although it is possible to have non-accredited investors in a hedge fund, the exemptions under the Investment Company Act, combined with the restrictions contained in Regulation D, effectively require hedge funds to be offered solely to accredited investors. An accredited investor is an individual with a minimum net worth of US $5,000,000 or, alternatively, a minimum income of US$200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year.
The regulatory landscape for Investment Advisors is changing, and there have been attempts to register hedge fund investment managers. There are numerous issues surrounding these proposed requirements. One issue of importance to hedge fund managers is the requirement that a client who is charged an incentive fee must be a "qualified client" under Advisers Act Rule 205-3. To be a qualified client, an individual must have US$750,000 in assets invested with the adviser or a net worth in excess of US$1.5 million, or be one of certain high-level employees of the investment adviser.
For the funds, the tradeoff of operating under these exemptions is that they have fewer investors to sell to, but they have few government-imposed restrictions on their investment strategies. The presumption is that hedge funds are pursuing more risky strategies, which may or may not be true depending on the fund, and that the ability to invest in these funds should be restricted to wealthier investors who are presumed to be more sophisticated and who have the financial reserves to absorb a possible loss.
In December 2004, the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers Act.[10] The requirement, with minor exceptions, applied to firms managing in excess of US$25,000,000 with over 15 investors. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry. The rule change was challenged in court by a hedge fund manager, and in June 2006, the U.S. Court of Appeals for the District of Columbia overturned it and sent it back to the agency to be reviewed. See Goldstein v. SEC.
Although the SEC is currently examining how it can address the Goldstein decision, commentators have stated that the SEC currently has neither the staff nor expertise to comprehensively monitor the estimated 8,000 U.S. and international hedge funds. See New Hedge Fund Advisor Rule. One of the Commissioners, Roel Campos, has said that the SEC is forming internal teams that will identify and evaluate irregular trading patterns or other phenomena that may threaten individual investors, the stability of the industry, or the financial world. "It's pretty clear that we will not be knocking on [hedge fund] doors very often," Campos told several hundred hedge fund managers, industry lawyers and others. And even if it did, "the SEC will never have the degree of knowledge or background that you do." In February 2007, the President's Working Group on Financial Markets rejected further regulation of hedge funds and said that the industry should instead follow voluntary guidelines.
Comparison to Private Equity Funds - Hedge funds are similar to private equity funds in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in relatively liquid assets, and permit investors to enter or leave the fund, perhaps requiring some months notice. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition funds. Between 2004 and February 2006 some hedge funds adopted 25 month lock-up rules expressly to exempt themselves from the SEC's new registration requirements and cause them to fall under the registration exemption that had been intended to exempt private equity funds.[citations needed]
Comparison to U.S. Mutual Funds - Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to invest). However, there are many differences between the two, including:
• Mutual funds are regulated by the SEC, while hedge funds are not
• A hedge fund investor must be an accredited investor with certain exceptions (employees, etc.)
• Mutual funds must price and be liquid on a daily basis
Some hedge funds that are based offshore report their prices to the Financial Times, but for most there is no method of ascertaining pricing on a regular basis. Additionally, mutual funds must have a prospectus available to anyone that requests one (either electronically or via US postal mail), and must disclose their asset allocation quarterly, while hedge funds do not have to abide by these terms.
Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time where the total returns are generated (net of fees) for their investors and then returned when the term ends, through a pass through requiring CPAs and US Tax W-forms. Hedge fund investors tolerate these policies because hedge funds are expected to generate higher total returns for their investors versus mutual funds. Recently, however, the mutual fund industry has created products with features that have traditionally only been found in hedge funds.
Mutual funds have appeared which utilize some of the trading strategies noted above. Grizzly Short Fund for example, is always net short, while Arbitrage Fund (ARBFX) specializes in merger arbitrage. Such funds are SEC regulated, but they offer hedge fund strategies and protection for mutual fund investors.
Also, a few mutual funds have introduced performance-based fees, where the compensation to the manager is based on the performance of the fund. However, under Section 205(b) of the Investment Advisers Act of 1940, such compensation is limited to so-called "fulcrum fees". Under these arrangements, fees can be performance-based so long as they increase and decrease symmetrically. For example, the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves, within limits and symmetrically, similarly to a hedge fund "0 and 50" fee: A 0% management fee coupled with a 50% performance fee if the fund outperforms its benchmark index. However, the 125 bp base fee is reduced (but not below zero) by 50% of underperformance and increased (but not to more than 250 bp) by 50% of outperformance.
