Hedge fund

From Wikistock

Generally, a hedge fund is a lightly regulated private investment fund often characterized by unconventional investment strategies and often making use of legal structures (sometimes offshore) to mitigate the effects of local regulation and tax regimes. In contrast to regular investment funds, which are usually limited to only being able to "go long" (buy) instruments such as bonds, equities or money markets, hedge funds also have the ability to "short" (sell) instruments which they believe will fall in price. In this way, hedge funds are able to create more complex investment structures which can, for example, profit in times of market volatility, or even in a falling market. They are primarily organized as limited partnerships, and previously were often simply called "limited partnerships" and were grouped with other similar partnerships such as those that invested in oil development. Hedge funds are normally open to institutional or otherwise accredited investors.

Contents 1 News 2 Strategies 3 U.S. regulation 3.1 Recent US regulatory developments 4 Recent UK regulatory developments 5 Fund of Funds 6 Comparison to private equity funds 7 Comparison to U.S. mutual funds 8 Hedge fund privacy 9 Top earners 10 Criticism 10.1 Questionable propriety 10.2 Systemic risk 10.3 Poor performance 10.4 Hedge Fund Fees 10.5 High fees 11 Hedge fund data 11.1 Notable hedge funds 11.2 Top 30 Funds of funds 11.3 Managed Account Platforms 11.4 Terminology 12 References 13 Further reading 14 External links 14.1 Trade associations 14.2 Indices 14.3 Hedge fund research

News

Strategies

Hedge funds do not constitute a homogeneous asset class. By taking different exposures, exploiting different market opportunities, using different techniques and different instruments, hedge fund managers pursue a wide range of strategies:

• Global macro – seeking assets that are mispriced relative to global alternatives.
• Arbitrage – seeking related assets that have deviated from some anticipated relationship.
  • Convertible arbitrage – between a convertible bond and equity.
  • Fixed income arbitrage – between related bonds.
  • Risk arbitrage – between securities whose prices appear to imply different probabilities for an event.
  • Statistical arbitrage (or 'StatArb') – between securities that have deviated from some statistically estimated relationship.
  • Derivative arbitrage – between a derivative security and the underlying security.
• Long / short equity – generic term covering all hedged investment in equities.
  • Short bias – emphasizing or investing solely short.
  • Equity market neutral – maintaining a close balance between long and short positions.
• Event driven – specialized in the analysis of a particular kind of event
  • Distressed securities – companies that are or may become bankrupt
  • Regulation D – distressed companies issuing securities
• Other
  • Emerging markets
  • Fund of hedge funds

U.S. regulation

Investment companies registered with the U.S. Securities and Exchange Commission (SEC) are subject to strict limitations on the short-selling and use of leverage that are essential to many hedge fund strategies. Worse yet from the managers point of view, advisers to investment funds available to the general public are forbidden to charge incentive fees.

Although hedge funds fall within the statutory definition of an investment company, hedge funds elect to operate pursuant to exemptions from the registration requirements. Either the funds can be offered to "qualified purchasers",[1] individuals with more than US$5,000,000 in investment assets the "qualified purchasers" under Section 3(c)(7) of the Investment Company Act of 1940 or to fewer than 100 investors under Section 3(c)(1) of the same law.[2] In addition to the specific investment company restrictions, hedge funds are sold via private placement under the Securities Act of 1933, and thus interests in a hedge fund cannot be offered or advertised to the general public, and are normally offered under Regulation D, with offerees limited to individuals who are "accredited investors" (those who have total incomes of over US$200,000 per year or a net worth of over US$1,000,000)[3]. Additionally, to avoid limitations on incentive fees, buyers of the funds must be "qualified clients" under Advisers Act Rule 205-3.[4]

For the funds, the trade off is that they have fewer investors to sell to, but they have few government imposed restrictions on their investment strategies. The presumption is that hedge funds are pursuing more risky strategies, which may or may not be true depending on the fund, and that the ability to invest in these funds should be restricted to wealthier investors who are presumed to be more sophisticated and who have the financial reserves to absorb a possible loss.

