Basic Information Handout T a r i q M u m t a z

What is Hedge Fund?
A hedge fund is a private investment fund open to a limited range of investors, which is permitted by regulators to undertake a wider range of activities than other investment funds and which pays a performance fee to its investment manager. In other words 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. 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, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

It was while writing an article about current investment trends for Fortune in 1948 that Jones was inspired to try his hand at managing money. He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage in an effort to enhance returns. In 1952, Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner. As the first money manager to combine short selling, the use of leverage, shared risk through a partnership with other investors and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.

The Rise of the Industry
When a 1966 article in Fortune magazine highlighted an obscure investment that outperformed every mutual fund on the market by double-digit figures over the past year and by high double-digits over the last five years, the hedge fund industry was born. By 1968, there were some 140 hedge funds in operation. In an effort to maximize returns, many funds turned away from Jones' strategy, which focused on stock picking coupled with hedging, and chose instead to engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the bear market of 1973-74.

The Hedge Fund Today
Hedge funds have evolved significantly since 1949. Modern hedge funds offer a variety of strategies, including many that do not involve traditional hedging techniques. The industry has also rapidly grown, with recent estimations pegging its size at $1 trillion - quite the leap from the $100,000 used to start the first fund half a century ago. There has also been an increasing move towards their regulation. In 2004, the Securities and Exchange Commission adopted changes that require hedge fund managers and sponsors to register as investment advisors under the Investment Advisor's Act of 1940. This greatly increases the number of requirements placed on hedge funds, including keeping up-to-date performance records, hiring a compliance officer and creating a code of ethics. All hedge funds that fall under the new SEC rules must be registered by Feb 1, 2006. This is seen as an important move in protecting investors.

A Brief History Of The Hedge Fund
Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949.

Comparison to Private Equity Funds
Hedge funds are similar to private equity funds in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in relatively liquid assets, and permit investors to enter or leave the fund, perhaps requiring some months notice. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition funds.

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 US 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.

For Example
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.

Comparison to U.S. Mutual Funds
Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to invest). However, there are many differences between the two, including: 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. Mutual funds must have a prospectus available to anyone that requests one (either electronically or via US postal mail), and must disclose their asset allocation quarterly, while hedge funds do not have to abide by these terms. Comparison Of Growth Patterns: Hedge Funds Vs Mutual Funds

Legal Structure
A hedge fund is a vehicle for holding and investing the funds of its investors. The fund itself is not a genuine business, having no employees and no assets other than its investment portfolio and a small amount of cash, while its investors are its clients. The investment manager, which has employees and property and which is the actual business, manages the portfolio. An investment manager is commonly termed a “hedge fund”, but this is not technically correct. An investment manager may have a large number of hedge funds under its management.

The Legal Entity
Limited partnerships are principally used for hedge funds aimed at US-based investors who pay tax, as the investors will receive relatively favorable tax treatment in the US. The specific legal structure of a hedge fund – in particular the tax environment of the fund’s expected investors usually determines its domicile and the type of legal entity used –. Regulatory considerations will also play a role. Many hedge funds are established in offshore tax havens 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. The general partner of the limited partnership is typically the investment manager (though is sometimes an offshore corporation) and the investors are the limited partners. Offshore corporate funds are used for non-US investors and

US entities that do not pay tax (such as pension funds), as such investors do not receive the same 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 investment manager will then manage the assets of the master fund in the usual way. This allows several feeder funds (e.g. an offshore corporate fund, a US 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 – most of the fund’s decisions are taken by the board of directors of the fund, which is self-appointing and independent but invariably loyal to the investment manager.

regulators, the Securities and Exchange Commission [SEC], and Financial Services Authority [FSA] seem to be slowly but steadily moving in that direction. Another financial services regulator, the Securities and Exchange Board of India [SEBI] recently made a decision to ban investments through participatory notes by unregulated entities. 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 fall within the statutory definition of an investment company, the limitedaccess, private nature of hedge funds permits them to operate pursuant to exemptions from the registration requirements. Those exemptions are for funds with 100 or fewer investors. 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.)[22] A 3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited number of investors. However, a 3(c)7 fund with more than 499 investors must register its securities with the SEC.[23] Both types of funds can charge performance or incentive fees.

