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HEDGE FUNDS

Basic Information Handout

T a r i q M u m t a z
What is Hedge Fund?
A hedge fund is a private investment fund open to a
limited range of investors, which is permitted by
regulators to undertake a wider range of activities
than other investment funds and which pays a
performance fee to its investment manager.
In other words 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.
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.
A Brief History Of The Hedge Fund
Sociologist, author, and financial journalist Alfred
W. Jones is credited with the creation of the first
hedge fund in 1949.
It was while writing an article about current investment
trends for Fortune in 1948 that Jones was inspired to
try his hand at managing money. He raised $100,000
(including $40,000 out of his own pocket) and set forth
to try to minimize the risk in holding long-term stock
positions by short selling other stocks. This investing
innovation is now referred to as the classic long/short
equities model. Jones also employed leverage in an
effort to enhance returns.
In 1952, Jones altered the structure of his investment
vehicle, converting it from a general partnership to a
limited partnership and adding a 20% incentive fee as
compensation for the managing partner. As the first
money manager to combine short selling, the use of
leverage, shared risk through a partnership with other
investors and a compensation system based on
investment performance, Jones earned his place in
investing history as the father of the hedge fund.
The Rise of the Industry
When a 1966 article in Fortune magazine highlighted
an obscure investment that outperformed every mutual
fund on the market by double-digit figures over the past
year and by high double-digits over the last five years,
the hedge fund industry was born. By 1968, there were
some 140 hedge funds in operation.
In an effort to maximize returns, many funds turned
away from Jones' strategy, which focused on stock
picking coupled with hedging, and chose instead to
engage in riskier strategies based on long-term leverage.
These tactics led to heavy losses in 1969-70, followed
by a number of hedge fund closures during the bear
market of 1973-74.
The Hedge Fund Today
Hedge funds have evolved significantly since 1949.
Modern hedge funds offer a variety of strategies,
including many that do not involve traditional hedging
techniques. The industry has also rapidly grown, with
recent estimations pegging its size at $1 trillion - quite
the leap from the $100,000 used to start the first fund
half a century ago.
There has also been an increasing move towards their
regulation. In 2004, the Securities and Exchange
Commission adopted changes that require hedge fund
managers and sponsors to register as investment
advisors under the Investment Advisor's Act of 1940.
This greatly increases the number of requirements
placed on hedge funds, including keeping up-to-date
performance records, hiring a compliance officer and
creating a code of ethics. All hedge funds that fall
under the new SEC rules must be registered by Feb 1,
2006. This is seen as an important move in protecting
investors.
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.
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:
ƒ Mutual funds are regulated by the SEC, while
hedge funds are not.
ƒ A hedge fund investor must be an accredited
investor with certain exceptions (employees,
etc.)
ƒ 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.
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.
Comparison Of Growth Patterns: Hedge Funds Vs
Mutual Funds
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.
For Example
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.
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, while its investors are its clients.
The investment manager, which has employees and
property and which is the actual business, manages
the portfolio. An investment manager is commonly
termed a “hedge fund”, but this is not technically
correct. An investment manager may have a large
number of hedge funds under its management.
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 specific legal structure of a hedge fund – in
particular the tax environment of the fund’s
expected investors usually determines its domicile
and the type of legal entity used –. 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.
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 investment manager
will then manage the assets of the master fund 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.
Hedge Fund Regulation1
Hedge funds are simply pools of money from
individuals and or groups of qualified investors who
met the requirements of the SEC. Unlike mutual
funds, they do not trade on exchanges, and are not
registered with the Securities and Exchange
Commission; their investors are not granted the
same consumer-protection benefits extended to
mutual funds through the 1940 Investment Company
Act.
There is also the issue of hedge fund fraud; some
cite a small example of fraudulent hedge fund
managers who have used false reports to deceive
investors while they use their assets to pursue other
interests. In a recent conference of the Investment
Company Institute {ICI} in Washington DC, Paul