Recent US regulatory developments

In October 2004, the SEC approved a rule change, finalized in December, final rule and rule amendments, implemented on February 1, 2006, that required most hedge fund advisers to register with the SEC as investment advisers under the Investment Advisers Act. The requirement applied to firms managing in excess of US$25,000,000 with over 15 investors. While there were minor exceptions to the rule, 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 rules were challenged in court by a hedge fund manager, and in June 2006, the U.S. Court of Appeals for the District of Columbia overturned it, and sent it back to the agency to be reviewed. See, Goldstein vs. SEC

Although the SEC is currently examining how it can address the Goldstein decision, commentators have stated that the SEC currently has neither the staff nor expertise to comprehensively monitor the estimated 8,000 U.S. and international hedge funds. See, New Hedge Fund Advisor Rule. One of the Commissioners, Roel Campos, has said that the SEC is forming internal teams that will identify and evaluate irregular trading patterns or other phenomena that may threaten individual investors, the stability of the industry, or the financial world. "It's pretty clear that we will not be knocking on (hedge fund) doors very often," Campos told several hundred hedge fund managers, industry lawyers and others. And even if it did, "the SEC will never have the degree of knowledge or background that you do."

Recent UK regulatory developments

In recent years, HM Revenue and Customs, formerly Inland Revenue, has adopted interpretations of the tax laws that seem likely to keep many funds offshore. One change was in June 2005, The United Kingdom's Financial Services Authority published two discussion papers about hedge funds -- one concerning systemic risks, the other on consumer protection. Due to the same concerns, later in the year the FSA created an internal team to supervise the management of 25 particularly high-impact hedge funds doing business within the UK.

Another regulatory body, the Takeover Panel, is reportedly concerned about the use by hedge funds of instruments known as contracts for difference, which it worries may have opaque effects on mergers and acquisitions.

Fund of Funds

There is a special type of investment fund called a fund of funds (FoFs), which invests only in other investment funds (e.g., hedge funds) rather than trading assets directly. Because some U.S. funds of funds may be specially registered with the SEC, they can accept investments from individuals who are not accredited investors or "financially sophisticated individuals" (defined term by the SEC, which subjectively includes those individuals whose financial sophistication allows them to make investment decisions without the protection of registration under Section 5), and often have lower investment minimums (sometimes as low as $25,000).

Funds of funds carry an additional layer of fees, typically a 1% management fee and, optionally, a 10% incentive (performance) fee, in return for their due diligence on a selection of hedge fund managers. Besides lower mininum investment hurdles and diversification, some funds of funds also add value (or "justify" the extra layer of performance fee) by dynamic allocation to different hedge funds strategies, such as Long/Short Equities, Event Driven, Distressed Debt, Convertible Arbitrage, Statistical Arbitrage, Macro and Multi-Strategies.

Fund of Hedge Fund management companies either invest directly into the hedge funds by buying shares or offer investors access to managed accounts which mirror the performance of the hedge fund. Managed or segregated accounts have grown in popularity because they provide investors with daily risk reporting and help protect the assets if the hedge fund goes into liquidation.

Comparison to private equity funds

Hedge funds are similar to private equity funds, in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in very liquid assets, and permit investors to enter or leave the fund easily. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition funds.

Between 2004 and February 2006, some U.S. hedge funds adopted 25 month lock-up rules expressly to exempt themselves from the SEC's new registration requirements. They now fall under the registration exemption drafted to exempt private equity funds.

Comparison to U.S. mutual funds

Like hedge funds, mutual funds are pools of investment capital. However, the two structures have several differences, including:

• Mutual funds are regulated by the SEC, while hedge funds may not be^{[citation needed]}
• A hedge fund investor must be an accredited investor^{[citation needed]}
• Mutual funds must price and be liquid on a daily basis^{[citation needed]}

Recently, however, the mutual fund industry has created products with features that have traditionally only been found in hedge funds.

Mutual funds have appeared which utilize some of the trading strategies noted above. Grizzly Short Fund (GRZZX), for example, is always net short, while Arbitrage Fund (ARBFX) specializes in merger arbitrage. Such funds are SEC regulated, but they offer hedge fund strategies and protection for mutual fund investors.

