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As the name implies, hedge funds often seek to hedge some of the risks
inherent in their investments using a variety of methods, most notably short
selling and derivatives. However, the term "hedge fund" has also come to
be applied to certain funds that, as well as (or instead of) hedging certain
risks, use short selling and other "hedging" methods as a trading strategy to
generate a return on their capital.
The net asset value of a hedge fund can run into many billions of dollars,
and the gross assets of the fund will usually be higher still due to leverage.
Hedge funds dominate certain specialty markets such as trading within
derivatives with high-yield ratings and distressed debt.
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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 $1
million, along with a significant amount of investment knowledge. You can
think of hedge funds as mutual funds for the super rich. They are similar to
mutual funds in that investments are pooled and professionally managed,
but differ in that the fund has far more flexibility in its investment
strategies.
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History
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With a minimum investment limit: The investors are high net worth
individuals. Exclusively favoring the crème de la crème, the usual
minimum investment amount is US$ 1, 000,000/ USD 1 million.
Examples
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planting and harvest, the farmer stands to make a lot of unexpected money,
but if the actual price drops by harvest time, he could be ruined.
Most hedge funds are highly specialized, relying on the specific expertise
of the manager or management team. Performance of many hedge fund
strategies, particularly relative value strategies, is not dependent on the
direction of the bond or equity markets -- unlike conventional equity or
mutual funds (unit trusts), which are generally 100% exposed to market
risk.
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Popular Misconception
The popular misconception is that all hedge funds are volatile -- that they
all use global macro strategies and place large directional bets on stocks,
currencies, bonds, commodities, and gold, while using lots of leverage. In
reality, less than 5% of hedge funds are global macro funds. Most hedge
funds use derivatives only for hedging or don't use derivatives at all, and
many use no leverage.
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Funds of Hedge Funds: Mix and match hedge funds and other pooled
investment vehicles. This blending of different strategies and asset classes
aims to provide a more stable long-term investment return than any of the
individual funds. Returns, risk, and volatility can be controlled by the mix
of underlying strategies and funds. Capital preservation is generally an
important consideration. Volatility depends on the mix and ratio of
strategies employed. Expected Volatility: Low - Moderate - High
Income: Invests with primary focus on yield or current income rather than
solely on capital gains. May utilize leverage to buy bonds and sometimes
fixed income derivatives in order to profit from principal appreciation and
interest income. Expected Volatility: Low
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Industry size
Estimates of industry size vary widely due to the lack of central statistics,
the lack of a single definition of hedge funds and the rapid growth of the
industry. As a general indicator of scale, the industry may have managed
around $2.5 trillion at its peak in the summer of 2008. The credit crunch
has caused assets under management (AUM) to fall sharply through a
combination of trading losses and the withdrawal of assets from funds by
investors. Recent estimates find that hedge funds have more than $2 trillion
in AUM
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The 25 largest hedge fund managers had $519.7 billion in assets under
management as of December 31, 2009. The largest manager is JP Morgan
Chase ($53.5 billion) followed by Bridgewater Associates ($43.6 billion),
Paulson & Co. ($32 billion), Brevan Howard ($27 billion), and Soros Fund
Management ($27 billion).
Fees
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A hedge fund manager will typically receive both a management fee and a
performance fee (also known as an incentive fee) from the fund. A typical
manager may charge fees of "2 and 20", which refers to a management fee
of 2% of the fund's net asset value each year and a performance fee of 20%
of the fund's profit
Management fees
The business models of most hedge fund managers provide for the
management fee to cover the operating costs of the manager, leaving the
performance fee for employee bonuses. However, the management fees for
large funds may form a significant part of the manager's profits.
Management fees associated with hedge funds have been under much
scrutiny, with several large public pension funds calling on managers to
reduce fees.
Performance fees
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Average incentive fees have declined since the start of the financial crisis,
with the decline being more pronounced in funds of hedge funds (FOFs).
