Hedge fund
Encyclopedia
A hedge fund is a private pool of capital actively managed by an investment adviser
. Hedge funds are only open for investment to a limited number of accredited
or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university endowments and foundations, or high net worth individuals. Worldwide, 61% of investment in hedge funds is from institutional sources . The funds generally invest in a diverse range of assets and employ a variety of investment strategies.
Hedge funds are distinct from mutual funds, individual retirement and investment accounts, and other types of traditional investment portfolios because they can undertake a wider range of investment and trading activities, and invest in a broader range of assets, including equities
, bonds
, commodities and derivatives
.
Most hedge fund investment strategies aim to achieve a positive return on investment whether markets are rising or falling. Hedge fund managers typically invest their own money in the fund they manage, which serves to align their interests with investors in the fund. Investors in hedge funds typically pay a management fee that goes toward the operational costs of the fund, and a performance fee
when the fund’s net asset value
is higher than that of the previous year. The net asset value of a hedge fund can be billions of dollars, due to investments from large institutional investors. , hedge funds represent 1.1% of the total funds and assets held by financial institutions. The estimated size of the global hedge fund industry is US$
1.9 trillion.
Because hedge funds are not sold to the public or retail investors, their advisers have historically not been subject to the same restrictions that govern other investment fund
advisers, with regard to how the fund may be structured and how strategies are employed. Hedge funds must now comply with many of the same statutory and regulatory restrictions as other institutional market participants. Regulations passed in the United States
and Europe
after the 2008 credit crisis are intended to increase government oversight of hedge funds and eliminate any regulatory gaps.
and Jerry Newman.
The speculative exploits of Jesse Livermore as chronicled in Reminiscences of a Stock Operator
(1923) also describe speculative vehicles dubbed "pools" that are similar, if not the same, in form and function as what would later be called "hedge funds". Preceding Livermore, future statesman Bernard M. Baruch also operated such pools before jettisoning his limited partners and was later known as the "lone wolf on Wall Street" as he managed his own fortune.
Investor Warren Buffett
, a former pupil and later acolyte of Benjamin Graham before founding a hedge fund in 1956, in a 2006 letter to the magazine publication of the Museum of American Finance
asserts the Graham-Newman partnership of the 1920s is the first hedge fund he is aware of and suggests others may have preceded it.
Sociologist, author, and financial journalist Alfred W. Jones
is credited with coining the phrase "hedged fund", in contrast to prior nomenclatures, but is often erroneously credited with creating the first hedge fund structure in 1949. To neutralize the effect of overall market movement, Jones balanced his portfolio by buying assets whose price he expected to increase, and selling short assets whose price he expected to decrease. Jones referred to his fund as being "hedged" to describe how the fund managed risk exposure from overall market movement. This type of portfolio became known as a hedge fund. Jones was the first money manager to combine a hedged investment strategy using leverage
and shared risk, with fees based on performance. A 1966 Fortune magazine article reported that Jones’ fund had outperformed the best mutual funds despite his 20% performance fee. By 1968 there were almost 200 hedge funds, and the first Fund of funds
that utilized hedge funds was created in 1969 in Geneva
.
Many of the early funds ceased trading during the Recession of 1969-70 and the 1973-1974 stock market crash due to heavy losses. In the 1970s hedge funds typically specialized in a single strategy, and most fund managers followed the long/short equity model. Hedge funds lost popularity during the downturn of the 1970s but received renewed attention in the late 1980s, following the success of several funds profiled in the media.
During the 1990s the number of hedge funds increased significantly, with investments provided by the new wealth that was created during the 1990s stock market rise
. The increased interest from traders and investors was due to the aligned-interest compensation structure and an investment vehicle that was designed to exceed general market returns. Over the next decade there was increased diversification in strategies, including: credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy, among others.
During the first decade of the new century, hedge funds regained popularity worldwide and in 2008, the worldwide industry held $1.93 trillion in assets under management. However the 2008 credit crunch
was hard on hedge funds and they declined in value and hampered "liquidity in some markets" causing some hedge funds to restrict investor withdrawals.
Total assets under management then rebounded and in April 2011 were estimated at almost $2 trillion. , the largest 225 hedge fund managers in the United States alone held almost $1.3 trillion. with the largest hedge fund manager, Bridgewater Associates
having $58.9 billion. In 2011, the largest hedge funds were Bridgewater Associates
($58.9 billion), Man Group
($39.2 billion), Paulson & Co.
($35.1 billion), Brevan Howard
($31 billion), and Och-Ziff ($29.4 billion).
and a performance fee
.
Management fees are calculated as a percentage of the fund's net asset value
and typically range from 1% to 4% per annum, with 2% being standard. They are usually expressed as an annual percentage, but calculated and paid monthly or quarterly. Management fees for hedge funds are designed to cover the operating costs of the manager, whereas the performance fee provides the manager's profits. However, due to economies of scale
the management fee from larger funds can generate a significant part of a manager's profits, and as a result some fees have been criticized by some public pension funds, such as CalPERS
, for being too high.
The Performance fee
is typically 20% of the fund's profits during any year, though they range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits.
Performance fees have been criticized by Warren Buffett
, who believes that because hedge funds share only the profits and not the losses, such fees create an incentive for high-risk investment management. Performance fee rates have fallen since the start of the credit crunch.
Almost all hedge fund performance fees include a "high water mark" (or "loss carryforward provision"), which means that the performance fee only applies to net profits (i.e. profits after losses in previous years have been recovered). This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather than attempting to recover the losses over a number of years without performance fee.
Some performance fees include a "hurdle", so that a fee is only paid on the fund's performance in excess of a benchmark rate (e.g. LIBOR) or a fixed percentage. A "soft" hurdle means the performance fee is calculated on all the fund's returns if the hurdle rate is cleared. A "hard" hurdle is calculated only on returns above the hurdle rate. A hurdle is intended to ensure that a manager is only rewarded if it generates returns in excess of the returns that the investor would have received if it had invested its money elsewhere.
Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year) or when withdrawals exceed a predetermined percentage of the original investment. The purpose of the fee is to discourage short-term investing, reduce turnover and deter withdrawals after periods of poor performance. Redemption fees usually remain in the fund and benefit the remaining investors.
, directional, event-driven, and relative value (arbitrage
). These four categories are distinguished by investment style and each have their own risk and return characteristics. Managed futures or multi-strategy funds may not fit into these categories, but are nonetheless popular strategies with investors. It is possible for hedge funds to commit to a certain strategy or employ multiple strategies to allow flexibility, for risk management purposes, or to achieve diversified returns. The hedge fund’s prospectus, also known as an offering memorandum, offers potential investors information about key aspects of the fund, including the fund's investment strategy, investment type, and leverage limit.
The elements contributing to a hedge fund strategy include: the hedge fund's approach to the market; the particular instrument used; the market sector
the fund specializes in (e.g. healthcare); the method used to select investments; and the amount of diversification within the fund. There are a variety of market approaches to different asset classes, including equity
, fixed income
, commodity
and currency
. Instruments used include: equities, fixed income, futures
, options
and swaps
. Strategies can be divided into those in which investments can be selected by managers, known as “discretionary/qualitative”, or those in which investments are selected using a computerized system, known as “systematic/quantitative”. The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager or a combination.
Sometimes hedge fund strategies are described as absolute return
and are classified as either market neutral
or directional. Market neutral funds have less correlation to overall market performance by “neutralizing” the effect of market swings, whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.
in share, bond or currency markets in anticipation of global macroeconomic events
in order to generate a risk-adjusted return. Global macro fund managers use macroeconomic ("big picture") analysis based on global market events and trends to identify opportunities for investment that would profit from anticipated price movements. While global macro strategies have a large amount of flexibility due to their ability to use leverage to take large positions in diverse investments in multiple markets, the timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns. Global macro is often categorized as a directional investment strategy.
Global macro strategies can be divided into discretionary and systematic approaches. Discretionary trading is carried out by investment managers who identify and select investments; systematic trading is based on mathematical models
and executed by software with limited human involvement beyond the programming and updating of the software. These strategies can also be divided into trend
or counter-trend approaches depending on whether the fund attempts to profit from following trends
(long or short-term) or attempts to anticipate and profit from reversals in trends.
Within global macro strategies, there are further sub-strategies including "systematic diversified", in which the fund trades in diversified markets, or "systematic currency", in which the fund trades in currency markets. Other sub-strategies include those employed by Commodity Trading Advisors (CTA), where the fund trades in futures
(or options
) in commodity
markets or in swaps. This is also known as a managed future fund. CTAs trade in commodities (such as gold) and financial instruments, including stock indexes. In addition they take both long and short positions, allowing them to make profit in both market upswings and downswings.
positions are hedged with short sales of equities or equity index
options
.
Within directional strategies, there are a number of sub-strategies. "Emerging markets
" funds focus on emerging markets such as China and India, whereas "sector funds" specialize in specific areas including technology, healthcare, biotechnology, pharmaceuticals, energy and basic materials. Funds using a "fundamental growth" strategy invest in companies with more earnings growth than the overall equity market or relevant sector, while funds using a "fundamental value" strategy invest in undervalued companies. Funds that use quantitative
techniques for equity
trading
are described as using a "quantitative directional" strategy. Funds using a "short bias
" strategy take advantage of declining equity prices using short positions.
Corporate transactional events generally fit into three categories: distressed securities, risk arbitrage and special situations. Distressed securities
include such events as restructurings, recapitalizations, and bankruptcies. A distressed securities investment strategy involves investing in the bonds or loans of companies facing bankruptcy
or severe financial distress, when these bonds or loans are being traded at a discount to their value. Hedge fund managers pursuing the distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds purchasing distressed debt may prevent those companies from going bankrupt, as such an acquisition deters foreclosure by banks. While event-driven investing in general tends to thrive during a bull market, distressed investing works best during a bear market.
Risk arbitrage
or merger arbitrage includes such events as mergers
, acquisitions, liquidations, and hostile takeovers. Risk arbitrage typically involves buying and selling the stocks of two or more merging companies to take advantage of market discrepancies between acquisition price and stock price. The risk element arises from the possibility that the merger or acquisition will not go ahead as planned; hedge fund managers will use research and analysis to determine if the event will take place.
Special situations are events that impact the value of a company's stock, including the restructuring
of a company or corporate transactions including spin-offs, share-buy-backs, security issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company's equity and equity-related instruments.
Other event-driven strategies include: credit arbitrage strategies, which focus on corporate fixed income
securities; an activist strategy, where the fund takes large positions in companies and uses the ownership to participate in the management; and legal catalyst strategy, which specializes in companies involved in major lawsuits.
or the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical, technical
or fundamental
techniques. Relative value is often used as a synonym for market neutral
, as strategies in this category typically have very little or no directional market exposure to the market as a whole. Other relative value sub-strategies include:
" can be a way of reducing the risk of an investment, hedge funds, like all other investment types, are not immune to risk. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500
between 1993 and 2010.
strategies in order to protect the fund and investors. According to the Financial Times, "big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management." Hedge fund managers may hold a large number of investment positions for short durations and are likely to have a particularly comprehensive risk management system in place. Funds may have "risk officers" who assess and manage risks but are not otherwise involved in trading, and may employ strategies such as formal portfolio risk models. A variety of measuring techniques and models may be used to calculate the risk incurred by a hedge fund's activities; fund managers may use different models depending on their fund's structure and investment strategy. Some factors,such as normality of return, are not always accounted for by conventional risk measurement methodologies. Funds which use value at risk
as a measurement of risk may compensate for this by employing additional models such as drawdown
and “time under water” to ensure all risks are captured.
In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence
to assess the risk that error or fraud at a hedge fund might result in loss to the investor. Considerations will include the organisation and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund's ability to develop as a company.
. Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/or registration requirements as other financial investment managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud. New regulations introduced in the US and the EU as of 2010 require hedge fund managers to report more information, leading to greater transparency. In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and external regulatory requirements. The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology, positions and leverage exposure.
and manager risk. Liquidity
refers to the degree to which an asset can be bought and sold or converted to cash; similar to private equity funds, hedge funds employ a lock-up period during which an investor cannot remove money. Manager risk refers to those risks which arise from the management of funds. As well as specific risks such as style drift, which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors include valuation risk
, capacity risk, concentration risk
and leverage risk. Valuation risk refers to the concern that the net asset value
of investments may be inaccurate; capacity risk can arise from placing too much money into one particular strategy, which may lead to fund performance deterioration; and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group of correlated funds. These risks may be managed through defined controls over conflict of interest, restrictions on allocation of funds, and set exposure limits for strategies.