Also, a few mutual funds have introduced performanced-based fees, where the compensation to the manager is based on the performance of the fund. However, under Section 205(b) of the Investment Advisers Act of 1940, such compensation is limited to so-called "fulcrum fees".[5] Under these arrangements, fees can be performance-based so long as they increase and decrease symmetrically.

For example, the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves, within limits and symmetrically, similarly to a hedge fund "0 and 50" fee: A 0% management fee coupled with a 50% performance fee if the fund outperforms its benchmark index. However, the 125 bp base fee is reduced (but not below zero) by 50% of underperformance and increased (but not to more than 250 bp by 50% of outperformance.[6]

Hedge fund privacy

As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to third parties. This is in contrast to a fully regulated mutual fund (or unit trust) which will typically have to meet regulatory requirements for disclosure. The hedge funds are typically domiciled in an offshore jurisdiction, such as Bermuda, Cayman Islands, British Virgin Islands, where regulation of investment funds permits wider powers of investment (the Cayman Islands have been estimated to be home to about 75% of world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM^[1]). Hedge funds have to file accounts and conduct their business in compliance with the less stringent requirements of these offshore centres. Investors in hedge funds enjoy a higher level of disclosure than investors in mutual funds including detailed discussions of risks assumed, significant positions, and investors usually have direct access to the investment advisors of the funds. This high level of disclosure is not available to non-investors, hence the notion of privacy attached to hedge funds.

A byproduct of this privacy and the lack of regulation is that there are no official hedge fund statistics. An industry consulting group, HFR (hfr.com), reported at the end of the second quarter 2003 there are 5660 hedge funds world wide managing $665 billion. To put that in perspective, at the same time the US mutual fund sector held assets of $7.818 trillion (according to the Investment Company Institute).

The combination of privacy and rich investors means that hedge funds are a target for criticism whenever markets move against some group's interests. For example, hedge funds were widely blamed for the speculative run-up in the bond market that preceded the global bond crisis of 1994, although the major players in the bond spree were actually large commercial and investment banks.

Top earners

Institutional Investor magazine annually ranks top-earning hedge fund managers. Earnings from a hedge fund are simply 100% of the capital gains on the manager's own equity stake in the fund plus 20% to 50% (depending on policy) of the gains on the other investors' capital.

The 2004 top earner was Edward Lampert of ESL Investments Inc. who earned $1.02 billion during the year (PR Newswire link).

The 2005 top earner was James Harris Simons with an earning of $1.5 billion according to Alpha magazine.^[2] However, Trader Monthly reported that Simons only earned about $1 billion and that the top earner was instead T. Boone Pickens with an estimated earning of over $1.5 billion during the year.^[3]

The full top 10 list of hedge fund earners according to Trader Monthly includes:

• 1. T.Boone Pickens - estimated 2005 earnings $1.5bn +
• 2. Stevie Cohen, SAC Capital Advisers - $1bn +
• 3. James Simons, Renaissance Technologies Corp. - $900m - $1bn
• 4. Paul Tudor Jones, Tudor Investment Corp. - $800m - $900m
• 5. Stephen Feinberg, Cerberus Capital Management - $500 - $600m
• 6. Bruce Kovner, Caxton Associates - $500m - $600m
• 7. Eddie Lampert, ESL Investments - $500m - $600m
• 8. David Shaw, D.E. Shaw & Co - $400m - $500m
• 9. Jeffrey Gendell, Tontine Partners - $300m - $400m
• 10. Louis Bacon, Moore Capital Management - $300m - $350m
• 10. Stephen Mandel, Lone Pine Capital - $300m - $350m

Criticism

Questionable propriety

The U.S. Judiciary Committee began an investigation into the propriety of Hedge Funds on June 28, 2006. The hearings have been recently reported on by CNBC, Bloomberg, and Marketwatch after a New York Times article exposed an investigation by Gary Aguirre, an investigating attorney, who was recently fired by the SEC. [7] [8]

Systemic risk

Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital Management (LTCM) in 1998, which necessitated a bailout coordinated by the U.S. Federal Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster.

