Hedge fund

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A hedge fund is an investment fund that is typically open to a limited range of investors who pay a performance fee to the fund's investment manager.

Every hedge fund has its own investment strategy that determines the type of investments it undertakes and these strategies are highly individual. As a class, hedge funds undertake a wider range of investment and trading activities than traditional long-only investment funds, and invest in a broader range of assets including long and short positions in shares, bonds and commodities. As the name implies, hedge funds often seek to hedge some of the risks inherent in their investments using a variety of methods, notably short selling and derivatives.

In most jurisdictions, hedge funds are open only to a limited range of professional or wealthy investors who meet criteria set by regulators, and are accordingly exempted from many of the regulations that govern ordinary investment funds. The net asset value of a hedge fund can run into many billions of dollars, and the gross assets of the fund will usually be higher still due to leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt.[1]

Contents

History

Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949.[2] Jones believed that price movements of an individual asset could be seen as having a component due to the overall market and a component due to the performance of the asset itself. To neutralize the effect of overall market movement, he balanced his portfolio by buying assets whose price he expected to be stronger than the market and selling short assets he expected to be weaker than the market. He saw that price movements due to the overall market would be cancelled out, because, if the overall market rose, the loss on shorted assets would be cancelled by the additional gain on longed assets and vice-versa. Because the effect is to 'hedge' that part of the risk due to overall market movements, this type of portfolio became known as a hedge fund.

Industry size

Estimates of industry size vary widely due to the absence of central statistics, the lack of an agreed definition of hedge funds and the rapid growth of the industry. As a general indicator of scale, the industry may have managed around $2.5 trillion at its peak in the summer of 2008.[2] The credit crunch has caused assets under management (AUM) to fall sharply through a combination of trading losses and the withdrawal of assets from funds by investors.[3] Recent estimates suggest that hedge funds have more than $2 trillion in AUM.[4] A recent survey of hedge fund administrators indicates single manager hedge funds have over $2.5 trillion in assets under administration ($AuA)[5] [6]

Largest hedge fund managers

The 25 largest hedge fund managers had $519.7 billion in assets under management as of December 31, 2009. The largest manager is JP Morgan Chase ($53.5 billion) followed by Bridgewater Associates ($43.6 billion), Paulson & Co. ($32 billion), Brevan Howard ($27 billion), and Soros Fund Management ($27 billion).[7]

Fees

A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee) from the fund. A typical manager may charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% of the fund's profit.[2]

Management fees

As with other investment funds, the management fee is calculated as a percentage of the fund's net asset value. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure.[8] [9] Management fees are usually expressed as an annual percentage, but calculated and paid monthly or quarterly.

The business models of most hedge fund managers provide for the management fee to cover the operating costs of the manager, leaving the performance fee for employee bonuses. However, the management fees for large funds may form a significant part of the manager's profits.[10] Management fees associated with hedge funds have been under much scrutiny, with several large public pension funds, notably CalPERS, calling on managers to reduce fees.

Performance fees

Performance fees (or "incentive fees") are one of the defining characteristics of hedge funds. The manager's performance fee is calculated as a percentage of the fund's profits, usually counting both realized and unrealized profits. By motivating the manager to generate returns, performance fees are intended to align the interests of manager and investor more closely than flat fees. In the business models of most managers, the performance fee is largely available for staff bonuses and so can be extremely lucrative for managers who perform well. Several publications provide estimates of the annual earnings of top hedge fund managers.[11][12] Typically, hedge funds charge 20% of returns as a performance fee.[13] However, the range is wide with highly regarded managers charging higher fees. For example Steven Cohen's SAC Capital Partners charges a 35-50% performance fee,[14] while Jim Simons' Medallion Fund charged a 45% performance fee.

Average incentive fees have declined since the start of the financial crisis, with the decline being more pronounced in funds of hedge funds (FOFs). Incentive fees for single manager funds fell to 19.2 percent (versus 19.34 percent in Q1 08) while FOFs fell to 6.9 percent (versus 8.05 percent in Q1 08). The average incentive fee for funds launched in 2009 was 17.6 percent, 1.6 percent below the broader industry average.[15]

Performance fees have been criticized by many people, including notable investor Warren Buffett, who believe that, by allowing managers to take a share of profit but providing no mechanism for them to share losses, performance fees give managers an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark.

