Thursday, June 19

Hedge Funds

A hedge fund is
An aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

· Private fund,
· Largely unregulated
· Pool of capital
· require a very large initial minimum investment
· Illiquid investments as they often require investors keep their money in the fund for at least one year.
· Managers can buy or sell any assets,
· Bet on falling as well as rising assets and
· Participate substantially in profits from money invested.
· Charges both Performance Fees and Management Fees
· Typically open only to qualified investors
· Dominate certain specialty markets such as trading within derivatives with high-yield ratings, and distressed debt.
Fees
Charges both a performance fee and a management fee (also known as Incentive Fees)
Generally referred as “2 and 20” implying 2% Management Fees on NAV and 20% Performance Fees on Increases in NAV.
Fees are payable by the fund to the investment manager. They are therefore taken directly from the assets that the investor holds in the fund.
Management fees are usually calculated annually and paid monthly, but can also be paid weekly.

A high water mark (also known as a loss carryforward provision) is often applied to a performance fee calculation.[8] This means that the manager only receives performance fees on the value of the fund that exceeds the highest net asset value it has previously achieved. For example, if a fund were launched at an NAV per share of $100, which then rose to $130 in its first year, a performance fee would be payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If in the third year the NAV per share rises to $143, a performance fee will be payable only on the $13 return from $130 to $143 rather than on the full return from $120 to $143.
This measure is intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. If a high water mark is not used, a fund that ends alternate years at $100 and $110 would generate performance fee every other year, enriching the manager but not the investors.
The mechanism does not provide complete protection to investors: a manager who has lost a significant percentage of the fund's value will often close the fund and start again with a clean slate, rather than continue working for no performance fee until the loss has been made good. This depends on the manager being able to persuade investors to trust it with their money in the new fund.
Some managers specify a hurdle rate, signifying that they will not charge a performance fee until the fund's annualized performance exceeds a benchmark rate, such as T-bill yield, LIBOR or a fixed percentage. This links performance fees to the ability of the manager to do better than the investor would have done if he had put the money elsewhere.
Managers who specify a "soft" hurdle rate charge a performance fee based on the entire annualized return once the hurdle rate has been achieved. Managers who use a "hard" hurdle rate only charge a performance fee on returns above the hurdle rate.
Some managers charge investors a withdrawal/redemption fee (also known as a surrender charge) if they withdraw money from the fund before a certain period of time has elapsed since the money was invested. The purpose is to encourage long-term investment in the fund: as a fund's investments need to be liquidated to raise cash for withdrawals, the fee allows the fund manager to reduce the turnover of its own investments and invest in more complex, longer-term strategies. The fee also dissuades investors from withdrawing funds after periods of poor performance.

Alfred W. Jones is credited with inventing hedge funds in 1949

While there is no legal definition for "hedge fund" under U.S. securities laws and regulations, typically they include any investment fund that, because of an exemption from the types of regulation that otherwise apply to mutual funds, brokerage firms or investment advisors, can invest in more complex and riskier investments than a public fund might.

As a hedge fund's investment activities are therefore limited only by the contracts governing the particular fund, it can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.
As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling.

It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment.
The term "hedge fund" has come in modern parlance to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other "hedging" methods to increase risk, and therefore return, rather than reduce it.

Hedge fund risk
Investing in certain types of hedge fund can be (but is not necessarily) a riskier proposition than investing in a regulated fund, despite a "hedge" being a means of reducing the risk of a bet or investment. The following are some of the primary reasons for the increased risk in hedge funds as an industry, though by no means all hedge funds have all of these characteristics, and some have none:
Leverage - in addition to money invested into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing sums many times greater than the initial investment.
Short selling - Where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns against it. Ordinary funds very rarely use short selling in this way.
Appetite for risk - hedge funds are culturally more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities and collateralized debt obligations based on sub-prime mortgages.
Lack of transparency - hedge funds are secretive entities with few public disclosure requirements. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision.
Lack of regulation - hedge funds are not subject to as much oversight from financial regulators as regulated funds, and therefore some may carry undisclosed structural risks.

Investors in hedge funds are, in most countries, required to be sophisticated investors who will be aware of the risk implications of these factors. They are willing to take these risks because of the corresponding rewards: leverage amplifies profits as well as losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns; secrecy helps to prevent imitation by competitors; and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis.

