Hedge fund

A hedge fund is a pooled investment fund

that trades in relatively liquid assets and is
able to make extensive use of more
complex trading, portfolio-construction
and risk management techniques in an
attempt to improve performance, such as
short selling, leverage, and derivatives.[1]
Financial regulators generally restrict
hedge fund marketing except to
institutional investors, high net worth
individuals and others who are considered
sufficiently sophisticated.

Hedge funds are regarded as alternative

investments. Their ability to make more
extensive use of leverage and more
complex investment techniques
distinguishes them from regulated
investment funds available to the retail
market, such as mutual funds and ETFs.
They are also considered distinct from
private-equity funds and other similar
closed-end funds, as hedge funds
generally invest in relatively liquid assets
and are generally open-ended, meaning
that they allow investors to invest and
withdraw capital periodically based on the
fund's net asset value, whereas private-
equity funds generally invest in illiquid
assets and only return capital after a
number of years.[2][3] However, other than a
fund's regulatory status there are no
formal or fixed definitions of fund types,
and so there are different views of what
can constitute a "hedge fund".

Although hedge funds are not subject to

many restrictions that apply to regulated
funds, regulations were passed in the
United States and Europe following the
financial crisis of 2007–2008 with the
intention of increasing government
oversight of hedge funds and eliminating
certain regulatory gaps.[4]

Although most modern hedge funds are

able to employ a wide variety of financial
instruments and risk management
techniques,[5] they can be very different
from each other with respect to their
strategies, risks, volatility and expected
return profile. It is common for hedge fund
investment strategies to aim to achieve a
positive return on investment regardless of
whether markets are rising or falling
("absolute return"). Although hedge funds
can be considered risky investments, the
expected returns of some hedge fund
strategies are less volatile than those of
retail funds with high exposure to stock
markets, because of the use of hedging
techniques.

A hedge fund typically pays its investment

manager a management fee (for example,
2% (annualised) of the net asset value of
the fund), and a performance fee (for
example, 20% of the increase in the fund's
net asset value during a year).[1]

Hedge funds have existed for many

decades, and have become increasingly
popular. They have now grown to be a
substantial fraction of the asset
management industry,[6] with assets
totaling around $3.2 trillion as of 2018.[7]
Some hedge fund managers had several
billion dollars of assets under
management (AUM).

Introduction
The word "hedge", meaning a line of
bushes around the perimeter of a field, has
long been used as a metaphor for placing
limits on risk.[8] Early hedge funds sought
to hedge specific investments against
general market fluctuations by shorting
the market, hence the name.[9]:4
Nowadays, however, many different
investment strategies are used, many of
which do not "hedge risk".[9]:16–34[10]

History
During the US bull market of the 1920s,
there were numerous private investment
vehicles available to wealthy investors. Of
that period the best known today is the
Graham-Newman Partnership, founded by
Benjamin Graham and his long-time
business partner Jerry Newman.[11] This
was cited by Warren Buffett in a 2006
letter to the Museum of American Finance
as an early hedge fund,[12] and based on
other comments from Buffett, Janet
Tavakoli deems Graham's investment firm
the first hedge fund.[13]

The sociologist Alfred W. Jones is credited

with coining the phrase "hedged
fund"[14][15] and is credited with creating
the first hedge fund structure in 1949.[16]
Jones referred to his fund as being
"hedged", a term then commonly used on
Wall Street to describe the management of
investment risk due to changes in the
financial markets.[17]

In the 1970s, hedge funds specialized in a

single strategy with most fund managers
following the long/short equity model.
Many hedge funds closed during the
recession of 1969–70 and the 1973–1974
stock market crash due to heavy losses.
They received renewed attention in the late
1980s.[15]

Cumulative hedge fund and other risk asset returns

(1997–2012)

During the 1990s, the number of hedge

funds increased significantly, with the
1990s stock market rise,[14] the aligned-
interest compensation structure (i.e.,
common financial interests) and the
promise of above high returns[18] as likely
causes. Over the next decade, hedge fund
strategies expanded to include: credit
arbitrage, distressed debt, fixed income,
quantitative, and multi-strategy.[15] US
institutional investors such as pension and
endowment funds began allocating
greater portions of their portfolios to
hedge funds.[19][20]

