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Hedge

Hedge

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Published by Justin Michael

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Published by: Justin Michael on Sep 08, 2010
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07/29/2011

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A hedge fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than traditional long-only investment funds, and that, ingeneral, pays a performance fee to its investment manager. Every hedge fund has its owninvestment strategy that determines the type of investments and the methods of investment itundertakes. Hedge funds, as a class, invest in a broad range of investments including shares,debt and commodities. Some people consider the fund created in 1949 by Alfred Winslow Jonesto be the first hedge fund.[citation needed]As the name implies, hedge funds often seek to hedge some of the risks inherent in their investments using a variety of methods, most notably short selling and derivatives. However, theterm "hedge fund" has also come to be applied to certain funds that, as well as (or instead of)hedging certain risks, use short selling and other "hedging" methods as a trading strategy togenerate a return on their capital.In most jurisdictions hedge funds are open only to a limited range of professional or wealthyinvestors who meet certain criteria set by regulators, and are accordingly exempted from manyregulations that govern ordinary investment funds. The exempted regulations typically cover shortselling, the use of derivatives and leverage, fee structures, and the rules by which investors canremove their capital from the fund. Light regulation and the presence of performance fees are thedistinguishing characteristics of hedge 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 specialtymarkets such as trading within derivatives with high-yield ratings and distressed debt.[1]Contents[hide]* 1 History* 2 Industry sizeo 2.1 Largest hedge fund managers* 3 Feeso 3.1 Management feeso 3.2 Performance fees+ 3.2.1 High water marks+ 3.2.2 Hurdle rateso 3.3 Withdrawal/redemption fees* 4 Strategieso 4.1 Global macroo 4.2 Directionalo 4.3 Event-driveno 4.4 Relative valueo 4.5 Miscellaneous* 5 Hedge fund risk* 6 Hedge fund structureo 6.1 Domicileo 6.2 Investment manager locationso 6.3 The legal entityo 6.4 Open-ended natureo 6.5 Side pocketso 6.6 Listed funds* 7 Regulatory issueso 7.1 U.S. regulation+ 7.1.1 Comparison to U.S. private equity funds+ 7.1.2 Comparison to U.S. mutual funds+ 7.1.3 Proposed U.S. regulationo 7.2 UK regulation
 
o 7.3 Offshore regulation* 8 Hedge fund indiceso 8.1 Non-investable indiceso 8.2 Investable indiceso 8.3 Hedge Fund Replication* 9 Debates and controversieso 9.1 Systemic risko 9.2 Transparencyo 9.3 Market capacityo 9.4 U.S. investigationso 9.5 Performance measuremento 9.6 Value in mean/variance efficient portfolioso 9.7 Notable hedge fund firms* 10 Notes* 11 References* 12 External links[edit] HistorySociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the firsthedge fund in 1949.[2] Jones believed that price movements of an individual asset could be seenas having a component due to the overall market and a component due to the performance of theasset itself. To neutralize the effect of overall market movement, he balanced his portfolio bybuying assets whose price he expected to be stronger than the market and selling short assetshe expected to be weaker than the market. He saw that price movements due to the overallmarket would be cancelled out, because, if the overall market rose, the loss on shorted assetswould be cancelled by the additional gain on assets bought and vice-versa. Because the effect isto 'hedge' that part of the risk due to overall market movements, this became known as a hedgefund.[edit] Industry sizeEstimates of industry size vary widely due to the lack of central statistics, the lack of a singledefinition of hedge funds and the rapid growth of the industry. As a general indicator of scale, theindustry may have managed around $2.5 trillion at its peak in the summer of 2008.[2] The creditcrunch 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 find thathedge funds have more than $2 trillion in AUM.[4][edit] Largest hedge fund managersThe 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 byBridgewater Associates ($43.6 billion), Paulson & Co. ($32 billion), Brevan Howard ($27 billion),and Soros Fund Management ($27 billion).[5][edit] FeesA hedge fund manager will typically receive both a management fee and a performance fee (alsoknown 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 aperformance fee of 20% of the fund's profit.[2][edit] Management feesAs with other investment funds, the management fee is calculated as a percentage of the fund'snet asset value. Management fees typically range from 1% to 4% per annum, with 2% being thestandard figure.[6] Management fees are usually expressed as an annual percentage, butcalculated and paid monthly or quarterly.
 
The business models of most hedge fund managers provide for the management fee to cover theoperating 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.[7]Management fees associated with hedge funds have been under much scrutiny, with severallarge public pension funds, notably CalPERS, calling on managers to reduce fees.[edit] Performance feesPerformance fees (or "incentive fees") are one of the defining characteristics of hedge funds. Themanager's performance fee is calculated as a percentage of the fund's profits, usually countingboth realized and unrealized profits. By incentivising the manager to generate returns,performance fees are intended to align the interests of manager and investor more closely thanflat fees do. In the business models of most managers, the performance fee is largely availablefor staff bonuses and so can be extremely lucrative for managers who perform well. Severalpublications publish annual estimates of the earnings of top hedge fund managers.[8][9] Typically,hedge funds charge 20% of returns as a performance fee.[10] However, the range is wide withhighly regarded managers charging higher fees. For example Steven Cohen's SAC CapitalPartners charges a 35-50% performance fee,[11] while Jim Simons' Medallion Fund charged a45% performance fee.Average incentive fees have declined since the start of the financial crisis, with the decline beingmore pronounced in funds of hedge funds (FOFs). Incentive fees for single manager funds fell to19.2 percent (versus 19.34 percent in Q1 08) while FOFs fell to 6.9 percent (versus 8.05 percentin Q1 08). The average incentive fee for funds launched in 2009 was 17.6 percent, 1.6 percentbelow the broader industry average.[12]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 usuallylimited by a high water mark. Ironically, Mr. Buffett charged incentive fees until his firm was verylarge.[citation needed]As the hedge fund remuneration structure is highly attractive it has been remarked that hedgefunds are best viewed "... not as a unique asset class but as a unique ‘fee structure’."By whom?Citation?[edit] High water marksA high water mark (or "loss carryforward provision") is often applied to a performance feecalculation. This means that the manager receives performance fees only on increases in the netasset 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 itsfirst year, a performance fee would be payable on the $20 return for each share. If the next year itdropped to $110, no fee would be payable. If in the third year the NAV per share rose to $130, aperformance 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.High water marks are intended to link the manager's interests more closely to those of investorsand to reduce the incentive for managers to seek volatile trades. If a high water mark is not used,a fund that ends alternate years at $100 and $110 would generate a performance fee every other year, enriching the manager but not the investors.The mechanism does not provide complete protection to investors: A manager who has lost asignificant 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 for.[13] Thistactic is dependent on the manager's ability to persuade investors to trust him or her with their money in the new fund.

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