Roye, the Director of investment at the Securities
and Exchange Commission {SEC} told the
conference attendees about the increases in hedge
fund fraud cases.
Today there is so much talk about hedge fund
regulations, not only here in the United States, but
also in England. The two leading financial market
1 S&P500 or FTSE100. However, such indices do not
http://sec.gov/rules/final/ia-2333.htm
regulators, the Securities and Exchange Commission
[SEC], and Financial Services Authority [FSA] seem
to be slowly but steadily moving in that direction.
Another financial services regulator, the Securities
and Exchange Board of India [SEBI] recently made
a decision to ban investments through participatory
notes by unregulated entities.
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. Those exemptions are for
funds with 100 or fewer investors.
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.)[22] A 3(c)1 Fund
cannot have more than 100 investors, while a 3(c)7
Fund can have an unlimited number of investors.
However, a 3(c)7 fund with more than 499 investors
must register its securities with the SEC.[23] Both
types of funds can charge performance or incentive
fees.
H edg e Fund Indices
There 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
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 2
ƒ Eurekahedge Indices
ƒ BarclayHedg
ƒ Hedge Fund Research
ƒ Credit Suisse Tremont
ƒ 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.
Three Broad Class Strategies
Most hedge funds are entrepreneurial organizations
that employ proprietary or well-guarded strategies.
The three broad hedge fund categories are based on
the types of strategies they use:
1. Arbitrage Strategies
Arbitrage is the exploitation of an observable price
inefficiency and, as such, pure arbitrage is
considered riskless. Consider a very simple example.
Say Acme stock currently trades at $10 and a single
stock futures contract due in six months is priced at
$14. The futures contract is a promise to buy or sell
the stock at a predetermined price. So by purchasing
the stock and simultaneously selling the futures
contract, you can, without taking on any risk, lock in
a $4 gain before transaction and borrowing costs.
Only a few hedge funds are pure arbitrageurs, but
when they are, historical studies often prove they are
a good source of low-risk reliably-moderate returns.
But, because observable price inefficiencies tend to
be quite small, pure arbitrage requires large, usually
leveraged investments and high turnover. Further,
arbitrage is perishable and self-defeating: if a
strategy is too successful, it gets duplicated and
gradually disappears.
Most so-called arbitrage strategies are better labeled
"relative value". These strategies do try to capitalize
2
http://www.eurekahedge.com/indices/default.asp
http://barclayhedge.com/
http://www.hedgefundresearch.com/
http://www.hedgeindex.com/hedgeindex/en/default.aspx?c
y=USD
http://www.ftse.com/Indices/index.jsp
on price differences, but they are not risk free. For
example, convertible arbitrage entails buying a
corporate convertible bond, which can be converted
into common shares, while simultaneously selling
short the common stock of the same company that
issued the bond. This strategy tries to exploit the
relative prices of the convertible bond and the stock:
the arbitrageur of this strategy would think the bond
is a little cheap and the stock is a little expensive.
The idea is to make money from the bond's yield if
the stock goes up but also make money from the
short sale if the stock goes down. However, as the
convertible bond and the stock can move
independently, the arbitrageur can lose on both the
bond and the stock, which means the position carries
risk.
Arbitrage Using Short Sales
2. Event-Driven Strategies
Event-driven strategies take advantage of transaction
announcements and other one-time events. One
example is merger arbitrage, which is used in the
event of an acquisition announcement and involves
buying the stock of the target company and hedging
the purchase by selling short the stock of the
acquiring company. Usually at announcement, the
purchase price that the acquiring company will pay
to buy its target exceeds the current trading price of
t he target company.
The merger arbitrageur bets the acquisition will
happen and cause the target company's price to
converge (rise) to the purchase price that the
acquiring company pays. This also is not pure
arbitrage. If the market happens to frown on the deal,
the acquisition may unravel and send the stock of
the acquirer up (in relief) and the target company's
stock down (wiping out the temporary bump) which
w ould cause a loss for the position.
There are various types of event-driven strategies.
One other example is "distressed securities", which
involves investing in companies that are re-
organizing or have been unfairly beaten down.
Another interesting type of event-driven fund is the
activist fund, which is predatory in nature. This type
takes sizeable positions in small, flawed companies
and then uses its ownership to force management
changes or a restructuring of the balance sheet.
3. Directional or Tactical Strategies
The largest group of hedge funds uses directional or
tactical strategies. One example is the macro fund,
made famous by George Soros and his Quantum
Fund, which dominated the hedge fund universe and