High water marks

A high water mark (or "loss carryforward provision") is often applied to a performance fee calculation. This means that the manager receives performance fees only on increases in the net asset value (NAV) of the fund in excess of the highest net asset value it has previously achieved. For example, if a fund were launched at a NAV per share of $100, which then rose to $120 in its first year, a performance fee would be payable on the $20 return for each share. If the next year it dropped to $110, no fee would be payable. If in the third year the NAV per share rose to $130, a performance fee would be payable only on the $10 profit from $120 (the high water mark) to $130, rather than on the full return during that year from $110 to $130.

The mechanism does not provide complete protection to investors: A manager who has lost a significant percentage of the fund's value may close the fund and start again with a clean slate, rather than continue working for no performance fee until the loss has been made up.[16] This tactic is dependent on the manager's ability to persuade investors to trust him or her with their money in the new fund.

Hurdle rates

Some managers specify a hurdle rate, signifying that they will not charge a performance fee until the fund's annualized performance exceeds a benchmark rate, such as T-bill yield, LIBOR or a fixed percentage.[2] This links performance fees to the ability of the manager to provide a higher return than an alternative, usually lower risk, investment.

With a "soft" hurdle, a performance fee is charged on the entire annualized return if the hurdle rate is cleared. With a "hard" hurdle, a performance fee is only charged on returns above the hurdle rate. Before the credit crisis of 2008, demand for hedge funds tended to outstrip supply, making hurdle rates relatively rare.[citation needed]

Withdrawal/redemption fees

Some funds charge investors a redemption fee (or "withdrawal fee" or "surrender charge") if they withdraw money from the fund. A redemption fee is often charged only during a specified period of time (typically a year) following the date of investment, or only to withdrawals representing a specified portion of an investment.[17]

The purpose of the fee is to discourage short-term investment in the fund, thereby reducing turnover and allowing the use of more complex, illiquid or long-term strategies. The fee may also dissuade investors from withdrawing funds after periods of poor performance.

Unlike management and performance fees, redemption fees are usually retained by the fund and therefore benefit the remaining investors rather than the manager.

Strategies

Hedge funds employ many different trading strategies, which are classified in many different ways. No standard system is used. A hedge fund will typically commit itself to a particular strategy, particular investment types and leverage limits via statements in its offering documentation, thereby giving investors some indication of the nature of the particular fund.

Each strategy can be said to be built from a number of different elements:

The four main strategy groups are based on the investment style and have their own risk and return characteristics. The most common label for a hedge fund is "long/short equity", meaning that the fund takes both long and short positions in shares traded on public stock exchanges.

Global macro

(Macro, Trading) Global Macro funds attempt to anticipate global macroeconomic events, generally using all markets and instruments to generate a return.

Directional

(Equity hedge) Hedged investments with exposure to the equity market.

Event-driven

(Special situations) Exploit pricing inefficiencies caused by anticipated specific corporate events.

Relative value

(Arbitrage, Market neutral) Exploit pricing inefficiencies between related assets that are mispriced.

Miscellaneous

Hedge fund risk

Despite a "hedge" being a means of reducing the risk of a bet or investment, investing in certain types of hedge fund can be a riskier proposition than investing in a regulated fund. Many hedge funds have some of these characteristics:

Leverage - in addition to money invested into the fund by investors, a hedge fund will typically borrow money or trade on margin, with certain funds borrowing sums many times greater than the initial investment. If a hedge fund has borrowed $9 for every $1 received from investors, a loss of only 10% of the value of the investments of the hedge fund will wipe out 100% of the value of the investor's stake in the fund, once the creditors have called in their loans. In September 1998, shortly before its collapse, Long-Term Capital Management had $125 billion of assets on a base of $4 billion of investors' money, a leverage of over 30 times. It also had off-balance sheet positions with a notional value of approximately $1 trillion.[18]
Short selling - due to the nature of short selling, the losses that can be incurred on a losing bet are in theory limitless, unless the short position directly hedges a corresponding long position. Ordinary funds very rarely use short selling in this way.
Appetite for risk - hedge funds are 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 private 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 fund managers are, in some jurisdictions, not subject to as much oversight from financial regulators as regulated funds, and therefore some may carry undisclosed structural risks.
Short volatility - certain hedge fund strategies involve writing out of the money call or put options. If these expire in the money the fund may take large losses.
Conflict of Interest - Inherent within the concept of paying a performance fee is the notion that an investment advisor may construct a portfolio of higher risk than would otherwise be taken, in hopes of increasing return and therefore performance fees.