Legal structure
A hedge fund is a vehicle for holding and investing the funds of its investors. The fund itself is not a genuine business, having no employees and no assets other than its investment portfolio and a small amount of cash, and its investors being its clients. The portfolio is managed by the investment manager, which has employees and property and which is the actual business. An investment manager is commonly termed a “hedge fund” (e.g. a person may be said to “work at a hedge fund”) but this is not technically correct. An investment manager may have a large number of hedge funds under its management.
It may be in a form of Partnership, a corporate entity, a trust or a fund.

Open-ended nature
Hedge funds are typically open-ended, in that the fund will periodically issue additional partnership interests or shares directly to new investors, the price of each being the net asset value (“NAV”) per interest/share. To realize the investment, the investor will redeem the interests or shares at the NAV per interest/share prevailing at that time. Therefore, if the value of the underlying investments has increased (and the NAV per interest/share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Investors do not typically trade shares among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund, which has a limited number of shares which are traded among investors, and which distributes its profits.

Listed funds
Corporate hedge funds often list their shares on smaller stock exchanges, such as the Irish Stock Exchange, in the hope that the low level of quasi-regulatory oversight will give comfort to investors and to attract certain funds, such as some pension funds, that have bars or caps on investing in unlisted shares. Shares in the listed hedge fund are not traded on the exchange, but the fund’s monthly net asset value and certain other events must be publicly announced there.
A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an investment manager. Although widely reported as a "hedge-fund IPO", the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.

Regulatory Issues
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 US$25,000,000 with over 15 investors. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry. The rule change was challenged in court by a hedge fund manager, and in June 2006, the U.S. Court of Appeals for the District of Columbia overturned it and sent it back to the agency to be reviewed.

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

Comparison to U.S. mutual funds
Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to invest). However, there are many differences between the two, including:
Mutual funds are regulated by the SEC, while hedge funds are not
A hedge fund investor must be an accredited investor with certain exceptions (employees, etc.)
Mutual funds must price and be liquid on a daily basis
For most hedge funds, there is no method of ascertaining pricing on a regular basis.
Mutual funds must have a prospectus available to anyone that requests one and must disclose their asset allocation quarterly, while hedge funds do not have to abide by these terms.
Recently, however, the mutual fund industry has created products with features that have traditionally only been found in hedge funds.
Also, a few mutual funds have introduced performance-based fees, where the compensation to the manager is based on the performance of the fund subject to certain restrictions and conditions.

Offshore regulation
Many offshore centers are keen to encourage the establishment of hedge funds. To do this they offer some combination of professional services, a favorable tax environment, and business-friendly regulation. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin Islands and Bermuda. The Cayman Islands have been estimated to be home to about 75% of world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM.[27]
Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centres. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager.
Many offshore hedge funds, such as the Soros funds, are structured as mutual funds rather than as limited partnerships.

Hedge Fund Indices
There are a number of indices that track the hedge fund industry.
These indices come in two types, Investable and Non-investable, both with substantial problems. Investable indices are created from funds that can be bought and sold, and only Hedge Funds that agree to accept investments on terms acceptable to the constructor of the index are included.
Non-investable benchmarks are indicative in nature, and aim to represent the performance of the universe of hedge funds using some measure such as mean, median or weighted mean from a hedge fund database. There are diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different databases.
Transparency
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. 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.
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.

Investigations of illegal conduct
In the U.S., the SEC is focusing more resources on investigating violations and illegal conduct on the part of hedge funds in the public securities markets.

Performance measurement
The issue of performance measurement in the hedge fund industry has led to literature that is both abundant and controversial. Traditional indicators (Sharpe, Treynor, Jensen) work best when returns follow a symmetrical distribution. In that case, risk is represented by the standard deviation. Unfortunately, hedge fund returns are not normally distributed, and hedge fund return series are autocorrelated. Consequently, traditional performance measures suffer from theoretical problems when they are applied to hedge funds, making them even less reliable than is suggested by the shortness of the available return series.
Innovative performance measures have been introduced in an attempt to deal with this problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003),
Omega by Keating and Shadwick (2002),
Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004), and
Kappa by Kaplan and Knowles (2004).

However, there is no consensus on the most appropriate absolute performance measure, and traditional performance measures are still widely used in the industry.

Notable hedge fund management companies
Sometimes also known as alternative investment management companies.
• Amaranth Advisors
• Bridgewater Associates
• Centaurus Energy
• Citadel Investment Group
• D. E. Shaw & Co.
• Fortress Investment Group
• Goldman Sachs Asset Management
• Harbert Management Corporation
• Long Term Capital Management
• Man Group
• Marshall Wace
• Pirate Capital LLC
• Renaissance Technologies
• SAC Capital Advisors
• Soros Fund Management
• The Children's Investment Fund

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