Hedge fund

Financial market participants
Collective investment schemes Credit unions Insurance companies Investment banks Pension funds Prime brokers Trusts
Finance series Financial market Participants Corporate finance Personal finance Public finance Banks and banking Financial regulation
v · d · e

A hedge fund is a private investment fund that participates in a range of assets and a variety of investment strategies intended to protect the fund's investors from downturns in the market while maximizing returns on market upswings.

Hedge funds are distinct from mutual funds, individual retirement and investment accounts, and other types of traditional investment portfolios in a number of ways. 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 equities, bonds and commodities. By taking a long position on a particular asset the manager is asserting that this position is likely to increase in value. When the manager takes a short position in another asset they would be asserting that the asset is likely to decrease in value. Most hedge fund investment strategies aim to secure positive return on investment regardless of overall market performance. Hedge fund managers typically invest their own money in the fund they manage, which serves to align their interests with investors in the fund.^[1][2] Investors in hedge funds typically pay a management fee that goes toward the operational costs of the fund, and a performance fee when the fund’s net asset value is higher than that of the previous year. The net asset value of a hedge fund can be billions of dollars, due to investments from large institutional investors including pension funds, university endowments and foundations. Worldwide, 61% of investment in hedge funds is from institutional sources as of February 2011^[update].^[3] As of 2009^[update], hedge funds represent 1.1% of the total funds and assets held by financial institutions.^[4] The estimated size of the global hedge fund industry is US$1.9 trillion.^[5]

Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. Because hedge funds are not sold to the public or retail investors its advisers have historically not been subject to the same restrictions that govern other investment fund advisers, with regard to how the fund may be structured and how strategies are employed. However, hedge funds must comply with many of the same statutory and regulatory restrictions as other institutional market participants.^[6] Regulations passed in the United States and Europe after the 2008 credit crisis are intended to increase government oversight of hedge funds and eliminate any regulatory gaps.^[7]

Contents 1 History 2 Industry size 3 Fees 3.1 Management fees 3.2 Performance fees 3.2.1 High water marks 3.2.2 Hurdle rates 3.3 Withdrawal/redemption fees 4 Strategies 4.1 Global macro 4.2 Directional 4.3 Event-driven 4.4 Relative value 4.5 Miscellaneous 5 Hedge fund risk 5.1 Risk management 5.2 Transparency and regulatory considerations 5.3 Risks shared with other investment types 6 Hedge fund structure 6.1 Domicile 6.2 Investment manager locations 6.3 The legal entity 6.4 Open-ended nature 6.5 Side pockets 6.6 Listed funds 7 Regulation 7.1 U.S. regulation 7.1.1 Comparison with other funds 7.1.2 Dodd-Frank 7.2 European regulation 7.3 Offshore and other locations 8 Hedge fund indices 8.1 Non-investable indices 8.2 Investable indices 8.3 Hedge fund replication 9 Debates and controversies 9.1 Systemic risk 9.2 Transparency 9.3 Market capacity 9.4 U.S. investigations 9.5 Performance measurement 9.6 Value in mean/variance efficient portfolios 10 Notable hedge fund firms 11 Notes 12 References 13 External links

[edit] History

Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949.^[8] Jones believed that changes in asset prices can be attributed partly to factors specific to the asset in question and partly to trends in the market as a whole. To neutralize the effect of overall market movement, he balanced his portfolio by buying assets whose price he expected to increase in the future, relative to the overall performance of the market, and selling short assets whose price he expected to decrease. He saw that price movements due to the overall market would balance 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. By taking this approach his investment strategy was market neutral, as returns depended only on him picking the right stock, not on whether the stock market went up or down. Jones referred to his fund as being "hedged" to describe how the fund managed risk exposure from overall market movement.^[9] This type of portfolio became known as a hedge fund.^[10]

Jones added a 20% performance fee in 1952 and converted his fund to a limited partnership, and thereby became the first money manager to combine a hedged investment strategy, leverage and shared risk, with compensation based on investment performance. At this time, only a few investors had adopted Jones' investment structure as it was not well known in the financial community. Attention was drawn to the fund and Jones' strategies in 1966 when Carol Loomis, a writer for Fortune magazine, wrote an article about Jones called "The Jones Nobody Keeps Up With". The article noted that Jones’ fund outperformed the best mutual funds even after the 20% performance fee and this news led to great interest within the financial community.^[11]

By 1968 there were around 200 hedge funds, and the first fund of hedge funds was created in 1969 in Geneva. Many of the early funds ceased trading due to the market downturns in 1969–70 and 1973–74 as they did not manage their risk. In the 1970s hedge funds typically specialized only in one strategy, and most fund managers followed the long/short equity model created by Jones. Hedge funds lost their popularity during the downturn of the 1970s but received renewed attention in the late 1980s, following the success of several funds profiled in the media.^[11] During the 1990s the number of hedge funds increased significantly, with investments provided by the new wealth that was generated in the 1990s stock market rise.^[10] The increase in the number of hedge funds resulted from traders and investors being attracted to the aligned-interest compensation structure and the freedom of participating in an investment vehicle that was not benchmark-driven.^[12] Over the next decade there was also a marked diversification in the strategies funds utilized, including: credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy, among others. This industry expansion led to hedge funds becoming more heterogeneous than they had before.^[11]