Incentive fees for single manager funds fell to 19.2 percent (versus 19.34
percent in Q1 08) while FOFs fell to 6.9 percent (versus 8.05 percent in Q1
08). The average incentive fee for funds launched in 2009 was 17.6 percent,
1.6 percent below the broader industry average.
A high water mark (or "loss carry forward provision") is often applied to a
performance fee calculation. This means that the manager receives
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performance fees only on increases in the net asset value (NAV) of the fund
in excess of the highest net asset value it has previously achieved. For
example, if a fund were launched at a NAV per share of $100, which then
rose to $120 in its first year, a performance fee would be payable on the
$20 return for each share. If the next year it dropped to $110, no fee would
be payable. If in the third year the NAV per share rose to $130, a
performance fee would be payable only on the $10 profit from $120 (the
high water mark) to $130, rather than on the full return during that year
from $110 to $130.
High water marks are 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 a performance fee every other year,
enriching the manager but not the investors.
Hurdle rates
Some managers specify a hurdle rate, signifying that they will not charge a
performance fee until the fund's annualized performance exceeds a
benchmark rate, such as T-bill yield, LIBOR or a fixed percentage. This
links performance fees to the ability of the manager to provide a higher
return than an alternative, usually lower risk, investment.
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Strategies
Hedge funds employ many different trading strategies, which are classified
in many different ways, with no standard system used. A hedge fund will
typically commit itself to a particular strategy, particular investment types
and leverage limits via statements in its offering documentation, thereby
giving investors some indication of the nature of the particular fund.
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The four main strategy groups are based on the investment style and have
their own risk and return characteristics. The most common label for a
hedge fund is "long/short equity", meaning that the fund takes both long
and short positions in shares traded on public stock exchanges.
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Short selling - due to the nature of short selling, the losses that can be
incurred on a losing bet are in theory limitless, unless the short position
directly hedges a corresponding long position. Ordinary funds very rarely
use short selling in this way.
Appetite for risk - hedge funds are 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 collateralized debt obligations
based on sub-prime mortgages.
Lack of transparency - hedge funds are private entities with few public
disclosure requirements. It can therefore be difficult for an investor to
assess trading strategies, diversification of the portfolio, and other factors
relevant to an investment decision.
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Short volatility - certain hedge fund strategies involve writing out of the
money call or put options. If these expire in the money the fund may make
large losses.
A hedge fund is a vehicle for holding and investing the money of its
investors. The fund itself has no employees and no assets other than its
investment portfolio and cash. The portfolio is managed by the investment
manager, which is the actual business and has employees.
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Domicile
The legal structure of a specific hedge fund – in particular its domicile and
the type of legal 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 financial centres 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.
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location and accounted for 39% of the number of global hedge funds. It
was followed by Delaware (US) 27%, British Virgin Islands 7% and
Bermuda 5%. Around 5% of global hedge funds are registered in the EU,
primarily in Ireland and Luxembourg.
London is Europe’s leading centre for hedge fund managers, with three-
quarters of European hedge fund investments, about $400 billion, at the end
of 2009. Asia, and more particularly China, is taking on a more important
role as a source of funds for the global hedge fund industry. The UK and
the U.S. are leading locations for management of Asian hedge funds' assets
with around a quarter of the total each.
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-U.S. investors and U.S. entities that do not
pay tax (such as pension funds), as such investors do not receive the same
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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.
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 net asset value (“NAV”) per interest/share. To
realize 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
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therefore also increased) then the investor will receive a larger sum on
redemption than it paid on investment. Investors do not typically trade
shares or interests 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.
Side pockets
Where a hedge fund holds assets that are hard to value reliably or are
relatively illiquid (in comparison to the redemption terms of the fund
itself), the fund may employ a "side pocket". A side pocket is a mechanism
whereby the fund segregates the illiquid assets from the main portfolio of
the fund and issues investors with a new class of interests or shares which
participate only in the assets in the side pocket. Those interests/shares
cannot be redeemed by the investor. Once the fund is able to sell the side
pocket assets, the fund will generally redeem the side pocket
interests/shares and pay investors the proceeds.