Many investment funds use leverage
, the practice of borrowing
money or trading on margin
in addition to capital from investors. Although leverage can increase potential returns, the opportunity for larger gains is weighed against the possibility of greater losses. Hedge funds employing leverage are likely to engage in extensive risk management practices. In comparison with investment banks, hedge fund leverage is relatively low; according to a National Bureau of Economic Research
working paper, the average leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.
Some types of funds, including hedge funds, are perceived as having a greater appetite for risk
, with the intention of maximizing returns, subject to the risk tolerance of investors and the fund manager. Managers will have an additional incentive to increase risk oversight when their own capital is invested in the fund.
s other than its investments. The portfolio is managed by the investment manager
, a separate entity which is the actual business and has employees.
As well as the investment manager, the functions of a hedge fund are delegated to a number of other service providers. The most common service providers are:
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 centre
s so that the investor, rather than the fund, pays tax on the increase in the value of the portfolio. The investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund.
It is estimated that around 60% of the number of hedge funds in 2010 were registered offshore, with the Cayman Islands accounting for 37%, the British Virgin Islands 7% and Bermuda 5%. Among onshore funds, Delaware (US) accounts for 27% and the EU (primarily Ireland and Luxembourg) accounts for 5%.
in order to draw on the major pools of financial talent and to be close to investors. With the bulk of hedge fund investment coming from the US East coast
– principally New York City
and the Gold Coast
area of Connecticut
– this has become the leading location for hedge fund managers. It was estimated there were 7,000 investment managers in the United States in 2004.
London is Europe’s
leading centre for hedge fund managers, with 70% of European hedge fund investments, about $420 billion, at the end of 2010. 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 US are leading locations for management of Asian hedge funds' assets with around a quarter of the total each.
s 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, which would otherwise be subject to more complex tax issues by investing in a tax-transparent entity such as a partnership, and US entities that do not pay tax such as state, corporate, private and union pension fund
s, which would otherwise be subject to unrelated business income tax in the United States. Unit trust
s are sometimes used to market to Japanese investors. Other than taxation, the type of entity used does not have a significant bearing on the nature of the fund.
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. The fund’s strategic decisions are taken by the board of directors
of the fund, which is independent but generally loyal to the investment manager.
, meaning that the fund will periodically accept further investment and allow investors to withdraw their money from the fund. For a fund structured as a company, shares will be both issued and redeemed at the net asset value
(“NAV”) per share, so that if the value of the underlying investments has increased (and the NAV per share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Similarly, where a fund is structured as a limited partnership the investor's account will be allocated its proportion of any increase or decrease in the NAV of the fund, allowing an investor to withdraw more (or less) when it withdraws its capital.
Investors do not typically trade
shares or limited partnership interests among themselves and hedge funds do not typically distribute profits
to investors before redemption. This contrasts with a closed-ended fund
, which either has a limited number of shares which are traded among investors, and which distributes its profits, or which has a limited lifespan at the end of which capital is returned to investors. Most hedge funds allow money to be withdrawn monthly or quarterly, while others allow it biannually or annually.
Side pockets are designed to address issues relating to the need to value investors' holdings 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 meantime in respect of the main portfolio. A similar problem, inverted, applies to subscriptions during the same period.
Side pockets are most commonly used by funds as an emergency measure. They were used extensively following the collapse of Lehman Brothers
in September 2008, when the market for certain types of assets held by hedge funds collapsed, preventing the funds from selling or obtaining a market value for the assets.
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.
on smaller stock exchange
s, such as the Irish Stock Exchange
, as this provides a low level of regulatory
oversight that is required by some investors. Shares in the listed hedge fund are not generally traded
on the exchange.
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.
, the most common tactic is the direct regulation of financial advisers—including hedge fund managers, which is primarily intended to protect investors against fraud. Specific regulations differ by national, federal and state jurisdiction. Historically, hedge funds have been exempted from certain registration and reporting requirements that apply to other investment companies, because in most jurisdictions regulation permits investments in hedge funds by only "qualified" investors who are able to make an informed decision about investment decisions without relying on regulatory oversight. In 2010, new regulations were passed in the US and European Union, which (among other changes) introduced new hedge fund reporting requirements. The Dodd-Frank Wall Street Reform Act was passed in the US in July 2010, and contains provisions which require hedge fund advisers with $150 million or more in assets to register with the SEC. In November 2010, the EU Parliament
passed the Alternative Investment Fund Managers Directive
, which seeks to provide greater monitoring and control of alternative investment fund managers operating in the EU.
. Hedge funds are privately-owned pools of investment capital with regulatory limits on the number and type of investor that each fund may have. Because of these regulatory restrictions on ownership, hedge funds have been exempted from mandatory registration with the US Securities and Exchange Commission (SEC) under the Investment Company Act of 1940
, which is generally intended to regulate investment funds sold to retail investors. The two primary exemptions in the Investment Company Act of 1940 that hedge funds relied on were (a) Section 3(c)1 which restricts funds to 100 or fewer investors and (b) Section 3(c)7, which requires all investors to meet a "qualified purchaser" criterion. These sections also both prohibit hedge funds from selling their securities through public offerings. Under 3(c)7, a qualified purchaser is defined to include an individual with at least $5,000,000 in investment assets. Companies, including institutional investors, generally qualify as qualified purchasers if they have at least $25,000,000 in investment assets. Although under Section 3(c)7 a fund can have an unlimited number of investors, if a fund has any class of equity securities owned by more than 499 investors, it must register its securities with the SEC under the Securities Exchange Act of 1934
.
Because Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940 prohibit hedge funds from making public offerings, funds must sell their securities in accordance with the private offering rules under the Securities Act of 1933
. The 1933 Act generally requires companies to file a registration statement with the SEC if they want to sell their securities publicly, or comply with private placement
rules under the Act. Though the securities of hedge funds are not registered under the 1933 Act, they remain subject to the anti-fraud provisions of the Act.
Hedge funds raise capital via private placement under Regulation D of the Securities Act of 1933, which means the shares are not registered. To comply with the private placement rules in Regulation D, hedge funds generally offer their securities 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 $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.
For SEC registered hedge fund advisers to charge an incentive or performance fee, the investors in the funds must be "qualified clients" as defined in the Investment Advisers Act of 1940 Rule 205–3. To be a qualified client an individual must have $750,000 in assets invested with the adviser or a net worth in excess of $1.5 million, or be one of certain high-level employees of the investment adviser. Under the Dodd-Frank Act, the SEC is required to periodically adjust the qualified client standard for inflation.
Because hedge funds do not have publicly traded securities, they are not subject to all of the reporting requirements of the Securities Exchange Act of 1934. Hedge funds that have a class of equity securities owned by more than 499 investors do, however, have to register under Section 12(g) of the 1934 Act and are subject the quarterly reporting requirements of the Act. Similar to other institutional investors, hedge fund managers with at least $100,000,000 in assets under management are required to file publicly quarterly reports disclosing ownership of registered equity securities. Also similar to other investors, hedge fund managers are subject to public disclosure if they own more than 5% of the class of any registered equity security. Hedge fund managers are also subject to anti-fraud provisions.
Prior to the requirements of the Dodd-Frank Act, many hedge fund advisers voluntarily registered with the SEC. Advisers who do so are subject to the same requirements as all other registered investment advisers. Registered advisers must provide information about their business practices and disciplinary history to the SEC and investors. They are required to have written compliance policies and have a chief compliance officer to enforce those policies. In addition, they are required to maintain certain books and records and have their practices examined by SEC staff. As a result of the Dodd-Frank Wall Street Reform Act, hedge fund advisers with at least $150,000,000 in assets under management will be required to register with the SEC as of July 21, 2011, while smaller advisers will be subject to state registration.
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 $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, and was later challenged in court by a hedge fund manager. In June 2006, the U.S. Court of Appeals for the District of Columbia overturned the rule and sent it back to the agency to be reviewed. In response to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the earlier challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity.
Many hedge funds also fall under the jurisdiction of the Commodity Futures Trading Commission
. Hedge fund advisers registered as Commodity Pool Operator
s (CPO) or Commodity Trading Advisor
s (CTA) would fall within this category, as would any manager of a hedge fund investing in markets under the CFTC’s jurisdiction, even if they qualify for an exemption from CPO or CTA registration. Hedge fund managers who meet these criteria are subject to rules and provisions of the Commodity Exchange Act
prohibiting fraud and manipulation.
s, with certain exceptions (employees, etc.), and cannot be marketed to retail investors; mutual funds, however, do not have this restriction. Finally, mutual funds must be liquid on a daily basis. If a mutual fund investor wishes to redeem his or her investment the fund must be able to meet that request immediately. Hedge funds 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.
Mutual funds must also determine the net asset value
(NAV) of the fund. While some hedge funds that are based offshore report their NAV to the Financial Times, for the most part there is no method of ascertaining pricing on a regular basis. In addition, mutual funds must have a prospectus available to anyone who requests one (either electronically or via US postal mail), and must disclose their asset allocation quarterly, whereas hedge funds do not have to abide by these terms.
All investment funds are subject to regulations that prohibit charging fees to investors, unless the investment performance of the fund is equivalent to that of an index or other measure of performance. This regulation is set out under Section 205(b) of the Investment Advisers Act of 1940
, which limits performance fees to so-called "fulcrum fees". Due to this regulation, hedge funds charging a performance fee are unique compared with other funds.
Additionally, Dodd-Frank requires hedge funds to provide information about their trades and portfolios to help regulators fulfill their obligation to monitor and regulate systemic risk. The aim is for this data to be analyzed and shared among regulators – including the newly created Financial Stability Oversight Council – and for the SEC to report to Congress on how the data is being used to protect both investors and market integrity. Under the so-called "Volcker Rule", regulators are also required to implement regulations for banks, their affiliates and holding companies to limit their relationships with hedge funds and also to prohibit these organizations from proprietary trading, and limit their investment in, and sponsorship of hedge funds.
(EU), as with the US, hedge funds are primarily regulated through advisers who manage the funds. In the United Kingdom
, which is the hedge fund centre of the EU, hedge fund managers are required to be authorised and regulated by the Financial Services Authority
(FSA), the national regulator. Historically, there have been different regulatory approaches within each country in the EU. In some countries there are specific restrictions on hedge fund activities, including controls on use of derivatives in Portugal
, and limits on leverage in France
.
In 2010, the EU approved a law that will require all EU hedge fund managers to register with national regulatory authorities. The EU's Directive on Alternative Investment Fund Managers
(AIFMD) was passed by the EU Parliament
on November 11, 2010 and is the first EU directive focused on "alternative investment fund managers", including hedge fund managers. According to the EU, the aim of the directive is to provide greater monitoring and control of alternative investment funds. The directive requires managers to disclose more information, on a more frequent basis, to regulators about their investment strategies. The directive also introduces a rule that hedge fund managers should hold larger amounts of capital. All hedge fund managers within the EU will also be subject to potential limitations on the amount of leverage they can use. Since AIFMD covers the entire EU, and individual countries have different rules for hedge fund marketing, the directive introduced a "passport" for hedge funds authorized in one EU country to operate throughout the EU. The scope of AIFMD is broad and encompasses managers located within the EU as well as non-EU managers that market their funds to European investors. Countries within the EU are required to adopt the directive in national legislation by early 2013.
offer business-friendly regulation, which has encouraged the establishment of hedge funds. Major centers include the Cayman Islands
, Dublin, Luxembourg
, the British Virgin Islands
, and Bermuda
. Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centers. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager.
In Asia
, Singapore
offers fewer licensing requirements and regulations for hedge funds than Hong Kong
and other financial capitals in the region. Singapore’s oversight of hedge funds will increase following the introduction of new rules and regulations in 2011, but small funds will be able to continue operating without a license. Hedge funds based in Hong Kong are subject to the same licensing requirements as mutual funds.
Many international hedge fund markets are affected by regulation passed in 2010 within the United States and European Union. Under the EU’s Alternative Investment Fund Managers directive, offshore hedge funds using prime brokers as depositaries will be required to use EU-registered credit institutions before they can be sold in the EU. The AIFMD’s regulatory requirements will essentially mandate equivalent regulations for non-EU investment funds, if they wish to operate in EU markets.