[edit] 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 reached a peak in the second quarter of 2008 when it managed $1.93 trillion.^[13] The credit crunch caused assets under management (AUM) to fall sharply through a combination of trading losses and the withdrawal of assets from funds by investors.^[14] In April 2011, it was estimated that hedge funds had total AUM of almost $2 trillion, approaching the amount held prior to the credit crisis.^[15]

As of January 1, 2011 (2011 -01-01)^[update] the largest 225 hedge fund managers in the United States held a total of $1.297 trillion.^[16] The largest manager in 2010 was Bridgewater Associates at $58.9 billion assets under management.^[17] In 2009, the largest hedge fund manager was 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).^[18]

[edit] 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. Hedge funds use varying fee structures,^[19] however they typically 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, although this charging structure has come under pressure recently as fund returns have declined.^[20]

[edit] 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.^[21][22] 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.^[23] 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.

[edit] 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.^[24][25] Typically, hedge funds charge 20% of returns as a performance fee.^[26] 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,^[27] 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.^[28]

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.

[edit] 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.^[29] This tactic is dependent on the manager's ability to persuade investors to trust him or her with their money in the new fund.

[edit] 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.^[20] 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]}

[edit] 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.^[30]

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.

[edit] Strategies

Hedge funds employ a wide range of trading strategies. Establishing a formalized system of classification is difficult due to the rapidity with which strategies change and evolve.^[31] However, hedge fund strategies are generally said to fall into four main categories: global macro, directional, event-driven, and relative value (arbitrage).^[32] These four categories are distinguished by investment style and each have their own risk and return characteristics. Managed futures or multi-strategy funds may not fit into these categories, but are nonetheless popular strategies with investors.^[33] It is possible for hedge funds to commit to a certain strategy^[34] or employ multiple strategies to allow flexibility, for risk management purposes, or to achieve diversified returns.^[31] The hedge fund’s prospectus, also known as an offering memorandum, offers potential investors information about key aspects of the fund, including the fund's investment strategy, investment type, and leverage limit.^[34]

The elements contributing to a hedge fund strategy include: the hedge fund's approach to the market; the particular instrument used; the market sector the fund specializes in (e.g. healthcare); the method used to select investments; and the amount of diversification within the fund. There are a variety of market approaches to different asset classes, including equity, fixed income, commodity and currency. Instruments used include:equities, fixed income, futures, options and swaps. Strategies can be divided into those in which investments can be selected by managers, known as “discretionary/qualitative”, or those in which investments are selected using a computerized system, known as “systematic/quantitative”.^[35] The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager or a combination.

Sometimes hedge fund strategies are described as absolute return and are classified as either market neutral or directional. Market neutral funds have less correlation to overall market performance by “neutralizing” the effect of market swings, whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.^[31][36]

[edit] Global macro

Hedge funds utilizing a global macro investing strategy take sizable positions in share, bond or currency markets in anticipation of global macroeconomic events in order to generate a risk-adjusted return.^[36] Global macro fund managers use macroeconomic ("big picture") analysis based on global market events and trends to identify opportunities for investment that would profit from anticipated price movements. While global macro strategies have a large amount of flexibility due to their ability to use leverage to take large positions in diverse investments in multiple markets, the timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns.^[37] Global macro is often categorized as a directional investment strategy.^[36]

Global macro strategies can be divided into discretionary and systematic approaches. Discretionary trading is carried out by investment managers who identify and select investments; systematic trading is based on mathematical models and executed by software with limited human involvement beyond the programming and updating of the software. These strategies can also be divided into trend or counter-trend approaches depending on whether the fund attempts to profit from following trends (long or short-term) or attempts to anticipate and profit from reversals in trends.^[35]

Within global macro strategies, there are further sub-strategies including "systematic diversified", in which the fund trades in diversified markets, or "systematic currency", in which the fund trades in currency markets.^[38] Other sub-strategies include those employed by Commodity Trading Advisors (CTA), where the fund trades in futures (or options) in commodity markets or in swaps.^[39] This is also known as a managed future fund.^[36] CTAs trade in commodities (such as gold) and financial instruments, including stock indexes. In addition they take both long and short positions, allowing them to make profit in both market upswings and downswings.^[40]

[edit] Directional

Directional investment strategies utilize market movements, trends, or inconsistencies when picking stocks across a variety of markets. Computer models can be used, or fund managers will identify and select investments. These types of strategies have a greater exposure to the fluctuations of the overall market than do market neutral strategies.^[31][36] Directional hedge fund strategies include U.S. and international long/short equity hedge funds, where long equity positions are hedged with short sales of equities or equity index options.