The ECB (European Central Bank) has issued a warning on hedge fund risk for financial stability and systematic risk:

"... the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability which warrants close monitoring despite the essential lack of any possible remedies. This risk is further magnified by evidence that broad hedge fund investment strategies have also become increasingly correlated, thereby further increasing the potential adverse effects of disorderly exits from crowded trades." ECB Financial Stability Review June 2006, p. 142

The Times wrote about this review:

"In one of the starkest warnings yet from an official institution over the role of the burgeoning but secretive industry, the ECB sounded a note of alarm over the possible repercussions from any collapse of a hedge fund, or group of funds." Gary Duncan, Economics Editor, June 02, 2006

However, the ECB statement itself has been criticized by a part of the financial research community, some of their arguments can be found in this paper [9].

Poor performance

Critics also maintain that hedge fund performance has suffered as aggregate asset sizes have climbed.

In 2005, Princeton University professor and noted financial theorist Burton G. Malkiel published a paper maintaining that hedge funds systematically underperform the market averages[10]. Malkiel contended that hedge fund indexes, particularly prior to 1995, were often statistically faulty and overstated hedge fund performance. Hedge funds, however, contested Malkiel's findings.[11]

Recent evidence suggests the myth of good performance in all markets is somewhat shaky even for fund of hedge funds. (Source:[12]).

Hedge funds may also simply bet wrong, with a high degree of leverage. In September 2006, the US fund Amaranth Advisors' natural gas trader lost roughly $6 billion of the firm's $9 billion assets on a series of ill-timed trades.

Hedge Fund Fees

Hedge funds typically charge two levels of fees. There is a management fee which typically ranges from 1.5% to 2.0% although there are funds that charge less, from 0.5% to 1.0%, and funds that charge as much as 5.0%. The fees are charged on the size of the capital invested, that is on the equity contribution of the investor or the gross asset value (GAV) of the shares owned by the investor.

There is also almost always a performance fee being a percentage of profits. The structuring of the management fee can vary, as can the proportion. Typically, hedge funds charge between 10% - 25% of gross returns in performance fees.

Sometimes the performance fees are levied only after a performance target has been met. This is called the Hurdle or Hurdle Rate. Typical hurdle rates are a fixed 5% - 8% or a variable rate linked to short term interest rates for example 3 month USD LIBOR. This practice has diminished as demand for hedge funds has outstripped supply. The typical hurdle is currently 0% i.e no hurdle.

Performance fees have been accused of introducing perverse behavior on the part of hedge fund managers in that they are not penalized for negative or poor performance. The High Watermark mechanism in part addresses this problem. Under a high watermark system, performance fees only apply to net new profits for each individual investor. That is, if a fund has risen say 30% and performance fees are 20% of returns, then performance fees are 20% of 30% which is 6%. If the fund then drops 10%, no performance fees are due to the hedge fund manager. Further, until the 10% loss is fully recovered, no performance fees will accrue to the hedge fund manager. Only when the loss is fully recovered, hence the concept of high watermark, will performance fees apply and then only to the performance calculated from the high watermark.

High fees

Criticism was also heaped upon hedge funds by investigative journalist Gary Weiss, in his caustic 2006 book Wall Street Versus America. The book contends that hedge funds have evolved into little more than high-fee mutual funds.

Performance-based management fees have been criticised by people including investor Warren Buffett for rewarding managers for high variability, rather than high long-term returns. A fund that may gain $100M in one year and lose $100M in the next year may pay its managers a performance fee of $30M or more for the profitable year, although the nominal return is zero, and the real return after fees is negative.

The typical hedge fund charges what is known in the industry as 2 and 20 by which is meant that management fees are 2% per annum and performance fees are 20% of whatever returns are generated. All these fees apply to gross asset values and gross performance.

Assume that a hedge fund returns 15% in a year net of all fees. This means that the gross returns must add back the 2% management fee and adjust for the 20% share of gross returns that accrue to the hedge fund manager.

Gross returns are therefore (15% + 2%) / (100% - 20%) = 21.25%.

