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A hedge fund generally refers to a lightly regulated private investment fund characterized by unconventional strategies (e.g., strategies other than investing long only in bonds, equities or money markets). They are primarily organized as limited partnerships, and previously were often simply called "limited partnerships" and were grouped with other limited partnerships such as those that invested in oil development.

The term hedge fund dates back to the first such fund founded by Alfred Winslow Jones in 1949. Jones' innovation was to sell short some stocks while buying others, thus some of the market risk was hedged. While most of today's hedge funds still trade stocks both long and short, many do not trade stocks at all.

For U.S.-based managers and investors, hedge funds are simply structured as limited partnerships or limited liability companies. The hedge fund manager is the general partner or manager and the investors are the limited partners or members. The funds are pooled together in the partnership or company and the general partner or manager makes all the investment decisions based on the strategy it outlined in the offering documents.

In return for managing the investors' funds, the hedge fund manager will receive a management fee and a performance or incentive fee. The management fee is computed as a percentage of assets under management, and the incentive fee is computed as a percentage of the fund's profits. A "high water mark" may be specified, under which the manager does not receive incentive fees unless the value of the fund exceeds the highest value it has achieved. The fee structures of hedge funds vary, but the yearly management fee typically ranges from 1-2% of the assets under management and the incentive fee is usually 10-20% of the profits of the fund. Certain highly regarded managers demand higher fees. In particular, Steven Cohen's SAC Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons' Renaissance Technologies Corp. charges a 5% management fee and a 44% incentive fee.

Research shows that incentive fees correlate to higher returns in mutual funds (Elton, Gruber, and Blake, 2003), perhaps suggesting the attractiveness of hedge funds, where incentive fees can be much higher and restrictions on trading are less.

Offshore hedge funds are usually domiciled in a tax haven and, for U.S.-based fund managers, are designed to allow the manager to manage the assets of foreign investors and tax exempt U.S. investors. In this structure, the manager will receive a management and incentive fee as in an onshore fund.

The typical hedge fund asset management firm includes both the domestic U.S. hedge fund and the offshore hedge fund. This allows hedge fund managers to attract capital from all over the world. Both funds will trade 'Pari passu' based on the strategy outlined in the offering documents.

Flows and levels

Assets under management of the hedge fund industry totalled $1,130bn at end-2005. This was up 13% on the previous year and nearly twice the total three years earlier. Because hedge funds typically use leverage , the positions that they can take in the financial markets are larger than their assets under management. The number of hedge funds increased 6% in 2005 to reach around 8,500. Research conducted by TowerGroup predicts that hedge fund assets will grow at an annualised rate of 15% between 2006 and 2008 while the actual number of hedge funds is likely to remain relatively flat.

Hedge funds can be registered in onshore or offshore locations. At the end of 2004, 55% of the number of hedge funds, managing nearly two-thirds of total hedge fund assets, were registered offshore. The most popular offshore location was the Cayman Islands followed by British Virgin Islands and Bermuda. The US was the most popular onshore location accounting for 34% of the number of funds and 24% of assets. EU countries were the next most popular location with 9% of the number of funds and 11% of assets. Asia accounted for most of the remainder.

Onshore locations are far more important in terms of the location of hedge fund managers. New York City and Greenwich, Connecticut are together the world’s leading location for hedge fund managers with about twice as many hedge fund managers as the next largest centre, London. This is not surprising considering that the US is the source of the bulk of hedge fund investments. London is Europe’s leading centre for the management of hedge funds. At end-2005, three-quarters of European hedge fund investments totalling $300bn were managed out of the UK, the vast majority from London. Assets managed out of London grew more than four-fold between 2002 and 2005 from $61bn to $225bn. Australia was the most important centre for the management of Asia-Pacific hedge funds. Managers located there accounted for around a quarter of the $115bn in Asia-Pacific hedge funds’ assets in 2005.

Strategies

The bulk of hedge fund assets are invested in funds that employ "long / short equity" strategies. Other hedge funds use alternative strategies such as selling short, arbitrage, trading options or derivatives, using leverage, investing in seemingly undervalued securities, trading commodity and FX contracts, and attempting to take advantage of the spread between current market price and the ultimate purchase price in situations such as mergers. When strategies become extremely complex they may acquire potential and unanticipated risk of catastrophic losses as in the case of Long-Term Capital Management.