The Dodd-Frank Act, passed in the US in 2010, will have several key implications for overseas hedge funds. Funds with more than 15 US clients and investors managing $25 million or more will have to register with the SEC by July 21, 2011. Registered managers must file and maintain information including the assets under management and trading positions. Prior to the Dodd-Frank act, some Asian hedge funds had registered with the SEC.
In traditional equity investment, indices play a central and unambiguous role. They are widely accepted as representative, and products such as futures and ETFs provide investable access to them in most developed markets. However hedge funds are illiquid, heterogeneous and ephemeral, which makes it hard to construct a satisfactory index. Non-investable indices are representative, but, due to various biases, their quoted returns may not be available in practice. Investable indices achieve liquidity at the expense of limited representativeness. Clone indices seek to replicate some statistical properties of hedge funds but are not directly based on them. None of these approaches is wholly satisfactory.
Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list of biases
.
Funds’ participation in a database is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money.
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 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”.
To make the index investable, hedge funds must agree to accept investments on the terms given by the constructor. To make the index liquid, these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. This means that investable indices do not represent the total universe of hedge funds, and most seriously they may under-represent more successful managers.
However, they rely on a statistical modelling process. As replication indices have a relatively short history it is not yet possible to know how reliable this process will be in practice, although initially indications are that much of hedge fund returns can be replicated in this manner without the problems of illiquidity, transparency and fraud that exist in direct hedge fund investments.
refers to the risk of instability across the entire financial system, as opposed to within a single company. Such risk may arise following a destabilizing event or events affecting a group of financial institutions linked through investment activity. Organizations such as the National Bureau of Economic Research
and the European Central Bank
have charged that hedge funds pose systemic risks to the financial sector, and following the failure of hedge fund Long-Term Capital Management
(LTCM) in 1998 there was widespread concern about the potential for systemic risk if a hedge fund failure led to the failure of its counterparties even though no financial assistance was provided to LTCM by the US Federal Reserve, incurring no cost for US taxpayers.
However these claims are widely disputed by the financial industry. Compared with investment banks and mutual funds, hedge funds are relatively small, in terms of the assets they manage, and operate generally with low leverage, thereby limiting the potential impact on systemic risk. Financial writer Sebastian Mallaby
has described hedge funds as "small enough to fail
". Hedge funds fail regularly, and numerous hedge funds failed during the financial crisis. In testimony to the House Financial Services Committee
in 2009, Ben Bernanke
, the Federal Reserve
Board Chairman said he “would not think that any hedge fund or private equity fund would become a systemically-critical firm individually”.
In October 2009, April 2010, and September 2010, the FSA surveyed 50 hedge fund managers regarding the sector's risks, leverage levels and counterparties. Based on information collected in the 2009 and 2010 surveys, the FSA published reports that affirmed that the European hedge fund industry posed no systemic risk to the financial system. The FSA determined that, based on indicators of risk, there was "no clear evidence to suggest that... any individual fund posed a significant systemic risk to the financial system." In particular, the reports noted that hedge funds have a relatively small "footprint" of securities compared to equity raised from investors, indicating that use of leverage was reasonable.
(or unit trust), which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment advisor of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, while some hedge funds have very limited transparency even to investors.
Funds may choose to report some information in the interest of recruiting additional investors. Much of the data available in consolidated databases is self-reported and unverified. A study was done on two major databases containing hedge fund data. The study noted that 465 common funds had significant differences in reported information (e.g. returns, inception date, net assets value, incentive fee, management fee, investment styles, etc.) and that 5% of return numbers and 5% of NAV numbers were dramatically different. With these limitations, investors have to do their own research, which may cost on the scale of $50,000.
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, several feeder funds, of which the largest was Fairfield Sentry, channelled money to Madoff.
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.
, the Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. Aguirre was fired from his job with the SEC when, as lead investigator of insider trading
allegations against Pequot Capital Management
, he tried to interview John Mack
, then being considered for chief executive officer
at Morgan Stanley
. The Judiciary Committee and the US Senate Finance Committee issued a scathing report in 2007, which found that Aguirre had been illegally fired in reprisal for his pursuit of Mack and in 2009, the SEC was forced to re-open its case against Pequot. Pequot settled with the SEC for $28 million and Arthur J. Samberg
, chief investment officer
of Pequot, was barred from working as an investment advisor. Pequot closed its doors under the pressure of investigations.
The SEC is focusing resources on investigating insider trading by hedge funds, though a statement by SEC Enforcement Director Robert Khuzami
put some of its impact in question and Senator Chuck Grassley
has asked for an explanation of Khuzami's remarks.
One estimate is that the average hedge fund returned 11.4% per year, representing a 6.7% return above overall market performance before fees, based on performance data from 8,400 hedge funds. Another is that between January 2000 and December 2009 the hedge funds outperformed other investments were significantly less volatile, with stocks falling −2.62% per year over the decade and hedge funds rising +6.54%.
Hedge funds performance is measured by comparing their returns to an estimate of their risk. Common measures are the Sharpe ratio
., Treynor measure
and Jensen's alpha
. These measures work best when returns follow normal distributions without autocorrelation
, and these assumptions are often not met in practice.
New performance measures have been introduced that attempt to address some of theoretical concerns with traditional indicators, including: modified Sharpe ratios; the Omega ratio introduced by Keating and Shadwick in 2002; Alternative Investments Risk Adjusted Performance (AIRAP) published by Sharma in 2004; and Kappa developed by Kaplan and Knowles in 2004.
, rational investors will seek to hold portfolios that are mean/variance efficient (that is, portfolios offer the highest level of return per unit of risk, and the lowest level of risk per unit of return). One of the attractive features of hedge funds (in particular market neutral
and similar funds) is that they sometimes have a modest correlation with traditional assets such as equities. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers, reducing overall portfolio risk.
However, there are three reasons why one might not wish to allocate a high proportion of assets into hedge funds. These reasons are:
Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in investor portfolios, but this is disputed for example by Mark Kritzman who performed a mean-variance optimization calculation on an opportunity set that consisted of a stock index fund, a bond index fund, and ten hypothetical hedge funds. The optimizer found that a mean-variance efficient portfolio did not contain any allocation to hedge funds, largely because of the impact of performance fees. To demonstrate this, Kritzman repeated the optimization using an assumption that the hedge funds incurred no performance fees. The result from this second optimization was an allocation of 74% to hedge funds.
The other factor reducing the attractiveness of hedge funds in a diversified portfolio is that they tend to under-perform during equity bear markets, just when an investor needs part of their portfolio to add value. For example, in January–September 2008, the Credit Suisse/Tremont Hedge Fund Index was down 9.87%. According to the same index series, even "dedicated short bias" funds had a return of −6.08% during September 2008. In other words, even though low average correlations may appear to make hedge funds attractive this may not work in turbulent period, for example around the collapse of Lehman Brothers
in September 2008.
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 or cash equivalents. 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 US 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.
Investment Advisor
The term Investment Advisor is an individual or firm who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities...
. Hedge funds are only open for investment to a limited number of accredited
Accredited investor
Accredited investor is a term defined by various securities laws that delineates investors permitted to invest in certain types of higher risk investments including seed money, limited partnerships, hedge funds, and angel investor networks...
or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university endowments and foundations, or high net worth individuals. Worldwide, 61% of investment in hedge funds is from institutional sources . The funds generally invest in a diverse range of assets and employ a variety of investment strategies.
Hedge funds are distinct from mutual funds, individual retirement and investment accounts, and other types of traditional investment portfolios because they can undertake a wider range of investment and trading activities, and invest in a broader range of assets, including equities
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
, bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, commodities and derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
.
Most hedge fund investment strategies aim to achieve a positive return on investment whether markets are rising or falling. Hedge fund managers typically invest their own money in the fund they manage, which serves to align their interests with investors in the fund. Investors in hedge funds typically pay a management fee that goes toward the operational costs of the fund, and a performance fee
Performance fee
A performance fee is a fee that an investment fund may be charged by the investment manager that manages its assets, calculated by reference to the increase in the fund's net asset value , which represents the value of the fund's investments...
when the fund’s net asset value
Net asset value
Net asset value is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds because shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net...
is higher than that of the previous year. The net asset value of a hedge fund can be billions of dollars, due to investments from large institutional investors. , hedge funds represent 1.1% of the total funds and assets held by financial institutions. The estimated size of the global hedge fund industry is US$
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
1.9 trillion.
Because hedge funds are not sold to the public or retail investors, their advisers have historically not been subject to the same restrictions that govern other investment fund
Collective investment scheme
A collective investment scheme is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group...
advisers, with regard to how the fund may be structured and how strategies are employed. Hedge funds must now comply with many of the same statutory and regulatory restrictions as other institutional market participants. Regulations passed in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
and Europe
Europe
Europe is, by convention, one of the world's seven continents. Comprising the westernmost peninsula of Eurasia, Europe is generally 'divided' from Asia to its east by the watershed divides of the Ural and Caucasus Mountains, the Ural River, the Caspian and Black Seas, and the waterways connecting...
after the 2008 credit crisis are intended to increase government oversight of hedge funds and eliminate any regulatory gaps.
History
The origin of the first hedge fund is uncertain. During the US bull market of the 1920s, there were numerous such vehicles offered privately to well-heeled investors. Of that period, the best known today owing to the legacies of one of its founders was the Graham-Newman Partnership founded by Benjamin GrahamBenjamin Graham
Benjamin Graham was an American economist and professional investor. Graham is considered the first proponent of value investing, an investment approach he began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd through various editions of their famous book...
and Jerry Newman.
The speculative exploits of Jesse Livermore as chronicled in Reminiscences of a Stock Operator
Reminiscences of a Stock Operator
Reminiscences of a Stock Operator is a 1923 novel by American author Edwin Lefèvre which is the thinly disguised biography of Jesse Lauriston Livermore...
(1923) also describe speculative vehicles dubbed "pools" that are similar, if not the same, in form and function as what would later be called "hedge funds". Preceding Livermore, future statesman Bernard M. Baruch also operated such pools before jettisoning his limited partners and was later known as the "lone wolf on Wall Street" as he managed his own fortune.
Investor Warren Buffett
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
, a former pupil and later acolyte of Benjamin Graham before founding a hedge fund in 1956, in a 2006 letter to the magazine publication of the Museum of American Finance
Museum of American Finance
The Museum of American Finance, is an American financial-history museum, located in the Financial District of the Manhattan borough of New York City, New York....
asserts the Graham-Newman partnership of the 1920s is the first hedge fund he is aware of and suggests others may have preceded it.
Sociologist, author, and financial journalist Alfred W. Jones
Alfred Winslow Jones
Alfred Winslow Jones , a sociologist, author, and financial journalist, is credited with forming the first modern hedge fund and is widely regarded as the father of the hedge fund industry.-Background:...
is credited with coining the phrase "hedged fund", in contrast to prior nomenclatures, but is often erroneously credited with creating the first hedge fund structure in 1949. To neutralize the effect of overall market movement, Jones balanced his portfolio by buying assets whose price he expected to increase, and selling short assets whose price he expected to decrease. Jones referred to his fund as being "hedged" to describe how the fund managed risk exposure from overall market movement. This type of portfolio became known as a hedge fund. Jones was the first money manager to combine a hedged investment strategy using leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
and shared risk, with fees based on performance. A 1966 Fortune magazine article reported that Jones’ fund had outperformed the best mutual funds despite his 20% performance fee. By 1968 there were almost 200 hedge funds, and the first Fund of funds
Fund of funds
A "fund of funds" is an investment strategy of holding a portfolio of other investment funds rather than investing directly in shares, bonds or other securities. This type of investing is often referred to as multi-manager investment...
that utilized hedge funds was created in 1969 in Geneva
Geneva
Geneva In the national languages of Switzerland the city is known as Genf , Ginevra and Genevra is the second-most-populous city in Switzerland and is the most populous city of Romandie, the French-speaking part of Switzerland...
.
Many of the early funds ceased trading during the Recession of 1969-70 and the 1973-1974 stock market crash due to heavy losses. In the 1970s hedge funds typically specialized in a single strategy, and most fund managers followed the long/short equity model. Hedge funds lost popularity during the downturn of the 1970s but received renewed attention in the late 1980s, following the success of several funds profiled in the media.