Side pockets are designed to address issues relating to the need to value an
investor's holding in the fund if they choose to redeem. If an investor
redeems when certain assets cannot be valued or sold, the fund cannot be
confident that the calculation of his redemption proceeds would be
accurate. Moreover, his redemption proceeds could only be obtained by
selling the liquid assets of the fund. If the illiquid assets subsequently
turned out to be worth less than expected, the remaining investors would
bear the full loss while the redeemed investor would have borne none. Side
pockets therefore allow a fund to ensure that all investors in the fund at the
time the relevant assets became illiquid will bear any loss on them equally
and allow the fund to continue subscriptions and redemptions in the
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Specific types of fund may also use side pockets in the ordinary course of
their business. A fund investing in insurance products, for example, may
routinely side pocket securities linked to natural disasters following the
occurrence of such a disaster. Once the damage has been assessed, the
security can again be valued with some accuracy.
A fund listing is distinct from the listing or initial public offering (“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.
Regulatory issues
Part of what gives hedge funds their competitive edge, and their cachet in
the public imagination is that they straddle multiple definitions and
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U.S. regulation
Although hedge funds are investment companies, they have avoided the
typical regulations for investment companies because of exceptions in the
laws. 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. The Securities Act
of 1933 disclosure requirements apply only if the company seeks funds
from the general public, and the quarterly reporting requirements of the
Securities Exchange Act of 1934 are only required if the fund has more
than 499 investors. A 3(c)7 fund with more than 499 investors must register
its securities with the SEC.
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In order to comply with 3(c)(1) or 3(c)(7), hedge funds raise capital via
private placement under the Securities Act of 1933, and normally the shares
sold do not have to be registered 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
person with a minimum net worth of $1,000,000 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. For banks and corporate entities, the minimum net worth is
$5,000,000 in invested assets.
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. The requirement, with minor
exceptions, applied to firms managing in excess of US$25,000,000 with
over 14 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 new rule was controversial, with
two commissioners dissenting. The rule change was challenged in court by
a hedge fund manager, and, in June 2006, the U.S. Court of Appeals for the
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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
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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. In addition, mutual funds must have a prospectus available
to anyone that requests one (either electronically or via U.S. postal mail),
and must disclose their asset allocation quarterly, whereas 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 U.S. 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 been found only in hedge funds.
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Mutual funds that utilize some of the trading strategies noted above have
appeared. Grizzly Short Fund (GRZZX), 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.
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.
Hedge funds are exempt from regulation in the United States. Several bills
have been introduced in the 110th Congress (2007–08), however, relating
to such funds. Among them are:
• S. 681, a bill to restrict the use of offshore tax havens and abusive tax
shelters to inappropriately avoid Federal taxation;
• H.R. 3417, which would establish a Commission on the Tax
Treatment of Hedge Funds and Private Equity to investigate
imposing regulations;
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UK regulation
As the UK is part of the European Union, the UK hedge fund industry will
also be affected by the EU's Directive on Alternative Investment Fund
Managers.
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Offshore regulation
Hedge funds have to file accounts and conduct their business in compliance
with the requirements of these offshore centres. 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.
There are many indices that track the hedge fund industry, and these fall
into three main categories. In their historical order of development they are
Non-investable, Investable and Clone.
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Non-investable indices
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.
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
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only publish their results when they are favorable, 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”.
Investable indices
The most recent addition to the field approach the problem in a different
manner. Instead of reflecting the performance of actual hedge funds they
take a statistical approach to the analysis of historic hedge fund returns, and
use this to construct a model of how hedge fund returns respond to the
movements of various investable financial assets. This model is then used
to construct an investable portfolio of those assets. This makes the index
investable, and in principle they can be as representative as the hedge fund
database from which they were constructed.