Hedge Fund Regulation1
Hedge funds are simply pools of money from individuals and or groups of qualified investors who met the requirements of the SEC. Unlike mutual funds, they do not trade on exchanges, and are not registered with the Securities and Exchange Commission; their investors are not granted the same consumer-protection benefits extended to mutual funds through the 1940 Investment Company Act. There is also the issue of hedge fund fraud; some cite a small example of fraudulent hedge fund managers who have used false reports to deceive investors while they use their assets to pursue other interests. In a recent conference of the Investment Company Institute {ICI} in Washington DC, Paul Roye, the Director of investment at the Securities and Exchange Commission {SEC} told the conference attendees about the increases in hedge fund fraud cases. Today there is so much talk about hedge fund regulations, not only here in the United States, but also in England. The two leading financial market

H edg e Fund Indices
There are a number of indices that track the hedge fund industry. These indices come in two types, Investable and Non-investable, both with substantial problems. There are also new types of tracking product launched by Goldman Sachs and Merrill Lynch, "clone indices" that aim to replicate the returns of hedge fund indices without actually holding hedge funds at all. Investable indices are created from funds that can be bought and sold, and only Hedge Funds that agree to accept investments on terms acceptable to the constructor of the index are included. Investability is an attractive property for an index because it makes the index more relevant to the choices available to investors in practice, and is taken for granted in traditional equity indices such as the S&P500 or FTSE100. However, such indices do not


represent the total universe of hedge funds and may under-represent the more successful managers, who may not find the index terms attractive. Fund indexes include 2

Eurekahedge Indices BarclayHedg Hedge Fund Research Credit Suisse Tremont FTSE Hedge
The index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index, making investable indices similar in some ways to fund of hedge funds portfolios.

on price differences, but they are not risk free. For example, convertible arbitrage entails buying a corporate convertible bond, which can be converted into common shares, while simultaneously selling short the common stock of the same company that issued the bond. This strategy tries to exploit the relative prices of the convertible bond and the stock: the arbitrageur of this strategy would think the bond is a little cheap and the stock is a little expensive. The idea is to make money from the bond's yield if the stock goes up but also make money from the short sale if the stock goes down. However, as the convertible bond and the stock can move independently, the arbitrageur can lose on both the bond and the stock, which means the position carries risk.

Arbitrage Using Short Sales

Three Broad Class Strategies
Most hedge funds are entrepreneurial organizations that employ proprietary or well-guarded strategies. The three broad hedge fund categories are based on the types of strategies they use:

1. Arbitrage Strategies
Arbitrage is the exploitation of an observable price inefficiency and, as such, pure arbitrage is considered riskless. Consider a very simple example. Say Acme stock currently trades at $10 and a single stock futures contract due in six months is priced at $14. The futures contract is a promise to buy or sell the stock at a predetermined price. So by purchasing the stock and simultaneously selling the futures contract, you can, without taking on any risk, lock in a $4 gain before transaction and borrowing costs. Only a few hedge funds are pure arbitrageurs, but when they are, historical studies often prove they are a good source of low-risk reliably-moderate returns. But, because observable price inefficiencies tend to be quite small, pure arbitrage requires large, usually leveraged investments and high turnover. Further, arbitrage is perishable and self-defeating: if a strategy is too successful, it gets duplicated and gradually disappears. Most so-called arbitrage strategies are better labeled "relative value". These strategies do try to capitalize

2. Event-Driven Strategies
Event-driven strategies take advantage of transaction announcements and other one-time events. One example is merger arbitrage, which is used in the event of an acquisition announcement and involves buying the stock of the target company and hedging the purchase by selling short the stock of the acquiring company. Usually at announcement, the purchase price that the acquiring company will pay to buy its target exceeds the current trading price of t he target company. The merger arbitrageur bets the acquisition will happen and cause the target company's price to converge (rise) to the purchase price that the acquiring company pays. This also is not pure arbitrage. If the market happens to frown on the deal, the acquisition may unravel and send the stock of the acquirer up (in relief) and the target company's stock down (wiping out the temporary bump) which w ould cause a loss for the position.

http://www.eurekahedge.com/indices/default.asp http://barclayhedge.com/ http://www.hedgefundresearch.com/ http://www.hedgeindex.com/hedgeindex/en/default.aspx?c y=USD http://www.ftse.com/Indices/index.jsp

There are various types of event-driven strategies. One other example is "distressed securities", which involves investing in companies that are reorganizing or have been unfairly beaten down. Another interesting type of event-driven fund is the activist fund, which is predatory in nature. This type takes sizeable positions in small, flawed companies and then uses its ownership to force management changes or a restructuring of the balance sheet.

