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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, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and the methods of investment it undertakes. 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 Jones to be the first hedge fund. 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, the term "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 to generate a return on their capital. In most jurisdictions hedge funds are open only to a limited range of professional or wealthy investors who meet certain criteria set by regulators, and are accordingly exempted from many regulations that govern ordinary investment funds. The exempted regulations typically cover short selling, the use of derivatives and leverage, fee structures, and the rules by which investors can remove their capital from the fund. Light regulation and the presence of performance fees are the distinguishing 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 specialty markets such as trading within derivatives with high-yield ratings and distressed debt.
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T.Y.B.F.M. An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact,
T.Y.B.F.M. because hedge fund managers make speculative investments, these funds can carry more risk than the overall market. A hedge fund is a term commonly used to describe any fund that isn't a conventional investment fund - that is, any fund using a strategy or set of strategies other than investing long in bonds, equities (mutual funds), and money markets (money market funds). Among these alternative strategies are:
hedging by selling short -- selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop using arbitrage - seeking to exploit pricing inefficiencies between related securities trading options or derivatives - contracts whose values are based on the performance of any underlying financial asset, index or other investment using leverage - borrowing to try to enhance returns investing in out-of-favor or unrecognized undervalued securities (debt or equity) Attempting to take advantage of the spread between the current market price and the ultimate purchase price in event driven situations such as mergers or hostile takeovers.
History
Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949. Jones believed that price movements of an individual asset could be seen as having a component due to the overall market and a component due to the performance of the asset itself. To neutralize the effect of overall market movement, he balanced his
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T.Y.B.F.M. portfolio by buying assets whose price he expected to be stronger than the market and selling short assets he expected to be weaker than the market. He saw that price movements due to the overall market would be cancelled out, because, if the overall market rose, the loss on shorted assets would be cancelled by the additional gain on assets bought and vice-versa. Because the effect is to 'hedge' that part of the risk due to overall market movements, this became known as a hedge fund.
Hedge Funds Basics Investment fund: Money is collected from a group of people and
invested. Foreign Institutional Investors (FIIs), Non-Resident Indians (NRIs) and persons of Indian Origin (PIOs) invest in securities in primary and secondary markets in shares, bonds, commodities, currencies etc.
With a minimum investment limit: The investors are high net worth
individuals. Exclusively favoring the crme de la crme, the usual minimum investment amount is US$ 1, 000,000/ USD 1 million.
T.Y.B.F.M. planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined. If the farmer sells a number of wheat futures contracts equivalent to his crop size at planting time, he effectively locks in the price of wheat at that time: the contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. The farmer has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times.
T.Y.B.F.M. Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks, who have lived through, and understand the consequences of, major stock market corrections. Many endowments and pension funds allocate assets to hedge funds.
Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.). Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded. Many hedge funds have the ability to deliver non-market correlated returns. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns. Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent. Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns. Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage. Hedge funds benefit by heavily weighting hedge fund managers remuneration towards performance incentives, thus attracting the
T.Y.B.F.M. best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund.
Popular Misconception
The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no leverage.
Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets. Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns. Huge variety of hedge fund investment styles many uncorrelated with each other provides investors with a wide choice of hedge fund strategies to meet their investment objectives. Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds. Hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets. Adding hedge funds to an investment portfolio provides
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Funds of Hedge Funds: Mix and match hedge funds and other pooled
investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Volatility depends on the mix and ratio of strategies employed. Expected Volatility: Low - Moderate - High
Income: Invests with primary focus on yield or current income rather than
solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. Expected Volatility: Low
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Short Selling: Sells securities short in anticipation of being able to rebuy them at a future date at a lower price due to the manager's assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. High risk. Expected Volatility: Very High
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May be widely diversified, or sector or geographically focused. Seeks to deliver more consistent returns than stock portfolios, mutual funds, unit trusts or individual hedge funds. Preferred investment of choice for many pension funds, endowments, insurance companies, private banks and highnet-worth families and individuals. Provides access to a broad range of investment styles, strategies and hedge fund managers for one easy-to-administer investment. Provides more predictable returns than traditional investment funds. Provides effective diversification for investment portfolios.
Provides an investment portfolio with lower levels of risk and can deliver returns uncorrelated with the performance of the stock market. Delivers more stable returns under most market conditions due to the fund-of-fund managers ability and understanding of the various hedge strategies. Significantly reduces individual fund and manager risk. Eliminates the need for time-consuming due diligence otherwise required for making hedge fund investment decisions. Allows for easier administration of widely diversified investments across a large variety of hedge funds.
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Allows access to a broader spectrum of leading hedge funds that may otherwise be unavailable due to high minimum investment requirements. Is an ideal way to gain access to a wide variety of hedge fund strategies, managed by many of the worlds premier investment professionals, for a relatively modest investment.
Industry size
Estimates of industry size vary widely due to the lack of central statistics, the lack of a single definition of hedge funds and the rapid growth of the industry. As a general indicator of scale, the industry may have managed around $2.5 trillion at its peak in the summer of 2008. The credit crunch has caused assets under management (AUM) to fall sharply through a combination of trading losses and the withdrawal of assets from funds by investors. Recent estimates find that hedge funds have more than $2 trillion in AUM
Estimated to be a $1 trillion industry and growing at about 20% per year with approximately 8350 active hedge funds. Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or through the use of derivatives. Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team.
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Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets -- unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk. Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept. Hedge fund managers are generally highly professional, disciplined and diligent. Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities. Beyond the averages, there are some truly outstanding performers. Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks that have lived through, and understand the consequences of, major stock market corrections. An increasing number of endowments and pension funds allocate assets to hedge funds.
Fees
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T.Y.B.F.M. A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee) from the fund. A typical manager may charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% of the fund's profit
Management fees
As with other investment funds, the management fee is calculated as a percentage of the funds net asset value. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. 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. Management fees associated with hedge funds have been under much scrutiny, with several large public pension funds calling on managers to reduce fees.