During the 1990s the number of hedge funds increased significantly, with investments provided by the new wealth that was created during the 1990s stock market rise
Dot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
. The increased interest from traders and investors was due to the aligned-interest compensation structure and an investment vehicle that was designed to exceed general market returns. Over the next decade there was increased diversification in strategies, including: credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy, among others.
During the first decade of the new century, hedge funds regained popularity worldwide and in 2008, the worldwide industry held $1.93 trillion in assets under management. However the 2008 credit crunch
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...
was hard on hedge funds and they declined in value and hampered "liquidity in some markets" causing some hedge funds to restrict investor withdrawals.
Total assets under management then rebounded and in April 2011 were estimated at almost $2 trillion. , the largest 225 hedge fund managers in the United States alone held almost $1.3 trillion. with the largest hedge fund manager, Bridgewater Associates
Bridgewater Associates
Bridgewater Associates is an American investment management firm founded by Ray Dalio in 1975 and is reported to be the world's largest hedge fund company with $122 billion in assets under management. The company has 270 clients including pension funds, endowments, foundations, foreign governments...
having $58.9 billion. In 2011, the largest hedge funds were Bridgewater Associates
Bridgewater Associates
Bridgewater Associates is an American investment management firm founded by Ray Dalio in 1975 and is reported to be the world's largest hedge fund company with $122 billion in assets under management. The company has 270 clients including pension funds, endowments, foundations, foreign governments...
($58.9 billion), Man Group
Man Group
Man Group plc is a British alternative investment management business. It provides a range of funds for institutional and private investors globally. The company manages about US$68 billion and employs around 1,700 people in 15 locations worldwide.Man’s headquarters are at Riverbank House...
($39.2 billion), Paulson & Co.
Paulson & Co.
Paulson & Co. Inc. is a hedge fund sponsor owned by its employees and founded in 1994 by John Paulson.-Overview:Paulson & Co. Inc. is an employee-owned, hedge fund headquartered in New York, New York...
($35.1 billion), Brevan Howard
Brevan Howard
Brevan Howard Asset Management a British-based hedge fund manager that is the largest in Europe. The fund, co-founded by Alan Howard and Jean-Philippe Blochet in 2002, has more than $26 billion under management. Blochet left the firm in November 2009. The group's master fund returned 20.4 percent...
($31 billion), and Och-Ziff ($29.4 billion).
Fees
Hedge fund managers typically charge their funds both a management feeManagement fee
In the investment advisory industry, a management fee is a periodic payment that is paid by investors in a pooled investment fund to the fund's investment adviser for investment and portfolio management services.-Mutual funds:...
and a performance fee
Performance fee
A performance fee is a fee that an investment fund may be charged by the investment manager that manages its assets, calculated by reference to the increase in the fund's net asset value , which represents the value of the fund's investments...
.
Management fees are calculated as a percentage of the fund's net asset value
Net asset value
Net asset value is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds because shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net...
and typically range from 1% to 4% per annum, with 2% being standard. They are usually expressed as an annual percentage, but calculated and paid monthly or quarterly. Management fees for hedge funds are designed to cover the operating costs of the manager, whereas the performance fee provides the manager's profits. However, due to economies of scale
Economies of scale
Economies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit...
the management fee from larger funds can generate a significant part of a manager's profits, and as a result some fees have been criticized by some public pension funds, such as CalPERS
CalPERS
The California Public Employees' Retirement System or CalPERS is an agency in the California executive branch that "manages pension and health benefits for more than 1.6 million California public employees, retirees, and their families"...
, for being too high.
The Performance fee
Performance fee
A performance fee is a fee that an investment fund may be charged by the investment manager that manages its assets, calculated by reference to the increase in the fund's net asset value , which represents the value of the fund's investments...
is typically 20% of the fund's profits during any year, though they range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits.
Performance fees have been criticized by Warren Buffett
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
, who believes that because hedge funds share only the profits and not the losses, such fees create an incentive for high-risk investment management. Performance fee rates have fallen since the start of the credit crunch.
Almost all hedge fund performance fees include a "high water mark" (or "loss carryforward provision"), which means that the performance fee only applies to net profits (i.e. profits after losses in previous years have been recovered). This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather than attempting to recover the losses over a number of years without performance fee.
Some performance fees include a "hurdle", so that a fee is only paid on the fund's performance in excess of a benchmark rate (e.g. LIBOR) or a fixed percentage. A "soft" hurdle means the performance fee is calculated on all the fund's returns if the hurdle rate is cleared. A "hard" hurdle is calculated only on returns above the hurdle rate. A hurdle is intended to ensure that a manager is only rewarded if it generates returns in excess of the returns that the investor would have received if it had invested its money elsewhere.
Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year) or when withdrawals exceed a predetermined percentage of the original investment. The purpose of the fee is to discourage short-term investing, reduce turnover and deter withdrawals after periods of poor performance. Redemption fees usually remain in the fund and benefit the remaining investors.
Strategies
Hedge funds employ a wide range of trading strategies but classifying them is difficult due to the rapidity with which they change and evolve. However, hedge fund strategies are generally said to fall into four main categories: global macroGlobal macro
Global Macro is defined as the strategy of investing, on a large scale, around the world using economic theory to justify the decision making process...
, directional, event-driven, and relative value (arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
). These four categories are distinguished by investment style and each have their own risk and return characteristics. Managed futures or multi-strategy funds may not fit into these categories, but are nonetheless popular strategies with investors. It is possible for hedge funds to commit to a certain strategy or employ multiple strategies to allow flexibility, for risk management purposes, or to achieve diversified returns. The hedge fund’s prospectus, also known as an offering memorandum, offers potential investors information about key aspects of the fund, including the fund's investment strategy, investment type, and leverage limit.
The elements contributing to a hedge fund strategy include: the hedge fund's approach to the market; the particular instrument used; the market sector
Market sector
The term market sector is used in economics and finance to describe a set of businesses that are buying and selling such similar goods and services that they are in direct competition with each other...
the fund specializes in (e.g. healthcare); the method used to select investments; and the amount of diversification within the fund. There are a variety of market approaches to different asset classes, including equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
, fixed income
Fixed income
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable....
, commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
and currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
. Instruments used include: equities, fixed income, futures
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
, options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
and swaps
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
. Strategies can be divided into those in which investments can be selected by managers, known as “discretionary/qualitative”, or those in which investments are selected using a computerized system, known as “systematic/quantitative”. The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager or a combination.
Sometimes hedge fund strategies are described as absolute return
Absolute return
The absolute return or simply return is a measure of the gain or loss on an investment portfolio expressed as a percentage of invested capital. The adjective absolute is used to stress the distinction with the relative return measures often used by long-only equity funds, i.e...
and are classified as either market neutral
Market neutral
An investment strategy or portfolio is considered market neutral if it seeks to entirely avoid some form of market risk, typically by hedging. In order to evaluate market neutrality, it is first necessary to specify the risk being avoided...
or directional. Market neutral funds have less correlation to overall market performance by “neutralizing” the effect of market swings, whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.
Global macro
Hedge funds utilizing a global macro investing strategy take sizable positionsPosition (finance)
In financial trading, a position is a binding commitment to buy or sell a given amount of financial instruments, such as securities, currencies or commodities, for a given price....
in share, bond or currency markets in anticipation of global macroeconomic events
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
in order to generate a risk-adjusted return. Global macro fund managers use macroeconomic ("big picture") analysis based on global market events and trends to identify opportunities for investment that would profit from anticipated price movements. While global macro strategies have a large amount of flexibility due to their ability to use leverage to take large positions in diverse investments in multiple markets, the timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns. Global macro is often categorized as a directional investment strategy.
Global macro strategies can be divided into discretionary and systematic approaches. Discretionary trading is carried out by investment managers who identify and select investments; systematic trading is based on mathematical models
Mathematics
Mathematics is the study of quantity, space, structure, and change. Mathematicians seek out patterns and formulate new conjectures. Mathematicians resolve the truth or falsity of conjectures by mathematical proofs, which are arguments sufficient to convince other mathematicians of their validity...
and executed by software with limited human involvement beyond the programming and updating of the software. These strategies can also be divided into trend
Trend following
Trend following is an investment strategy that tries to take advantage of long-term moves that seem to play out in various markets. The strategy aims to work on the market trend mechanism and take benefit from both sides of the market, enjoying the profits from the ups and downs of the stock or...
or counter-trend approaches depending on whether the fund attempts to profit from following trends
Market trends
A market trend is a putative tendency of a financial market to move in a particular direction over time. These trends are classified as secular for long time frames, primary for medium time frames, and secondary for short time frames...
(long or short-term) or attempts to anticipate and profit from reversals in trends.
Within global macro strategies, there are further sub-strategies including "systematic diversified", in which the fund trades in diversified markets, or "systematic currency", in which the fund trades in currency markets. Other sub-strategies include those employed by Commodity Trading Advisors (CTA), where the fund trades in futures
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
(or options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
) in commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
markets or in swaps. This is also known as a managed future fund. CTAs trade in commodities (such as gold) and financial instruments, including stock indexes. In addition they take both long and short positions, allowing them to make profit in both market upswings and downswings.
Directional
Directional investment strategies utilize market movements, trends, or inconsistencies when picking stocks across a variety of markets. Computer models can be used, or fund managers will identify and select investments. These types of strategies have a greater exposure to the fluctuations of the overall market than do market neutral strategies. Directional hedge fund strategies include US and international long/short equity hedge funds, where long equityLong (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
positions are hedged with short sales of equities or equity index
Index (economics)
In economics and finance, an index is a statistical measure of changes in a representative group of individual data points. These data may be derived from any number of sources, including company performance, prices, productivity, and employment. Economic indices track economic health from...
options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
.
Within directional strategies, there are a number of sub-strategies. "Emerging markets
Emerging markets
Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. Based on data from 2006, there are around 28 emerging markets in the world . The economies of China and India are considered to be the largest...
" funds focus on emerging markets such as China and India, whereas "sector funds" specialize in specific areas including technology, healthcare, biotechnology, pharmaceuticals, energy and basic materials. Funds using a "fundamental growth" strategy invest in companies with more earnings growth than the overall equity market or relevant sector, while funds using a "fundamental value" strategy invest in undervalued companies. Funds that use quantitative
Statistics
Statistics is the study of the collection, organization, analysis, and interpretation of data. It deals with all aspects of this, including the planning of data collection in terms of the design of surveys and experiments....
techniques for equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
trading
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
are described as using a "quantitative directional" strategy. Funds using a "short bias
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
" strategy take advantage of declining equity prices using short positions.
Event-driven
Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event. An event-driven investment strategy finds investment opportunities in corporate transactional events such as consolidations, acquisitions, recapitalizations, bankruptcies, and liquidations. Managers employing such a strategy capitalize on valuation inconsistencies in the market before or after such events, and take a position based on the predicted movement of the security or securities in question. Large institutional investors such as hedge funds are more likely to pursue event-driven investing strategies than traditional equity investors because they have the expertise and resources to analyze corporate transactional events for investment opportunities.Corporate transactional events generally fit into three categories: distressed securities, risk arbitrage and special situations. Distressed securities
Distressed securities
Distressed securities are securities of companies or government entities that are either already in default, under bankruptcy protection, or in distress and heading toward such a condition. The most common distressed securities are bonds and bank debt...
include such events as restructurings, recapitalizations, and bankruptcies. A distressed securities investment strategy involves investing in the bonds or loans of companies facing bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
or severe financial distress, when these bonds or loans are being traded at a discount to their value. Hedge fund managers pursuing the distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds purchasing distressed debt may prevent those companies from going bankrupt, as such an acquisition deters foreclosure by banks. While event-driven investing in general tends to thrive during a bull market, distressed investing works best during a bear market.
Risk arbitrage
Risk arbitrage
Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.Two principal types of merger are possible: a cash merger, and a stock merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash...
or merger arbitrage includes such events as mergers
Mergers and acquisitions
Mergers and acquisitions refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or...
, acquisitions, liquidations, and hostile takeovers. Risk arbitrage typically involves buying and selling the stocks of two or more merging companies to take advantage of market discrepancies between acquisition price and stock price. The risk element arises from the possibility that the merger or acquisition will not go ahead as planned; hedge fund managers will use research and analysis to determine if the event will take place.