Short selling managers typically target overvalued stocks, characterized by prices they believe are too high given the fundamentals of the underlying companies. It is often used as a hedge to offset longonly portfolios and by those who feel the market is approaching a bearish cycle.

1.3 Macro
Aims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, in turn affecting currency, stock, and bond markets. Rather than considering how individual corporate securities may fare, the manager constructs his portfolio based on a top-down view of global economic trends, considering factors such as interest rates, economic policies, inflation, etc and seeks to profit from changes in the value of entire asset classes.

3. Directional or Tactical Strategies
The largest group of hedge funds uses directional or tactical strategies. One example is the macro fund, made famous by George Soros and his Quantum Fund, which dominated the hedge fund universe and newspaper headlines in the 1990s. Macro funds are global, making "top-down" bets on currencies, interest rates, commodities or foreign economies. Because they are for "big picture" investors, macro funds often do not analyze individual companies.

For Example
The manager may hold long positions in the U.S. dollar and Japanese equity indices while shorting the euro and U.S. treasury bills. Uses leverage and derivatives to accentuate the impact of market moves. The leveraged directional investments tend to make the largest impact on performance.

Risk based Inve stment Strate gie s
The five risk based strategies, have their own risk, and return characteristics.

[2] High Risk Strategies 2.1 Aggressive Growth
A primarily equity-based strategy whereby the manager invests in companies, with smaller or micro capitalization stocks, characterized by low or no dividends, but experiencing or expected to experience strong growth in earnings per share. The manager may consider a company's business fundamentals when investing and/or may invest in stocks on the basis of technical factors, such as stock price momentum. Managers employing this strategy generally utilize short selling to some degree, although a substantial long bias is common. This includes sector specialist funds such as technology, banking, or biotechnology.

[1] Very High Risk Strategies 1.1 Emerging Markets
Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation, volatile growth and the potential for significant future growth. Examples include Brazil, China, India, and Russia. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available. This strategy is defined purely by geography; the manager may invest in any asset class (e.g., equities, bonds, currencies) and may construct his portfolio on any basis (e.g. value, growth, arbitrage)

1.2 Short Selling 3
In order to short sell, the manager borrows securities from a prime broker and immediately sells them on the market. The manager later repurchases these securities, ideally at a lower price than he sold them for, and returns them to the broker. In this way, the manager is able to profit from a fall in a security's value.
In finance, short selling or "shorting" is the practice of selling a financial instrument that the seller does not own at the time of the sale. Short selling is done with intent of later purchasing the financial instrument at a lower price. Short-sellers attempt to profit from an expected decline in the price of a financial instrument. For Details : http://www.investopedia.com/university/shortselling/

2.2 Market Timing
The manager attempts to predict the short-term movements of various markets (or market segments) and based on those predictions, moves capital from one asset class to another in order to capture market gains and avoid market losses. While a variety of asset classes may be used, the most typical ones are mutual funds and money market funds. Market timing managers focusing on these asset classes are sometimes referred to as mutual fund switchers. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy.

[3] Moderate Risk Strategies 3.1 Special Situations
The manager invests, both long and short, in stocks and/or bonds which are expected to change in price over a short period due to an unusual event. Examples of event-driven situations are mergers, hostile takeovers, reorganizations, or leveraged buyouts. It may involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company.

IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. Characteristics of the portfolio, such as asset classes, market capitalization, etc., are likely to vary significantly from time to time. The manager may also employ a combination of different approaches at a given time

4.2 Multi Strategy
The manager typically utilizes many specific, predetermined investment strategies, e.g., Value, Aggressive Growth, and Special Situations in order to better diversify their portfolio and/or to more fully use their range of portfolio management skills and philosophies and also in order to realize short or long-term gains. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Although the relative weighting of the chosen strategies may vary over time, each strategy plays a significant role in portfolio construction.