newspaper headlines in the 1990s. Macro funds are
global, making "top-down" bets on currencies,
interest rates, commodities or foreign economies.
Because they are for "big picture" investors, macro
funds often do not analyze individual companies.
Risk based Inve stment Strate gie s
The five risk based strategies, have their own risk,
and return characteristics.
[1] Very High Risk Strategies
1.1 Emerging Markets
Invests in equity or debt of emerging (less mature)
markets that tend to have higher inflation, volatile
growth and the potential for significant future
growth. Examples include Brazil, China, India, and
Russia. Short selling is not permitted in many
emerging markets, and, therefore, effective hedging
is often not available. This strategy is defined
purely by geography; the manager may invest in any
asset class (e.g., equities, bonds, currencies) and
may construct his portfolio on any basis (e.g. value,
growth, arbitrage)
1.2 Short Selling 3
In order to short sell, the manager borrows securities
from a prime broker and immediately sells them on
the market. The manager later repurchases these
securities, ideally at a lower price than he sold them
for, and returns them to the broker. In this way, the
manager is able to profit from a fall in a security's
value.
3 Market timing managers focusing on these asset
In finance, short selling or "shorting" is the practice of selling a financial
instrument that the seller does not own at the time of the sale. Short
selling is done with intent of later purchasing the financial instrument at a
lower price. Short-sellers attempt to profit from an expected decline in the
price of a financial instrument.
For Details : http://www.investopedia.com/university/shortselling/
Short selling managers typically target overvalued
stocks, characterized by prices they believe are too
high given the fundamentals of the underlying
companies. It is often used as a hedge to offset long-
only portfolios and by those who feel the market is
approaching a bearish cycle.
1.3 Macro
Aims to profit from changes in global economies,
typically brought about by shifts in government
policy that impact interest rates, in turn affecting
currency, stock, and bond markets. Rather than
considering how individual corporate securities may
fare, the manager constructs his portfolio based on a
top-down view of global economic trends,
considering factors such as interest rates, economic
policies, inflation, etc and seeks to profit from
changes in the value of entire asset classes.
For Example
The manager may hold long positions in the U.S. dollar
and Japanese equity indices while shorting the euro and
U.S. treasury bills. Uses leverage and derivatives to
accentuate the impact of market moves. The leveraged
directional investments tend to make the largest impact
on performance.
[2] High Risk Strategies
2.1 Aggressive Growth
A primarily equity-based strategy whereby the
manager invests in companies, with smaller or micro
capitalization stocks, characterized by low or no
dividends, but experiencing or expected to
experience strong growth in earnings per share. The
manager may consider a company's business
fundamentals when investing and/or may invest in
stocks on the basis of technical factors, such as
stock price momentum. Managers employing this
strategy generally utilize short selling to some
degree, although a substantial long bias is common.
This includes sector specialist funds such as
technology, banking, or biotechnology.
2.2 Market Timing
The manager attempts to predict the short-term
movements of various markets (or market segments)
and based on those predictions, moves capital from
one asset class to another in order to capture market
gains and avoid market losses. While a variety of
asset classes may be used, the most typical ones are
mutual funds and money market funds.
classes are sometimes referred to as mutual fund
switchers. Unpredictability of market movements
and the difficulty of timing entry and exit from
markets add to the volatility of this strategy.
[3] Moderate Risk Strategies
3.1 Special Situations
The manager invests, both long and short, in stocks
and/or bonds which are expected to change in price
over a short period due to an unusual event.
Examples of event-driven situations are mergers,
hostile takeovers, reorganizations, or leveraged
buyouts. It may involve simultaneous purchase of
stock in companies being acquired, and the sale of
stock in its acquirer, hoping to profit from the
spread between the current market price and the
ultimate purchase price of the company.
3.2 Value
A primarily equity-based strategy whereby the
manager invests in securities perceived to be selling
at deep discounts to their intrinsic or potential worth.
The manager takes long positions in stocks that he
believes are undervalued, i.e. the stock price is low
given company fundamentals such as high earnings
per share, good cash flow, strong management, etc.
Possible reasons that a stock may sell at a perceived
discount could be that the company is out of favor
with investors or that its future prospects are not
correctly judged by Wall Street analysts. Securities
may be out of favor or under-followed by analysts.
Long-term holding, patience, and strong discipline
are often required, until the ultimate value is