Performance fees
Performance fees (or "incentive fees") are one of the defining characteristics of hedge funds. The manager's performance fee is calculated as a percentage of the fund's profits, usually counting both realized and unrealized profits. By incentivizing the manager to generate returns, performance fees are intended to align the interests of manager and investor more closely than flat fees do. In the business models of most managers, the performance fee is largely available for staff bonuses and so can be
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T.Y.B.F.M. extremely lucrative for managers who perform well. Several publications publish annual estimates of the earnings of top hedge fund managers. Typically, hedge funds charge 20% of returns as a performance fee. 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, 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. 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. Ironically, Mr. Buffett charged incentive fees until his firm was very large. As the hedge fund remuneration structure is highly attractive it has been remarked that hedge funds are best viewed "... not as a unique asset class but as a unique fee structure.
T.Y.B.F.M. 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. High water marks are intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. If a high water mark is not used, a fund that ends alternate years at $100 and $110 would generate 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 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 for. This tactic is dependent on the manager's ability to persuade investors to trust him or her with their money in the new fund.
Hurdle rates
Some managers specify a hurdle rate, signifying that they will not charge a performance fee until the fund's annualized performance exceeds a benchmark rate, such as T-bill yield, LIBOR or a fixed percentage. This links performance fees to the ability of the manager to provide a higher return than an alternative, usually lower risk, investment.
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T.Y.B.F.M. 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. Prior to the credit crisis of 2008, demand for hedge funds tended to outstrip supply, making hurdle rates relatively rare.
Strategies
Hedge funds employ many different trading strategies, which are classified in many different ways, with no standard system used. A hedge fund will typically commit itself to a particular strategy, particular investment types and leverage limits via statements in its offering documentation, thereby giving investors some indication of the nature of the particular fund.
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T.Y.B.F.M. Each strategy can be said to be built from a number of different elements:
Style: global macro, directional, event-driven, relative value (arbitrage), managed futures (CTA) Market: equity, fixed income, commodity, currency Instrument: long/short, futures, options, swaps Exposure: directional, market neutral Sector: emerging market, technology, healthcare etc. Method: discretionary/qualitative (where the individual investments are selected by managers), systematic/quantitative (or "quant" where the investments are selected according to numerical methods using a computerized system) Diversification: multi-manager, multi-strategy, multi-fund, multimarket
The four main strategy groups are based on the investment style and have their own risk and return characteristics. The most common label for a hedge fund is "long/short equity", meaning that the fund takes both long and short positions in shares traded on public stock exchanges.
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Short selling - due to the nature of short selling, the losses that can be
incurred on a losing bet are in theory limitless, unless the short position directly hedges a corresponding long position. Ordinary funds very rarely use short selling in this way.
Appetite for risk - hedge funds are more likely than other types of funds
to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities, and collateralized debt obligations based on sub-prime mortgages.
Lack of transparency - hedge funds are private entities with few public
disclosure requirements. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio, and other factors relevant to an investment decision.
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Short volatility - certain hedge fund strategies involve writing out of the
money call or put options. If these expire in the money the fund may make large losses. Investors in hedge funds are, in most countries, required to be sophisticated investors who are assumed to be aware of these risks, and willing to take these risks because of the corresponding rewards: Leverage amplifies profits as well as losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns; secrecy helps to prevent imitation by competitors; and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis. One approach to diagnosing hedge fund risk is operational due diligence.
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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 funds expected investors. Regulatory considerations will also play a role. Many hedge funds are established in offshore financial centres so that the fund can avoid paying tax on the increase in the value of its portfolio. An investor will still pay tax on any profit it makes when it realizes its investment, and the investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund. Around 60% of the numbers of hedge funds in 2009 were registered in offshore locations. The Cayman Islands was the most popular registration
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T.Y.B.F.M. location and accounted for 39% of the number of global hedge funds. It was followed by Delaware (US) 27%, British Virgin Islands 7% and Bermuda 5%. Around 5% of global hedge funds are registered in the EU, primarily in Ireland and Luxembourg.
T.Y.B.F.M. tax benefits from investing in a limited partnership. Unit trusts are typically marketed to Japanese investors. Other than taxation, the type of entity used does not have a significant bearing on the nature of the fund. Many hedge funds are structured as master-feeder funds. In such a structure, the investors will invest into a feeder fund, which will, in turn, invest all of its assets into the master fund. The assets of the master fund will then be managed by the investment manager in the usual way. This allows several feeder funds (e.g. an offshore corporate fund, a U.S. limited partnership and a unit trust) to invest into the same master fund, allowing an investment manager the benefit of managing the assets of a single entity while giving all investors the best possible tax treatment. The 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 funds strategic decisions are taken by the board of directors of the fund, which is independent but generally loyal to the investment manager.
Open-ended nature
Hedge funds are typically open-ended, in that the fund will periodically issue additional partnership interests or shares directly to new investors, the price of each being the net asset value (NAV) per interest/share. To realize the investment, the investor will redeem the interests or shares at the NAV per interest/share prevailing at that time. Therefore, if the value of the underlying investments has increased (and the NAV per interest/share has
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T.Y.B.F.M. therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Investors do not typically trade shares or interests among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund, which has a limited number of shares which are traded among investors, and which distributes its profits.
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 an investor's holding 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
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T.Y.B.F.M. 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.
Regulatory issues
Part of what gives hedge funds their competitive edge, and their cachet in the public imagination is that they straddle multiple definitions and
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T.Y.B.F.M. categories; some aspects of their dealings are well-regulated, while others are unregulated or at best quasi-regulated.
U.S. regulation
The typical public investment company in the United States is required to be registered with the U.S. Securities and Exchange Commission (SEC). Mutual funds are the most common type of registered investment companies. Aside from registration and reporting requirements, investment companies are subject to strict limitations on short-selling and the use of leverage. There are other limitations and restrictions placed on public investment company managers, including the prohibition on charging incentive or performance fees. Although hedge funds are investment companies, they have avoided the typical regulations for investment companies because of exceptions in the laws. The two major exemptions are set forth in Sections 3(c) 1 and 3(c) 7 of the Investment Company Act of 1940. Those exemptions are for funds with 100 or fewer investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7 Fund"). A qualified purchaser is an individual with over US$5,000,000 in investment assets. (Some institutional investors also qualify as accredited investors or qualified purchasers.) A 3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited number of investors. The Securities Act of 1933 disclosure requirements apply only if the company seeks funds from the general public, and the quarterly reporting requirements of the Securities Exchange Act of 1934 are only required if the fund has more than 499 investors. A 3(c)7 fund with more than 499 investors must register its securities with the SEC.