Special situations are events that impact the value of a company's stock, including the restructuring
Restructuring
Restructuring is the corporate management term for the act of reorganizing the legal, ownership, operational, or other structures of a company for the purpose of making it more profitable, or better organized for its present needs...
of a company or corporate transactions including spin-offs, share-buy-backs, security issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company's equity and equity-related instruments.
Other event-driven strategies include: credit arbitrage strategies, which focus on corporate fixed income
Fixed income
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable....
securities; an activist strategy, where the fund takes large positions in companies and uses the ownership to participate in the management; and legal catalyst strategy, which specializes in companies involved in major lawsuits.
Relative value
Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, the underlying securityUnderlying
In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying...
or the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical, technical
Technical analysis
In finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...
or fundamental
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
techniques. Relative value is often used as a synonym for market neutral
Market neutral
An investment strategy or portfolio is considered market neutral if it seeks to entirely avoid some form of market risk, typically by hedging. In order to evaluate market neutrality, it is first necessary to specify the risk being avoided...
, as strategies in this category typically have very little or no directional market exposure to the market as a whole. Other relative value sub-strategies include:
- Fixed income arbitrageFixed income arbitrageFixed-income arbitrage is an investment strategy generally associated with hedge funds, which consists of the discovery and exploitation of inefficiencies in the pricing of bonds, i.e...
– exploit pricing inefficiencies between related fixed income securities. - Equity market neutral – exploits differences in stock prices by being longLong (finance)In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
and short in stocks within the same sector, industry, market capitalization, country, which also creates a hedge against broader market factors. - Convertible arbitrageConvertible arbitrageConvertible arbitrage is a market-neutral investment strategy often employed by hedge funds. It involves the simultaneous purchase of convertible securities and the short sale of the same issuer's common stock....
– exploit pricing inefficiencies between convertible securitiesConvertible securityA convertible security is a security that can be converted into another security. Most convertible securities are bonds or preferred stocks that pay regular quarterly interest and can be converted into shares of common stock if the stock price appreciates to a predetermined...
and the corresponding stockStockThe capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s. - Asset-backed securities (Fixed-Income asset-backed) – fixed income arbitrageFixed income arbitrageFixed-income arbitrage is an investment strategy generally associated with hedge funds, which consists of the discovery and exploitation of inefficiencies in the pricing of bonds, i.e...
strategy using asset-backed securitiesAsset-backed securityAn asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
. - Credit long / short – the same as long / short equity but in credit markets instead of equity markets.
- Statistical arbitrageStatistical arbitrageIn the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
– identifying pricing inefficiencies between securities through mathematical modeling techniques - Volatility arbitrage – exploit the change in implied volatilityVolatility (finance)In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
instead of the change in price. - Yield alternatives – non-fixed income arbitrageFixed income arbitrageFixed-income arbitrage is an investment strategy generally associated with hedge funds, which consists of the discovery and exploitation of inefficiencies in the pricing of bonds, i.e...
strategies based on the yield instead of the price. - Regulatory arbitrage – the practice of taking advantage of regulatory differences between two or more markets.
- Risk arbitrageRisk arbitrageRisk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.Two principal types of merger are possible: a cash merger, and a stock merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash...
- exploiting market discrepancies between acquisition price and stock price
Miscellaneous
In addition to those strategies within the four main categories, there are several strategies that do not fit into these categorizations or can apply across several of them.- Fund of hedge funds (Multi-manager) – a hedge fund with a diversified portfolio of numerous underlying single-manager hedge funds.
- Multi-strategy – a hedge fund using a combination of different strategies to reduce market risk.
- Multi-manager – a hedge fund wherein the investment is spread along separate sub-managers investing in their own strategy.
- 130-30 funds – equity funds with 130% long and 30% short positions, leaving a net long position of 100%.
- Risk parityRisk parityRisk parity is an alternative approach to investment portfolio management which focuses on allocation of risk rather than allocation of capital...
- equalizing risk by allocating funds to a wide range of categories while maximizing gains through financial leveraging.
Hedge fund risk
Because investments in hedge funds can add diversification to investment portfolios, investors may use them as a tool to reduce their overall portfolio risk exposures. Managers of hedge funds use particular trading strategies and instruments with the specific aim of reducing market risks to produce risk-adjusted returns, which are consistent with investors' desired level of risk. Hedge funds ideally produce returns relatively uncorrelated with market indices. While "hedgingHedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
" can be a way of reducing the risk of an investment, hedge funds, like all other investment types, are not immune to risk. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
between 1993 and 2010.
Risk management
Investors in hedge funds are, in most countries, required to be sophisticated qualified investors who are assumed to be aware of the investment risks, and accept these risks because of the potential returns relative to those risks. Fund managers may employ extensive risk managementFinancial risk management
Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc...
strategies in order to protect the fund and investors. According to the Financial Times, "big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management." Hedge fund managers may hold a large number of investment positions for short durations and are likely to have a particularly comprehensive risk management system in place. Funds may have "risk officers" who assess and manage risks but are not otherwise involved in trading, and may employ strategies such as formal portfolio risk models. A variety of measuring techniques and models may be used to calculate the risk incurred by a hedge fund's activities; fund managers may use different models depending on their fund's structure and investment strategy. Some factors,such as normality of return, are not always accounted for by conventional risk measurement methodologies. Funds which use value at risk
Value at risk
In financial mathematics and financial risk management, Value at Risk is a widely used risk measure of the risk of loss on a specific portfolio of financial assets...
as a measurement of risk may compensate for this by employing additional models such as drawdown
Drawdown (economics)
The Drawdown is the measure of the decline from a historical peak in some variable ....
and “time under water” to ensure all risks are captured.
In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence
Operational due diligence
The phrase Operational Due Diligence , in the context of alternative investments such as hedge funds , means different things to different people....
to assess the risk that error or fraud at a hedge fund might result in loss to the investor. Considerations will include the organisation and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund's ability to develop as a company.
Transparency and regulatory considerations
Since hedge funds are private entities and have few public disclosure requirements, this is sometimes perceived as a lack of transparencyTransparency (market)
In economics, a market is transparent if much is known by many about:* What products, services or capital assets are available.* What price.* Where....
. Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/or registration requirements as other financial investment managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud. New regulations introduced in the US and the EU as of 2010 require hedge fund managers to report more information, leading to greater transparency. In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and external regulatory requirements. The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology, positions and leverage exposure.
Risks shared with other investment types
Hedge funds share many of the same types of risk as other investment classes, including liquidity riskLiquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
and manager risk. Liquidity
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
refers to the degree to which an asset can be bought and sold or converted to cash; similar to private equity funds, hedge funds employ a lock-up period during which an investor cannot remove money. Manager risk refers to those risks which arise from the management of funds. As well as specific risks such as style drift, which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors include valuation risk
Valuation risk
Valuation Risk combines aspects of data management, financial engineering and modelling and uncertainties related to the changing conditions of financial markets....
, capacity risk, concentration risk
Concentration risk
Concentration risk is a banking term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtors to whom the bank has lent money. This risk is calculated using a "concentration ratio" which explains what percentage of the outstanding accounts each bank loan...
and leverage risk. Valuation risk refers to the concern that the net asset value
Net asset value
Net asset value is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds because shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net...
of investments may be inaccurate; capacity risk can arise from placing too much money into one particular strategy, which may lead to fund performance deterioration; and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group of correlated funds. These risks may be managed through defined controls over conflict of interest, restrictions on allocation of funds, and set exposure limits for strategies.
Many investment funds use leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
, the practice of borrowing
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
money or trading on margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
in addition to capital from investors. Although leverage can increase potential returns, the opportunity for larger gains is weighed against the possibility of greater losses. Hedge funds employing leverage are likely to engage in extensive risk management practices. In comparison with investment banks, hedge fund leverage is relatively low; according to a National Bureau of Economic Research
National Bureau of Economic Research
The National Bureau of Economic Research is an American private nonprofit research organization "committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community." The NBER is well known for providing start and end...
working paper, the average leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.
Some types of funds, including hedge funds, are perceived as having a greater appetite for risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
, with the intention of maximizing returns, subject to the risk tolerance of investors and the fund manager. Managers will have an additional incentive to increase risk oversight when their own capital is invested in the fund.
Hedge fund structure
A hedge fund itself has no employees and no assetAsset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s other than its investments. The portfolio is managed by the investment manager
Investment management
Investment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
, a separate entity which is the actual business and has employees.
As well as the investment manager, the functions of a hedge fund are delegated to a number of other service providers. The most common service providers are:
- Prime broker – prime brokeragePrime brokeragePrime brokerage is the generic name for a bundled package of services offered by investment banks and securities firms to hedge funds and other professional investors needing the ability to borrow securities and cash to be able to invest on a netted basis and achieve an absolute return...
services include lending money, acting as counterparty to derivative contracts, lending securities for the purpose of short selling, trade execution, clearing and settlement. Many prime brokers also provide custodyCustodian bankA Custodian bank, or simply custodian, is a specialized financial institution responsible for safeguarding a firm's or individual's financial assets and is not likely to engage in "traditional" commercial or consumer/retail banking such as mortgage or personal lending, branch banking, personal...
services. Prime brokers are typically parts of large investment banks.
- Administrator – the administrator typically deals with the issue of shares, and performs related back officeBack officeA back office is a part of most corporations where tasks dedicated to running the company itself takes place. The term "Back office" comes from the building layout of early companies where the front office would contain the sales and other customer-facing staff and the back office would be those...
functions. In some funds, particularly in the US, some of these functions are performed by the investment manager, a practice that gives rise to a potential conflict of interest inherent in having the investment manager both determine the NAV and benefit from its increase through performance fees. Outside of the US, regulations often require this role to be taken by a third party.
- Distributor – the distributor is responsible for marketing the fund to potential investors. Frequently, this role is taken by the investment manager.
Domicile
The legal structure of a specific hedge fund – in particular its domicileDomicile (law)
In law, domicile is the status or attribution of being a permanent resident in a particular jurisdiction. A person can remain domiciled in a jurisdiction even after they have left it, if they have maintained sufficient links with that jurisdiction or have not displayed an intention to leave...
and the type of legal entity used – is usually determined by the tax environment of the fund’s expected investors. Regulatory
Regulation
Regulation is administrative legislation that constitutes or constrains rights and allocates responsibilities. It can be distinguished from primary legislation on the one hand and judge-made law on the other...
considerations will also play a role. Many hedge funds are established in offshore financial centre
Offshore financial centre
An offshore financial centre , though not precisely defined, is usually a small, low-tax jurisdiction specializing in providing corporate and commercial services to non-resident offshore companies, and for the investment of offshore funds....
s so that the investor, rather than the fund, pays tax on the increase in the value of the portfolio. The investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund.
It is estimated that around 60% of the number of hedge funds in 2010 were registered offshore, with the Cayman Islands accounting for 37%, the British Virgin Islands 7% and Bermuda 5%. Among onshore funds, Delaware (US) accounts for 27% and the EU (primarily Ireland and Luxembourg) accounts for 5%.
Investment manager locations
In contrast to the funds themselves, investment managers are primarily located onshoreOnshore
Onshore is a term used in finance to denote the jurisdiction in which a company is domiciled and in which it pays a significant rate of tax. It is the opposite of offshore, which denotes a tax haven...
in order to draw on the major pools of financial talent and to be close to investors. With the bulk of hedge fund investment coming from the US East coast
East Coast of the United States
The East Coast of the United States, also known as the Eastern Seaboard, refers to the easternmost coastal states in the United States, which touch the Atlantic Ocean and stretch up to Canada. The term includes the U.S...
– principally New York City
New York City
New York is the most populous city in the United States and the center of the New York Metropolitan Area, one of the most populous metropolitan areas in the world. New York exerts a significant impact upon global commerce, finance, media, art, fashion, research, technology, education, and...
and the Gold Coast
Gold Coast (Connecticut)
The Gold Coast, also known as Southwestern Connecticut or Lower Fairfield County, is a region of the state of Connecticut, United States, that includes the entire southern portion of Fairfield County as defined by the U.S. Census Bureau, Super-Public Use Microdata Area Region 09600.This area is...
area of Connecticut
Connecticut
Connecticut is a state in the New England region of the northeastern United States. It is bordered by Rhode Island to the east, Massachusetts to the north, and the state of New York to the west and the south .Connecticut is named for the Connecticut River, the major U.S. river that approximately...