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Systemic risk
The ECB (European Central Bank) issued a warning in June 2006 on hedge
fund risk for financial stability and systemic risk: "... the increasingly
similar positioning of individual hedge funds within broad hedge fund
investment strategies is another major risk for financial stability, which
warrants close monitoring despite the essential lack of any possible
remedies. Some believe that broad hedge fund investment strategies have
also become increasingly correlated, thereby further increasing the potential
adverse effects of disorderly exits from crowded trades." However the ECB
statement has been disputed by parts of the financial industry.
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-
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Transparency
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Some hedge funds, mainly American, do not use third parties either as the
custodian of their assets or as their administrator (who will calculate the
NAV of the fund). 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. In
December 2008, Bernard Madoff was arrested for running a $50 billion
Ponzi scheme. While Madoff did not run a hedge fund, his case clearly
does illustrate the value of independent verification of assets.
Market capacity
Alpha appears to 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 managers, which may dilute the
talent available in the industry, though these causes are disputed.
U.S. investigations
Performance measurement
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The question of how performance should be adjusted for the amount of risk
that is being taken 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.
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However, there are three reasons why one might not wish to allocate a high
proportion of assets into hedge funds. These reasons are:
1. Hedge funds are highly individual and it is hard to estimate the likely
returns or risks;
2. Hedge funds’ low correlation with other assets tends to dissipate
during stressful market events, making them much less useful for
diversification than they may appear; and
3. Hedge fund returns are reduced considerably by the high fee
structures that are typically charged.
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that the hedge funds incurred no performance fees. The result from this
second optimization was an allocation of 74% to hedge funds.
Hedge funds posted disappointing returns in 2008, but the average hedge
fund return of -18.65% (the HFRI Fund Weighted Composite Index return)
was far better than the returns generated by most assets other than cash.
The S&P 500 total return was -37.00% in 2008, and that was one of the
best performing equity indices in the world. Several equity markets lost
more than half their value. Most foreign and domestic corporate debt
indices also suffered in 2008, posting losses significantly worse than the
average hedge fund. Mutual funds also performed much worse than hedge
funds in 2008. According to Lipper, the average U.S. domestic equity
mutual fund decreased 37.6% in 2008. The average international equity
mutual fund declined 45.8%. The average sector mutual fund dropped
39.7%. The average China mutual fund declined 52.7% and the average
Latin America mutual fund plummeted 57.3%. Real estate, both residential
and commercial, also suffered significant drops in 2008. In summary,
hedge funds outperformed many similarly-risky investment options in
2008.
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• Amaranth Advisors
• Bridgewater Associates
• Citadel Investment Group
• D.E. Shaw
• Fortress Investment Group
• GLG Partners
• Long-Term Capital Management
• Man Group
• Marshall Wace
• Renaissance Technologies
• SAC Capital Advisors
• Soros Fund Management
• The Children's Investment Fund Management (TCI)
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funds are only one species in a wide universe – and that they differ from
other hedge funds as much as grizzlies differ from other animals.
Founded in 1995, by Dion Friedland, when global hedge fund assets were
just approaching the $250 billion mark, The Hedge Fund Association™
(HFA) is a not-for-profit international group of industry professionals with
a mission to provide a forum for thought leaders, innovators, practitioners
and investors who are shaping the way business is conducted in the global
hedge fund industry. With the maturity and institutionalization of the global
hedge fund industry, the HFA advocates for the industry by giving voice to
the issues affecting the industry through the education of investors, the
media, regulators and legislators.
Membership in the HFA includes hedge fund firms, global financial
institutions with hedge fund offerings including retail and private banks,
asset management firms and broker dealers, investors including funds of
hedge funds, family offices, public and private pension funds, endowments
and foundations, high net worth individuals, allocators, and the industry’s
service providers including prime brokers, administrators, custodians,
auditors, lawyers, risk managers, technologists and third party marketers.