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T.Y.B.F.M. In order to comply with 3(c)(1) or 3(c)(7), hedge funds raise capital via private placement under the Securities Act of 1933, and normally the shares sold do not have to be registered under Regulation D. Although it is possible to have non-accredited investors in a hedge fund, the exemptions under the Investment Company Act, combined with the restrictions contained in Regulation D, effectively require hedge funds to be offered solely to accredited investors. An accredited investor is an individual person with a minimum net worth of $1,000,000 or, alternatively, a minimum income of US$200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. For banks and corporate entities, the minimum net worth is $5,000,000 in invested assets. There have been attempts to register hedge fund investment managers. There are numerous issues surrounding these proposed requirements. A client who is charged an incentive fee must be a "qualified client" under Advisers Act Rule 205-3. To be a qualified client, an individual must have US$750,000 in assets invested with the adviser or a net worth in excess of US$1.5 million, or be one of certain high-level employees of the investment adviser. In December 2004, the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers Act. The requirement, with minor exceptions, applied to firms managing in excess of US$25,000,000 with over 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. The new rule was controversial, with two commissioners dissenting. The rule change was challenged in court by a hedge fund manager, and, in June 2006, the U.S. Court of Appeals for the
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T.Y.B.F.M. District of Columbia overturned it and sent it back to the agency to be reviewed. See Goldstein v. SEC. In response to the court decision, in 2007 the SEC adopted Rule 206(4)-8. Rule 206(4)-8, unlike the earlier challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity. In February 2007, the President's Working Group on Financial Markets rejected further regulation of hedge funds and said that the industry should instead follow voluntary guidelines. In November 2009 the House Financial Services Committee passed a bill that would allow states to oversee hedge funds and other investment advisors with $100m or less in assets under management, leaving larger investment managers up to the Securities and Exchange Commission. Because the SEC currently regulates advisers with $25m or more under management, the bill would shift 43% of these companies, or roughly 710, back over to state oversight.
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T.Y.B.F.M. registration requirements and cause them to fall under the registration exemption that had been intended to exempt private equity funds.
Mutual funds are regulated by the SEC, while hedge funds are not A hedge fund investor must be an accredited investor with certain exceptions (employees, etc.) Mutual funds must price and be liquid on a daily basis
Some hedge funds that are based offshore report their prices to the Financial Times, but for most there is no method of ascertaining pricing on a regular basis. In addition, mutual funds must have a prospectus available to anyone that requests one (either electronically or via U.S. postal mail), and must disclose their asset allocation quarterly, whereas hedge funds do not have to abide by these terms. Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time where the total returns are generated (net of fees) for their investors and then returned when the term ends, through a pass through requiring CPAs and U.S. Tax W-forms. Hedge fund investors tolerate these policies because hedge funds are expected to generate higher total returns for their investors versus mutual funds. Recently, however, the mutual fund industry has created products with features that have traditionally been found only in hedge funds.
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T.Y.B.F.M. Mutual funds that utilize some of the trading strategies noted above have appeared. Grizzly Short Fund (GRZZX), for example, is always net short, while Arbitrage Fund (ARBFX) specializes in merger arbitrage. Such funds are SEC regulated, but they offer hedge fund strategies and protection for mutual fund investors. Also, a few mutual funds have introduced performance-based fees, where the compensation to the manager is based on the performance of the fund. However, under Section 205(b) of the Investment Advisers Act of 1940, such compensation is limited to so-called "fulcrum fees". Under these arrangements, fees can be performance-based so long as they increase and decrease symmetrically. For example, the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves, within limits and symmetrically, similarly to a hedge fund "0 and 50" fee: A 0% management fee coupled with a 50% performance fee if the fund outperforms its benchmark index. However, the 125 BP base fee is reduced (but not below zero) by 50% of underperformance and increased (but not to more than 250 BP) by 50% of outperformance.
S. 681, a bill to restrict the use of offshore tax havens and abusive tax shelters to inappropriately avoid Federal taxation; H.R. 3417, which would establish a Commission on the Tax Treatment of Hedge Funds and Private Equity to investigate imposing regulations;
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S. 1402, a bill to amend the Investment Advisors Act of 1940, with respect to the exemption to registration requirements for hedge funds; and S. 1624, a bill to amend the Internal Revenue Code of 1986 to provide that the exception from the treatment of publicly traded partnerships as corporations for partnerships with passive-type income shall not apply to partnerships directly or indirectly deriving income from providing investment adviser and related asset management services. S. 3268, a bill to amend the Commodity Exchange Act to prevent excessive price speculation with respect to energy commodities. The bill would give the federal regulator of futures markets the resources to detect, prevent, and punish price manipulation and excessive speculation.
UK regulation
Hedge funds managed by UK hedge fund managers are always incorporated outside the UK, usually in an offshore location such as the Cayman Islands, and are not directly regulated by the UK authorities. However, a hedge fund manager based in the UK is required to be authorized and regulated by the UK's Financial Services Authority, and accordingly the UK hedge fund industry is regulated. As the UK is part of the European Union, the UK hedge fund industry will also be affected by the EU's Directive on Alternative Investment Fund Managers.
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Offshore regulation
Many offshore centers are keen to encourage the establishment of hedge funds. To do this they offer some combination of professional services, a favorable tax environment, and business-friendly regulation. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin Islands, and Bermuda. The Cayman Islands have been estimated to be home to about 75% of worlds hedge funds, with nearly half the industry's estimated $1.225 trillion. Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centres. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager.
T.Y.B.F.M. expense of limited representativeness. Clone indices seek to replicate some statistical properties of hedge funds but are not directly based on them. None of these approaches is wholly satisfactory.
Non-investable indices
Non-investable indices are indicative in nature, and aim to represent the performance of some database of hedge funds using some measure such as mean, median or weighted mean from a hedge fund database. The databases have diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different indices. Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list of biases. Funds participation in a database is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money. The short lifetimes of many hedge funds means that there are many new entrants and many departures each year, which raises the problem of survivorship bias. If we examine only funds that have survived to the present, we will overestimate past returns because many of the worstperforming 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
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T.Y.B.F.M. only publish their results when they are favorable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias or backfill bias.
Investable indices
Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. To create an investable index, the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. When investors buy these products the index provider makes the investments in the underlying funds, making an investable index similar in some ways to a fund of hedge funds portfolio. To make the index investable, hedge funds must agree to accept investments on the terms given by the constructor. To make the index liquid, these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. This means that investable indices do not represent the total universe of hedge funds, and most seriously they may under-represent more successful managers.