Within directional strategies, there are a number of sub-strategies. "Emerging markets" funds focus on emerging markets such as China and India,^[41] whereas "sector funds" specialize in specific areas including technology, healthcare, biotechnology, pharmaceuticals, energy and basic materials. Funds using a "fundamental growth" strategy invest in companies with more earnings growth than the overall equity market or relevant sector, while funds using a "fundamental value" strategy invest in undervalued companies.^[42] Funds that use quantitative techniques for equity trading are described as using a "quantitative directional" strategy.^[43] Funds using a "short bias" strategy take advantage of declining equity prices using short positions.^[44]

[edit] Event-driven

Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event.^[45] An event-driven investment strategy finds investment opportunities in corporate transactional events such as consolidations, acquisitions, recapitalizations, bankruptcies, and liquidations. Managers employing such a strategy capitalize on valuation inconsistencies in the market before or after such events, and take a position based on the predicted movement of the security or securities in question. Large institutional investors such as hedge funds are more likely to pursue event-driven investing strategies than traditional equity investors because they have the expertise and resources to analyze corporate transactional events for investment opportunities.^[37][46]

Corporate transactional events generally fit into three categories: distressed securities, risk arbitrage and special situations.^[37] Distressed securities include such events as restructurings, recapitalizations, and bankruptcies.^[37] A distressed securities investment strategy involves investing in the bonds or loans of companies facing bankruptcy or severe financial distress, when these bonds or loans are being traded at a discount to their value. Hedge fund managers pursuing the distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds purchasing distressed debt may prevent those companies from going bankrupt, as such an acquisition deters foreclosure by banks.^[36] While event-driven investing in general tends to thrive during a bull market, distressed investing works best during a bear market.^[46]

Risk arbitrage or merger arbitrage includes such events as mergers, acquisitions, liquidations, and hostile takeovers.^[37] Risk arbitrage typically involves buying and selling the stocks of two or more merging companies to take advantage of market discrepancies between acquisition price and stock price. The risk element arises from the possibility that the merger or acquisition will not go ahead as planned; hedge fund managers will use research and analysis to determine if the event will take place.^[46][47]

Special situations are events that impact the value of a company's stock, including the restructuring of a company or corporate transactions including spin-offs, share-buy-backs, security issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company's equity and equity-related instruments.^[48]

Other event-driven strategies include: credit arbitrage strategies, which focus on corporate fixed income securities; an activist strategy, where the fund takes large positions in companies and uses the ownership to participate in the management; and legal catalyst strategy, which specializes in companies involved in major lawsuits.

[edit] Relative value

Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, the underlying security or the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical, technical or fundamental techniques.^[49] Relative value is often used as a synonym for market neutral, as strategies in this category typically have very little or no directional market exposure to the market as a whole.^[50] Other relative value sub-strategies include:

• Fixed income arbitrage – exploit pricing inefficiencies between related fixed income securities.
• Equity market neutral – exploits differences in stock prices by being long and short in stocks within the same sector, industry, market capitalization, country, which also creates a hedge against broader market factors.
• Convertible arbitrage – exploit pricing inefficiencies between convertible securities and the corresponding stocks.
• Asset-backed securities (Fixed-Income asset-backed) – fixed income arbitrage strategy using asset-backed securities.
• Credit long / short – the same as long / short equity but in credit markets instead of equity markets.
• Statistical arbitrage – identifying pricing inefficiencies between securities through mathematical modeling techniques
• Volatility arbitrage – exploit the change in implied volatility instead of the change in price.
• Yield alternatives – non-fixed income arbitrage strategies based on the yield instead of the price.
• Regulatory arbitrage – the practice of taking advantage of regulatory differences between two or more markets.

[edit] Miscellaneous

In addition to those strategies within the four main categories, there are several strategies that do not fit into these categorizations or can apply across several of them.

• Fund of hedge funds (Multi-manager) – a hedge fund with a diversified portfolio of numerous underlying single-manager hedge funds.
• Multi-strategy – a hedge fund using a combination of different strategies to reduce market risk.
• Multi-manager – a hedge fund wherein the investment is spread along separate sub-managers investing in their own strategy.
• 130-30 funds – equity funds with 130% long and 30% short positions, leaving a net long position of 100%.