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In the last nine years, the number of hedge funds has risen by about 20
percent per year and the rate of growth in hedge fund assets has been even
more rapid. Currently, there are estimated to be approximately 8350 hedge
funds managing $1 trillion. While the number and size of hedge funds are
small relative to mutual funds, their growth reflects the importance of this
alternative investment category for institutional investors and wealthy
individual investors.
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The award was presented in New York this week at a ceremony that
celebrated the achievements of the hedge fund industry. The awards were
judged by a panel of experts from leading institutions including JP Morgan,
Goldman Sachs and Bear Stearns. The judges cited Investcorp's penetration
of the U.S. institutional market, its growth in assets under management and
its new single manager platform as the critical success factors. Deepak
Gurnani and Ibrahim Gharghour, co-heads of Asset Management at
Investcorp, both expressed their delight at receiving this recognition.
Deepak Gurnani said: "It is a great tribute to be recognized by our industry
peers as well as by the premier awards in the hedge fund industry. This is
testament to the long term achievements of Investcorp's hedge fund
business over the past nine years and our success in building a strong
business, not least in establishing leading risk management processes to set
us apart from other providers.' Ibrahim Gharghour added: 'This award also
recognizes our substantial recent progress in the United States, where we
have attracted substantial US institutional money into our programme. In
addition, last year, we set up a single manager platform and have already
partnered with two high profile groups, Interlachen Capital Group and Cura
Capital Management, in order to provide our investors greater variety and
access to leading specialist funds.
Investcorp is one of the leading institutional investors in hedge funds with
approximately $4.6 billion under management, of which $1.7 billion is
proprietary investment.
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and general parents) and rely on external service providers to conduct the
funds day-to-day business, including managing the fund portfolio and
providing administrative services. So for this type of operation structure,
hedge funds establish relationships with all the necessary industry service
providers:
1- The sponsors and the investors:
The sponsor is the creator of the fund and he will typically hold a member
of the founder shares in the fund; that is as we talked early (page 1) the
sponsor will be the general partner and the investor will be the limited
partner.
2- The Manager or Management Company:
He/she is responsible for office overhead, and is usually established in a
major onshore financial center as London or New York.
3- The Investment Adviser:
The role of investment advisor is simply to give professional advice on the
funds investment in a way that is consistent with the funds investment
objectives and policies, the investment adviser may be a part of the same
overall organization as the hedge fund he serves, or he may be unrelated to
it.
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In side by side structures, also called mirror funds or clone funds, several
funds having identical or substantially similar investment policies invest in
parallel in a group of cloned portfolio. These portfolios usually share a
common investment adviser, portfolio managers and a custodian or
administrator, and the cloning process essentially consists in facilitating
bunched trades among the cloned funds and rebalancing cloned funds that
have experienced different cash flows.
The master/feeder structure is an efficient alternative to side-by-side funds.
In this structure a series of funds (called feeders) sell shares to investors
under the 12 terms of their prospectus and contribute their respective
proceeds to another fund (called the master fund) rather than investing
directly.
2- Managed accounts.
3- Umbrella funds.
4- Multiclass/Multiseries Funds.6
1- Hedge Fund Market Size:
If we are going to talk about how big is the hedge fund industry, then it will
definitely a question without an accurate answer because as we know that
SEC doesn’t regulate hedge fund i.e. hedge fund are not required to register
but the SEC estimates, however, that there are between 6,000 and 7,000
funds that manage approximately $600 to $650 billion in assets. The report
predicts that in the next five to 10 years, the assets invested in hedge funds
will exceed $1 trillion.
And that is wonder us to know why hedge fund is exempt from SEC
regulations, the answer is simply is of the hedge funds are only offered to
wealthy individuals and institutions. A combination of statutory provisions
and rules under the 1933 Act and the Investment Company Act for private
rather than public offerings allow for them — and the securities they issue
to investors
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— To remain unregistered. Many funds use the safe harbor in the 1933 Act
that allows them to sell to "accredited investors." These are individuals with
an annual income of $200,000 or more, married couples with a joint
income of $300,000 or more, or individuals with a net worth of $1 million.