T.Y.B.F.M. However, they rely on a statistical modeling 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.
T.Y.B.F.M. backed securities. The funds' financial problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside assistance. It was the largest fund bailout since Long Term Capital Management's collapse in 1998. The U.S. Securities and Exchange Commission is investigating.
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. 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. 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. With these limitations, investors have to do their own research, which may cost on the scale of $50,000.
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T.Y.B.F.M. 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 which allegedly defrauded clients of close to $180 million. In December 2008, Bernard Madoff was arrested for running a $50 billion Ponzi scheme. While Madoff did not run a hedge fund, his case clearly does illustrate the value of independent verification of assets.
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.
U.S. investigations
In June 2006, the Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. The U.S. Securities and Exchange Commission (SEC) is also focusing resources on investigating insider trading by hedge funds.
Performance measurement
Performance statistics are hard to obtain because of restrictions on advertising and the lack of centralized collection. However summaries are occasionally available in various journals.
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T.Y.B.F.M. The question of how performance should be adjusted for the amount of risk that is being taken has led to literature that is both abundant and controversial. Traditional indicators (Sharpe, Treynor, Jensen) work best when returns follow a symmetrical distribution. In that case, risk is represented by the standard deviation. Unfortunately, hedge fund returns are not normally distributed, and hedge fund return series are auto correlated. Consequently, traditional performance measures suffer from theoretical problems when they are applied to hedge funds, making them even less reliable than is suggested by the shortness of the available return series. Several innovative performance measures have been introduced in an attempt to deal with this problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003), Omega by Keating and Shadwick (2002), Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004), and Kappa by Kaplan and Knowles (2004). However, there is no consensus on the most appropriate absolute performance measure, and traditional performance measures are still widely used in the industry.
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T.Y.B.F.M. 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. For example, in January-September 2008, the Credit Suisse/Tremont Hedge Fund Index 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.
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Amaranth Advisors Bridgewater Associates Citadel Investment Group D.E. Shaw Fortress Investment Group GLG Partners Long-Term Capital Management Man Group Marshall Wace Renaissance Technologies SAC Capital Advisors Soros Fund Management The Children's Investment Fund Management (TCI)
In the hedge-fund kingdom, global macro funds can be compared to grizzlies. Aiming to profit from changes in global economies, and using leverage and derivatives to accentuate the impact of market moves, such funds are not for the faint of heart. They can be enormously profitable, but are volatile, not terribly predictable, and can also produce occasional sudden falls. For example, during the first quarter of 1994 hedge-fund superstar Michael Steinhardt (whose funds produced an average annual return of 24 percent over several decades) bet European interest rates would decline, causing bonds to rise. Instead, his funds lost 29 percent when the Fed raised interest rates in the U.S., causing European interest rates to kick up. I compare macro funds to grizzlies not only to highlight these common aggressive characteristics but to point out that like grizzlies, macro hedge
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T.Y.B.F.M. funds are only one species in a wide universe and that they differ from other hedge funds as much as grizzlies differ from other animals.
T.Y.B.F.M. But many hedge funds successfully employ them to increase performance while actively managing risk. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no leverage. The reality is that less than 5% of hedge funds are global macro funds causing speculative waves and contagions, like Quantum, Tiger, and Strome. Estimated to be growing at about 20% per year, there are between 4,000 and 5,000 active hedge funds in this industry. Measured against major equity and bond indices, global hedge fund indices do indeed appear more attractive, with lower volatility and higher return. But there is a wide range of outcomes, and history is full of people who thought they had found the alchemist's stone - some magical ingredient that turns dross into gold. Indeed, in 1998, John Meriwether, the anti-hero of Michael Lewis' book Liars Poker, bet his firm, Long Term Capital Management (LTCM), on the theories espoused by his partners, the Nobel prize-winning economists, Robert Merton and Myron Scholes, and lost. LTCM was a hedge fund, founded by Meriwether in 1994, engaged in arbitraging pricing differentials in the bond markets, through betting on convergence in the prices of similar assets. The theory worked very well - for a time - but when differentials blew out, the firm's highly leveraged positions quickly lost money, necessitating an eventual bail-out by a group of banks. LTCM had nearly $1 trillion in bad investments, but only $2 billion in assets that it could sell to pay off its debts. Its borrowing in the 1997 alone averaged between 50 and 100 times its asset base, and it borrowed from the biggest of banks and brokerage houses in the world, thereby endangering a banking system already rocked by losses in Russia and the Far East.
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T.Y.B.F.M. which have SEC regulations and disclosure requirements that largely prevent them from using short selling, leverage, concentrated investments, and derivatives. This flexibility, which includes use of hedging strategies to protect downside risk, gives hedge funds the ability to best manage investment risks. The strong results can be linked to performance incentives in addition to investment flexibility. Unlike many mutual fund managers, hedge fund managers are usually heavily invested in a significant portion of the funds they run and share the rewards as well as risks with the investors. "Incentive fees" remunerate hedge fund managers only when returns are positive, whereas mutual funds pay their financial managers according to the volume of assets managed, regardless of performance. This incentive fee structure tends to attract many of Wall Streets best practitioners and other financial experts to the hedge fund industry. In the last nine years, the number of hedge funds has risen by about 20 percent per year and the rate of growth in hedge fund assets has been even more rapid. Currently, there are estimated to be approximately 8350 hedge funds managing $1 trillion. While the number and size of hedge funds are small relative to mutual funds, their growth reflects the importance of this alternative investment category for institutional investors and wealthy individual investors.
T.Y.B.F.M. The award was presented in New York this week at a ceremony that celebrated the achievements of the hedge fund industry. The awards were judged by a panel of experts from leading institutions including JP Morgan, Goldman Sachs and Bear Stearns. The judges cited Investcorp's penetration of the U.S. institutional market, its growth in assets under management and its new single manager platform as the critical success factors. Deepak Gurnani and Ibrahim Gharghour, co-heads of Asset Management at Investcorp, both expressed their delight at receiving this recognition. Deepak Gurnani said: "It is a great tribute to be recognized by our industry peers as well as by the premier awards in the hedge fund industry. This is testament to the long term achievements of Investcorp's hedge fund business over the past nine years and our success in building a strong business, not least in establishing leading risk management processes to set us apart from other providers.' Ibrahim Gharghour added: 'This award also recognizes our substantial recent progress in the United States, where we have attracted substantial US institutional money into our programme. In addition, last year, we set up a single manager platform and have already partnered with two high profile groups, Interlachen Capital Group and Cura Capital Management, in order to provide our investors greater variety and access to leading specialist funds. Investcorp is one of the leading institutional investors in hedge funds with approximately $4.6 billion under management, of which $1.7 billion is proprietary investment.