recognized by the market. The manager can take
short positions in stocks he believes are overvalued.
3.3 Funds of Hedge Funds
The manager invests in other hedge funds (or
managed accounts programs) rather than directly
investing in securities such as stocks, bonds, etc.
These underlying hedge funds may follow a variety
of investment strategies or may all employ similar
approaches. Because investor capital is diversified
among a number of different hedge fund managers,
funds of funds generally exhibit lower risk than do
single-manager hedge funds. Funds of funds are also
referred to as multi-manager funds. It’s a diversified
portfolio of generally uncorrelated hedge funds and
it’s a preferred investment of choice for many
pension funds, endowments, insurance companies,
private banks and high-net-worth families and
individuals.
[4] Variable Risk Strategies
4.1 Opportunistic
Rather than consistently selecting securities
according to the same strategy, the manager's
investment theme changes from strategy to strategy
as opportunities arise to profit from events such as
IPOs, sudden price changes often caused by an
interim earnings disappointment, hostile bids, and
other event-driven opportunities.
Characteristics of the portfolio, such as asset classes,
market capitalization, etc., are likely to vary
significantly from time to time. The manager may
also employ a combination of different approaches
at a given time
4.2 Multi Strategy
The manager typically utilizes many specific, pre-
determined investment strategies, e.g., Value,
Aggressive Growth, and Special Situations in order
to better diversify their portfolio and/or to more
fully use their range of portfolio management skills
and philosophies and also in order to realize short or
long-term gains.
This style of investing allows the manager to
overweight or underweight different strategies to
best capitalize on current investment opportunities.
Although the relative weighting of the chosen
strategies may vary over time, each strategy plays a
significant role in portfolio construction.
[5] Low risk strategies
5.1 Distressed Securities
The manager invests in the debt and/or equity of
companies having financial difficulty. Such
companies are generally in bankruptcy
reorganization or are emerging from bankruptcy or
appear likely to declare bankruptcy in the near
future. Because of their distressed situations, the
manager can buy such companies' securities at
deeply discounted prices. The manager stands to
make money on such a position should the company
successfully reorganize and return to profitability.
Also, the manager could realize a profit if the
company is liquidated, provided that the manager
had bought senior debt in the company for less than
its liquidation value. "Orphan equity" issued by
newly reorganized companies emerging from
bankruptcy may be included in the manager's
portfolio. The manager may take short positions in
companies whose situations he deems will worsen,
rather than improve, in the short term.
5.2 Income
Invests with primary focus on yield or current
income rather than solely on capital gains, though it
may also utilize leverage to buy bonds and
(sometimes) fixed income derivatives in order to
profit from principal appreciation and interest
income. Other strategies (e.g. distressed securities,
market neutral arbitrage, macro) may heavily
involve fixed-income securities trading as well.
5.3 Market Neutral - Securities Hedging
The manager invests similar amounts of capital in
securities both long and short, generally in the same
sectors of the market, maintaining a portfolio with
low net market exposure. Long positions are taken in
securities expected to rise in value while short
positions are taken in securities expected to fall in
value. Due to the portfolio's low net market
exposure, performance is insulated from market
volatility.
Market risk is greatly reduced, but effective stock
analysis and stock picking is essential to obtaining
meaningful results. Leverage may be used to
enhance returns. It sometimes uses market index
futures to hedge out systematic (market) risk. It uses
Tbills as a relative benchmark index.
5.4 Market Neutral – Arbitrage
The manager seeks to exploit specific inefficiencies
in the market by trading a carefully hedged portfolio
of offsetting long and short positions. By pairing
individual long positions with related short positions,
market-level risk is greatly reduced, resulting in a
portfolio that bears a low correlation to the market.
For Example
Long convertible bonds and short underlying
issuer’s equity. For example, can be long
convertible bonds and short the underlying issuers
equity. It may also use futures to hedge out interest
rate risk. These relative value strategies include
fixed income arbitrage, mortgage backed securities,
capital structure arbitrage, and closed-end fund
arbitrage.
Fe es S tr u cture
A hedge fund manager will typically receive both a
management fee and a performance fee (also known as an
incentive fee).
Fees are payable by the fund to the investment manager.
They are therefore taken directly from the assets that the
investor holds in the fund.
Management fees
As with other investment funds, the management fee is
calculated as a percentage of the fund's net asset value (the
total of the investors' capital accounts) 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 year-