[edit] Hedge fund risk

Because investments in hedge funds can add diversification to investment portfolios, investors may use them as a tool to reduce their overall portfolio risk exposures.^[51] Managers of hedge funds use particular trading strategies and instruments with the specific aim of reducing market risks to produce risk-adjusted returns, which are consistent with investors' desired level of risk.^[52] Hedge funds ideally produce returns relatively uncorrelated with market indices.^[53] While "hedging" can be a way of reducing the risk of an investment, hedge funds, like all other investment types, are not immune to risk. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500 between 1993 and 2010.^[54]

[edit] Risk management

Investors in hedge funds are, in most countries, required to be sophisticated qualified investors who are assumed to be aware of the investment risks, and accept these risks because of the potential returns relative to those risks. Fund managers may employ extensive risk management strategies in order to protect the fund and investors. According to the Financial Times, "big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management."^[52] Hedge fund managers may hold a large number of investment positions for short durations and are likely to have a particularly comprehensive risk management system in place. Funds may have "risk officers" who assess and manage risks but are not otherwise involved in trading, and may employ strategies such as formal portfolio risk models.^[55] A variety of measuring techniques and models may be used to calculate the risk incurred by a hedge fund's activities; fund managers may use different models depending on their fund's structure and investment strategy.^[53][56] Some factors ,such as normality of return, are not always accounted for by conventional risk measurement methodologies. Funds which use value at risk as a measurement of risk may compensate for this by employing additional models such as drawdown and “time under water” to ensure all risks are captured.^[57]

In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence to assess the risk that error or fraud at a hedge fund might result in loss to the investor. Considerations will include the organisation and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund's ability to develop as a company.^[58]

[edit] Transparency and regulatory considerations

Since hedge funds are private entities and have few public disclosure requirements, this is sometimes perceived as a lack of transparency.^[59] Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/or registration requirements as other financial investment managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud.^[56] New regulations introduced in the U.S. and the EU as of 2010 require hedge fund managers to report more information, leading to greater transparency.^[60] In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and external regulatory requirements.^[52] The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology, positions and leverage exposure.^[61]

[edit] Risks shared with other investment types

Hedge funds share many of the same types of risk as other investment classes, including liquidity risk and manager risk.^[56] Liquidity refers to the degree to which an asset can be bought and sold or converted to cash; similar to private equity funds, hedge funds employ a lock-up period during which an investor cannot remove money.^[36][62] Manager risk refers to those risks which arise from the management of funds. As well as specific risks such as style drift, which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors include valuation risk, capacity risk, concentration risk and leverage risk.^[59] Valuation risk refers to the concern that the net asset value of investments may be inaccurate;^[63] capacity risk can arise from placing too much money into one particular strategy, which may lead to fund performance deterioration;^[64] and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group of correlated funds.^[65] These risks may be managed through defined controls over conflict of interest,^[63] restrictions on allocation of funds,^[64] and set exposure limits for strategies.^[65]

Many investment funds use leverage, the practice of borrowing money or trading on margin in addition to capital from investors. Although leverage can increase potential returns, the opportunity for larger gains is weighed against the possibility of greater losses.^[62] Hedge funds employing leverage are likely to engage in extensive risk management practices.^[55][59] In comparison with investment banks, hedge fund leverage is relatively low; according to a National Bureau of Economic Research working paper, the average leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.^[66]

Some types of funds, including hedge funds, are perceived as having a greater appetite for risk, with the intention of maximizing returns,^[62] subject to the risk tolerance of investors and the fund manager. Managers will have an additional incentive to increase risk oversight when their own capital is invested in the fund.^[55]

[edit] Hedge fund structure

A hedge fund itself has no employees and no assets . 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 of shares, 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.

[edit] 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 investor, rather than the fund, pays tax on the increase in the value of the portfolio. The investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund.

Though estimates vary, one is that around 60% of the number of hedge funds in 2010 were registered offshore, with Cayman Islands accounting for 37%, British Virgin Islands 7% and Bermuda 5%. Among onshore funds Delaware (US) accounts for 27% and the EU (primarily Ireland and Luxembourg) for 5%.^[67]

[edit] 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.^[68]

London is Europe’s leading centre for hedge fund managers, with 70% of European hedge fund investments, about $420 billion, at the end of 2010. Asia, and more particularly China, is taking on a more important role as a source of funds for the global hedge fund industry. The UK and the U.S. are leading locations for management of Asian hedge funds' assets with around a quarter of the total each.^[67]

[edit] 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 state, corporate, private and union 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.

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.

[edit] 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. Most hedge funds have quarterly liquidity, others have semi-annual or annual liquidity.^[69][70]

[edit] 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.