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T.Y.B.F.M. and general parents) and rely on external service providers to conduct the funds day-to-day business, including managing the fund portfolio and providing administrative services. So for this type of operation structure, hedge funds establish relationships with all the necessary industry service providers:
6- The Custodian:
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T.Y.B.F.M. The custodians primary responsibilities include safekeeping of the funds assets, clearing and settlings all trades and monitoring corporate actions such as dividend payments and proxy-related information.
8- The auditors:
The auditors role is to ensure that the hedge fund is in compliance with\ accounting practices and any applicable laws, and to verify the annual financial statement, if any.
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T.Y.B.F.M. In side by side structures, also called mirror funds or clone funds, several funds having identical or substantially similar investment policies invest in parallel in a group of cloned portfolio. These portfolios usually share a common investment adviser, portfolio managers and a custodian or administrator, and the cloning process essentially consists in facilitating bunched trades among the cloned funds and rebalancing cloned funds that have experienced different cash flows. The master/feeder structure is an efficient alternative to side-by-side funds. In this structure a series of funds (called feeders) sell shares to investors under the 12 terms of their prospectus and contribute their respective proceeds to another fund (called the master fund) rather than investing directly. 2- Managed accounts. 3- Umbrella funds. 4- Multiclass/Multiseries Funds.6
T.Y.B.F.M. To remain unregistered. Many funds use the safe harbor in the 1933 Act that allows them to sell to "accredited investors." These are individuals with an annual income of $200,000 or more, married couples with a joint income of $300,000 or more, or individuals with a net worth of $1 million.
2- Key Players
We can divide the key players in two categories, buyers of hedge funds and provider of hedge funds.
Wealthy individual:
Wealthy individuals (High Net Worth Individuals or HNWI) individuals with assets in excess of US$ 1 million - account for over 60% of the approximately $600bn invested in hedge funds. There are signs that hedge funds are becoming a standard element in HNWI not just super wealthy portfolios.
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T.Y.B.F.M. particularly- a large number of companies are starting up. Anecdotal evidence suggests US managers are opening in larger scale in London. 3- Most advisors noted a specific life cycle for hedge funds. New start ups, to be viable, had to raise about $20m. If performance is good the fund reopens 12 months later and grows to $60-100m. If performance is sustained, a further 12 months on, the fund can re-open and grow to $300-600m. But in practice few funds grow beyond the $25-30m size. 4-The credibility of the investment decision making process is critical to fundraising. The investment managers must have considerable experience and those with good reputations can raise $250m at launch. Experience in short selling is critical as are robust risk control measures. There are signs that with the amount of institutional money facing the market, standards and expectations on managers are falling. Also we can consider the players in the previous section as key player in Hedge fund even though some of them are not directly involved in such things.
3-Competitive Positioning
The hedge fund market has been growing dramatically in recent years. According to the survey conducted by an American hedge fund research company, the size of hedge fund market--which was worth US$324 billion in early 2000--exceeded US$1 trillion for the first time by early January 2005.
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T.Y.B.F.M. fund has risen. Currencies (USD, GBP and Euro) refer to specific currency classes of a fund.
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T.Y.B.F.M. In spite of difference of views, the roles played by some of the large hedge funds have often been associated with major financial crisis that took place in the 90s.
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T.Y.B.F.M. significant degree of leverage to increase its expected return. In August, and September of 1998, as the global financial crisis worsened, it became clear to LTCM that many of the assumptions inherent in the arbitrage positions it held were incorrect. Due to LTCMs leverage (which at one point has exceeded 50 to 1), those incorrect assumptions resulted in substantial losses for the firm and eroded its capital base5. Liquidation of LTCMs positions could have potentially disrupted the financial markets, resulting in losses for other participants in those markets. Finally, a consortium of banks worked out a rescue plan facilitated by the Federal Reserve Bank of New York, acknowledged that LTCMs potential impact on the worlds financial markets raises legitimate questions about the activities of hedge funds in general, as well as the proper role that regulators should play with respect to those activities. However, he also asserted that it was too soon to tell whether LTCMs investment strategies represent the norm in the hedge funds industry or, whether LTCM was an overly aggressive player among otherwise responsible market participants. In response to the near collapse of Long-Term Capital Management, LP (LTCM), the Technical Committee of the IOSCO formed a special Task Force on Hedge Funds and Other Highly Leveraged Institutions to address regulatory issues relating to the activities of highly leveraged institutions (HLIs) or hedge funds. The Committee in its report underlined that HLIs, like other institutional investors, can provide benefits to global financial markets. It also highlighted the combination of characteristics typically associated with HLIs such as significant leverage, and the legal and other uncertainties arising out of the extensive operations in offshore centers posing particular challenges which need to be managed carefully in order to avoid risks to the financial system. The committee, as a defense against systemic risk in the market , recommended strong and prudent risk management processes at the regulated firms with which the HLIs trade.
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T.Y.B.F.M. The Committee also highlighted the importance of transparent disclosure by the regulated entities dealing with HLIs and HLIs themselves on a voluntary basis, as a means to maintain market integrity. In spite of occasional negative perception about the role of hedge funds, such perceived misdemeanors by certain hedge funds have been considered more as occasional aberrations than general industry wide behaviour. This is also corroborated by the fact that many jurisdictions are gradually opening up their markets for hedge funds to establish and market their products. Further, for the purpose of this paper it must be emphasized here that allowing access to offshore hedge funds to invest in India through FII route will not provide any opportunity to them to build up leveraged position onshore as borrowing by FIIs are not allowed under the terms of RBIs general permission.