Many offshore centers are keen to encourage the establishment of hedge funds. To do this they offer some combination of professional services, a favorable tax environment, and business-friendly regulation. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin Islands and Bermuda. The Cayman Islands have been estimated to be home to about 75% of world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM.
Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centers. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager Many offshore hedge funds, such as the Soros funds, are structured as mutual funds rather than as limited partnerships.
Hedge Fund Indices - here are a number of indices that track the hedge fund industry. These indices come in two types, Investable and Non-investable, both with substantial problems. There are also new types of tracking product launched by Goldman Sachs and Merrill Lynch, "clone indices" that aim to replicate the returns of hedge fund indices without actually holding hedge funds at all.
Investable indices are created from funds that can be bought and sold, and only Hedge Funds that agree to accept investments on terms acceptable to the constructor of the index are included. Investability is an attractive property for an index because it makes the index more relevant to the choices available to investors in practice, and is taken for granted in traditional equity indices such as the S&P500 or FTSE100. However, such indices do not represent the total universe of hedge funds and may under-represent the more successful managers, who may not find the index terms attractive. Fund indexes include Barclay Hedge, Hedge Fund Research, Eurekaa edge Indices, Credit Suisse Tremont and FTSE Hedge.
The index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index, making investable indices similar in some ways to fund of hedge funds portfolios. Non-investable benchmarks are indicative in nature, and aim to represent the performance of the universe of hedge funds using some measure such as mean, median or weighted mean from a hedge fund database. There are diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different databases.
Non-investable indices inherit the databases' shortcomings, or strengths, in terms of scope and quality of data. Funds’ participation in a database is voluntary, leading to “self reporting bias” because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money. This tends to lead to a clustering of returns around the mean rather than representing the full diversity existing in the hedge fund universe. Examples of non-investable indices include an equal weighted benchmark series known as the HFN Averages, and revolutionary rules based set known as the Lehman Brothers/HFN Global Index Series which leverages an Enhanced Strategy Classification System.
The short lifetimes of many hedge funds means that there are many new entrants and many departures each year, which raises the problem of “survivorship bias”. If we examine only funds that have survived to the present, we will overestimate past returns because many of the worst-performing funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial. As the HFR and CISDM databases began in 1994, it is likely that they will be more accurate over the period 1994/2000 than the Credit Suisse database, which only began in 2000.
When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favourable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias” or “backfill bias”.
In traditional equity investment, indices play a central and unambiguous role. They are widely accepted as representative, and products such as futures and ETFs provide liquid access to them in most developed markets. However, among hedge funds no index combines these characteristics. Investable indices achieve liquidity at the expense of representativeness. Non-investable indices are representative, but their quoted returns may not be available in practice. Neither is wholly satisfactory.
Systemic Risk - Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital Management (LTCM) in 1998, which necessitated a bailout coordinated by the U.S. Federal Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster. The excessive leverage (through derivatives) that can be used by hedge funds to achieve their return is outlined as one of the main factors of the hedge funds contribution to systematic risk.
However, the ECB statement itself has been criticized by a part of the financial research community. These arguments are developed by the EDHEC Risk and Asset Management Research Centre: The main conclusions of the study are that “the ECB article’s conclusion of a risk of “disorderly exits from crowded trades” is based on mere speculation. While the question of systemic risk is of importance, we do not dispose of enough data to reliably address this question at this stage”, “ it would be worthwhile for financial regulators to work towards obtaining data on hedge fund leverage and counterparty credit risk. Such data would allow a reliable assessment of the question of systemic risk”, and “besides evaluating potential systemic risk, it should be recognised that hedge funds play an important role as “providers of liquidity and diversification”.
The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge funds in June 2007. The funds invested in mortgage-backed securities. The funds' financial problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside assistance. It was the largest fund bailout since Long Term Capital Management's collapse in 1998. The U.S. Securities and Exchange commission is investigating.
Transparency - As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to third parties. This is in contrast to a fully regulated mutual fund (or unit trust) which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment advisor of the fund, and may enjoy more personalised reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy. Several hedge funds are completely "black box", meaning that their returns are uncertain to the investor.
