What is a Hedge Fund?

A hedge fund is a private investment fund charging a performance fee and typically open to only a limited range of qualified investors. In the United States, hedge funds are open to accredited investors only. Because of this restriction, they are usually exempt from any direct regulation by regulatory bodies. Hedge funds are credited to Alfred Winslow Jones for their invention in 1949.

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 te rm 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 can legally 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.[citation needed]

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.

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.[2] 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.[3]

[edit] 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 possible.

[edit] Management fees

As with other investment funds, the management fee is calculated as a percentage of the net asset value 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.

[edit] Performance fees

Performance fees, which give a share of positive returns to the manager, are one of the defining characteristics of hedge funds. The 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.[citations needed]

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.

[edit] High water marks

A High water mark is often applied to a performance fee calculation.[4] 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 Carryforward Provision.

Poorly performing funds frequently close down rather than work without fees, as would be required by their high water mark policies. [5]

[edit] 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 some period. This links performance fees to the ability of the manager to do better than the investor would have done if he had put the money elsewhere.

Though logically appealing, this practice has diminished as demand for hedge funds has outstripped supply and hurdles are now rare.[citations needed]

[edit] 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.

Convertible arbitrage between a convertible bond and the same company’s equity.

Fixed income arbitrage between related bonds.

Risk arbitrage between securities whose prices appear to imply different probabilities for one event.

Statistical arbitrage (or StatArb) between securities that have deviated from some statistically estimated relationship.

Derivative arbitrage between a derivative and its security.

* Long / short equity generic term covering all hedged investment in equities.

Short bias emphasizing or solely using short positions.

Equity market neutral maintaining a close balance between long and short positions.

Event driven specialized in the analysis of a particular kind of event.

Distressed securities companies that are or may become bankrupt.

Regulation D distressed companies issuing securities.

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.

Emerging markets — this usually means unhedged, long positions in small overseas markets.

Fund of hedge funds — unhedged, long only positions in hedge funds (though the underlying funds, of course, may be hedged). Additional leverage is sometimes

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 funds 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 realises 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 worlds 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.[citations needed]

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.[6]

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 corpora te 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 funds 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 net asset value (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 between 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 between 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 funds monthly net asset value and certain other events must be publicly announced there.

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[7], the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.[8]

[edit] Hedge fund management worldwide

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 Europes leading centre for the management of hedge funds. At the end of 2006, three-quarters of European hedge fund investments, totalling $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.[9]

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 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). [4] 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.) [5] 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. [6]. 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. [7]

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.[citations needed]

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.[8] 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.[9] 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 eva luate 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.[citation needed]

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.[10][11][12]

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.[citations needed]

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 them (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 passthrough 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 (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.

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.[13] 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. [14]

Offshore regulation

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 worlds hedge funds, with nearly half the industry’s estimated $1.225 trillion AUM[10].

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.

Many offshore hedge funds, such as the Soros funds, are structured as mutual funds rather than as limited partnerships.