[edit] 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",^[71] the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.^[72]

[edit] Regulation

A range of regulatory methods are used to provide oversight of hedge funds worldwide. According to a report by the International Organization of Securities Commissions, the most common tactic is the direct regulation of financial advisers—including hedge fund managers, which is primarily intended to protect investors against fraud. Specific regulations differ by national, federal and state jurisdiction. Historically, hedge funds have been exempt from certain registration and reporting requirements that apply to other investment companies, because in most jurisdictions regulation permits investments in hedge funds by only "qualified" investors who are able to make an informed decision about investment decisions without relying on regulatory oversight.^[36] In 2010, new regulations were passed in the U.S. and European Union, which (among other changes) introduced new hedge fund reporting requirements. The Dodd-Frank Wall Street Reform Act was passed in the U.S. in July 2010, and contains provisions which require hedge fund advisers with $150 million or more in assets to register with the SEC.^[7] In November 2010, the EU Parliament passed the Alternative Investment Fund Managers Directive, which seeks to provide greater monitoring and control of alternative investment fund managers operating in the EU.^[73]

[edit] U.S. regulation

Hedge funds within the U.S. are subject to various regulatory trading reporting and record keeping requirements that also apply to other investors in publicly traded securities.^[6] Before the Dodd-Frank Act made registration mandatory for hedge fund advisers with more than US$150 million in assets under management, hedge funds were primarily regulated through their managers or advisers, under the anti-fraud provisions of the Investment Advisers Act of 1940. Hedge funds are privately-owned pools of investment capital with regulatory limits on the number and type of investor that each fund may have. Because of these regulatory restrictions on ownership, hedge funds have been exempt from mandatory registration with the U.S. Securities and Exchange Commission (SEC) under the Investment Company Act of 1940, which is generally intended to regulate investment funds sold to retail investors.^[36] The two primary exemptions in the Investment Company Act of 1940 that hedge funds relied on were (a) Section 3(c)1 which restricts funds to 100 or fewer investors and (b) Section 3(c)7, which requires all investors to meet a "qualified purchaser" criterion. These sections also both prohibit hedge funds from selling their securities through public offerings.^[74][75] Under 3(c)7, a qualified purchaser is defined to include an individual with at least $5,000,000 in investment assets. Companies, including institutional investors, generally qualify as qualified purchasers if they have at least $25,000,000 in investment assets.^[76] Although under Section 3(c)7 a fund can have an unlimited number of investors, if a fund has any class of equity securities owned by more than 499 investors, it must register its securities with the SEC under the Securities Exchange Act of 1934.^[77][78]

Because Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940 prohibit hedge funds from making public offerings, funds must sell their securities in accordance with the private offering rules under the Securities Act of 1933. The 1933 Act generally requires companies to file a registration statement with the SEC if they want to sell their securities publicly, or comply with private placement rules under the Act.^[79] Though the securities of hedge funds are not registered under the 1933 Act, they remain subject to the anti-fraud provisions of the Act.

Hedge funds raise capital via private placement under Regulation D of the Securities Act of 1933, which means the shares are not registered. To comply with the private placement rules in Regulation D, hedge funds generally offer their securities solely to accredited investors. An accredited investor is an individual person with a minimum net worth of $1,000,000 or, alternatively, a minimum income of $200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. For banks and corporate entities, the minimum net worth is $5,000,000 in invested assets.^[80]

For SEC registered hedge fund advisers to charge an incentive or performance fee, the investors in the funds must be "qualified clients" as defined in the Investment Advisers Act of 1940 Rule 205–3. To be a qualified client an individual must have $750,000 in assets invested with the adviser or a net worth in excess of $1.5 million, or be one of certain high-level employees of the investment adviser.^[81] Under the Dodd-Frank Act, the SEC is required to periodically adjust the qualified client standard for inflation.^[82]

Because hedge funds do not have publicly traded securities, they are not subject to all of the reporting requirements of the Securities Exchange Act of 1934. Hedge funds that have a class of equity securities owned by more than 499 investors do, however, have to register under Section 12(g) of the 1934 Act and are subject the quarterly reporting requirements of the Act.^[83] Similar to other institutional investors, hedge fund managers with at least $100,000,000 in assets under management are required to file publicly quarterly reports disclosing ownership of registered equity securities. Also similar to other investors, hedge fund managers are subject to public disclosure if they own more than 5% of the class of any registered equity security.^[77] Hedge fund managers are also subject to anti-fraud provisions.

Prior to the requirements of the Dodd-Frank Act, many hedge fund advisers voluntarily registered with the SEC. Advisers who do so are subject to the same requirements as all other registered investment advisers. Registered advisers must provide information about their business practices and disciplinary history to the SEC and investors. They are required to have written compliance policies and have a chief compliance officer to enforce those policies. In addition, they are required to maintain certain books and records and have their practices examined by SEC staff.^[6] As a result of the Dodd-Frank Wall Street Reform Act, hedge fund advisers with at least $150,000,000 in assets under management will be required to register with the SEC as of July 21, 2011, while smaller advisers will be subject to state registration.^[84]

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.^[85] The requirement, with minor exceptions, applied to firms managing in excess of $25,000,000 with over 14 investors. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry.^[86] The new rule was controversial, with two commissioners dissenting,^[87] and was later challenged in court by a hedge fund manager. In June 2006, the U.S. Court of Appeals for the District of Columbia overturned the rule and sent it back to the agency to be reviewed.^[88] In response to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the earlier challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity.^[89]