Investors in hedge funds are, in most countries, required to be sophisticated investors who are assumed to be aware of these risks, and willing to take these risks because of the corresponding rewards:

One approach to diagnosing hedge fund risk is operational due diligence.

Hedge fund structure

A hedge fund is a vehicle for holding and investing the money of its investors. The fund itself has no employees and no assets other than its investment portfolio and cash. 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:

Prime broker – prime brokerage 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 custody services. Prime brokers are typically parts of large investment banks.
Administrator – the administrator typically deals with the issue and redemption of interests and shares, calculates the net asset value of the fund, and performs related back office functions. In some funds, particularly in the U.S., 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 U.S., 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 domicile 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 centres so that the fund can avoid paying tax on the increase in the value of its portfolio. An investor will still pay tax on any profit it makes when it realizes its investment, and the investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund.

An IFSL Research report states: "Around 60% of the number of hedge funds in 2009 were registered in offshore locations. The Cayman Islands was the most popular registration location and accounted for 39% of the number of global hedge funds. It was followed by Delaware (US) 27%, British Virgin Islands 7% and Bermuda 5%. Around 5% of global hedge funds are registered in the EU, primarily in Ireland and Luxembourg."[19]

Investment manager locations

In contrast to the funds themselves, investment managers are primarily located onshore 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 U.S. 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.[20]

London is Europe’s leading centre for hedge fund managers, with three-quarters of European hedge fund investments, about $400 billion, at the end of 2009. 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 U.S. are leading locations for management of Asian hedge funds' assets with around a quarter of the total each.[21]

The legal entity

Limited partnerships are principally used for hedge funds aimed at US-based investors who pay tax, as the investors will receive relatively favorable tax treatment in the US. The 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-U.S. investors, which would otherwise be subject to more complex tax issues by investing in a tax-transparent entity such as a partnership, and U.S. entities that do not pay tax such as pension funds, which would otherwise be subject to unrelated business income tax in the United States. Unit trusts 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.

Many hedge funds are structured as master-feeder funds. In such a structure, the investors will invest into a feeder fund, which will, in turn, invest all of its assets into the master fund. The assets of the master fund will then be managed by the investment manager in the usual way. This allows several feeder funds (e.g. an offshore corporate fund, a U.S. limited partnership and an entity established for a particular investor) to invest into the same master fund, allowing an investment manager the benefit of managing the assets of a single entity while giving all investors the best possible tax treatment. The master fund will be tax-transparent for US tax purposes.

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.

Open-ended nature

Hedge funds are typically open-ended, 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.

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 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 shares on smaller stock exchanges, 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",[22] the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.[23]

Regulatory issues

Part of what gives hedge funds their competitive edge, and their cachet in the public imagination, is that they straddle multiple definitions and categories; some aspects of their dealings are well-regulated, while others are unregulated or at best quasi-regulated.

U.S. regulation

The typical public investment company in the United States is required to be registered with the U.S. Securities and Exchange Commission (SEC). Mutual funds are the most common type of registered investment companies. Aside from registration and reporting requirements, investment companies are subject to strict limitations on short-selling and the use of leverage. There are other limitations and restrictions placed on public investment company managers, including the prohibition on charging incentive or performance fees.

Although hedge funds are investment companies, they have avoided the typical regulations for investment companies because of exceptions in the laws. The two major exemptions are set forth in Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940. Those exemptions are for funds with 100 or fewer investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7 Fund").[24] A qualified purchaser is an individual with over US$5,000,000 in investment assets. (Some institutional investors also qualify as accredited investors or qualified purchasers.)[25] A 3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited number of investors. The Securities Act of 1933 disclosure requirements apply only if the company seeks funds from the general public, and the quarterly reporting requirements of the Securities Exchange Act of 1934 are only required if the fund has more than 499 investors.[26] A 3(c)7 fund with more than 499 investors must register its securities with the SEC.[27]

In order to comply with 3(c)(1) or 3(c)(7), hedge funds raise capital via private placement under the Securities Act of 1933, and normally the shares sold do not have to be registered under Regulation D. Although it is possible to have non-accredited investors in a hedge fund,[citation needed] the exemptions under the Investment Company Act, combined with the restrictions contained in Regulation D, effectively require hedge funds to be offered solely to accredited investors.[28] An accredited investor is an individual person with a minimum net worth of $1,000,000 or, alternatively, a minimum income of US$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.[28]