Restrictions on marketing and the lack of regulation is that there are no official hedge fund statistics. An industry consulting group, HFR (hfr.com), reported at the end of the second quarter 2003 that there are 5,660 hedge funds world wide managing $665 billion. For comparison, at the same time the US mutual fund sector held assets of $7.818 trillion
Some hedge funds, mainly American, do not use third parties either as the custodian of their assets or as their administrator. This can lead to conflicts of interest, and in extreme cases can assist fraud. In a recent example, Kirk Wright of International Management Associates has been accused of mail fraud and other securities violations which allegedly defrauded clients of close to $180 million.
Market Capacity - Analysis of the rather disappointing hedge fund performance in 2004 and 2005 called into question the alternative investment industry's value proposition. Alpha may have been becoming rarer for two related reasons. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more and more managers, which may dilute the talent available in the industry.
However, the market capacity effect has been questioned by the EDHEC Risk and Asset Management Research Centre through a decomposition of hedge fund returns between pure alpha, dynamic betas, and static betas. While pure alpha is generated by exploiting market opportunities, the dynamic betas depend on the manager’s skill in adapting the exposures to different factors, and these authors claim that these two sources of return do not exhibit any erosion. This suggests that the market environment (static betas) explains a large part of the poor performance of hedge funds in 2004 and 2005.
Investigations of Illegal Conduct - In the U.S., the SEC is focusing more resources on investigating violations and illegal conduct on the part of hedge funds in the public securities markets. Linda C. Thomsen, enforcement director of the SEC, said in November 2007 that federal regulators were concerned about illegal trading and the potential for harm to hedge fund investors. She said, “These days, the money is in hedge funds, so the potential for abuse, the potential for securities law violations is there because there is so much money there.” Outside firms offering services to the hedge funds such as Prime Brokerage may be held accountable for failing to report illegal conduct on account of their client hedge funds
Performance Measurement - The issue of performance measurement in the hedge fund industry has led to literature that is both abundant and controversial. Traditional indicators (Sharpe, Treynor, Jensen) work best when returns follow a symmetrical distribution. In that case, risk is represented by the standard deviation. Unfortunately, hedge fund returns are not normally distributed, and hedge fund return series are auto correlated. Consequently, traditional performance measures suffer from theoretical problems when they are applied to hedge funds, making them even less reliable than is suggested by the shortness of the available return series.
Innovative performance measures have been introduced in an attempt to deal with this problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003), Omega by Keating and Shadwick (2002), Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004), and Kappa by Kaplan and Knowles (2004). An overview of these performance measures is available in Géhin, W., 2006, The Challenge of Hedge Fund Performance Measurement: a Toolbox rather than a Pandora’s Box, EDHEC Risk and Asset Management Research Center, Position Paper, December. However, there is no consensus on the most appropriate absolute performance measure, and traditional performance measures are still widely used in the industry.
Relationships with Analysts - In June 2006. the U.S. Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts, and other issues related to the funds. Connecticut Attorney General Richard Blumenthal testified that an appeals court ruling striking down oversight of the funds by federal regulators left investors "in a regulatory void, without any disclosure or accountability." The hearings heard testimony from, among others, Gary Aguirre, a staff attorney who was recently fired by the SEC.
The top 10 are as follows:
• RAB Special Situations Fund (RAB Capital, London) - 47.69%
• The Children's Investment Fund (The Children's Investment Fund Mgmt. London) - 44.27%
• Highland CDO Opportunity Fund (Highland Capital Management, Dallas) - 43.98%
• BTR Global Opportunity Fund, Class D (Salida Capital, Toronto) - 43.42%
• SR Phoenicia Fund (Sloane Robinson, London) - 43.10%
• Atticus European Fund (Atticus Management, New York) - 40.76%
• Gradient European Fund A (Gradient Capital Partners, London) - 39.18%
• Polar Capital Paragon Absolute Return Fund (Polar Capital Partners, London) - 38.00%
• Paulson Enhanced Partners Fund (Paulson & Co., New York) - 37.97%
• Firebird Global Fund (Firebird Management, New York) - 37.18%
The full top 10 list of hedge fund earners according to Trader Monthly includes:
T. Boone Pickens - estimated 2005 earnings $1.5bn +
Steven A. Cohen, SAC Capital Advisers - $1bn +
James H. Simons, Renaissance Technologies Corp. - $900m - $1bn
Paul Tudor Jones, Tudor Investment Corp. - $800m - $900m
Stephen Feinberg, Cerberus Capital Management - $500 - $600m
Bruce Kovner, Caxton Associates - $500m - $600m
Eddie Lampert, ESL Investments - $500m - $600m
David E. Shaw, D. E. Shaw & Co. - $400m - $500m
Jeffrey Gendell, Tontine Partners - $300m - $400m
Louis Bacon, Moore Capital Management - $300m - $350m
[Notable Hedge Fund Management Companies Sometimes also known as Alternative Investment Management Companies.