– this has become the leading location for hedge fund managers. It was estimated there were 7,000 investment managers in the United States in 2004.
London is Europe’s
Europe
Europe is, by convention, one of the world's seven continents. Comprising the westernmost peninsula of Eurasia, Europe is generally 'divided' from Asia to its east by the watershed divides of the Ural and Caucasus Mountains, the Ural River, the Caspian and Black Seas, and the waterways connecting...
leading centre for hedge fund managers, with 70% of European hedge fund investments, about $420 billion, at the end of 2010. 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 US are leading locations for management of Asian hedge funds' assets with around a quarter of the total each.
The legal entity
Limited partnershipLimited partnership
A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners , there are one or more limited partners . It is a partnership in which only one partner is required to be a general partner.The GPs are, in all major respects,...
s 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
Limited partnership
A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners , there are one or more limited partners . It is a partnership in which only one partner is required to be a general partner.The GPs are, in all major respects,...
of the limited partnership is typically the investment manager (though is sometimes an offshore
Offshore financial centre
An offshore financial centre , though not precisely defined, is usually a small, low-tax jurisdiction specializing in providing corporate and commercial services to non-resident offshore companies, and for the investment of offshore funds....
corporation) and the investors are the limited partners
Limited partnership
A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners , there are one or more limited partners . It is a partnership in which only one partner is required to be a general partner.The GPs are, in all major respects,...
. Offshore corporate funds are used for non-US investors, which would otherwise be subject to more complex tax issues by investing in a tax-transparent entity such as a partnership, and US entities that do not pay tax such as state, corporate, private and union pension fund
Pension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
s, which would otherwise be subject to unrelated business income tax in the United States. Unit trust
Unit trust
A unit trust is a form of collective investment constituted under a trust deed.Found in Australia, Ireland, the Isle of Man, Jersey, New Zealand, South Africa, Singapore, Malaysia and the UK, unit trusts offer access to a wide range of securities....
s are sometimes used to market to Japanese investors. Other than taxation, the type of entity used does not have a significant bearing on the nature of the fund.
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. The fund’s strategic decisions are taken by the board of directors
Board of directors
A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors...
of the fund, which is independent but generally loyal to the investment manager.
Open-ended nature
Hedge funds are typically open-endedOpen-end fund
An open-end fund is a collective investment scheme which can issue and redeem shares at any time. An investor will generally purchase shares in the fund directly from the fund itself rather than from the existing shareholders...
, meaning that the fund will periodically accept further investment and allow investors to withdraw their money from the fund. For a fund structured as a company, shares will be both issued and redeemed at the net asset value
Net asset value
Net asset value is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds because shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net...
(“NAV”) per share, so that if the value of the underlying investments has increased (and the NAV per share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Similarly, where a fund is structured as a limited partnership the investor's account will be allocated its proportion of any increase or decrease in the NAV of the fund, allowing an investor to withdraw more (or less) when it withdraws its capital.
Investors do not typically trade
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
shares or limited partnership interests among themselves and hedge funds do not typically distribute profits
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
to investors before redemption. This contrasts with a closed-ended fund
Closed-end fund
A closed-end fund is a collective investment scheme with a limited number of shares. It is called a closed-end fund because new shares are rarely issued once the fund has launched, and because shares are not normally redeemable for cash or securities until the fund liquidates.Typically an...
, which either has a limited number of shares which are traded among investors, and which distributes its profits, or which has a limited lifespan at the end of which capital is returned to investors. Most hedge funds allow money to be withdrawn monthly or quarterly, while others allow it biannually or annually.
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 investors' holdings 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 meantime in respect of the main portfolio. A similar problem, inverted, applies to subscriptions during the same period.
Side pockets are most commonly used by funds as an emergency measure. They were used extensively following the collapse of Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
in September 2008, when the market for certain types of assets held by hedge funds collapsed, preventing the funds from selling or obtaining a market value for the assets.
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.
Listed funds
Corporate hedge funds sometimes list their sharesShare (finance)
A joint stock company divides its capital into units of equal denomination. Each unit is called a share. These units are offered for sale to raise capital. This is termed as issuing shares. A person who buys share/shares of the company is called a shareholder, and by acquiring share or shares in...
on smaller stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...
s, such as the Irish Stock Exchange
Irish Stock Exchange
-History:The Irish Stock Exchange is Ireland's only stock exchange and has been in existence since 1793. It is an Irish private company limited by guarantee. It was first recognised by legislation in 1799 when the Irish Parliament passed the Stock Exchange Act...
, as this provides a low level of regulatory
Regulation
Regulation is administrative legislation that constitutes or constrains rights and allocates responsibilities. It can be distinguished from primary legislation on the one hand and judge-made law on the other...
oversight that is required by some investors. Shares in the listed hedge fund are not generally traded
Stock trader
A stock trader or a stock investor is an individual or firm who buys and sells stocks in the financial markets. Many stock traders will trade bonds as well...
on the exchange.
A fund listing is distinct from the listing or initial public offering
Initial public offering
An initial public offering or stock market launch, is the first sale of stock by a private company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises...
(“IPO”) of shares in an investment manager
Investment management
Investment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
. Although widely reported as a "hedge-fund IPO", the IPO of Fortress Investment Group LLC
Fortress Investment Group
Fortress Investment Group LLC is an investment management firm based in New York, New York. The company went public on February 9, 2007.-History:...
was for the sale of the investment manager, not of the hedge funds that it managed.
Regulation
A range of regulatory methods are used to provide oversight of hedge funds worldwide. According to a report by the International Organization of Securities CommissionsInternational Organization of Securities Commissions
The International Organization of Securities Commissions is an association of organisations that regulate the world’s securities and futures markets....
, the most common tactic is the direct regulation of financial advisers—including hedge fund managers, which is primarily intended to protect investors against fraud. Specific regulations differ by national, federal and state jurisdiction. Historically, hedge funds have been exempted from certain registration and reporting requirements that apply to other investment companies, because in most jurisdictions regulation permits investments in hedge funds by only "qualified" investors who are able to make an informed decision about investment decisions without relying on regulatory oversight. In 2010, new regulations were passed in the US and European Union, which (among other changes) introduced new hedge fund reporting requirements. The Dodd-Frank Wall Street Reform Act was passed in the US in July 2010, and contains provisions which require hedge fund advisers with $150 million or more in assets to register with the SEC. In November 2010, the EU Parliament
European Parliament
The European Parliament is the directly elected parliamentary institution of the European Union . Together with the Council of the European Union and the Commission, it exercises the legislative function of the EU and it has been described as one of the most powerful legislatures in the world...
passed the Alternative Investment Fund Managers Directive
Alternative Investment Fund Managers Directive
The Alternative Investment Fund Managers Directive is a proposed European Union law which will put hedge funds and private equity funds under the supervision of an EU regulatory body. These kinds of business vehicle have not been subject to the same rules to protect the investing public as mutual...
, which seeks to provide greater monitoring and control of alternative investment fund managers operating in the EU.
US regulation
Hedge funds within the US are subject to various regulatory trading reporting and record keeping requirements that also apply to other investors in publicly traded securities. Before the Dodd-Frank Act made registration mandatory for hedge fund advisers with more than US$150 million in assets under management, hedge funds were primarily regulated through their managers or advisers, under the anti-fraud provisions of the Investment Advisers Act of 1940Investment Advisers Act of 1940
The Investment Advisers Act of 1940, codified at through , is a United States federal law that was created to regulate the actions of investment advisers as defined by the law.-Overview:The law provides in part:-Contents:...
. Hedge funds are privately-owned pools of investment capital with regulatory limits on the number and type of investor that each fund may have. Because of these regulatory restrictions on ownership, hedge funds have been exempted from mandatory registration with the US Securities and Exchange Commission (SEC) under the Investment Company Act of 1940
Investment Company Act of 1940
The Investment Company Act of 1940 is an act of Congress. It was passed as a United States Public Law on August 22, 1940, and is codified at through . Along with the Securities Exchange Act of 1934 and Investment Advisers Act of 1940, and extensive rules issued by the Securities and Exchange...
, which is generally intended to regulate investment funds sold to retail investors. The two primary exemptions in the Investment Company Act of 1940 that hedge funds relied on were (a) Section 3(c)1 which restricts funds to 100 or fewer investors and (b) Section 3(c)7, which requires all investors to meet a "qualified purchaser" criterion. These sections also both prohibit hedge funds from selling their securities through public offerings. Under 3(c)7, a qualified purchaser is defined to include an individual with at least $5,000,000 in investment assets. Companies, including institutional investors, generally qualify as qualified purchasers if they have at least $25,000,000 in investment assets. Although under Section 3(c)7 a fund can have an unlimited number of investors, if a fund has any class of equity securities owned by more than 499 investors, it must register its securities with the SEC under the Securities Exchange Act of 1934
Securities Exchange Act of 1934
The Securities Exchange Act of 1934 , , codified at et seq., is a law governing the secondary trading of securities in the United States of America. It was a sweeping piece of legislation...
.
Because Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940 prohibit hedge funds from making public offerings, funds must sell their securities in accordance with the private offering rules under the Securities Act of 1933
Securities Act of 1933
Congress enacted the Securities Act of 1933 , in the aftermath of the stock market crash of 1929 and during the ensuing Great Depression...
. The 1933 Act generally requires companies to file a registration statement with the SEC if they want to sell their securities publicly, or comply with private placement
Private placement
Private placement is a funding round of securities which are sold without an initial public offering, usually to a small number of chosen private investors...
rules under the Act. Though the securities of hedge funds are not registered under the 1933 Act, they remain subject to the anti-fraud provisions of the Act.
Hedge funds raise capital via private placement under Regulation D of the Securities Act of 1933, which means the shares are not registered. To comply with the private placement rules in Regulation D, hedge funds generally offer their securities 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 $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.
For SEC registered hedge fund advisers to charge an incentive or performance fee, the investors in the funds must be "qualified clients" as defined in the Investment Advisers Act of 1940 Rule 205–3. To be a qualified client an individual must have $750,000 in assets invested with the adviser or a net worth in excess of $1.5 million, or be one of certain high-level employees of the investment adviser. Under the Dodd-Frank Act, the SEC is required to periodically adjust the qualified client standard for inflation.
Because hedge funds do not have publicly traded securities, they are not subject to all of the reporting requirements of the Securities Exchange Act of 1934. Hedge funds that have a class of equity securities owned by more than 499 investors do, however, have to register under Section 12(g) of the 1934 Act and are subject the quarterly reporting requirements of the Act. Similar to other institutional investors, hedge fund managers with at least $100,000,000 in assets under management are required to file publicly quarterly reports disclosing ownership of registered equity securities. Also similar to other investors, hedge fund managers are subject to public disclosure if they own more than 5% of the class of any registered equity security. Hedge fund managers are also subject to anti-fraud provisions.
Prior to the requirements of the Dodd-Frank Act, many hedge fund advisers voluntarily registered with the SEC. Advisers who do so are subject to the same requirements as all other registered investment advisers. Registered advisers must provide information about their business practices and disciplinary history to the SEC and investors. They are required to have written compliance policies and have a chief compliance officer to enforce those policies. In addition, they are required to maintain certain books and records and have their practices examined by SEC staff. As a result of the Dodd-Frank Wall Street Reform Act, hedge fund advisers with at least $150,000,000 in assets under management will be required to register with the SEC as of July 21, 2011, while smaller advisers will be subject to state registration.
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 $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, and was later challenged in court by a hedge fund manager. In June 2006, the U.S. Court of Appeals for the District of Columbia overturned the rule and sent it back to the agency to be reviewed. In response to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the earlier challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity.
Many hedge funds also fall under the jurisdiction of the Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
. Hedge fund advisers registered as Commodity Pool Operator
Commodity Pool Operator
"A CPO is an individual or organization which operates or solicits funds for a commodity pool; that is, an enterprise in which funds contributed by a number of persons are combined for the purpose of trading futures contracts or commodity options, or to invest in another commodity pool." National...
s (CPO) or Commodity Trading Advisor
Commodity trading advisor
A commodity trading advisor is an asset manager who follows a set of systematic investment strategies in futures contracts and options on futures contracts. The advisors originally operated predominantly in commodities markets, but today they invest in any liquid futures market. They are...
s (CTA) would fall within this category, as would any manager of a hedge fund investing in markets under the CFTC’s jurisdiction, even if they qualify for an exemption from CPO or CTA registration. Hedge fund managers who meet these criteria are subject to rules and provisions of the Commodity Exchange Act
Commodity Exchange Act
Commodity Exchange Act is a federal act passed in 1936 by the U.S. Government ....
prohibiting fraud and manipulation.