3.2 Value
A primarily equity-based strategy whereby the manager invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. The manager takes long positions in stocks that he believes are undervalued, i.e. the stock price is low given company fundamentals such as high earnings per share, good cash flow, strong management, etc. Possible reasons that a stock may sell at a perceived discount could be that the company is out of favor with investors or that its future prospects are not correctly judged by Wall Street analysts. Securities may be out of favor or under-followed by analysts. Long-term holding, patience, and strong discipline are often required, until the ultimate value is recognized by the market. The manager can take short positions in stocks he believes are overvalued.

[5] Low risk strategies 5.1 Distressed Securities
The manager invests in the debt and/or equity of companies having financial difficulty. Such companies are generally in bankruptcy reorganization or are emerging from bankruptcy or appear likely to declare bankruptcy in the near future. Because of their distressed situations, the manager can buy such companies' securities at deeply discounted prices. The manager stands to make money on such a position should the company successfully reorganize and return to profitability. Also, the manager could realize a profit if the company is liquidated, provided that the manager had bought senior debt in the company for less than its liquidation value. "Orphan equity" issued by newly reorganized companies emerging from bankruptcy may be included in the manager's portfolio. The manager may take short positions in companies whose situations he deems will worsen, rather than improve, in the short term.

3.3 Funds of Hedge Funds
The manager invests in other hedge funds (or managed accounts programs) rather than directly investing in securities such as stocks, bonds, etc. These underlying hedge funds may follow a variety of investment strategies or may all employ similar approaches. Because investor capital is diversified among a number of different hedge fund managers, funds of funds generally exhibit lower risk than do single-manager hedge funds. Funds of funds are also referred to as multi-manager funds. It’s a diversified portfolio of generally uncorrelated hedge funds and it’s a preferred investment of choice for many pension funds, endowments, insurance companies, private banks and high-net-worth families and individuals.

[4] Variable Risk Strategies 4.1 Opportunistic
Rather than consistently selecting securities according to the same strategy, the manager's investment theme changes from strategy to strategy as opportunities arise to profit from events such as

5.2 Income
Invests with primary focus on yield or current income rather than solely on capital gains, though it may also utilize leverage to buy bonds and (sometimes) fixed income derivatives in order to profit from principal appreciation and interest income. Other strategies (e.g. distressed securities,

market neutral arbitrage, macro) may heavily involve fixed-income securities trading as well.

5.3 Market Neutral - Securities Hedging
The manager invests similar amounts of capital in securities both long and short, generally in the same sectors of the market, maintaining a portfolio with low net market exposure. Long positions are taken in securities expected to rise in value while short positions are taken in securities expected to fall in value. Due to the portfolio's low net market exposure, performance is insulated from market volatility. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns. It sometimes uses market index futures to hedge out systematic (market) risk. It uses Tbills as a relative benchmark index.

end and charges a 2% management fee, the management fee will be $20 million. Management fees are usually expressed as an annual percentage but both calculated and paid monthly (or sometimes quarterly or weekly) at annualized rates.

Performance Fees
One of the defining characteristics of hedge funds are performance fees, which give a share of positive returns to the manager. The manager's performance fee is calculated as a percentage of the fund's profits, counting both unrealized profits and actual realized trading profits. Performance fees exist because investors are usually willing to pay managers more generously when the investors have themselves made money. Thus, the performance fee is extremely lucrative for managers who perform well. Typically, hedge funds charge 20% of gross returns as a performance fee. However, the range is wide with highly regarded managers charging higher fees. In particular, Steven Cohen's SAC Capital Partners charges a 3% management fee and a 35-50% performance fee, while Jim Simons' Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its flagship Medallion Fund. Performance fees are intended to align the interests of manager and investor better than flat fees that are payable even when performance is poor. However, many people, including notable investor Warren Buffett, for giving managers an incentive to take excessive risk rather than targeting high long-term returns, have criticized performance fees. In an attempt to control this problem, fees are usually limited by a high water mark and sometimes limited by a hurdle rate. Alternatively, a "clawback" provision may be included, whereby the investment manager might be required to return performance fees when the value of the fund drops.