Many hedge funds also fall under the jurisdiction of the Commodity Futures Trading Commission. Hedge fund advisers registered as Commodity Pool Operators (CPO) or Commodity Trading Advisors (CTA) would fall within this category, as would any manager of a hedge fund investing in markets under the CFTC’s jurisdiction, even if they qualify for an exemption from CPO or CTA registration. Hedge fund managers who meet these criteria are subject to rules and provisions of the Commodity Exchange Act prohibiting fraud and manipulation.^[90]

[edit] Comparison with other funds

The regulations and restrictions that apply to hedge funds and mutual funds differ in three major ways. First, mutual funds are required to be registered with and regulated by the SEC, while hedge funds historically have not. Investors in hedge funds must be accredited investors, with certain exceptions (employees, etc.), and cannot be marketed to retail investors; mutual funds, however, do not have this restriction. Finally, mutual funds must be liquid on a daily basis. If a mutual fund investor wishes to redeem his or her investment the fund must be able to meet that request immediately. Hedge funds ordinarily do not have daily liquidity, but rather "lock up" periods of time where the total returns are generated (net of fees) for their investors and then returned when the term ends.

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

All investment funds are subject to regulations that prohibit charging fees to investors, unless the investment performance of the fund is equivalent to that of an index or other measure of performance. This regulation is set out under Section 205(b) of the Investment Advisers Act of 1940, which limits performance fees to so-called "fulcrum fees". Due to this regulation, hedge funds charging a performance fee are unique compared with other funds.^[91]

[edit] Dodd-Frank

The Dodd-Frank Wall Street Reform Act was passed in the U.S. in July 2010, aiming to increase regulation of financial companies, including hedge funds.^[7][60] The act requires advisers to private pools of capital of $150 million or more in assets to register with the SEC as investment advisers and become subject to all the rules that apply to registered advisers by July 21, 2011. Previous exemptions from registration provided under the Investment Advisers Act of 1940 will no longer apply to most hedge fund advisers.^[84] Under Dodd-Frank, hedge fund managers who have less than $100 million in assets under management will be overseen by the state where the manager is domiciled and become subject to state regulation.^[84] This will significantly increase the number of hedge funds under state supervision, as the threshold for SEC regulation was previously $30 million.^[92] In addition to U.S. hedge funds, many overseas funds with more than 15 U.S. clients and investors, and managing more than $25 million for these clients, will also have to register with the SEC by July 21, 2011.^[7] Mandatory registration of hedge fund advisers was supported by the largest hedge fund trade group, the Managed Funds Association (MFA), which announced its support for registration in testimony to a U.S. congressional committee on May 7, 2009.^[93]

Additionally, Dodd-Frank requires hedge funds to provide information about their trades and portfolios to help regulators fulfill their obligation to monitor and regulate systemic risk. The aim is for this data to be analyzed and shared among regulators – including the newly created Financial Stability Oversight Council – and for the SEC to report to Congress on how the data is being used to protect both investors and market integrity.^[92] Under the so-called "Volcker Rule", regulators are also required to implement regulations for banks, their affiliates and holding companies to limit their relationships with hedge funds and also to prohibit these organizations from proprietary trading, and limit their investment in, and sponsorship of hedge funds.^[92]

[edit] European regulation

Within the European Union (EU), as with the U.S., hedge funds are primarily regulated through advisers who manage the funds.^[36] In the United Kingdom, which is the hedge fund center of the EU, hedge fund advisers are required to be authorized and regulated by the Financial Services Authority (FSA), the national regulator.^[73] Historically, there have been different regulatory approaches within each country in the EU. In some countries there are specific restrictions on hedge fund activities, including controls on use of derivatives in Portugal, and limits on leverage in France.^[36]

In 2010, the EU approved a law to require hedge funds to register with national regulatory authorities. The EU's Directive on Alternative Investment Fund Managers (AIFMD) was passed by the EU Parliament on November 11, 2010 and is the first EU directive focused on "alternative investment fund managers", including hedge fund managers.^[73] According to the EU, the aim of the directive is to provide greater monitoring and control of alternative investment funds.^[94] The directive requires managers to disclose more information, on a more frequent basis, to regulators about their investment strategies. The directive also introduces a rule that hedge fund managers should hold larger amounts of capital. All hedge fund managers within the EU will also be subject to potential limitations on the amount of leverage they can use.^[60] Since AIFMD covers the entire EU, and individual countries have different rules for hedge fund marketing, the directive introduced a "passport" for hedge funds authorized in one EU country to operate throughout the EU.^[60][73] The scope of the AIFMD is broad and encompasses managers located within the EU as well as non-EU managers that market their funds to European investors. Countries within the EU are required to adopt the directive in national legislation by early 2013.^[60]

[edit] Offshore and other locations

Offshore centers offer business-friendly regulation, which has encouraged the establishment of hedge funds. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin Islands, and Bermuda.^[95] Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centers. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager.