Comparison with other funds
The regulations and restrictions that apply to hedge funds and mutual funds differ in three major ways. First, mutual funds are required to be registered with and regulated by the SEC, while hedge funds historically have not. Investors in hedge funds must be accredited investorAccredited investor
Accredited investor is a term defined by various securities laws that delineates investors permitted to invest in certain types of higher risk investments including seed money, limited partnerships, hedge funds, and angel investor networks...
s, with certain exceptions (employees, etc.), and cannot be marketed to retail investors; mutual funds, however, do not have this restriction. Finally, mutual funds must be liquid on a daily basis. If a mutual fund investor wishes to redeem his or her investment the fund must be able to meet that request immediately. Hedge funds 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.
Mutual funds must also determine the net asset value
Net asset value
Net asset value is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds because shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net...
(NAV) of the fund. While some hedge funds that are based offshore report their NAV to the Financial Times, for the most part there is no method of ascertaining pricing on a regular basis. In addition, mutual funds must have a prospectus available to anyone who requests one (either electronically or via US postal mail), and must disclose their asset allocation quarterly, whereas hedge funds do not have to abide by these terms.
All investment funds are subject to regulations that prohibit charging fees to investors, unless the investment performance of the fund is equivalent to that of an index or other measure of performance. This regulation is set out under Section 205(b) of the Investment Advisers Act of 1940
Investment Advisers Act of 1940
The Investment Advisers Act of 1940, codified at through , is a United States federal law that was created to regulate the actions of investment advisers as defined by the law.-Overview:The law provides in part:-Contents:...
, which limits performance fees to so-called "fulcrum fees". Due to this regulation, hedge funds charging a performance fee are unique compared with other funds.
Dodd-Frank
The Dodd-Frank Wall Street Reform Act was passed in the US in July 2010, aiming to increase regulation of financial companies, including hedge funds. The act requires advisers with private pools of capital exceeding $150 million or more in assets to register with the SEC as investment advisers and become subject to all rules which apply to registered advisers by July 21, 2011. Previous exemptions from registration provided under the Investment Advisers Act of 1940 will no longer apply to most hedge fund advisers. Under Dodd-Frank, hedge fund managers who have less than $100 million in assets under management will be overseen by the state where the manager is domiciled and become subject to state regulation. This will significantly increase the number of hedge funds under state supervision, as the threshold for SEC regulation was previously $30 million. In addition to US hedge funds, many overseas funds with more than 15 US clients and investors, and managing more than $25 million for these clients, will also have to register with the SEC by July 21, 2011. Mandatory registration of hedge fund advisers was supported by the largest hedge fund trade group, the Managed Funds Association (MFA), which announced its support for registration in testimony to a US congressional committee on May 7, 2009.Additionally, Dodd-Frank requires hedge funds to provide information about their trades and portfolios to help regulators fulfill their obligation to monitor and regulate systemic risk. The aim is for this data to be analyzed and shared among regulators – including the newly created Financial Stability Oversight Council – and for the SEC to report to Congress on how the data is being used to protect both investors and market integrity. Under the so-called "Volcker Rule", regulators are also required to implement regulations for banks, their affiliates and holding companies to limit their relationships with hedge funds and also to prohibit these organizations from proprietary trading, and limit their investment in, and sponsorship of hedge funds.
European regulation
Within the European UnionEuropean Union
The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...
(EU), as with the US, hedge funds are primarily regulated through advisers who manage the funds. In the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
, which is the hedge fund centre of the EU, hedge fund managers are required to be authorised and regulated by the Financial Services Authority
Financial Services Authority
The Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...
(FSA), the national regulator. Historically, there have been different regulatory approaches within each country in the EU. In some countries there are specific restrictions on hedge fund activities, including controls on use of derivatives in Portugal
Portugal
Portugal , officially the Portuguese Republic is a country situated in southwestern Europe on the Iberian Peninsula. Portugal is the westernmost country of Europe, and is bordered by the Atlantic Ocean to the West and South and by Spain to the North and East. The Atlantic archipelagos of the...
, and limits on leverage in France
France
The French Republic , The French Republic , The French Republic , (commonly known as France , is a unitary semi-presidential republic in Western Europe with several overseas territories and islands located on other continents and in the Indian, Pacific, and Atlantic oceans. Metropolitan France...
.
In 2010, the EU approved a law that will require all EU hedge fund managers to register with national regulatory authorities. The EU's Directive on Alternative Investment Fund Managers
Alternative Investment Fund Managers Directive
The Alternative Investment Fund Managers Directive is a proposed European Union law which will put hedge funds and private equity funds under the supervision of an EU regulatory body. These kinds of business vehicle have not been subject to the same rules to protect the investing public as mutual...
(AIFMD) was passed by the EU Parliament
European Parliament
The European Parliament is the directly elected parliamentary institution of the European Union . Together with the Council of the European Union and the Commission, it exercises the legislative function of the EU and it has been described as one of the most powerful legislatures in the world...
on November 11, 2010 and is the first EU directive focused on "alternative investment fund managers", including hedge fund managers. According to the EU, the aim of the directive is to provide greater monitoring and control of alternative investment funds. The directive requires managers to disclose more information, on a more frequent basis, to regulators about their investment strategies. The directive also introduces a rule that hedge fund managers should hold larger amounts of capital. All hedge fund managers within the EU will also be subject to potential limitations on the amount of leverage they can use. Since AIFMD covers the entire EU, and individual countries have different rules for hedge fund marketing, the directive introduced a "passport" for hedge funds authorized in one EU country to operate throughout the EU. The scope of AIFMD is broad and encompasses managers located within the EU as well as non-EU managers that market their funds to European investors. Countries within the EU are required to adopt the directive in national legislation by early 2013.
Offshore and other locations
Offshore centersOffshore financial centre
An offshore financial centre , though not precisely defined, is usually a small, low-tax jurisdiction specializing in providing corporate and commercial services to non-resident offshore companies, and for the investment of offshore funds....
offer business-friendly regulation, which has encouraged the establishment of hedge funds. Major centers include the Cayman Islands
Cayman Islands
The Cayman Islands is a British Overseas Territory and overseas territory of the European Union located in the western Caribbean Sea. The territory comprises the three islands of Grand Cayman, Cayman Brac, and Little Cayman, located south of Cuba and northwest of Jamaica...
, Dublin, Luxembourg
Luxembourg
Luxembourg , officially the Grand Duchy of Luxembourg , is a landlocked country in western Europe, bordered by Belgium, France, and Germany. It has two principal regions: the Oesling in the North as part of the Ardennes massif, and the Gutland in the south...
, the British Virgin Islands
British Virgin Islands
The Virgin Islands, often called the British Virgin Islands , is a British overseas territory and overseas territory of the European Union, located in the Caribbean to the east of Puerto Rico. The islands make up part of the Virgin Islands archipelago, the remaining islands constituting the U.S...
, and Bermuda
Bermuda
Bermuda is a British overseas territory in the North Atlantic Ocean. Located off the east coast of the United States, its nearest landmass is Cape Hatteras, North Carolina, about to the west-northwest. It is about south of Halifax, Nova Scotia, Canada, and northeast of Miami, Florida...
. Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centers. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager.
In Asia
Asia
Asia is the world's largest and most populous continent, located primarily in the eastern and northern hemispheres. It covers 8.7% of the Earth's total surface area and with approximately 3.879 billion people, it hosts 60% of the world's current human population...
, Singapore
Singapore
Singapore , officially the Republic of Singapore, is a Southeast Asian city-state off the southern tip of the Malay Peninsula, north of the equator. An island country made up of 63 islands, it is separated from Malaysia by the Straits of Johor to its north and from Indonesia's Riau Islands by the...
offers fewer licensing requirements and regulations for hedge funds than Hong Kong
Hong Kong
Hong Kong is one of two Special Administrative Regions of the People's Republic of China , the other being Macau. A city-state situated on China's south coast and enclosed by the Pearl River Delta and South China Sea, it is renowned for its expansive skyline and deep natural harbour...
and other financial capitals in the region. Singapore’s oversight of hedge funds will increase following the introduction of new rules and regulations in 2011, but small funds will be able to continue operating without a license. Hedge funds based in Hong Kong are subject to the same licensing requirements as mutual funds.
Many international hedge fund markets are affected by regulation passed in 2010 within the United States and European Union. Under the EU’s Alternative Investment Fund Managers directive, offshore hedge funds using prime brokers as depositaries will be required to use EU-registered credit institutions before they can be sold in the EU. The AIFMD’s regulatory requirements will essentially mandate equivalent regulations for non-EU investment funds, if they wish to operate in EU markets.
The Dodd-Frank Act, passed in the US in 2010, will have several key implications for overseas hedge funds. Funds with more than 15 US clients and investors managing $25 million or more will have to register with the SEC by July 21, 2011. Registered managers must file and maintain information including the assets under management and trading positions. Prior to the Dodd-Frank act, some Asian hedge funds had registered with the SEC.
Hedge fund indices
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.In traditional equity investment, indices play a central and unambiguous role. They are widely accepted as representative, and products such as futures and ETFs provide investable access to them in most developed markets. However hedge funds are illiquid, heterogeneous and ephemeral, which makes it hard to construct a satisfactory index. Non-investable indices are representative, but, due to various biases, their quoted returns may not be available in practice. Investable indices achieve liquidity at the expense of limited representativeness. Clone indices seek to replicate some statistical properties of hedge funds but are not directly based on them. None of these approaches is wholly satisfactory.
Non-investable indices
Non-investable indices are indicative in nature, and aim to represent the performance of some database of hedge funds using some measure such as mean, median or weighted mean from a hedge fund database. The databases have diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different indices.Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list of biases
Selection bias
Selection bias is a statistical bias in which there is an error in choosing the individuals or groups to take part in a scientific study. It is sometimes referred to as the selection effect. The term "selection bias" most often refers to the distortion of a statistical analysis, resulting from the...
.
Funds’ participation in a database is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money.
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 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
Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. To create an investable index, the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. When investors buy these products the index provider makes the investments in the underlying funds, making an investable index similar in some ways to a fund of hedge funds portfolio.To make the index investable, hedge funds must agree to accept investments on the terms given by the constructor. To make the index liquid, these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. This means that investable indices do not represent the total universe of hedge funds, and most seriously they may under-represent more successful managers.
Hedge fund replication
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.However, they rely on a statistical modelling process. As replication indices have a relatively short history it is not yet possible to know how reliable this process will be in practice, although initially indications are that much of hedge fund returns can be replicated in this manner without the problems of illiquidity, transparency and fraud that exist in direct hedge fund investments.
Systemic risk
Systemic riskSystemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
refers to the risk of instability across the entire financial system, as opposed to within a single company. Such risk may arise following a destabilizing event or events affecting a group of financial institutions linked through investment activity. Organizations such as the National Bureau of Economic Research
National Bureau of Economic Research
The National Bureau of Economic Research is an American private nonprofit research organization "committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community." The NBER is well known for providing start and end...
and the European Central Bank
European Central Bank
The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...
have charged that hedge funds pose systemic risks to the financial sector, and following the failure of hedge fund Long-Term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
(LTCM) in 1998 there was widespread concern about the potential for systemic risk if a hedge fund failure led to the failure of its counterparties even though no financial assistance was provided to LTCM by the US Federal Reserve, incurring no cost for US taxpayers.
However these claims are widely disputed by the financial industry. Compared with investment banks and mutual funds, hedge funds are relatively small, in terms of the assets they manage, and operate generally with low leverage, thereby limiting the potential impact on systemic risk. Financial writer Sebastian Mallaby
Sebastian Mallaby
Sebastian Mallaby is a British-born journalist and author; and director of the Maurice R. Greenberg Center for Geoeconomic Studies and Paul A. Volcker senior fellow for international economics at the Council on Foreign Relations . He has worked as a journalist for the Financial Times, and was a...
has described hedge funds as "small enough to fail
Too Big to Fail
Too Big to Fail is a television drama film in the United States broadcast on HBO on May 23, 2011. It is based on the non-fiction book Too Big to Fail by Andrew Ross Sorkin. The TV film was directed by Curtis Hanson...