5.4 Market Neutral – Arbitrage
The manager seeks to exploit specific inefficiencies in the market by trading a carefully hedged portfolio of offsetting long and short positions. By pairing individual long positions with related short positions, market-level risk is greatly reduced, resulting in a portfolio that bears a low correlation to the market.

For Example
Long convertible bonds and short underlying issuer’s equity. For example, can be long convertible bonds and short the underlying issuers equity. It may also use futures to hedge out interest rate risk. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage.

Fe es S tr u cture
A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee). Fees are payable by the fund to the investment manager. They are therefore taken directly from the assets that the investor holds in the fund.

For example
Suppose at the beginning of year 1 a hedge fund has a net asset value of 100, and throughout the year the fund realizes a 25% return, raising the net asset value to 125. Then if an investor entered the fund with a $1,000,000 investment at the beginning of year 1 then his or her "shares" would be worth $1,250,000 gross of fees. If the benchmark was cash, say 5%, then the fees would be paid on the $200,000 upside in excess of cash. That is, the first 5% of the return would not have to have fees paid on it. If the fees were 2 and 20, then the investor would pay $20,000 in fixed fee (2%) and 20% of the upside above cash, that is, an additional $40,000 for a total of $60,000 in fees. This would make the investment value, gross of fees, equal to $1,190,000.

Management fees
As with other investment funds, the management fee is calculated as a percentage of the fund's net asset value (the total of the investors' capital accounts) at the time when the fee becomes payable. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. Therefore, if a fund has $1 billion of assets at year-

The performance fee is sometimes calculated net of a benchmark. That is, the returns that fees are paid on are sometimes only those returns in excess of some benchmark. Sometimes the benchmark is a risk-free interest rate such as LIBOR (often called the cash benchmark, meaning performance fees are paid on the profit that would be made in excess of an investment in cash) and other times it is a market index such as the MSCI World Index or the S&P 500 index.

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 do better than the investor would have done if he had put the money elsewhere. Because demand for hedge funds has outstripped supply, most managers do not now need hurdle rates in order to attract investors. For this reason, hurdle rates are now rare.

High Water marks
A high water mark (also known as a loss carry forward provision) is often applied to a performance fee calculation. This means that the manager only receives performance fees on the value of the fund that exceeds the highest net asset value it has previously achieved. The high water mark is an important concept: investors in hedge funds enter the fund at a certain net asset value, which we will call the entering NAV. If the fund loses money in a given year and then makes back that money in a subsequent year, the investor is usually not required to pay a management fee on any portion of the upside in the subsequent year that was below the entering NAV.

Withdrawal/Redemption Fees
Some managers charge investors a withdrawal/redemption fee (also known as a surrender charge) if they withdraw money from the fund before a certain period has elapsed since the money was invested. The purpose is to encourage long-term investment in the fund: as a fund's investments need to be liquidated to raise cash for withdrawals, the fee allows the fund manager to reduce the turnover of its own investments and invest in more complex, longer-term strategies. The fee also dissuades investors from withdrawing funds after periods of poor performance. The fee is typically known as a "withdrawal fee" where the fund is a limited partnership and a "redemption fee" where the fund is a corporate entity.

For example
Suppose an investor enters a hedge fund with a $1,000,000 at the beginning of year 1, and in that year the fund is down 20%, that is, the value of the investment drops to $800,000 gross of fees. The investor still pays the management fee (that is why it is called a fixed fee), but the investor pays no management fee. Now suppose that after year two the investment value is up to $1,200,000, representing over a 30% gain in year two for the fund. The investor, nevertheless, only pays a management fee on $200,000, that is, he or she only pays a fee on the amount in excess of the entering NAV. The entering NAV in this case is called the high water mark. In subsequent years if there is a drop in NAV, the new high water mark will be the entering NAV of the previous year, or the previous high water mark, whichever is greater.

Hedge Fund Returns
As hedge funds are often viewed as providing returns that are "cheap" relative to risk, their performance is usually evaluated on a risk-adjusted return basis. The common number that is quoted is the Sharpe Ratio, which is the ratio of annualized excess returns to the annualized standard deviation of returns.

The data in Table 7 of "Hedge Funds Demystified" gives an idea of the relative performance of hedge funds compared with some standard indexes over the period January 1993 December 1997. The table represents returns on each Hedge Fund Sector, that is, the returns and standard deviations in each column represent the returns that were realized on an equal weighted investment portfolio of all the hedge funds in a given sector.