Total fees to the hedge fund manager are therefore 21.25% - 15.00% = 6.25%

Net returns to the investor = 15%

Thus of the gross returns generated by the hedge fund manager, some 30% of the returns are retained as fees and 70% paid to the investor. While the precise quanta of fee shares will depend on the precise fee terms of each fund and the level of gross returns generated, the numbers above are within the realm of contemplation.

Hedge fund data

Notable hedge funds

• Amaranth Advisors
• Amplitude Capital (website)
• Andor Capital Management (website)
• Angelo, Gordon & Co. (website)
• Black River Asset Management (website)
• Bridgewater Associates (website)
• Cheyne Capital (website)
• Camelot Global Investment (website)
• Citadel Investment Group (website)
• Clinton Group (website)
• Denison & Porter (website)
• D. E. Shaw (website)
• Eclectica Asset Management (website)
• Erste Bank Alternative Investments (website)
• Everest Capital (website)
• Estlander & Rönnlund (website)
• Fortress Investment Group (website)
• Guidance Capital (website)
• Locust Capital Management
• Marathon Asset Management (website)
• Peloton Partners LLP (website)
• Pequot Capital Management (website)
• Permal
• Perry Capital
• Prosperity Capital Management (website)
• Renaissance Technologies
• SAC Capital Advisors
• SFA Secured Loan Fund, LLC (website)
• Sierra Enterprises Group (link)
• Soros Fund Management
• Superfund Group
• Tudor Investment Corporation (website)
• Vision Investment Management (website)
• MIR Investment Management (website)

Top 30 Funds of funds

Ranked by December 2005 Assets Under Management

• UBS Global Asset Management (GAM) (London, UK and Stamford, CT) $45.0 billion ([13])
• Man Investments (London, UK and Pfaffikon, Switzerland) $35.6 billion ([14])
• Union Bancaire Privée (UBP) (Geneva, Switzerland) $20.8 billion ([15])
• HSBC Private Bank (Suisse) / HSBS Republic Investments (London, UK) $20.2 billion ([16])
• Permal Asset Management (New York, NY) $18.8 billion ([17])
• Société Générale (Paris, France) $15.9 billion ([18])
• Quellos Capital Management (Seattle, WA) $15.0 billion ([www.quellos.com])
• Ivy Asset Management (Jericho, NY) $14.9 billion ([19])
• Grosvenor Capital Management (Chicago, IL) $14.7 billion ([20])
• Goldman Sachs Hedge Fund Strategies (Princeton, NJ) $14.2 billion ([21])
• Financial Risk Management (FRM) (London, UK) $ 13.3 billion ([22])
• Pictet & Cie. (Geneva, Switzerland) $13.0 billion ([23])
• Crédit Agricole Alternative Investment Products Group (Paris, France) $11.8 billion ([24])
• Notz Stucki & Cie. (Geneva, Switzerland) $10.7 billion ([25])
• Blackstone Alternative Asset Management (New York, NY) $9.3 billion ([26])
• Arden Asset Management (New York, NY) $9.2 billion ([27])
• Pacific Alternative Asset Management Co. (PAAMCO) (Irvine, CA) $8.9 billion]] ([28])
• J.P. Morgan Alternative Asset Management (New York, NY) $8.8 billion ([29])
• Mesirow Advanced Strategies (Chicago, IL) $8.2 billion ([30])
• Tremont Capital Management (Rye, NY) $8.2 billion ([31])
• CSFB Alternative Capital (New York, NY) $7.9 billion ([32])
• AIG Global Investment Group (New York, NY) $6.7 billion ([33])
• Harris Alternatives (Chicago, IL) $6.7 billion ([34])
• DB Absolute Return Strategies (New York, NY) $6.6 billion ([35])
• RBS Asset Management (London, UK) $6.5 billion ([36])
• Lehman Brothers Alternative Investment Management (New York, NY) $6.2 billion ([37])
• EIM (Nyon, Switzerland) $6.0 billion ([38])
• Gottex Fund Management (Lausanne, Switzerland) $5.1 billion ([39])
• Morgan Stanley Alternative Investment Partners (West Conshohocken, PA) $5.1 billion ([40])

InvestmentSeek.com has a listing of most fund of funds managers with their links ([41])