2- Key Players
We can divide the key players in two categories, buyers of hedge funds and
provider of hedge funds.
a) Buyers of Hedge Funds:
Current ownership is divided between Wealthy individuals (High Net
Worth Individuals or HNWI) and institutions. And it is divided as follows:
- US HNWI and Europe HNWI.
- US Insurance, US Pensions, Europe insurance, Europe Pensions and US
non-profit.
Now let us have a close look for wealthy individual,
Wealthy individual:
Wealthy individuals (High Net Worth Individuals or HNWI) – individuals
with assets in excess of US$ 1 million - account for over 60% of the
approximately $600bn invested in hedge funds. There are signs that hedge
funds are becoming a standard element in HNWI – not just super wealthy –
portfolios.
b) Provider of Hedge Funds:
1- Very high fees and very high profitability. The typical hedge fund
manager charges a management fee in excess of 1% (versus 40-50 bp on
the typical long only portfolio) and usually is entitled to 20% of the profit if
a certain target return is exceeded.
2- The vast majority of hedge fund managers are located in North America
– largely in the New York and Los Angeles areas. But in Europe – London
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fund has risen. Currencies (USD, GBP and Euro) refer to specific currency
classes of a fund.
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In spite of difference of views, the roles played by some of the large hedge
funds have often been associated with major financial crisis that took place
in the 90’s.
East Asian Crisis
The impact of the East Asian crisis which materialized in the middle of
1997, and the subsequent turbulence that swept the world’s financial
markets over the next 12-18 months, has been significant not only in terms
of the financial, economic and social consequences that these events
wrought on emerging market economies, but also in terms of drawing the
world’s attention to outstanding issues concerning the structure, operation
and regulation of the international financial system. Causes of the crisis
remain among the most contentious issues and continue to be debated at the
academic as well as policy level. The Emerging Markets Committee of
IOSCO identified multiple causes of the East Asian crisis. The Committee
also made a reference to the role played by some hedge funds complex
trading strategies involving futures were thought by some authorities to
have exerted a destabilizing influence on market performance in their
jurisdictions. Currency speculators pursued a so-called “double play” aimed
at playing off the Hong Kong currency board system against the
administrations stock and futures markets. However, subsequent research
could not produce robust evidence implicating the hedge funds for
precipitating the crisis. Researchers have, however, attributed the negative
public perception of the role of hedge fund managers in crisis partly to the
limited information available about what they actually do.
Long Term Capital Management (LTCM)
Another major financial crisis involving a large hedge fund was that of the
huge loss (US $ 4 billion) suffered by LTCM in 1998. LTCM built its
positions on sophisticated arbitrage trading strategies. In addition, it used a
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Two fast growing emerging markets, India and China are keenly observed
for new investment propositions, particularly investment in hedge funds.
Presence of systematic institutional framework for hedging, regulatory
factors, a well-developed capital economy, liberalized stable economy,
rapid reforms, democratic set-up, good information disclosure standards,
better return on capital have rather favored India score over China as a
superior place for investment in hedge funds.
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funds in India, you need to first understand what they are and how it works.
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• During the process the prime broker and custodian are in direct
contact with fund administrator.
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with hedge fund managers involved with hedge fund investments and
those who have already invested in hedge funds.
• Check the pros and cons of long-term hedge funds vs. short-term
hedge funds.
• Check if diverse hedge fund strategies and techniques are put to use.