". Hedge funds fail regularly, and numerous hedge funds failed during the financial crisis. In testimony to the House Financial Services Committee
United States House Committee on Financial Services
The United States House Committee on Financial Services is the committee of the United States House of Representatives that oversees the entire financial services industry, including the securities, insurance, banking, and housing industries...
in 2009, Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
, the Federal Reserve
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
Board Chairman said he “would not think that any hedge fund or private equity fund would become a systemically-critical firm individually”.
In October 2009, April 2010, and September 2010, the FSA surveyed 50 hedge fund managers regarding the sector's risks, leverage levels and counterparties. Based on information collected in the 2009 and 2010 surveys, the FSA published reports that affirmed that the European hedge fund industry posed no systemic risk to the financial system. The FSA determined that, based on indicators of risk, there was "no clear evidence to suggest that... any individual fund posed a significant systemic risk to the financial system." In particular, the reports noted that hedge funds have a relatively small "footprint" of securities compared to equity raised from investors, indicating that use of leverage was reasonable.
Transparency
As private, lightly regulated entities, hedge funds are not obliged to disclose their activities to third parties. This is in contrast to a regulated mutual fundMutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
(or unit trust), which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment advisor of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, while some hedge funds have very limited transparency even to investors.
Funds may choose to report some information in the interest of recruiting additional investors. Much of the data available in consolidated databases is self-reported and unverified. A study was done on two major databases containing hedge fund data. The study noted that 465 common funds had significant differences in reported information (e.g. returns, inception date, net assets value, incentive fee, management fee, investment styles, etc.) and that 5% of return numbers and 5% of NAV numbers were dramatically different. With these limitations, investors have to do their own research, which may cost on the scale of $50,000.
Some hedge funds, mainly American, do not use third parties either as the custodian
Custodian bank
A Custodian bank, or simply custodian, is a specialized financial institution responsible for safeguarding a firm's or individual's financial assets and is not likely to engage in "traditional" commercial or consumer/retail banking such as mortgage or personal lending, branch banking, personal...
of their assets or as their administrator (who will calculate the NAV
Net asset value
Net asset value is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds because shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net...
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
Bernard Madoff
Bernard Lawrence "Bernie" Madoff is a former American businessman, stockbroker, investment advisor, and financier. He is the former non-executive chairman of the NASDAQ stock market, and the admitted operator of a Ponzi scheme that is considered to be the largest financial fraud in U.S...
was arrested for running a $50 billion Ponzi scheme
Ponzi scheme
A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from any actual profit earned by the individual or organization running the operation...
. While Madoff did not run a hedge fund, several feeder funds, of which the largest was Fairfield Sentry, channelled money to Madoff.
Market capacity
AlphaAlpha (investment)
Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers' performances...
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.
US investigations
In June 2006, prompted by a letter from Gary J. AguirreGary J. Aguirre
Gary J. Aguirre is an American lawyer, former investigator with the United States Securities and Exchange Commission and whistleblower. After working in a law firm briefly, he became a public defender, then worked as a trial lawyer in California. Having reached his professional and financial...
, the Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. Aguirre was fired from his job with the SEC when, as lead investigator of insider trading
Insider trading
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
allegations against Pequot Capital Management
Pequot Capital Management
Pequot Capital Management was a multi-billion dollar hedge fund sponsor founded in 1998 by Arthur J. Samberg that was forcibly terminated by order of the Securities and Exchange Commission in 2010. The firm's investment funds invested in a range of markets through a variety of strategies...
, he tried to interview John Mack
John J. Mack
John J. Mack is the current Chairman of the Board at Morgan Stanley, the New York-based investment bank and brokerage firm. Mack announced his retirement as Chief Executive Officer on September 10, 2009, which was effective January 1, 2010. Former Co-President James P...
, then being considered for chief executive officer
Chief executive officer
A chief executive officer , managing director , Executive Director for non-profit organizations, or chief executive is the highest-ranking corporate officer or administrator in charge of total management of an organization...
at Morgan Stanley
Morgan Stanley
Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....
. The Judiciary Committee and the US Senate Finance Committee issued a scathing report in 2007, which found that Aguirre had been illegally fired in reprisal for his pursuit of Mack and in 2009, the SEC was forced to re-open its case against Pequot. Pequot settled with the SEC for $28 million and Arthur J. Samberg
Arthur J. Samberg
Arthur J. Samberg was the chief investment officer, president and chairman of Pequot Capital Management, a $5 billion hedge fund with approximately $510 million dollars of uncalled capital.-Early life:...
, chief investment officer
Chief investment officer
The chief investment officer is a job title for the board level head of investments within an organization. The CIO's purpose is to understand, manage, and monitor their organization's portfolio of assets, devise strategies for growth, act as the liaison with investors, and recognize and avoid...
of Pequot, was barred from working as an investment advisor. Pequot closed its doors under the pressure of investigations.
The SEC is focusing resources on investigating insider trading by hedge funds, though a statement by SEC Enforcement Director Robert Khuzami
Robert Khuzami
Robert S. Khuzami is currently the director of the Division of Enforcement of the U.S. Securities and Exchange Commission. He is a former United States federal prosecutor and general counsel of Deutsche Bank AG....
put some of its impact in question and Senator Chuck Grassley
Chuck Grassley
Charles Ernest "Chuck" Grassley is the senior United States Senator from Iowa . A member of Republican Party, he previously served in the served in the United States House of Representatives and the Iowa state legislature...
has asked for an explanation of Khuzami's remarks.
Performance measurement
Performance statistics for individual hedge funds are difficult to obtain, as the funds have historically not been required to report their performance to a central repository and restrictions against public offerings and advertisement have led many managers to refuse to provide performance information publicly. However, summaries of individual hedge fund performance are occasionally available in industry journals and databases. and investment consultancy Hennessee Group.One estimate is that the average hedge fund returned 11.4% per year, representing a 6.7% return above overall market performance before fees, based on performance data from 8,400 hedge funds. Another is that between January 2000 and December 2009 the hedge funds outperformed other investments were significantly less volatile, with stocks falling −2.62% per year over the decade and hedge funds rising +6.54%.
Hedge funds performance is measured by comparing their returns to an estimate of their risk. Common measures are the Sharpe ratio
Sharpe ratio
The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of the excess return per unit of deviation in an investment asset or a trading strategy, typically referred to as risk , named after William Forsyth Sharpe...
., Treynor measure
Treynor ratio
The Treynor ratio , named after Jack L. Treynor, is a measurement of the returns earned in excess of that which could have been earned on an investment that has no diversifiable risk , per each unit of market risk assumed.The Treynor ratio relates...
and Jensen's alpha
Jensen's alpha
In finance, Jensen's alpha is used to determine the abnormal return of a security or portfolio of securities over the theoretical expected return....
. These measures work best when returns follow normal distributions without autocorrelation
Autocorrelation
Autocorrelation is the cross-correlation of a signal with itself. Informally, it is the similarity between observations as a function of the time separation between them...
, and these assumptions are often not met in practice.
New performance measures have been introduced that attempt to address some of theoretical concerns with traditional indicators, including: modified Sharpe ratios; the Omega ratio introduced by Keating and Shadwick in 2002; Alternative Investments Risk Adjusted Performance (AIRAP) published by Sharma in 2004; and Kappa developed by Kaplan and Knowles in 2004.
Value in mean/variance efficient portfolios
According to modern portfolio theoryModern portfolio theory
Modern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...
, rational investors will seek to hold portfolios that are mean/variance efficient (that is, portfolios offer the highest level of return per unit of risk, and the lowest level of risk per unit of return). One of the attractive features of hedge funds (in particular market neutral
Market neutral
An investment strategy or portfolio is considered market neutral if it seeks to entirely avoid some form of market risk, typically by hedging. In order to evaluate market neutrality, it is first necessary to specify the risk being avoided...
and similar funds) is that they sometimes have a modest correlation with traditional assets such as equities. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers, reducing overall portfolio risk.
However, there are three reasons why one might not wish to allocate a high proportion of assets into hedge funds. These reasons are:
- Hedge funds are highly individual and it is hard to estimate the likely returns or risks;
- 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
- Hedge fund returns are reduced considerably by the high fee structures that are typically charged.
Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in investor portfolios, but this is disputed for example by Mark Kritzman who performed a mean-variance optimization calculation on an opportunity set that consisted of a stock index fund, a bond index fund, and ten hypothetical hedge funds. The optimizer found that a mean-variance efficient portfolio did not contain any allocation to hedge funds, largely because of the impact of performance fees. To demonstrate this, Kritzman repeated the optimization using an assumption that the hedge funds incurred no performance fees. The result from this second optimization was an allocation of 74% to hedge funds.
The other factor reducing the attractiveness of hedge funds in a diversified portfolio is that they tend to under-perform during equity bear markets, just when an investor needs part of their portfolio to add value. For example, in January–September 2008, the Credit Suisse/Tremont Hedge Fund Index was down 9.87%. According to the same index series, even "dedicated short bias" funds had a return of −6.08% during September 2008. In other words, even though low average correlations may appear to make hedge funds attractive this may not work in turbulent period, for example around the collapse of Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
in September 2008.
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 or cash equivalents. 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 US 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.
Notable hedge fund firms
- Amaranth AdvisorsAmaranth AdvisorsAmaranth Advisors LLC was an American investment adviser managing multi-strategy hedge fund founded by Nicholas Maounis and headquartered in Greenwich, Connecticut. The firm had up to $9 billion in assets under management and collapsed in September 2006 after losing in excess of $5 billion on...
- BlackRockBlackRockBlackRock, Inc. is an American multinational investment management corporation and the world's largest asset manager. BlackRock is headquartered in Manhattan, New York City, New York, United States and is the leading provider of investment, advisory, and risk management solutions...
- Bridgewater AssociatesBridgewater AssociatesBridgewater Associates is an American investment management firm founded by Ray Dalio in 1975 and is reported to be the world's largest hedge fund company with $122 billion in assets under management. The company has 270 clients including pension funds, endowments, foundations, foreign governments...
- Brevan HowardBrevan HowardBrevan Howard Asset Management a British-based hedge fund manager that is the largest in Europe. The fund, co-founded by Alan Howard and Jean-Philippe Blochet in 2002, has more than $26 billion under management. Blochet left the firm in November 2009. The group's master fund returned 20.4 percent...
- GLG PartnersGLG PartnersGLG Partners, Inc. is an American global hedge fund sponsor that, as of 14th October 2010, is a wholly owned subsidiary of British alternative investment manager Man plc...
- Harmonic Capital Partners
- Long-Term Capital ManagementLong-Term Capital ManagementLong-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
- Man Investments
- Marshall WaceMarshall waceMarshall Wace LLP is a hedge fund in the City of London that was founded by Paul Marshall and Ian Wace. Marshall is chairman and chief investment officer and Wace is chief executive officer....
- Och-Ziff Capital ManagementOch-Ziff Capital ManagementOch-Ziff Capital Management Group is an American hedge fund manager and global alternative asset management firm. In early 2011, the firm had more than $28 billion in assets under management....
- Paulson & Co.
- Renaissance TechnologiesRenaissance TechnologiesRenaissance Technologies is a hedge fund management company of about 275 employees and more than $ billion in assets under management in three funds...
- Soros Fund ManagementSoros Fund ManagementSoros Fund Management LLC is an American, privately held, hedge fund management firm founded in 1969 by George Soros. In 2010 it was reported to be one of the most profitable firms in the hedge fund industry, averaging a 20% annual rate of return over four decades.-Overview:Soros Fund Management...
- The Children's Investment Fund Management (TCI)
See also
- Steven A. CohenSteven A. CohenSteven "Steve" A. Cohen is an American hedge fund manager. He is the founder of SAC Capital Advisors, a Stamford, Connecticut-based hedge fund focusing primarily on equity market strategies....
- Carl IcahnCarl IcahnCarl Celian Icahn is an American business magnate and investor.-Biography:Icahn was raised in Far Rockaway, Queens, New York City, where he attended Far Rockaway High School. His father was a cantor, his mother was a schoolteacher...
- Investment bankingInvestment bankingAn investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities...
- List of hedge funds
- Stock broking