Managed Account Platforms

• Lxyor (website)
• Guggenheim (website)
• MSS (website)
• CASAM Managed Account Platform (website)
• Protege Financial Portfolio Builder (website)

Terminology

• Derivatives market
• Investment fund
• Venture capital

References

1. ↑ Institutional Investor, 15 May 2006, Article Link, although statistics in the Hedge Fund industry are notoriously speculative
2. ↑ $363M is average pay for top hedge fund managers. Institutional Investor, Alpha magazine (USA TODAY article, 26 May, 2005). Retrieved on May 27, 2006.
3. ↑ Traders Monthly. Top Hedge Fund Earners of 2005.

4. Hedge Fund Amaranth wiped out by unhedged gas position losing $5+ billion

5. "Hedge" Fund Amaranth to Close After loss of $6.5 of 9 billion on Unhedged Gas Bet

Further reading

• Lhabitant, François-Serge (2002). Hedge Funds: Myths and Limits. John Wiley & Sons. ISBN 0-470-84477-9.
• Lhabitant, François-Serge (2004). Hedge Funds: Quantitative Insights. John Wiley & Sons. ISBN 0-470-85667-X.
• Lhabitant, François-Serge (2004). Handbook of hedge Funds. John Wiley & Sons. ISBN 0-470-02663-4.

• Ineichen, Alexander M., Absolute Returns - Risk and Opportunities of Hedge Fund Investing, New York: John Wiley & Sons, 2003. ISBN 0-471-25120-8
• Ineichen, Alexander M., Asymmetric Returns - The Future of Active Asset Management, New York: John Wiley & Sons, 2006, forthcoming. ISBN 0-470-04266-4
• Weiss, Gary, Wall Street Versus America: The Rampant Greed and Dishonesty That Imperil Your Investments, New York: Portfolio, 2006. Argues that hedge funds tend to underperform market indexes and are excessively hyped by the media. ISBN 1-59184-094-5
• Hedge Fund Flameout

• Gregoriou, Greg (2006). Funds of Hedge Funds. Butterworth-Heineman, an imprint of Elsevier. ISBN 0-7506-7984-0.
• Nelken, Izzy (2005). Hedge Fund Investment Management. Butterworth-Heineman, an imprint of Elsevier. ISBN 0-7506-6007-4.
• Kessler, Andy (2004). Running Money : Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score. Collins. ISBN 0-06-074064-7.

• Drobny, Steven (2006). Inside the House of Money: Top Hedge Fund Traders on Profiting in the Global Markets. Wiley. ISBN 0-4717-9447-3.

External links

• Harvard Business School's Baker Library Guide to Hedge Funds
• SECLaw.com's Hedge Fund Information Center
• Hedge Funds vs. Mutual Funds
• The long and short - The Guardian, September 24 2005 - This article explains hedge funds in layman's terms, why they are of interest to the general reader and contains interviews with fund managers.
• What is a Hedge Fund? University of Iowa Center for International Finance and Development
• Institutional Investors 2004 Ranking
• Hedge Funds: Risk and Return, study by Prof. Burton G. Malkiel critical of published hedge fund performance numbers
• http://www.hdmgmt.co.uk/gam.html Case Study of ISO 9001 investment process project at a significant hedge fund
• http://www.cisdm.org Center for International Securities and Derivatives Markets at the University of Massachusetts is a research center specializing in hedge fund research
• How to Set Up Your Own Hedge Fund and Due Diligence, Disclosure and Fund Managers - by Hannah Terhune, JD LLM (Taxation, New York University)

Trade associations

• Alternative Investment Management Association (AIMA)
• the Hedge Fund Association (HFA)
• Managed Funds Association (MFA)

Indices

• FTSE Hedge Indices
• DOW Jones Hedge Fund Indexes
• EDHEC Alternative Indexes
• HFRI Monthly Performance Indices
• HFRX Indices
• HFN Real Time Averages
• Hedge Fund Consistency Index

Hedge fund research

• Hedge Fund Research Initiative of the International Center for Finance at the Yale School of Management
• Risk and Asset Management Center of the EDHEC Business School