There have been attempts to register hedge fund investment managers. There are numerous issues surrounding these proposed requirements. A client who is charged an incentive fee must be a "qualified client" under Advisers Act Rule 205-3. To be a qualified client, an individual must have US$750,000 in assets invested with the adviser or a net worth in excess of US$1.5 million, or be one of certain high-level employees of the investment adviser.[29]

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.[30] The requirement, with minor exceptions, applied to firms managing in excess of US$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.[31] The new rule was controversial, with two commissioners dissenting.[32] 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. See Goldstein v. SEC. In response to the court decision, in 2007 the SEC adopted Rule 206(4)-8. Rule 206(4)-8, 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.[33]

In February 2007, the President's Working Group on Financial Markets rejected further regulation of hedge funds and said that the industry should instead follow voluntary guidelines.[34][35][36] In November 2009 the House Financial Services Committee passed a bill that would allow states to oversee hedge funds and other investment advisors with $100m or less in assets under management, leaving larger investment managers up to the Securities and Exchange Commission. Because the SEC currently regulates advisers with $25m or more under management, the bill would shift 43% of these companies, or roughly 710, back over to state oversight[37]

Comparison to U.S. 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.[citation needed]

Between 2004 and February 2006, some hedge funds adopted 25-month lock-up rules expressly to exempt themselves from the SEC's new registration requirements and cause them to fall under the registration exemption that had been intended to exempt private equity funds.[citation needed]

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:

Some hedge funds that are based offshore report their prices to the Financial Times, but for most there is no method of ascertaining pricing on a regular basis. In addition, mutual funds must have a prospectus available to anyone that requests one (either electronically or via U.S. postal mail), and must disclose their asset allocation quarterly, whereas hedge funds do not have to abide by these terms.

Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time where the total returns are generated (net of fees) for their investors and then returned when the term ends, through a passthrough requiring CPAs and U.S. Tax W-forms. Hedge fund investors tolerate these policies because hedge funds are expected to generate higher total returns for their investors versus mutual funds.

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

Mutual funds that utilize some of the trading strategies noted above have appeared. 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 performance-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".[38] 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) used to have a management fee that behaved, 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 outperformed its benchmark index. However, the 125 bp base fee was reduced (but not below zero) by 50% of underperformance and increased (but not to more than 250 bp) by 50% of outperformance.[39]

Proposed U.S. regulation

Hedge funds are exempt from regulation in the United States. Several bills have been introduced in the 110th Congress (2007–08), however, relating to such funds. Among them are:

None of the bills has received serious consideration yet.

UK regulation

Hedge funds managed by UK hedge fund managers are always incorporated outside the UK, usually in an offshore location such as the Cayman Islands, and are not directly regulated by the UK authorities. However, a hedge fund manager based in the UK is required to be authorised and regulated by the UK's Financial Services Authority, and accordingly the UK hedge fund industry is regulated.

As the UK is part of the European Union, the UK hedge fund industry will also be affected by the EU's Directive on Alternative Investment Fund Managers.

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.[40]

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.

Hedge fund indices

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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.

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.

Debates and controversies

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 (but not financed) by the U.S. Federal Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster. The excessive leverage (through derivatives) that can be used by hedge funds to achieve their return[41] is outlined as one of the main factors of the hedge funds' contribution to systemic risk.

The ECB (European Central Bank) issued a warning in June 2006 on hedge fund risk for financial stability and systemic 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. Some believe that broad hedge fund investment strategies have also become increasingly correlated, thereby further increasing the potential adverse effects of disorderly exits from crowded trades."[42][43] However the ECB statement has been disputed by parts of the financial industry.[44]

The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge funds in June 2007.[45] The funds invested in mortgage-backed securities. The funds' financial problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside assistance. It was the largest fund bailout since Long Term Capital Management's collapse in 1998. The U.S. Securities and Exchange commission is investigating.[46]

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 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, while some hedge funds have very limited transparency even to investors.[citation needed]

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.[47] 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.[48] With these limitations, investors have to do their own research, which may cost on the scale of $50,000.[49]

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[50] which allegedly defrauded clients of close to $180 million.[51] In December 2008, Bernard Madoff was arrested for running a $50 billion Ponzi scheme.[52] While Madoff did not run a hedge fund, several hedge funds (so called feeder funds), of which the largest was Fairfield Sentry, were overseen by Madoff and practically all their funds were funnelled to Madoff.