Amaranth Advisors
Bridgewater Associates
Caxton Associates
Centaurs Energy
Citadel Investment Group
D. E. Shaw & Co.
Fortress Investment Group
Goldman Sachs Asset Management
Long Term Capital Management
Man Group
Pirate Capital LLC
Renaissance Technologies
SAC Capital Advisors
Soros Fund Management
Marshall Wace
In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities. Thus the hedger is indifferent to the movements of the market as a whole, and is interested only in the performance of the 'under-priced' security relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis," where the basis is the difference between the hedge's theoretical value and its actual value (or between spot and futures prices in Working's time).
Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, expects to face natural risks such as the risk of competition, of poor or unpopular products, and so on.
The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency. Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits.
Example Hedge - A stock trader believes that the stock price of Company A will rise over the next month, due to this company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.
Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of Company A's direct competitor, Company B. If the trader were able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a call option on Company A shares) the trade might be essentially riskless and be called an arbitrage. But since some risk remains in the trade, it is said to be "hedged."
The first day the trader's portfolio is:
• Long 1000 shares of Company A at $1 each
• Short 500 shares of Company B at $2 each
(Notice that the trader has sold short the same value of shares.)
On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, goes up by 10%, while Company B goes up by just 5%:
• Long 1000 shares of Company A at $1.10 each — $100 profit
• Short 500 shares of Company B at $2.10 each — $50 loss
(In a short position, the investor loses money when the price goes up.)
The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash -- 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:
Value of long position (Company A):
• Day 1 — $1000
• Day 2 — $1100
• Day 3 — $550 => $450 loss
Value of short position (Company B):
• Day 1 — $1000
• Day 2 — $1050
• Day 3 — $525
Without the hedge, the trader would have lost $450. But the hedge - the short sale of Company B - gives a profit of $475, for a net profit of $25 during a dramatic market collapse.
Types of hedging –
The example above is a "classic" sort of hedge, known in the industry as a "pairs trade" due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values, known as models, the types of hedges have increased greatly.
Natural Hedges
Many hedges do not involve exotic financial instruments or derivatives. A natural hedge is an investment that reduces the undesired risk by matching cash flows, i.e. revenues and expenses. For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure. Another example is a company that opens a subsidiary in another country and borrows in the local currency to finance its operations, even though the local interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the local currency, the parent company has reduced its foreign currency exposure.
Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars. One of the oldest means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life. Categories of hedgeable risk
For the following categories of the risk, for exporters, that the value of their accounting currency will fall against the value of the importers, also known as volatility risk.
• Interest rate risk – is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed income instruments or interest rate swaps.
• Equity – the risk, for those whose assets are equity holdings, that the value of the equity falls
Futures contracts and forward contracts are a means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the nineteenth century, but over the last fifty years a huge global market developed in products to hedge financial market risk.
Hedging Credit Risk - Credit risk is the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, naturally an early market developed between banks and traders: that involving selling obligations at a discounted rate. See for example forfeiting, bill of lading, or discounted bill.
Hedging Currency Risk - Currency hedging (also known as Foreign Exchange Risk hedging) is used both by financial investors to parse out the risks they encounter when investing abroad, as well as by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.
For example, labor costs are such that much of the simple commoditized manufacturing in the global economy today goes on in China and South-East Asia (Philippines, Vietnam, Indonesia, etc.). The cost benefit of moving manufacturing to outsource providers outweighs the uncertainties of doing business in foreign countries, so many businesses are moving manufacturing operations overseas. But the benefits of doing this have to be weighted also against currency risk.
If the cost of manufacturing goods in another country is denominated in a currency other than the one that the finished goods will be sold for, there is the risk that changes in the values of each currency will reduce profit or produce a loss. Currency hedging is akin to insurance that limits the impact of foreign exchange risk.
Currency hedging is not always available, but is readily found at least in the major currencies of
the world economy, the growing list of which qualify as major liquid markets beginning with the Major 8 Currency as USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD which are also called the "Benchmark Currencies", and expands to include several others by virtue of liquidity.