In Asia, Singapore offers fewer licensing requirements and regulations for hedge funds than Hong Kong and other financial capitals in the region.^[7] Singapore’s oversight of hedge funds will increase following the introduction of new rules and regulations in 2011,^[73] but small funds will be able to continue operating without a license. Hedge funds based in Hong Kong are subject to the same licensing requirements as mutual funds.^[7]

Many international hedge fund markets are affected by regulation passed in 2010 within the United States and European Union. Under the EU’s Alternative Investment Fund Managers directive, offshore hedge funds using prime brokers as depositaries will be required to use EU-registered credit institutions before they can be sold in the EU.^[96] The AIFMD’s regulatory requirements will essentially mandate equivalent regulations for non-EU investment funds, if they wish to operate in EU markets.^[73]

The Dodd-Frank Act, passed in the U.S. in 2010, will have several key implications for overseas hedge funds. Funds with more than 15 U.S. clients and investors managing $25 million or more will have to register with the SEC by July 21, 2011. Registered managers must file and maintain information including the assets under management and trading positions. Prior to the Dodd-Frank act, some Asian hedge funds had registered with the SEC.^[7]

[edit] Hedge fund indices

This article needs additional citations for verification. Please help improve this article by adding reliable references. Unsourced material may be challenged and removed. (November 2008)

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.

[edit] 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”.

[edit] 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.

[edit] 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.

[edit] Debates and controversies

[edit] Systemic risk

Systemic risk refers to the risk of instability across the entire financial system, as opposed to within a single company. Such risk may arise following a destabilizing event or events affecting a group of financial institutions linked through investment activity.^[97] Organizations such as the National Bureau of Economic Research^[97] and the European Central Bank have charged that hedge funds pose systemic risks to the financial sector,^[98][99] and following the failure of hedge fund Long-Term Capital Management (LTCM) in 1998 there was widespread concern about the potential for systemic risk if a hedge fund failure lead to the failure of its counterparties even though no financial assistance was provided to LTCM by the U.S. Federal Reserve, incurring no cost for U.S. taxpayers.^[100]

However these claims are widely disputed by the financial industry.^[101] Compared with investment banks and mutual funds, hedge funds are relatively small, in terms of the assets they manage, and operate generally with low leverage, thereby limiting the potential impact on systemic risk. Financial writer Sebastian Mallaby has described hedge funds as "small enough to fail".^[102][103] Hedge funds fail regularly, and numerous hedge funds failed during the financial crisis.^[104] In testimony to the House Financial Services Committee in 2009, Ben Bernanke, the Federal Reserve Board Chairman said he “would not think that any hedge fund or private equity fund would become a systemically-critical firm individually”.^[105]

In October 2009, April 2010, and September 2010, the FSA surveyed 50 hedge fund managers regarding the sector's risks, leverage levels and counterparties. Based on information collected in the 2009 and 2010 surveys, the FSA published reports that affirmed that the European hedge fund industry posed no systemic risk to the financial system. The FSA determined that, based on indicators of risk, there was "no clear evidence to suggest that... any individual fund posed a significant systemic risk to the financial system."^[106] In particular, the reports noted that hedge funds have a relatively small "footprint" of securities compared to equity raised from investors, indicating that use of leverage was reasonable.^[107][108]

[edit] 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.^[109]

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.^[110] 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.^[111] With these limitations, investors have to do their own research, which may cost on the scale of $50,000.^[112]

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^[113] which allegedly defrauded clients of close to $180 million.^[114] In December 2008, Bernard Madoff was arrested for running a $50 billion Ponzi scheme.^[115] While Madoff did not run a hedge fund, several feeder funds, of which the largest was Fairfield Sentry, channelled money to Madoff.

[edit] 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.^[116]

[edit] U.S. investigations

In June 2006, prompted by a letter from Gary J. Aguirre, the Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. Aguirre was fired from his job with the SEC when, as lead investigator of insider trading allegations against Pequot Capital Management, he tried to interview John Mack, then being considered for chief executive officer at Morgan Stanley.^[117] The Judiciary Committee and the U.S. Senate Finance Committee issued a scathing report in 2007, which found that Aguirre had been illegally fired in reprisal^[118] for his pursuit of Mack and in 2009, the SEC was forced to re-open its case against Pequot. Pequot settled with the SEC for $28 million and Arthur J. Samberg, chief investment officer of Pequot, was barred from working as an investment advisor.^[119] Pequot closed its doors under the pressure of investigations.^[120]

The SEC is focusing resources on investigating insider trading by hedge funds,^[121][122] though a statement by SEC Enforcement Director Robert Khuzami put some of its impact in question^[123] and Senator Chuck Grassley has asked for an explanation of Khuzami's remarks.^[124]