Market capacity

Alpha 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.[53]

U.S. investigations

In June 2006, the Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts.[54]

The U.S. Securities and Exchange Commission (SEC) is also focusing resources on investigating insider trading by hedge funds.[55][56]

Performance measurement

Performance statistics are hard to obtain because of restrictions on advertising and the lack of centralized collection. However summaries are occasionally available in various journals.[57][58]

The question of how performance should be adjusted for the amount of risk that is being taken 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.[2]

Several 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.[2]

Value in mean/variance efficient portfolios

According to Modern Portfolio Theory, 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.[2]

However, there are three reasons why one might not wish to allocate a high proportion of assets into hedge funds. These reasons are:

  1. Hedge funds are highly individual and it is hard to estimate the likely returns or risks;
  2. 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
  3. 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[59][60] 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.[2] For example, in January-September 2008, the Credit Suisse/Tremont Hedge Fund Index[61] 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. 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 U.S. 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

Notes

  1. ^ Karmin, Craig (August 30, 2007). "Hedge Funds Do About 60% Of Bond Trading, Study Says". The Wall Street Journal. http://online.wsj.com/article/SB118843899101713108.html. Retrieved 2007-12-19. Durbin Hunter
  2. ^ a b c d e f g h "AIMA Roadmap to Hedge Funds". http://www.aima.org/download.cfm/docid/6133E854-63FF-46FC-95347B445AE4ECFC. Retrieved 2010-08-14. 
  3. ^ Kishan, Saijel (2008-11-27). "Satellite Halts Hedge Fund Withdrawals, Fires 30 After Losses". Bloomberg. http://www.bloomberg.com/apps/news?pid=20601087&sid=atrq052in_gE&refer=home. Retrieved 2010-08-14. 
  4. ^ "Hedge Fund Assets Hit $2 Trillion". FINalternatives. 2009-12-09. http://www.finalternatives.com/node/9918. Retrieved 2010-08-14. 
  5. ^ "Q2 2010 HFN Administrator Survey". Channel Capital Group Inc.. 2010-09-07. http://www.hedgefund.net/reports/Admin_Survey/q210_survey.htm. Retrieved 2010-09-14. 
  6. ^ "International Association of Hedge Funds Professionals (IAHFP)". International Association of Hedge Funds Professionals (IAHFP). http://www.hedge-funds-association.com. 
  7. ^ "Updated The biggest hedge funds - Pensions & Investments". Pionline.com. http://www.pionline.com/article/20100308/CHART2/100309910. Retrieved 2010-08-14. 
  8. ^ New York Times, "2 + 20, And Other Hedge Math", Mark Hulbert, March 4, 2007.
  9. ^ http://www.businessweek.com/magazine/content/07_20/b4034053.htm
  10. ^ "Financial Rimes, "Hedge fund investors have a great chance to cut fees", James Mackintosh, 6 February 2009". Ft.com. 2009-02-06. http://www.ft.com/cms/s/0/cf7f91e2-f3f0-11dd-9c4b-0000779fd2ac.html. Retrieved 2010-08-14. 
  11. ^ "Trader Monthly's Top 100 for 2007 Unveiled". 1440 Wall Street, April 7, 2008. http://www.1440wallstreet.com/index.php/comments/trader_monthlys_top_100_for_2007_unveiled/. Retrieved May 25, 2008. 
  12. ^ "Best-Paid Hedge Fund Managers". Institutional Investor, Alpha magazine, May 25, 2008. http://www.iimagazine.com/article.aspx?articleID=1914753. Retrieved May 25, 2008. 
  13. ^ "Hedge Fund Math: Why Fees Matter (Newsletter), Epoch Investment Partners Inc." (PDF). http://www.eipny.com/pdf/HedgeFundMathWhyFeesMatter110907.pdf. Retrieved 2010-08-14. 