Currency hedging, like many other forms of financial hedging, can be done in two primary ways: with standardized contracts, or with customized contracts (also known as over-the-counter or OTC). The financial investor may be a hedge fund that decides to invest in a company in, for example, Brazil, but does not want to necessarily invest in the Brazilian currency. The hedge fund can separate out the credit risk (i.e. the risk of the company defaulting), from the currency risk of the Brazilian Real by "hedging" out the currency risk. In effect, this means that the investment is effectively a USD investment, in Brazil. Hedging allows the investor to transfer the currency risk to someone else, who wants to take up a position in the currency. The hedge fund has to pay this other investor to take on the currency exposure, similar to insuring against other types of events. As with other types of financial products, hedging may allow economic activity to take place that would otherwise not have been possible (as a loan, for example, may allow an individual to purchase a home that would be "too expensive" if the individual had to pay cash). The increased investment is assumed in this way to raise economic efficiency.
Related concepts
Forwards
A contracted agreement specifying an amount of currency to be delivered, at an exchange rate decided on the date of contract.
Forward Rate Agreement
A contract agreement specifying an interest rate amount to be settled, at a pre-determined interest rate on the date of the contract. This is also known as FRAs.
Currency option
A contract that gives the owner the right but not the obligation to take (call option) or deliver (put option) a specified amount of currency, at an exchange rate decided at the date of purchase.
Non-Deliverable Forwards (NDF)
A strictly risk-transfer financial product similar to a Forward Rate Agreement, but only used where monetary policy restrictions on the currency in question limit the free flow and conversion of capital. NDFs are, as the name suggests, not delivered, but rather, these are settled in a reference currency, usually USD or EUR, where the parties exchange the gain or loss that the NDF instrument yields, and if the buyer of the controlled currency truly needs that hard currency, he can take the reference payout and go to the government in question and convert the USD or EUR payout. The insurance effect is the same, it's just that the supply of insured currency is restricted and controlled by government.
Interest rate parity and Covered Interest Arbitrage
The simple concept that two similar investments in two different currencies ought to yield the same return. If the two similar investments are not at face value offering the same interest rate return, the difference should conceptually be made up by changes in the exchange rate over the life of the investment. IRP basically gives you the math to calculate a projected or implied forward rate of exchange. This calculated rate is not and cannot be considered a prediction or forecast, but rather is the arbitrage-free calculation for what the exchange rate is implied to be in order for it to be impossible to make a free profit by converting money to one currency, investing it for a period, then converting back and making more money than if you had invested in the same opportunity in the original currency.
Distributed Funds Transfer Hedge (DFT-hedge)
Hedging Equity & Equity Futures
Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, you short futures when you buy equity. Or long futures when you short stock.
There are many ways to hedge, and one is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures. Buy 10000 GBP worth of Vodafone and short 10000 worth of FTSE futures.
Another method to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone is 2, then for a 10000 GBP long position in Vodafone you will hedge with a 20000 GBP equivalent short position in the FTSE futures (the Index that Vodafone trades in).
Futures hedging - If you primarily trade in futures, you hedge your futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. So if you are long futures in your trade you can hedge by shorting synthetics, and vice versa.
Contract for differences - A Contract for Differences (CfD) is a two way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. For instance, consider a deal between an electricity producer and an electricity retailer who both trade through an electricity market pool. If the producer and the retailer agree to a strike price of $50 per MWh, for 1 MWh in a trading period, and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer. Conversely, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price.
In effect, the pool volatility is nullified and the parties pay and receive $50 per MWh. However, the party who pays the difference is "out of the money" because without the hedge they would have received the benefit of the pool price.
Origins
The term is derived from the phrase "hedging your bets" used in gambling games such as roulette. The hedges on a roulette table are the lines between numbers or number groups. Placing a hedged bet is one where the chips lie across one or more hedges (i.e. on a line between two numbers or on a corner between three or four numbers). The bet then covers all the numbers involved at an appropriately reduced stake (e.g. 1/2, 1/3, 1/4).
An aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).
Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.
It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.
The Differences Between Mutual Funds and Hedge Funds
Mutual funds and hedge funds differ in many ways, particularly the fees charged; leveraging, pricing, and liquidity practices employed; the degree of regulatory oversight to which each is subject; and the characteristics of the typical investors who use each investment vehicle.
U.S. mutual funds are among the most strictly regulated financial products. They are subject to numerous requirements designed to ensure they operate in the best interests of their shareholders. Hedge funds are private investment pools subject to far less regulatory oversight.