Hedge Funds Returns




Hedge funds lie at the active end of the investing spectrum as they seek positive absolute returns, regardless of the performance of an index or sector benchmark. Unlike mutual funds, which are "long-only" (make only buy-sell decisions), a hedge fund engages in more aggressive strategies and positions, such as short selling, trading in derivative instruments like options and using leverage (borrowing) to enhance the risk/reward profile of their bets. This activeness of hedge funds explains their popularity in bear markets. In a bull market, hedge funds may not perform as well as mutual funds, but in a bear market taken as a group or asset class - they should do better than mutual funds because they hold short positions and hedges. The absolute return goals of hedge funds vary, but a goal might be stated as something like "6 to 9% annualized return regardless of the market conditions". The hedge-fund promise of pursuing absolute returns means hedge funds are "liberated" with respect to registration, investment positions, liquidity and fee structure. First, hedge funds in general are not registered with the SEC. They have been able to avoid registration by limiting the number of investors and requiring that their investors be accredited, which means they meet an income or net worth standard. Furthermore, hedge funds are prohibited from soliciting or advertising to a general audience, a prohibition that lends to their mystique. In hedge funds, liquidity is a key concern for investors. Liquidity provisions vary, but invested funds may be difficult to withdraw "at will". For example, many funds have a lock-out period, which is an initial period of time during which investors cannot remove their money. Lastly, hedge funds are more expensive even though a portion of the fees is performance-based. Typically, they charge an annual fee equal to 1% of assets managed (sometimes up to 2%), plus they receive a share - usually 20% - of the investment gains. The managers of many funds, however, invest their own money along with the other investors of the fund and, as such, may be said to "eat their own cooking".

Leverage - In addition to money invested into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing sums many times greater than the initial investment. If a hedge fund has borrowed $9 for every $1 received from investors, a loss of only 10% of the value of the investments of the hedge fund will wipe out 100% of the value of the investor's stake in the fund, once the creditors have called in their loans.
In September 1998, shortly before its collapse, Long Term Capital Management had $125 billion of assets on a base of $4 billion of investors' money, an advantage of over 30 times. It also had off-balance sheet positions with a notional value of approximately $1 trillion.

Short Selling - Due to the nature of short selling, the losses that can be incurred on a losing bet are theoretically limitless, unless the short position directly hedges a corresponding long position. Therefore, where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy, it can suffer very high losses if the market turns against it. Ordinary funds very rarely use short selling in this way. Lack of Transparency - Hedge funds are secretive
entities with few public disclosure requirements. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision.

Lack of Regulation - Hedge funds are not subject to as
much oversight from financial regulators as regulated funds, and therefore some may carry undisclosed structural risks.

Hedge Largest Hedge Funds by Assets under Management
Name JP Morgan Farallon Capital Bridgewater Associates Renaissance Technologies Och-Ziff Capital Management Goldman Sachs Asset Management DE Shaw Paulson and Company Barclays Global Investors Man Investments ESL Investments

Hedge R i sks
Investing in certain types of hedge fund can be (but is not necessarily) a riskier proposition than investing in a regulated fund, despite a "hedge" being a means of reducing the risk of a bet or investment. The following are some of the primary reasons for the increased risk in hedge funds as an industry:

AUM 4 $44.7bn $36bn $36bn $34bn $33.2bn $32.5bn $32.2bn $29bn $18.9bn $18.8bn $17.5bn

Assets Under Management (AUM) is a term used by financial services companies in the mutual fund and money management, investment management, wealth management, and private banking businesses to gauge how much money they are managing.

1. http://www.hedgefundworld.com/forming_a_hedge_fund.htm 2. Hedge Funds Do About 60% Of Bond Trading, Study Says", The Wall Street Journal 3. America's biggest hedge funds control $743 billion - September 8, 2005 4. Hedge Fund Asset Flows & Trends Report 2008 5. Hedge Fund Math: Why Fees Matter (Newsletter), Epoch Investment Partners Inc. 6. The Investment Company Act of 1940 7. The Investment Company Act of 1940 8. The Investment Advisers Act of 1940

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