  14. ^ "Forbes 400 Richest Americans: Stephen A. Cohen". Forbes.com. 2006-09-19. http://www.forbes.com/lists/2006/54/biz_06rich400_Steven-A-Cohen_PZMO.html. Retrieved 2010-08-14. 
  15. ^ Opalesque (10 March 2010). "Incentive fees fall since start of the financial crisis". http://www.opalesque.com/IndustryUpdates/691/HFR_Hedge_fund_liquidations_fall_to_levels217.html. 
  16. ^ "Hedge Funds: Fees Down? Close Shop". Businessweek.com. 2005-08-08. http://www.businessweek.com/bwdaily/dnflash/aug2005/nf2005088_1711_db042.htm. Retrieved 2010-08-14. 
  17. ^ http://www.hedgeworld.com/education/index.cgi?page=hedge_fund_basics
  18. ^ "Lessons from the Collapse of Hedge Fund, Long-Term Capital Management". Riskinstitute.ch. http://riskinstitute.ch/146490.htm. Retrieved 2010-08-14. 
  19. ^ Hedge Funds, pg 2 International Financial Services London
  20. ^ "Final Rule: Registration Under the Advisers Act of Certain Hedge Fund Advisers; Release No. Release No. IA-2333; File No. S7-30-04; December 2, 2004". Sec.gov. http://sec.gov/rules/final/ia-2333.htm#IA. Retrieved 2010-08-14. 
  21. ^ Hedge Funds, pg 2 and 3 International Financial Services London
  22. ^ Fortress files for first U.S. hedge fund IPO, Marketwatch
  23. ^ FORTRESS INVESTMENT GROUP LLC, SEC Registration Statement
  24. ^ Marx Law Library, University of Cincinnati College of Law. "The Investment Company Act of 1940". Law.uc.edu. http://www.law.uc.edu/CCL/InvCoAct/sec3.html. Retrieved 2010-08-14. 
  25. ^ Marx Law Library, University of Cincinnati College of Law. "The Investment Company Act of 1940". Law.uc.edu. http://www.law.uc.edu/CCL/InvCoAct/sec2.html. Retrieved 2010-08-14. 
  26. ^ Skeel D. (2005). Behind the Hedge. Legal Affairs.
  27. ^ http://www.hedgefundworld.com/forming_a_hedge_fund.htm
  28. ^ a b Marx Law Library, University of Cincinnati College of Law. "General Rules and Regulations promulgated under the Securities Act of 1933". Law.uc.edu. http://www.law.uc.edu/CCL/33ActRls/rule501.html. Retrieved 2010-08-14. 
  29. ^ Marx Law Library, University of Cincinnati College of Law. "Rules and Regulations promulgated under the Investment Advisers Act of 1940". Law.uc.edu. http://www.law.uc.edu/CCL/InvAdvRls/rule205-3.html. Retrieved 2010-08-14. 
  30. ^ http://sec.gov/rules/final/ia-2333.htm
  31. ^ http://sec.gov/rules/final/ia-2333.htm#P78_37183
  32. ^ Astarita MJ. New Hedge Fund Advisor Rule.
  33. ^ Adelfio NE, Griffin N. (2007). United States: SEC Affirms Its Enforcement Authority With New Anti-Fraud Rule Under the Advisers Act. Mondaq.
  34. ^ Officials Reject More Oversight of Hedge Funds
  35. ^ "President’s Working Group Releases Common Approach to Private Pools of Capital Guidance on hedge fund issues focuses on systemic risk, investor protection". Treasury.gov. 2007-02-22. http://www.treasury.gov/press/releases/hp272.htm. Retrieved 2010-08-14. 
  36. ^ [1][dead link]
  37. ^ Opalesque (9 November 2009). "House Financial Services Committee passed bill allowing U.S. states to oversee smaller hedge funds". http://www.opalesque.com/55729/regulation/Regulatory_Update_House_Financial_Services_Committee_passed236.html. 
  38. ^ Marx Law Library, University of Cincinnati College of Law. "The Investment Advisers Act of 1940". Law.uc.edu. http://www.law.uc.edu/CCL/InvAdvAct/sec205.html. Retrieved 2010-08-14. 
  39. ^ http://www.tfscapital.com/products/mutual/files/Prospectus.pdf
  40. ^ Institutional Investor, May 15, 2006, Article Link, although statistics in the Hedge Fund industry are notoriously speculative
  41. ^ http://www.ustreas.gov/press/releases/reports/hedgfund.pdf
  42. ^ "Financial Stability Review June 2006" (PDF). http://www.ecb.int/pub/pdf/other/financialstabilityreview200606en.pdf. Retrieved 2010-08-14. 