end and charges a 2% management fee, the management
fee will be $20 million. Management fees are usually
expressed as an annual percentage but both calculated and
paid monthly (or sometimes quarterly or weekly) at
annualized rates.
Performance Fees
One of the defining characteristics of hedge funds are
performance fees, which give a share of positive returns to
the manager. The manager'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. Thus, the
performance fee is extremely lucrative for managers who
perform well. Typically, hedge funds charge 20% of gross
returns as a performance fee. However, the range is wide
with highly regarded managers charging higher fees.
In particular, Steven Cohen's SAC Capital Partners
charges a 3% management fee and a 35-50% performance
fee, while Jim Simons' Renaissance Technologies Corp.
charged a 5% management fee and a 44% incentive fee in
its flagship Medallion Fund.
Performance fees are intended to align the interests of
manager and investor better than flat fees that are payable
even when performance is poor.
However, many people, including notable investor Warren
Buffett, for giving managers an incentive to take excessive
risk rather than targeting high long-term returns, have
criticized performance fees. In an attempt to control this
problem, fees are usually limited by a high water mark and
sometimes limited by a hurdle rate. Alternatively, a "claw-
back" provision may be included, whereby the investment
manager might be required to return performance fees
when the value of the fund drops.
For example
Suppose at the beginning of year 1 a hedge fund has
a net asset value of 100, and throughout the year the
fund realizes a 25% return, raising the net asset
value to 125. Then if an investor entered the fund
with a $1,000,000 investment at the beginning of
year 1 then his or her "shares" would be worth
$1,250,000 gross of fees. If the benchmark was cash,
say 5%, then the fees would be paid on the $200,000
upside in excess of cash. That is, the first 5% of the
return would not have to have fees paid on it. If the
fees were 2 and 20, then the investor would pay
$20,000 in fixed fee (2%) and 20% of the upside
above cash, that is, an additional $40,000 for a total
of $60,000 in fees. This would make the investment
value, gross of fees, equal to $1,190,000.
The performance fee is sometimes calculated net of a
benchmark. That is, the returns that fees are paid on are
sometimes only those returns in excess of some benchmark.
Sometimes the benchmark is a risk-free interest rate such
as LIBOR (often called the cash benchmark, meaning
performance fees are paid on the profit that would be made
in excess of an investment in cash) and other times it is a
market index such as the MSCI World Index or the S&P
500 index.
High Water marks
A high water mark (also known as a loss carry forward
provision) is often applied to a performance fee calculation.
This means that the manager only receives performance
fees on the value of the fund that exceeds the highest net
asset value it has previously achieved.
The high water mark is an important concept: investors in
hedge funds enter the fund at a certain net asset value,
which we will call the entering NAV. If the fund loses
money in a given year and then makes back that money in
a subsequent year, the investor is usually not required to
pay a management fee on any portion of the upside in the
subsequent year that was below the entering NAV.
For example
Suppose an investor enters a hedge fund with a $1,000,000
at the beginning of year 1, and in that year the fund is
down 20%, that is, the value of the investment drops to
$800,000 gross of fees.
The investor still pays the management fee (that is why it is
called a fixed fee), but the investor pays no management
fee. Now suppose that after year two the investment value
is up to $1,200,000, representing over a 30% gain in year
two for the fund.
The investor, nevertheless, only pays a management fee on
$200,000, that is, he or she only pays a fee on the amount
in excess of the entering NAV. The entering NAV in this
case is called the high water mark. In subsequent years if
there is a drop in NAV, the new high water mark will be
the entering NAV of the previous year, or the previous high
water mark, whichever is greater.
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 do better
than the investor would have done if he had put the money
elsewhere.
Because demand for hedge funds has outstripped supply,
most managers do not now need hurdle rates in order to
attract investors. For this reason, hurdle rates are now rare.
Withdrawal/Redemption Fees
Some managers charge investors a withdrawal/redemption
fee (also known as a surrender charge) if they withdraw
money from the fund before a certain period has elapsed
since the money was invested.
The purpose is to encourage long-term investment in the
fund: as a fund's investments need to be liquidated to raise
cash for withdrawals, the fee allows the fund manager to
reduce the turnover of its own investments and invest in
more complex, longer-term strategies. The fee also
dissuades investors from withdrawing funds after periods
of poor performance.
The fee is typically known as a "withdrawal fee" where the
fund is a limited partnership and a "redemption fee" where