[edit] Performance measurement

Performance statistics for individual hedge funds are difficult to obtain, as the funds have historically not been required to report their performance to a central repository and restrictions against public offerings and advertisement have led many managers to refuse to provide performance information publicly. However, summaries of individual hedge fund performance are occasionally available in industry journals^[125][126] and databases.^[127] and investment consultancy Hennessee Group.^[128]

One estimate is that the average hedge fund returned 11.4% per year,^[129] representing a 6.7% return above overall market performance before fees, based on performance data from 8,400 hedge funds.^[36] Another is that between January 2000 and December 2009 the hedge funds outperformed other investments were significantly less volatile, with stocks falling −2.62% per year over the decade and hedge funds rising +6.54%.^[128]

Hedge funds performance is measured by comparing their returns to an estimate of their risk.^[130] Common measures are the Sharpe ratio.,^[131] Treynor measure and Jensen's alpha.^[132] These measures work best when returns follow normal distributions without autocorrelation, and these assumptions are often not met in practice.^[133]

New performance measures have been introduced that attempt to address some of theoretical concerns with traditional indicators, including: modified Sharpe ratios;^[133][134] the Omega ratio introduced by Keating and Shadwick in 2002;^[135] Alternative Investments Risk Adjusted Performance (AIRAP) published by Sharma in 2004;^[136] and Kappa developed by Kaplan and Knowles in 2004.^[137]

[edit] 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.^[20]

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^[138][139] 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.^[20] For example, in January–September 2008, the Credit Suisse/Tremont Hedge Fund Index^[140] 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.

[edit] Notable hedge fund firms

• Amaranth Advisors
• Bridgewater Associates
• Citadel Investment Group
• D.E. Shaw
• Fortress Investment Group
• GLG Partners
• Highbridge Capital Management
• Long-Term Capital Management
• Man Group
• Marshall Wace
• Moore Capital Management^[141][142]
• Paulson & Co.^[143][144]
• Renaissance Technologies
• SAC Capital Advisors
• Soros Fund Management
• The Children's Investment Fund Management (TCI)
• Tudor Investment^[145][146]

[edit] Notes

[edit] References

• Frank S. Partnoy & Randall S. Thomas, 'Gap Filling, Hedge Funds, and Financial Innovation' (2006) Vanderbilt Law & Econ. Research Paper No. 06-21
• Marcel Kahan & Edward B. Rock, ‘Hedge Funds in Corporate Governance and Corporate Control’ (2007) 155 University of Pennsylvania Law Review 1021
• Makrem Boumlouka, 'Regulation and Transparency in US OTC Derivative Markets', Original Thoughts Series #1, August 2010, Hedge Fund Society Hedge Fund Society
• Nicole M. Boyson, Christof W. Stahel, and Rene M. Stulz, 2010, "Hedge Fund Contagion and Liquidity Shocks", The Journal of Finance, 65: 1789–1816

[edit] External links

• Videos explaining hedge funds and indexing

v · d · eHedge funds and alternative investments Investment strategy Arbitrage / Relative value Equity market neutral · Fixed income arbitrage · Convertible arbitrage · Statistical arbitrage · Volatility arbitrage · Capital structure arbitrage Event-driven Merger arbitrage / Risk arbitrage · Distressed securities · Activist shareholder Directional Long/short equity · Global macro · CTA/managed futures · Dedicated short · Convergence trade Other Fund of hedge funds / Multi-manager Trading Algorithmic trading · Day trading · High-frequency trading · Prime brokerage · Program trading · Proprietary trading · Trend following Related terms Markets Equity · Fixed income · Commodities · Money markets · FX · Derivatives · Structured securities Misc Alpha · Beta · Delta neutral · Hedging · Shorting · Securitization · Technical analysis · Fundamental analysis · AUM Investors Institutional Investors · Pension funds · Insurance companies · Endowments · Investment Banks · Commercial Banks · Fund of hedge funds · High net worth individuals · Family offices · Sovereign wealth funds Hedge funds · Hedge fund managers · Alternative investment firms

v · d · eInvestment management Collective investment scheme structures Common contractual fund · Fond commun de placement · Investment trust · Unit trust · Mutual fund · ICVC · SICAV · Unit Investment Trust · Exchange-traded fund · Offshore fund · Unitised insurance fund Investment styles Active or Passive management · Value or Growth investing · Hedge fund · Socially responsible investing · Impact investing · Fund of funds · Manager of managers · Index fund Theory and terminology Efficient-market hypothesis · Net asset value · Open-end fund · Closed-end fund Related topics List of asset management firms · Umbrella fund · UCITS

v · d · eGeneral areas of finance Financial markets · Investment management · Financial institutions · Personal finance · Public finance · Mathematical finance · Quantitative behavioral finance · Financial economics · Experimental finance · Computational finance · Statistical finance