List of Hedge Funds in India 1st Hedge Fund - HFG India Continuum Fund:
Hudson Fairfax Group (HFG) is an investment partnership focused on Indias aerospace, defense, homeland security and other strategic sectors. It is based in New York with an advisory office in New Delhi. Its team has five decades of focused experience in the sector combining investment and industry expertise. Hudson Fairfax Group, through its predecessor company, started as an investment advisory firm in 2005. It ran an investment fund, the HFG India Continuum Fund, which invested in publicly traded Indian securities. During the operation of its fund, HFG was a Registered Investment Advisor (RIA) with the U.S. Securities & Exchange Commission and a Foreign Institutional Investor (FII) with the Securities & Exchange Board of India.
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T.Y.B.F.M. Avatar Investment Management is the investment advisor to three funds. Headquartered in Mauritius, the funds are focused on the Indian public and private equity markets. In order to meet the approval of various regulatory bodies around the world, only accredited investors may apply to invest.
T.Y.B.F.M. India Capital Fund SM is an open-ended Investment Company incorporated in Mauritius which has invested in India since 1994.
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T.Y.B.F.M. Atyant, Rahul spent four years leading Meridian Investments, generating a 430% absolute return for the firms high net worth clients.
REGULATORY
ISSUE
FOR
ALLOWING
FOREIGN
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T.Y.B.F.M. Some hedge funds have invested in offshore derivative instruments (PNs) issued by FIIs against underlying Indian securities. Through this route hedge funs can derive economic benefit of investing in Indian securities without directly entering the Indian market as FIIs or their sub-accounts. Through recent amendments to the FII Regulations (Regulation 15A and 20 A), the regulatory regime has been further strengthened and periodic disclosures regime has been introduced. As at the end of March, 2004, total investment by hedge funds. In the offshore derivative instruments (PNs) against Indian equity, are Rs. 8050 crores which represents about 8% total net equity investments of all FIIs. On the basis of market value, the hedge funds account for about 5% of the market value of the total assets held by the FIIs in India. The current fiscal year (2003-2004) has seen a spectacular increase in FII activities in Indian market. Till this report is filed FIIs have already invested US $ 10 bn. during this year alone which is a record. Robust economic fundamentals, strong corporate earnings and improvement in market micro structure are driving the FII interest in India. Investors all over the world are keen to come to Indian market. From informal discussions with institutional investors including some reputed and well established hedge funds, one could gauge the extent of interest they have about Indian markets. During the discussions they have requested whether India, like other Asian emerging markets, can provide a regulatory framework that will allow them to directly invest in Indian market in a transparent manner. In this context, the following approach may be considered for allowing the well-established hedge funds to invest in Indian markets as a registered entity under the SEBI (Foreign Institutional Investors) Regulations, 1995.
T.Y.B.F.M. Though hedge funds are not an excluded category of foreign institutional investors under the SEBI (FII) Regulations, 1995 they are , however, by virtue of not being regulated by securities regulators in their place of incorporation or operations , cannot come as FII under the present provisions of SEBI (FII) Regulations. Regulation 6 (i) (b) of the FII Regulations require an FII applicant to be a regulated entity in its place of incorporation or operations. The FII Regulations allow sub-accounts sponsored by registered FIIs to invest in India. Regulation 2 (k) defines sub-account which includes foreign corporate or foreign individuals and those institutions, established or incorporated outside India and those funds, or portfolios, established outside India, whether incorporated or not, on whose behalf investments are proposed to be made in India by a foreign institutional investor. Further, provisions of the regulation 13 lay down the conditions and procedure for granting registration to a sub-account of an FII. Hedge Funds of almost all variations can meet the requirements of sub-accounts if they are fit and proper persons. However, based on (an internal administrative decision) if an applicant indicates in the application that it is a hedge fund, the consideration of the application is withheld. Since granting of registration to FII/sub-accounts is based on the disclosure of details and on the undertaking given by the applicant in the application form, it could be possible that a few entities who described their activities in the application form in terms other than hedge funds could have already got registration as sub- accounts. However, it must be remembered that all sub-accounts have to be sponsored by registered FIIs who are required to be regulated entities by the relevant regulators in their home countries.
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T.Y.B.F.M. As mentioned in earlier paragraphs, hedge funds do not have any universally accepted definition. Therefore, identifying a hedge fund is the first challenge that a regulator faces. An approach for identifying hedge funds, as suggested by IOSCO is to look at the kinds of characteristics of fund management strategies employed by institutions. Hedge funds would at least exhibit some of the following characteristics: i) Borrowing and leverage restrictions, which are typically included in Mutual Fund Regulation are not applied, and many (but not all) hedge funds use high levels of leverage. ii) Significant performance fees (often in the form or percentage of profits) are paid to the manager in addition to an annual management fees. iii) Investors are typically permitted to redeem their interests periodically, e.g. quarterly, semi-annually or annually; iv) Often significant own funds are invested by manager; v) Derivatives are used, often for speculative purposes, and there is ability to short sell securities; vi) More diverse risks or complex underlying products are involved. The distinguishing characteristics of hedge funds are not limited to this and the list may need to adapt depending on the changing market dynamics. Further, it might be appropriate to also consider the investment strategy followed by particular funds, such as long/short exposures, leverage and / or hedging and arbitrage techniques. On the basis of these characteristics, it will be possible to identify an applicant as a hedge fund.
T.Y.B.F.M. investment in commodity related financial products will not be an option for any hedge funds under the present FII Regulations. The SEBI (Foreign Institutional Investors) Regulations, 1995 also lays down scrip-wise and fund wise maximum limits a fund can invest. Further, through circular no. SMD/DC/CIR-11/02 dated February 12, 2002 and SEBI/DNAD/CIR-21/2004/03/09 dated March 9, 2004 issued by Secondary Market Department, position limits for investment by FIIs in derivatives has been advised. These limits will help diversify the foreign hedge fund investments and will help in jettisoning concentration in any specific scrip. The provisions of Chapter III (Regulation 15 (3) (a)) disallows short selling by FIIs and stipulates that all trades by FIIs are delivery based. The provision will clearly keep the hedge funds if allowed to invest as FIIs out of short selling at least in the cash segment. It is therefore, clear that existing provisions in the FII Regulations include several checks and balances which can keep our market safe from potential market abuse and manipulation.