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a hedge fund might get in trouble if its assets experience a sharp drop and
the market for these assets lacks liquidity so that the fund cannot exit its
positions. The collapse of a hedge fund could have far-reaching
implications if the fund is large enough. When the Long Term Capital Fund
lost more than $4 billion in August and September 1998, the Federal
Reserve Bank of New York organized a rescue by private banks to avoid
possible widespread damage from a possible disorderly liquidation or
bankruptcy of the fund. However, the debacle at the hedge fund Amaranth
in late 2006 had only a trivial impact on the markets. Nonetheless, the
Amaranth losses led to calls for regulation of hedge funds. For instance, the
New York Times (2006) published an editorial stating that “regulators need
to act now to translate their various calls for hedge-fund oversight into
enforceable rules and, in some instances, into concrete proposals for
Congress to enact.”Hedge funds rely on their ability to move out of trades
quickly when prices turn against them, which raises an issue of liquidity
risk. If too many funds have set up the same trades, they may not all be able
to exit their positions at the same time. In that case, two adverse
developments can ensue: prices may have to overreact and liquidity may
fall sharply. With low liquidity, hedge funds that rely on trading quickly to
control their risks cannot do so. Hence, such hedge funds become more
risky, which increases threats to financial institutions and can lead to
further overreaction in prices as financial institutions have to reduce their
positions as well.
Further, when hedge funds use leverage, they cannot just ride out a serious
adverse shock; instead, they must reduce their exposures to satisfy the
banks from which they borrowed. As a result, adverse shocks could lead
hedge funds to dump securities and cash out precisely when things are
going poorly, which could make matters worse.
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Finally, hedge funds could lead prices to overreact by making trades that
push prices away from fundamental values and lead to excess volatility
risks. Though hedge funds have certainly been accused of creating
volatility, the case that they have done so is far from ironclad. For example,
hedge funds were net buyers during the stock market crash of 1987, so that
they helped stabilize markets at that time (Presidential Task Force on
Market Mechanisms, 1998). During the Asian currency crisis of 1997, the
prime minister of Malaysia attacked George Soros for causing the crisis.
However, an IMF study concluded that hedge fund positions were too small
to have much of an impact on emerging markets (Eichengreen et al., 1998).
Earlier, the same George Soros had apparently taken a $10 billion bet
against the British pound, which effectively forced the British pound out of
the European exchange rate mechanism, and won $1 billion in the process.
There is some evidence that hedge funds did not sell Internet stocks when
their valuations were high (Brunnermeier and Nagel, 2004), but the
evidence is not completely clear because the data available does not include
various hedges that hedge funds might have used.
How concerned should one be about these four types of risks that hedge
funds supposedly create? Investor protection should not motivate the SEC
to regulate the hedge fund industry, because the small investors who are
supposedly the focus of the SEC are already blocked from investing in
hedge funds. There is no reason to believe that the occasional hedge fund
losses of savvy and well-to-do investors, however painful they may be to
these investors, have a social cost. These investors can choose not to invest
in a fund, and they also have legal recourse against acts of fraud.
The risks posed to financial institutions are real, though often overstated.
Brokers and banks have greatly improved their systems to evaluate their
exposures to hedge funds in recent years. Derivatives contracts are much
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better designed for defaults than they were in the past. Financial institutions
are already regulated.
Moreover, a bank that takes on too much risk through a hedge fund could
also take on too much risk with an individual or a proprietary trading desk
that employs hedge fund strategies; in either case, the problem is not
specifically a hedge fund issue, but rather involves the regulation of
financial institutions.
Liquidity risk is a serious issue. Though adverse shocks may force hedge
funds to contract, hedge funds have strong incentives not to be caught in a
situation in which they would have to make distress sales of securities.
Empirically, hedge funds do not have their worst performance when large
shocks affect capital markets (Boyson, Stahel, and Stulz, 2006). It is not
clear how well banks monitor concentration risks in the positions of
investment managers they deal with—be they hedge funds or other
investors. Regulators could encourage them to monitor more actively.
There is no reason to believe that regulation of hedge funds would be a
more efficient approach.