Risk arbitrage

Main article: Risk arbitrage

One very common hedge strategy is to buy shares of a company that is in the process of a merger or acquisition. The company's stock has an announced price that it will be worth on the date of the merger, so if the stock is under that value prior to the merger, it is a safe investment to purchase the stock and wait. This strategy can be risky, as there is a possibility that the merger will not go through and the stock will be left at its current value. Frequently, the trader will also short sell the stock of the acquiring company in addition to buying the stock of the target.

Most of the early hedge funds did just this. They became very popular as a way of seeing gains better than the investment grade bond market, while still having low risk.

However the side effect of this popularity was to dramatically increase the interest in all of the non-standard investment strategies, and soon other funds were being set up with new strategies aimed primarily at high growth. Although there is no hedging in these cases, the term is still used for these funds as well.

Some people break the hedge fund universe into seven broad classifications: (1) event driven, (2) fixed-income arbitrage, (3) global convertible bond arbitrage, (4) equity market-neutral, (5) long/short equity, (6) global macros, and (7) commodity trading.

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. For this and other reasons, hedge funds elect to operate as unregistered investment companies. As a result, interests in a hedge fund cannot be offered or advertised to the general public, and are limited to individuals who are both "accredited investors" (who have total incomes of over US$200,000 per year or a net worth of over US$1,000,000) and "qualified purchasers" (who own at least US$5,000,000 in qualified investments). Further, any one hedge fund is limited to 499 investors ("limited partners"). 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 regulatory developments - US

Unlike mutual funds, hedge funds are not required to register with the SEC. This means that hedge funds are subject to very few regulatory controls. Because of this lack of regulatory oversight, hedge funds historically have generally been available solely to accredited investors and large institutions. Most hedge funds also have voluntarily restricted investment to wealthy investors through high investment minimums (e.g., $1 million).

Historically, U.S.-based hedge funds were not required to register with the SEC. (However, unregistered funds were and are subject to the anti-fraud provisions of the U.S. Investment Advisers Act of 1940.) In October 2004, the SEC approved a rule change, finalized in December, final rule and rule amendments, implemented on February 1, 2006, that requires most hedge fund advisers to register with the SEC as investment advisers under the Investment Advisers Act. The requirement will apply to hedge funds managing US$30,000,000 or more and open to new investors. The SEC has stated that it is adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry.

The SEC currently has neither the staff nor expertise to comprehensively monitor the estimated 8,000 U.S. and international hedge funds.

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 regulatory developments - UK

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.

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.

Funds of funds

Main article: Fund of funds

There is a special type of investment vehicle called a fund of funds, a fund which invests in other hedge funds rather than trading assets itself. 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 qualified purchasers, 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 and selection of hedge fund managers. Besides lower mininum investment hurdle 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.

Comparison to Private Equity funds

Hedge funds are similar to private equity funds, such as venture capital 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 Mutual funds

Like hedge funds, mutual funds are pools of investment capital. However, mutual funds are highly regulated by the SEC. One consequence of this regulation is that mutual funds cannot compensate managers based on the performance of the fund, which many believe dilutes the incentive of the fund managers to perform.

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, e.g. Bermuda, Cayman Islands, British Virgin Islands, where regulation of investment funds permits wider powers of investment (the Cayman Islands have been estimated to home to about 75% of world’s hedge funds, with nearly half the industry's estimated $1.1 trillion AUM). Hedge funds have to file accounts and conduct their business in compliance with the less onerous 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 investor's 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 T. Boone Pickens who earned over $1.5 billion during the year. (Traders Monthly).

See also

Hedge fund managers

Hedge funds

Funds of funds

Hedge fund strategies

Peloton Partners

Terminology

Further reading

  • Lhabitant, François-Serge, Hedge Funds: Quantitative Insights, John Wiley & Sons, 2004.
  • Ineichen, Alexander M., Absolute Returns - Risk and Opportunities of Hedge Fund Investing, New York: John Wiley & Sons, 2003.
  • Ineichen, Alexander M., Asymmetric Returns - The Future of Active Asset Management, New York: John Wiley & Sons, 2006, forthcoming.
  • 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.


External links

Footnotes

  1. Institutional Investor, 15 May 2006, Article Link, although statistics in the Hedge Fund industry are notoriously speculative

Trade associations

Indices

Hedge Fund Research

General areas of finance
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