Regulatory Requirements
Mutual Funds
Mutual funds are investment companies that must register with the U.S. Securities and Exchange Commission (SEC) and, as such, are subject to rigorous regulatory oversight. Virtually every aspect of a mutual fund's structure and operation is subject to strict regulation under four federal laws: the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisers Act. The SEC is charged with overseeing the mutual fund industry's compliance with these regulations. The Internal Revenue Code sets additional requirements regarding a fund's portfolio diversification and its distribution of earnings, and the National Association of Securities Dealers, Inc. (NASD) oversees most mutual fund advertisements and other sales materials. In addition, mutual funds must have directors who are responsible for extensive oversight of the fund's policies and procedures. For virtually all funds, at least a majority of their directors must be independent from the fund's management.
The Investment Company Act is the cornerstone of mutual fund regulation. It regulates the structure and operation of mutual funds and requires funds to safeguard their portfolio securities, forward price their securities, and keep detailed books and records. In addition, the 1933 Act requires all prospective fund investors to receive a prospectus containing specific information about the fund's management, holdings, fees and expenses, and performance.
Hedge Funds
Hedge funds-unlike mutual funds-are not required to register with the SEC. They issue securities in "private offerings" not registered with the SEC under the Securities Act of 1933. Furthermore, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934.
Like mutual funds and other securities market participants, hedge funds are subject to prohibitions against fraud, and their managers have the same fiduciary duties as other investment advisers.
Fees
Mutual Funds
Federal law imposes a fiduciary duty on a mutual fund's investment adviser regarding the compensation it receives from the fund. In addition, mutual fund sales charges and other distribution fees are subject to specific regulatory limits under NASD rules. Mutual fund fees and expenses are disclosed in detail, as required by law, in a fee table at the front of every prospectus. They are presented in a standardized format, so that an investor can easily understand them and can compare expense ratios among different funds.
Hedge Funds
There are no limits on the fees a hedge fund adviser can charge its investors. Typically, the hedge fund manager charges an asset-based fee and a performance fee. Some have front-end sales charges, as well.
Leveraging Practices
Mutual Funds
The Investment Company Act severely restricts a mutual fund's ability to leverage or borrow against the value of securities in its portfolio. The SEC requires that funds engaging in certain investment techniques, including the use of options, futures, forward contracts and short selling, "cover" their positions. The effect of these constraints has been to strictly limit leveraging by mutual fund portfolio managers.
Hedge Funds
Leveraging and other higher-risk investment strategies are a hallmark of hedge fund management. Hedge funds were originally designed to invest in equity securities and use leverage and short selling to "hedge" the portfolio's exposure to movements of the equity markets. Today, however, advisers to hedge funds utilize a wide variety of investment strategies and techniques. Many are very active traders of securities.
Pricing and Liquidity
Mutual Funds
Mutual funds are required to value their portfolios and price their securities daily based on market quotations that are readily available at market value and others at fair value, as determined in good faith by the board of directors. In addition to providing investors with timely information regarding the value of their investments, daily pricing is designed to ensure that both new investments and redemptions are made at accurate prices. Moreover, mutual funds are required by law to allow shareholders to redeem their shares at any time.
Hedge Funds
There are no specific rules governing hedge fund pricing. Hedge fund investors may be unable to determine the value of their investment at any given time
Investor Characteristics
Mutual Funds
The only qualification for investing in a mutual fund is having the minimum investment to open an account with a fund company, which is typically around $1,000, but can be lower. After the account has been opened, there is generally no minimum additional investment required, and many fund investors contribute relatively small amounts to their mutual funds on a regular basis as part of a long-term investment strategy.
Hedge Funds
A significantly higher minimum investment is required from hedge fund investors. Under the Investment Company Act of 1940, certain hedge funds only may accept investments from individuals who hold at least $5 million in investments. This measure is intended to help limit participation in hedge funds and other types of unregulated pools to highly sophisticated individuals. Hedge funds can also accept other types of investors if they rely on other exemptions under the Investment Company Act or are operated outside the United States.
Visit the SEC website for more complete information on hedge funds edging Your Bets:
What are hedge funds?
Like mutual funds, hedge funds pool investors' money and invest those funds in financial instruments in an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.
Unlike mutual funds, however, hedge funds are not required to register with the SEC. Hedge funds typically issue securities in “private offerings” that are not registered with the SEC under the Securities Act of 1933. In addition, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934. But hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary duties as other investment advisers.