The fact that hedge funds can cause volatility in prices is a potentially valid
concern, but needs to be based on facts and experience. Hedge funds often
profit by providing liquidity to the markets—by buying securities that are
temporarily depressed because of market disruptions. The role of hedge
funds in making markets more liquid and in reducing market inefficiencies
makes it necessary for those who want to restrict their activities to have a
compelling case that their possible adverse impact on market volatility
outweighs their positive effects. So far, this case has not been made. At the
same time, one should not overstate the extent to which hedge funds make
markets efficient. Though hedge funds do well at eliminating small
discrepancies in prices that can be arbitraged, the liquidity they provide
may disappear quickly in the presence of a systemic shock—and this
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liquidity withdrawal may worsen the shock. Further, if asset prices depart
systemically from fundamentals, one cannot count on hedge funds to bring
them back to fundamentals.
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For example, over the last few years, more hedge funds have become
activist investors. In some countries, such activism has led to demands for
regulation. Some hedge funds have also specialized in lending. Again,
regulatory authorities are unlikely to allow unregulated hedge funds to
compete with regulated banks.
Recently, much concern has arisen from the fact that hedge funds borrow
shares to vote in corporate control contests without bearing the risks of
stock ownership (Hu and Black, 2006)—when a fund borrows shares and
holds them to vote, it pays a fee to the lender, but the lender keeps the price
risk of the shares. Regulations may be enacted to prevent such actions.
Finally, we saw that as hedge funds succeed, strong forces will push them
to become more like financial institutions. However, as hedge fund
management companies compete with regulated financial institutions,
regulated financial institutions seem certain to express concerns about the
lack of a level playing field.
How Will the Hedge Fund Industry Perform Over the Next
Ten Years?
As discussed earlier, Ibbotson and Chen (2005) estimate the average alpha
of the hedge fund industry to be above 3 percent per year. Large funds
seem to have performed somewhat better. As a rough estimate, suppose that
the value-weighted alpha for hedge funds is 4 percent, net of fees. During
their sample period, the yearly average size of the hedge fund industry is
$262 billion according to one consulting firm. Thus, the skills of hedge
fund managers were contributing on average $10 billion a year to investors.
The industry is now at least three times as large. For the performance of
hedge funds to generate 4 percent net of fees for investors, the skills of
hedge fund managers have to produce an additional $20 billion of alpha.
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However, as more money enters the hedge fund industry, it either funds
existing strategies, new strategies that typically cannot be as good as the
ones already implemented, or new managers. More hedge funds chasing the
same price discrepancies means that these discrepancies get eliminated
faster, leading to smaller profits for the funds. Hence, additional money
entering hedge funds in the future will typically not find average returns as
high as in the past.
A clear example of this problem is the recent performance of convertible
arbitrage funds. The typical trade for a convertible arbitrage fund is to buy
convertible bonds issued by a firm and to hedge the purchase with short
sales of the stock of the firm. As more funds buy convertible bonds, the
strategy becomes less profitable because the funds push the price up, so that
the performance of this strategy falls. Not surprisingly, the increase in
convertible arbitrage funds, from 26 in 1994 to 145 in 2003 according to
one database, eventually led to poor performance and a drop in the number
of such funds.
Bibliography
Websites:-
http://en.wikipedia.org/wiki/Hedge_fund
http://www.investopedia.com/terms/h/hedgefund.asp
http://www.hedgefund.net/hfn_public/default.aspx
http://www.magnum.com/hedgefunds/abouthedgefunds.asp
http://www.investorwords.com/2296/hedge_fund.html
http://www.hedgefundintelligence.com/
http://www.hedgeco.net/hedgeducation/hedge-fund-articles/
http://www.hedgefundtools.com/
http://hedgefundproductions.com/
http://www.thehedgefundjournal.com/
http://www.thehfa.org/
http://www.thehedgefundjournal.com/
http://www.hedgefund-index.com/
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Books:-
1) All About Hedge Funds: The Easy Way To Get Started by Robert
Jaeger
2) Hedge Funds For Dummies by Ann C. Logue
3) Investment Strategies of Hedge Funds by Filippo Stefanini
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