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Hedge fund

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The term "hedge fund" dates back to the first such fund founded by Alfred Winslow Jones in 1949. Jones' innovation was to sell short some stocks while buying others, thus some of the market risk was hedged. While most of today's hedge funds still trade stocks both long and short, many do not trade stocks at all and the term hedge fund has come to mean a relatively unregulated investment fund, often a partnership rather than a corporation in form, and characterized by unconventional strategies (i.e., strategies other than investing long only in bonds, equities or money markets).

For U.S.-based managers and investors, hedge funds are simply structured as limited partnerships. The hedge fund manager is the general partner and the investors are the limited partners. The funds are pooled together in the partnership and the general partner (hedge fund manager) makes all the investment decisions based on the strategy the hedge fund manager has outlined in their offering documents. In return for managing these funds, the hedge fund manager will receive a management fee and an incentive fee.

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

The fee structures of these limited partnerships (U.S. based hedge funds) vary but typically the management fee ranges from 1-2% of the assets under management and an additional fee called an "incentive fee" will be charged on the profits of the fund at a specified date. The incentive fee is usually 20% of the profits of the fund and can include "hurdles" or other items.

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

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

Flows and levels

The number of hedge funds increased from less than 1,000 in 1990 to over 8,000 in 2004. During this period assets under management grew from $25bn to $934bn. In 2004 alone, hedge funds assets increased by $139bn, $75bn from net inflows and $64bn from positive performance. It is estimated that funds increased to over $1.1 trillion at the end of 2005. Recent years have been characterised by increased investment from institutional investors such as pension funds, universities, endowments and charitable organisations. Because hedge funds typically use leverage, the positions that they can take in the financial markets are larger than their assets under management.

The US was by far the leading source of hedge fund investments accounting for 69% of the total stock of hedge fund assets under management at the end of 2004. Europe was the source of 23% of assets and Asia 5%. New York is the world’s leading location for hedge fund managers with about twice as many hedge fund managers as the next largest centre, London. Other important centres in the US for hedge fund managers include California and Connecticut. Japan was the most important centre for Asia-Pacific hedge fund managers. Managers located there accounted for nearly a quarter of the $47.4bn in Asia-Pacific hedge funds’ assets in June 2004. Other important locations in this region included Australia (managers accounted for 18% Asia-Pacific assets) Hong Kong (17%) and Singapore (3%).

London is Europe’s leading centre for the management of hedge funds. At the end of 2004, nearly three-quarters of European-based hedge funds’ assets totalling $256bn were managed out of the UK, the vast majority from London. Assets managed out of London more than tripled between 2002 and 2004 from $61bn to $190bn. These figures, which are compiled by EuroHedge, do not include fund of funds and US hedge funds which have trading desks in London and primarily invest outside Europe. If these are taken into account, hedge fund managers located in London probably accounted for more than 90% of European hedge funds assets. [1]

Administration of hedge fund assets

In mid-2004, 39 firms provided either on-shore or offshore "Administration Services" to hedge funds that were managing $1.1 trillion, up from 30 firms managing $745bn a year before. "Taking into account fund of funds `double-counting,'" the review said that "average assets under administration for a hedge fund administrator is US$29bn". "The total number of funds has broken the 10,000 barrier, though the grand total of 11,362 does include both master-feeders and separate feeder and sub-funds." The 39 Administrators tracked for the mid-2004 number were:

Strategies

Hedge funds use alternative strategies such as selling short, arbitrage, trading options or derivatives, using leverage, investing in seemingly undervalued securities, trading commodity and FX contracts, and attempting to take advantage of the spread between current market price and the ultimate purchase price in situations such as mergers. When strategies become extremely complex they may acquire potential and unanticipated risk of catastrophic losses as in the case of Long-Term Capital Management.

Risk arbitrage

Main article: Risk arbitrage

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

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

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

Regulation

Investment companies registered with the U.S. Securities and Exchange Commission (SEC) are subject to strict limitations on the short-selling and use of leverage that are essential to many hedge fund strategies. For this and other reasons, hedge funds elect to operate as unregistered investment companies. As a result, interests in a hedge fund cannot be offered or advertised to the general public, and are limited to individuals who are both "accredited investors" (who have total incomes of over US$200,000 per year or a net worth of over US$1,000,000) and "qualified purchasers" (who own at least US$5,000,000 in qualified investments). For the funds, the trade off is that they have fewer investors to sell to, but they have few government imposed restrictions on their investment strategies. The presumption is that hedge funds are pursuing more risky strategies, which may or may not be true depending on the fund, and that the ability to invest in these funds should be restricted to wealthier investors who are presumed to be more sophisticated and who have the financial reserves to absorb a possible loss.

Recent regulatory developments US

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

Historically, hedge funds have not been subject to regular SEC oversight. In October 2004, the SEC approved a rule change, finalized in December, final rule and rule amendments, implemented on February 1, 2006, that requires most hedge fund advisers to register with the SEC as investment advisers under the Investment Advisers Act. The requirement will apply to hedge funds managing $25 million dollars or more. The SEC is adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry, according to the SEC.

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

One of the commissioners, Roel Campos, has said that the SEC is forming internal teams that will identify and evaluate irregular trading patterns or other phenomena that may threaten individual investors, the stability of the industry or the financial world.

"It's pretty clear that we will not be knocking on (hedge fund) doors very often," Campos told several hundred hedge fund managers, industry lawyers and others. And even if it did, "the SEC will never have the degree of knowledge or background that you do."

Recent regulatory developments UK

In recent years, HM Revenue and Customs, formerly Inland Revenue, has adopted interpretations of the tax laws that seem likely to keep many funds offshore.

In June 2005, The United Kingdom's Financial Services Authority published two discussion papers about hedge funds -- one concerning systemic risks, the other on consumer protection.

Due to the same concerns, later in the year the FSA created an internal team to supervise the management of 25 particularly high-impact hedge funds doing business within the UK.

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

More to come.

Funds of funds

A special type of investment vehicle called a fund of funds, a fund which invests in other hedge funds rather than trading assets itself. Because some U.S. funds of funds may be specially registered with the SEC, they can accept investments from individuals who are not accredited investors or qualified purchasers, and often have lower investment minimums (sometimes as low as $25,000)..

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

Comparison to Private Equity funds

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

Hedge funds are regular investors in private equity companies' acquisition funds.

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

Comparison to Mutual funds

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

Hedge fund privacy

As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to third parties. This is in contrast to a fully regulated mutual fund (or unit trust) which will typically have to meet regulatory requirements for disclosure. The hedge funds are typically domiciled in an offshore jurisdiction, e.g. Bermuda, Cayman Islands, Virgin Islands, where regulation of investment funds permits wider powers of investment. Hedge funds have to file accounts and conduct their business in compliance with the less onerous requirements of these offshore centres. Investors in hedge funds enjoy a higher level of disclosure than investors in mutual funds including detailed discussions of risks assumed, significant positions, and investors usually have direct access to the investment advisors of the funds. This high level of disclosure is not available to non-investors, hence the notion of privacy attached to hedge funds.

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

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

Hedge funds

Large hedge funds

In Asia

Top earners

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

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

Hedge fund managers

See also

Further reading

  • Lhabitant, François-Serge, Hedge Funds: Quantitative Insights, John Wiley & Sons, 2004.

General

Trade associations

Indices

Hedge Fund Research

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