T.Y.B.F.M. concentration in the cash market and excessive positions in the derivative segment of our market. As mentioned earlier, these types of funds raise special regulatory concerns which are necessary to be addressed with special regulatory provisions. In this context, following additional provisions have been suggested with respect to hedge funds seeking registration as FII: 1. The investment adviser to the hedge funds should be a regulated investment advisor under the relevant Investor Advisor Act or the fund is registered under Collective Investment Fund Regulations or Investment Companies Act. 2. At least 20% of the corpus of the fund should be contributed by the investors such as pension funds, university funds, charitable trusts or societies, endowments, banks and insurance companies. The presence of institutional investors in the fund is expected to ensure better governance on the part of the fund manager and fund administrators. Further, institutional investors may help fund managers to take a long term perspective of the market. 3. The fund should be a broad based fund in terms of the SEBI (Foreign Institutional Investors) Regulations, particularly in terms of the explanation to Regulation 6 (1) (d). 4. The fund manager or investment adviser must have experience of at least 3 years of managing funds with similar investment strategy that the applicant fund has adopted. This provision is expected to allow well managed funds to access our market and at the same time, keep our markets insulated from the possible adverse effects of trial and errors by uninitiated rookies. Hedge funds as a whole are becoming an important segment of the asset management industry and gaining popularity from investors particularly
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T.Y.B.F.M. from the high net worth investors, universities, charitable funds, endowments, pension funds, insurance and other institutional investors. The asset under management of the hedge funds are growing on a double digit rate. All hedge funds are not necessarily speculative funds though most of them provide an alternative investment options for the investors through innovative investment strategy. The issues discussed and suggestions placed above are intended to widen the FII window to allow these alternatives invest pools to our securities markets in a transparent and orderly manner. In addition, the suggestions also provide for adequate safety measures to address legitimate concerns associated with these funds. The alternative investment pools if allowed to investment in Indian markets will be a source of additional liquidity and will also diversify the pool of foreign investments in Indian market. Two fast growing emerging markets, India and China are keenly observed for new investment propositions, particularly investment in hedge funds. Presence of systematic institutional framework for hedging, regulatory factors, a well-developed capital economy, liberalized stable economy, rapid reforms, democratic set-up, good information disclosure standards, better return on capital have rather favored India score over China as a superior place for investment in hedge funds. Investment in hedge funds is a cynosure of interest for sophisticated investors, wealthy individuals or families and big institutions. They are class of investors who believe in the finance mantra - higher risk, higher opportunity investments and higher rewards. Yes, investment in India focused hedge funds - for those with an appetite for risks, most willing to take risks in anticipation of explosive reward. Investment in hedge funds in India has been gaining momentum post 2001-2002. To invest in hedge
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T.Y.B.F.M. funds in India, you need to first understand what they are and how it works.
India Capital Pvt. Ltd. India Capital Fund. India Deep Value Fund Absolute India Fund (AIF) Fair Value Naissance Jaipur (India) Fund Avatar Investment Management Passport India Fund HFG India Continuum Fund Monsoon Capital Equity Value Fund Karma Capital Management, LLC Vasishta South Asia Fund Limited Atyant Capital Atlantis India Opportunities Fund
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Subscription amount is paid to the custodian. Custodian confirms receipt of payment to fund administrator. Fund administrator instructs issue of share to investor. Fund administrator issues reports on hedge fund performance. Investment manager instructs custodian to move funds to prime broker for investment in market.
During the process the prime broker and custodian are in direct contact with fund administrator.
Prior to finalizing investment, take couple of months to know about the hedge fund industry in India. The age of hedge fund industry, the key players, their worth, the operational risks, the pros and cons of investing in hedge funds etc
Identify potential hedge funds, refer commercial directories or databases. Account for your investment goals, risk tolerance level, amount allocated for investment.
Get to understand the ground realities of regulatory factors, its implications; how business is run in India all helps.
Read blogs, financial magazines, websites, news articles, white papers on hedge funds in India. Talk to personnel; preferably interact
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T.Y.B.F.M. with hedge fund managers involved with hedge fund investments and those who have already invested in hedge funds.
Notice annual events like Hedge funds world India to gain an assessment of the burgeoning Indian hedge fund industry.
Approach wealth manager in wealth management companies, securities broker or licensed investment consultant for advice on hedge fund investments in India.
Understand terms related to hedge funds, remittance, management fee and performance fee, withdrawal and redemption fees.
Check the pros and cons of long-term hedge funds vs. short-term hedge funds.
Ensure your activities are that of an accredited investor (with a net worth of more than $1 million).
Maintain direct communication with hedge fund manager. Check if diverse hedge fund strategies and techniques are put to use. Receive and file monthly or quarterly updates. Engage in data mining, keep track of trends. Check with accountant with regard to tax reporting and implications. Know your rights, where to seek help in terms of a dissatisfied hedge fund investment operation, or any other complaint in general that doesn't confirm with regulations.
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T.Y.B.F.M. a hedge fund might get in trouble if its assets experience a sharp drop and the market for these assets lacks liquidity so that the fund cannot exit its positions. The collapse of a hedge fund could have far-reaching implications if the fund is large enough. When the Long Term Capital Fund lost more than $4 billion in August and September 1998, the Federal Reserve Bank of New York organized a rescue by private banks to avoid possible widespread damage from a possible disorderly liquidation or bankruptcy of the fund. However, the debacle at the hedge fund Amaranth in late 2006 had only a trivial impact on the markets. Nonetheless, the Amaranth losses led to calls for regulation of hedge funds. For instance, the New York Times (2006) published an editorial stating that regulators need to act now to translate their various calls for hedge-fund oversight into enforceable rules and, in some instances, into concrete proposals for Congress to enact.Hedge funds rely on their ability to move out of trades quickly when prices turn against them, which raises an issue of liquidity risk. If too many funds have set up the same trades, they may not all be able to exit their positions at the same time. In that case, two adverse developments can ensue: prices may have to overreact and liquidity may fall sharply. With low liquidity, hedge funds that rely on trading quickly to control their risks cannot do so. Hence, such hedge funds become more risky, which increases threats to financial institutions and can lead to further overreaction in prices as financial institutions have to reduce their positions as well. Further, when hedge funds use leverage, they cannot just ride out a serious adverse shock; instead, they must reduce their exposures to satisfy the banks from which they borrowed. As a result, adverse shocks could lead hedge funds to dump securities and cash out precisely when things are going poorly, which could make matters worse.