What are "Funds of Hedge Funds?"
A fund of hedge funds is an investment company that invests in hedge funds -- rather than investing in individual securities. Some funds of hedge funds register their securities with the SEC. These funds of hedge funds must provide investors with a prospectus and must file certain reports quarterly with the SEC.
Note: Not all funds of hedge funds register with the SEC.
Many registered funds of hedge funds have much lower investment minimums (e.g., $25,000) than individual hedge funds. Thus, some investors that would be unable to invest in a hedge fund directly may be able to purchase shares of registered funds of hedge funds.
What information should I seek if I am considering investing in a hedge fund or a fund of hedge funds?
• Read a fund's prospectus or offering memorandum and related materials. Make sure you understand the level of risk involved in the fund's investment strategies and ensure that they are suitable to your personal investing goals, time horizons, and risk tolerance. As with any investment, the higher the potential returns, the higher the risks you must assume.
• Understand how a fund's assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources.
• Ask questions about fees. Fees impact your return on investment. Hedge funds typically charge an asset management fee of 1-2% of assets, plus a "performance fee" of 20% of a hedge fund's profits. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return. Funds of hedge funds typically charge a fee for managing your assets, and some may also include a performance fee based on profits. These fees are charged in addition to any fees paid to the underlying hedge funds.
Tip: If you invest in hedge funds through a fund of hedge funds, you will pay two layers of fees: the fees of the fund of hedge funds and the fees charged by the underlying hedge funds.
• Understand any limitations on your right to redeem your shares. Hedge funds typically limit opportunities to redeem, or cash in, your shares (e.g., to four times a year), and often impose a "lock-up" period of one year or more, during which you cannot cash in your shares.
• Research the backgrounds of hedge fund managers. Know with whom you are investing. Make sure hedge fund managers are qualified to manage your money, and find out whether they have a disciplinary history within the securities industry. You can get this information (and more) by reviewing the adviser’s Form ADV. You can search for and view a firm’s Form ADV using the SEC’s Investment Adviser Public Disclosure (IAPD) website. You also can get copies of Form ADV for individual advisers and firms from the investment adviser, the SEC’s Public Reference Room, or (for advisers with less than $25 million in assets under management) the state securities regulator where the adviser's principal place of business is located. If you don’t find the investment adviser firm in the SEC’s IAPD database, be sure to call your state securities regulator or search the NASD's Broke rCheck database for any information they may have.
• Don't be afraid to ask questions. You are entrusting your money to someone else. You should know where your money is going, who is managing it, how it is being invested, how you can get it back, what protections are placed on your investment and what your rights are as an investor. In addition, you may wish to read NASD’s investor alert, which describes some of the high costs and risks of investing in funds of hedge funds.
What protections do I have if I purchase a hedge fund?
Hedge fund investors do not receive all of the federal and state law protections that commonly apply to most registered investments. For example, you won't get the same level of disclosures from a hedge fund that you'll get from registered investments. Without the disclosures that the securities laws require for most registered investments, it can be quite difficult to verify representations you may receive from a hedge fund. You should also be aware that, while the SEC may conduct examinations of any hedge fund manager that is registered as an investment adviser under the Investment Advisers Act, the SEC and other securities regulators generally have limited ability to check routinely on hedge fund activities.
The SEC can take action against a hedge fund that defrauds investors, and we have brought a number of fraud cases involving hedge funds. Commonly in these cases, hedge fund advisers misrepresented their experience and the fund's track record. Other cases were classic "Ponzi schemes," where early investors were paid off to make the scheme look legitimate. In some of the cases we have brought, the hedge funds sent phony account statements to investors to camouflage the fact that their money had been stolen. That's why it is extremely important to thoroughly check out every aspect of any hedge fund you might consider as an investment
What should I do if I have a complaint about a hedge fund or a fund of hedge funds?
If you encounter a problem with your hedge fund or fund of hedge funds, please contact
Securities and Exchange Commission,
Office of Investor Education and Advocacy
100 F Street, North East Avenue
Washington, D.C. 20549-0213
United States of America.
www.sec.gov
Securities and Exchange Board of India,
SEBI Bhavan, Plot No. G – 5, G Block,
Bandra – Kurla Complex,
Bandra ( East ), Mumbai – 400 051
Maharashtra State, India.
www.sebi.gov.in
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