  43. ^ Gary Duncan (2006-06-02). "ECB warns on hedge fund risk". London: The Times. http://business.timesonline.co.uk/tol/business/economics/article670960.ece. Retrieved 2007-05-01. 
  44. ^ "edhec-risk.com" (PDF). http://www.edhec-risk.com/edito/RISKArticleEdito.2006-07-27.4050/attachments/EDHEC%20response%20to%20ECB%20statement%20on%20HFs.pdf. Retrieved 2010-08-14. 
  45. ^ Bookstaber, Richard (2007-08-16). "Blowing up the Lab on Wall Street". Time.com. http://www.time.com/time/business/article/0,8599,1653556,00.html. Retrieved 2010-08-14. 
  46. ^ Times Online, "SEC Probing Bear Stearns hedge funds," June 27, 2007[dead link]
  47. ^ Cassar, G., & Gerakos, J. (2009). Determinants of Hedge Fund Internal Controls and Fees. Retrieved from [2]
  48. ^ Liang, B. (2000). Hedge Funds: The Living and the Dead. Journal of Financial & Quantitative Analysis, 35(3), 309-326. Retrieved from Business Source Complete.
  49. ^ Stulz, R. (2007). Hedge Funds Past, Present, and Future. Journal of Economic Perspectives, 21(2), 175-194. doi: 10.1257/jep.21.2.175
  50. ^ "SEC v. Kirk S. Wright, International Management Associates, LLC; International Management Associates Advisory Group, LLC; International Management Associates Platinum Group, LLC; International Management Associates Emerald Fund, LLC; International Management Associates Taurus Fund, LLC; International Management Associates Growth & Income Fund, LLC; International Management Associates Sunset Fund, LLC; Platinum II Fund, LP; and Emerald II Fund, LP, Civil Action". Sec.gov. http://www.sec.gov/litigation/litreleases/lr19581.htm. Retrieved 2010-08-14. 
  51. ^ By Amanda Cantrell, CNNMoney.com staff writer (2006-03-30). "Hedge fund manager faces fraud charges". Money.cnn.com. http://money.cnn.com/2006/03/30/markets/wright_charged/index.htm. Retrieved 2010-08-14. 
  52. ^ "Wall Street legend Bernard Madoff arrested over 50 billion Ponzi scheme". The Times (London). December 12, 2008. http://www.timesonline.co.uk/tol/news/world/us_and_americas/article5331997.ece. Retrieved May 4, 2010. 
  53. ^ Géhin and Vaissié, 2006, The Right Place for Alternative Betas in Hedge Fund Performance: an Answer to the Capacity Effect Fantasy, The Journal of Alternative Investments, Vol. 9, No. 1, pp. 9-18
  54. ^ Post Store (2006-06-29). "Scrutiny Urged for Hedge Funds". Washingtonpost.com. http://www.washingtonpost.com/wp-dyn/content/article/2006/06/28/AR2006062801909.html. Retrieved 2010-08-14. 
  55. ^ "Testimony Concerning Insider Trading by Linda Chatman Thomsen". Securities and Exchange Commission. September 26, 2006. http://www.sec.gov/news/testimony/2006/ts092606lct.htm#2. Retrieved 2007-12-19. 
  56. ^ "Hedge Funds to Face More Scrutiny From U.S. Market Regulators". Bloomberg News. December 5, 2006. http://www.bloomberg.com/apps/news?pid=20601087&sid=aFvR74yK0J20&refer=home. Retrieved 2007-12-19. 
  57. ^ Willoughby, Jack (2007-10-01). "High Performance - Barron's Online". Online.barrons.com. http://online.barrons.com/article/SB119101983536943198.html?mod=b_hps_9_0001_b_this_weeks_magazine_home_top. Retrieved 2010-08-14. 
  58. ^ The Wall Street Journal. http://online.wsj.com/public/resources/documents/BA_HedgeFund50_071001.pdf. 
  59. ^ ’’Portfolio Efficiency with Performance Fees’’, Economics and Political Strategy (newsletter), February 2007, Peter L. Bernstein Inc.
  60. ^ Hulbert, Mark ‘’2 + 20, and Other Hedge Fund Math’’, New York Times, March 4, 2007.
  61. ^ "Credit Suisse/Tremont Hedge Index web page". Hedgeindex.com. http://www.hedgeindex.com/hedgeindex/en/default.aspx?cy=USD. Retrieved 2010-08-14. 
  62. ^ http://www.hedgepedia.com/content/top-100-largest-hedge-funds-2009

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