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T.Y.B.F.M. Finally, hedge funds could lead prices to overreact by making trades that push prices away from fundamental values and lead to excess volatility risks. Though hedge funds have certainly been accused of creating volatility, the case that they have done so is far from ironclad. For example, hedge funds were net buyers during the stock market crash of 1987, so that they helped stabilize markets at that time (Presidential Task Force on Market Mechanisms, 1998). During the Asian currency crisis of 1997, the prime minister of Malaysia attacked George Soros for causing the crisis. However, an IMF study concluded that hedge fund positions were too small to have much of an impact on emerging markets (Eichengreen et al., 1998). Earlier, the same George Soros had apparently taken a $10 billion bet against the British pound, which effectively forced the British pound out of the European exchange rate mechanism, and won $1 billion in the process. There is some evidence that hedge funds did not sell Internet stocks when their valuations were high (Brunnermeier and Nagel, 2004), but the evidence is not completely clear because the data available does not include various hedges that hedge funds might have used. How concerned should one be about these four types of risks that hedge funds supposedly create? Investor protection should not motivate the SEC to regulate the hedge fund industry, because the small investors who are supposedly the focus of the SEC are already blocked from investing in hedge funds. There is no reason to believe that the occasional hedge fund losses of savvy and well-to-do investors, however painful they may be to these investors, have a social cost. These investors can choose not to invest in a fund, and they also have legal recourse against acts of fraud. The risks posed to financial institutions are real, though often overstated. Brokers and banks have greatly improved their systems to evaluate their exposures to hedge funds in recent years. Derivatives contracts are much
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T.Y.B.F.M. better designed for defaults than they were in the past. Financial institutions are already regulated. Moreover, a bank that takes on too much risk through a hedge fund could also take on too much risk with an individual or a proprietary trading desk that employs hedge fund strategies; in either case, the problem is not specifically a hedge fund issue, but rather involves the regulation of financial institutions. Liquidity risk is a serious issue. Though adverse shocks may force hedge funds to contract, hedge funds have strong incentives not to be caught in a situation in which they would have to make distress sales of securities. Empirically, hedge funds do not have their worst performance when large shocks affect capital markets (Boyson, Stahel, and Stulz, 2006). It is not clear how well banks monitor concentration risks in the positions of investment managers they deal withbe they hedge funds or other investors. Regulators could encourage them to monitor more actively. There is no reason to believe that regulation of hedge funds would be a more efficient approach. The fact that hedge funds can cause volatility in prices is a potentially valid concern, but needs to be based on facts and experience. Hedge funds often profit by providing liquidity to the marketsby buying securities that are temporarily depressed because of market disruptions. The role of hedge funds in making markets more liquid and in reducing market inefficiencies makes it necessary for those who want to restrict their activities to have a compelling case that their possible adverse impact on market volatility outweighs their positive effects. So far, this case has not been made. At the same time, one should not overstate the extent to which hedge funds make markets efficient. Though hedge funds do well at eliminating small discrepancies in prices that can be arbitraged, the liquidity they provide may disappear quickly in the presence of a systemic shockand this
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T.Y.B.F.M. liquidity withdrawal may worsen the shock. Further, if asset prices depart systemically from fundamentals, one cannot count on hedge funds to bring them back to fundamentals.
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T.Y.B.F.M. For example, over the last few years, more hedge funds have become activist investors. In some countries, such activism has led to demands for regulation. Some hedge funds have also specialized in lending. Again, regulatory authorities are unlikely to allow unregulated hedge funds to compete with regulated banks. Recently, much concern has arisen from the fact that hedge funds borrow shares to vote in corporate control contests without bearing the risks of stock ownership (Hu and Black, 2006)when a fund borrows shares and holds them to vote, it pays a fee to the lender, but the lender keeps the price risk of the shares. Regulations may be enacted to prevent such actions. Finally, we saw that as hedge funds succeed, strong forces will push them to become more like financial institutions. However, as hedge fund management companies compete with regulated financial institutions, regulated financial institutions seem certain to express concerns about the lack of a level playing field.
How Will the Hedge Fund Industry Perform Over the Next Ten Years?
As discussed earlier, Ibbotson and Chen (2005) estimate the average alpha of the hedge fund industry to be above 3 percent per year. Large funds seem to have performed somewhat better. As a rough estimate, suppose that the value-weighted alpha for hedge funds is 4 percent, net of fees. During their sample period, the yearly average size of the hedge fund industry is $262 billion according to one consulting firm. Thus, the skills of hedge fund managers were contributing on average $10 billion a year to investors. The industry is now at least three times as large. For the performance of hedge funds to generate 4 percent net of fees for investors, the skills of hedge fund managers have to produce an additional $20 billion of alpha.
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T.Y.B.F.M. However, as more money enters the hedge fund industry, it either funds existing strategies, new strategies that typically cannot be as good as the ones already implemented, or new managers. More hedge funds chasing the same price discrepancies means that these discrepancies get eliminated faster, leading to smaller profits for the funds. Hence, additional money entering hedge funds in the future will typically not find average returns as high as in the past. A clear example of this problem is the recent performance of convertible arbitrage funds. The typical trade for a convertible arbitrage fund is to buy convertible bonds issued by a firm and to hedge the purchase with short sales of the stock of the firm. As more funds buy convertible bonds, the strategy becomes less profitable because the funds push the price up, so that the performance of this strategy falls. Not surprisingly, the increase in convertible arbitrage funds, from 26 in 1994 to 145 in 2003 according to one database, eventually led to poor performance and a drop in the number of such funds.
Bibliography Websites:http://en.wikipedia.org/wiki/Hedge_fund http://www.investopedia.com/terms/h/hedgefund.asp http://www.hedgefund.net/hfn_public/default.aspx http://www.magnum.com/hedgefunds/abouthedgefunds.asp http://www.investorwords.com/2296/hedge_fund.html http://www.hedgefundintelligence.com/ http://www.hedgeco.net/hedgeducation/hedge-fund-articles/ http://www.hedgefundtools.com/ http://hedgefundproductions.com/ http://www.thehedgefundjournal.com/ http://www.thehfa.org/ http://www.thehedgefundjournal.com/ http://www.hedgefund-index.com/
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Books:1) All About Hedge Funds: The Easy Way To Get Started by Robert Jaeger 2) Hedge Funds For Dummies by Ann C. Logue 3) Investment Strategies of Hedge Funds by Filippo Stefanini
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