the fund is a corporate entity.
Hedge Fund Returns
As hedge funds are often viewed as providing returns that
are "cheap" relative to risk, their performance is usually
evaluated on a risk-adjusted return basis. The common
number that is quoted is the Sharpe Ratio, which is the
ratio of annualized excess returns to the annualized
standard deviation of returns.
The data in Table 7 of "Hedge Funds
Demystified" gives an idea of the
relative performance of hedge funds
compared with some standard indexes
over the period January 1993 -
December 1997. The table represents
returns on each Hedge Fund Sector, that
is, the returns and standard deviations in
each column represent the returns that
were realized on an equal weighted
investment portfolio of all the hedge
funds in a given sector.
Hedge Funds Actively Seek Absolute
Returns
Hedge funds lie at the active end of the investing spectrum
as they seek positive absolute returns, regardless of the
performance of an index or sector benchmark. Unlike
mutual funds, which are "long-only" (make only buy-sell
decisions), a hedge fund engages in more aggressive
strategies and positions, such as short selling, trading in
derivative instruments like options and using leverage
(borrowing) to enhance the risk/reward profile of their bets.
This activeness of hedge funds explains their popularity in
bear markets. In a bull market, hedge funds may not
perform as well as mutual funds, but in a bear market -
taken as a group or asset class - they should do better than
mutual funds because they hold short positions and hedges.
The absolute return goals of hedge funds vary, but a goal
might be stated as something like "6 to 9% annualized
return regardless of the market conditions".
The hedge-fund promise of pursuing absolute returns
means hedge funds are "liberated" with respect to
registration, investment positions, liquidity and fee
structure. First, hedge funds in general are not registered
with the SEC. They have been able to avoid registration by
limiting the number of investors and requiring that their
investors be accredited, which means they meet an income
or net worth standard. Furthermore, hedge funds are
prohibited from soliciting or advertising to a general
audience, a prohibition that lends to their mystique.
In hedge funds, liquidity is a key concern for investors.
Liquidity provisions vary, but invested funds may be
difficult to withdraw "at will". For example, many funds
have a lock-out period, which is an initial period of time
during which investors cannot remove their money.
Lastly, hedge funds are more expensive even though a
portion of the fees is performance-based. Typically, they
charge an annual fee equal to 1% of assets managed
(sometimes up to 2%), plus they receive a share - usually
20% - of the investment gains. The managers of many
funds, however, invest their own money along with the
other investors of the fund and, as such, may be said to "eat
their own cooking".
Hedge R i sks
Investing in certain types of hedge fund can be (but is not
necessarily) a riskier proposition than investing in a
regulated fund, despite 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 in hedge funds as an industry:
Leverage - In addition to money invested into the fund
by investors, a hedge fund will typically borrow money,
with certain funds borrowing sums many times greater than
the initial investment. If a hedge fund has borrowed $9 for
every $1 received from investors, 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.
In September 1998, shortly before its collapse, Long Term
Capital Management had $125 billion of assets on a base
of $4 billion of investors' money, an advantage of over 30
times. It also had off-balance sheet positions with a
notional value of approximately $1 trillion.
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. Ordinary funds very rarely use
short selling in this way.
Lack of Transparency - Hedge funds are secretive
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.
Lack of Regulation - Hedge funds are not subject to as
much oversight from financial regulators as regulated
funds, and therefore some may carry undisclosed structural
risks.
Hedge Largest Hedge Funds by
Assets under Management
Name AUM 4
JP Morgan $44.7bn
Farallon Capital $36bn
Bridgewater Associates $36bn
Renaissance Technologies $34bn
Och-Ziff Capital Management $33.2bn
Goldman Sachs Asset Management
DE Shaw
$32.5bn
$32.2bn
Paulson and Company $29bn
Barclays Global Investors $18.9bn
Man Investments $18.8bn
ESL Investments $17.5bn
4
Assets Under Management (AUM) is a term used by financial services
companies in the mutual fund and money management, investment
management, wealth management, and private banking businesses to
gauge how much money they are managing.
References

1. http://www.hedgefundworld.com/forming_a_hedge_fund.htm

2. Hedge Funds Do About 60% Of Bond Trading, Study Says", The Wall Street Journal

3. America's biggest hedge funds control $743 billion - September 8, 2005

4. Hedge Fund Asset Flows & Trends Report 2008

5. Hedge Fund Math: Why Fees Matter (Newsletter), Epoch Investment Partners Inc.

6. The Investment Company Act of 1940

7. The Investment Company Act of 1940

8. The Investment Advisers Act of 1940

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Tariq Mumtaz