During the first decade of the 21st century

hedge funds gained popularity worldwide,
and by 2008 the worldwide hedge fund
industry held US$1.93 trillion in assets
under management (AUM).[21][22] However,
the financial crisis of 2007–2008 caused
many hedge funds to restrict investor
withdrawals and their popularity and AUM
totals declined.[23] AUM totals rebounded
and in April 2011 were estimated at
almost $2 trillion.[24][25] As of
February 2011, 61% of worldwide
investment in hedge funds came from
institutional sources.[26]

In June 2011, the hedge fund management

firms with the greatest AUM were
Bridgewater Associates (US$58.9 billion),
Man Group (US$39.2 billion), Paulson &
Co. (US$35.1 billion), Brevan Howard
(US$31 billion), and Och-Ziff
(US$29.4 billion).[27] Bridgewater
Associates had $70 billion in assets under
management as of 1 March 2012.[28][29] At
the end of that year, the 241 largest hedge
fund firms in the United States collectively
held $1.335 trillion.[30] In April 2012, the
hedge fund industry reached a record high
of US$2.13 trillion total assets under
management.[31] In the middle of the
2010s, the hedge fund industry
experienced a general decline in the "old
guard" fund managers. Dan Loeb called it
a "hedge fund killing field" due to the
classic long/short falling out of favor
because of unprecedented easing by
central banks. The US stock market
correlation became untenable to short
sellers.[32] The hedge fund industry today
has reached a state of maturity that is
consolidating around the larger, more
established firms such as Citadel, Elliot,
Millennium, Bridgewater, and others. The
rate of new fund start ups is now outpaced
by fund closings.[33]

In July 2017, hedge funds recorded their

eighth consecutive monthly gain in returns
with assets under management rising to a
record $3.1 trillion.[34]

Notable hedge fund

managers
In 2015, Forbes listed:

Tom Steyer, hedge-fund manager of NextGen America

George Soros, fund manager of Quantum Group of
Funds

Ray Dalio, fund manager of Bridgewater Associates

John Meriwether of Long-Term Capital

Management, most successful returns
from 27% to 59% through 1993 to 1998
until its collapse and liquidation.
George Soros of Quantum Group of
Funds
Ray Dalio of Bridgewater Associates, the
world's largest hedge fund firm with
US$160 billion in assets under
management as of 2017[35][36]
Steve Cohen of Point72 Asset
Management, formerly known as
founder of S.A.C. Capital
Advisors[37][38][39]
John Paulson of Paulson & Co., whose
hedge funds as of December 2015 had
$19 billion assets under management[40]
David Tepper of Appaloosa
Management
Paul Tudor Jones of Tudor Investment
Corporation
Daniel Och of Och-Ziff Capital
Management Group[41][42] with more
than $40 billion in assets under
management in 2013[43][44]
Israel Englander of Millennium
Management, LLC
Leon Cooperman of Omega Advisors[45]
Michael Platt of BlueCrest Capital
Management (UK), Europe's third-largest
hedge-fund firm[46]
James Dinan of York Capital
Management[47]
Stephen Mandel of Lone Pine Capital
with $26.7 billion under management at
end June 2015[48]
Larry Robbins of Glenview Capital
Management, with $9.2 billion of assets
under management as of July 2014[49]
Glenn Dubin of Highbridge Capital
Management[50][51][52]
Paul Singer of Elliott Management
Corporation, an activist hedge fund with
more than US$23 billion in assets under
management in 2013,[53][54] and a
 portfolio worth $8.1 billion as of the first
quarter of 2015[55][56][57]
Michael Hintze of CQS, with $14.4 billion
of assets under management as of June
2015[58]
David Einhorn of Greenlight
Capital,[59][60] as the top 20 billionaire
hedge fund managers.[61]
Bill Ackman of Pershing Square Capital
Management LP

Strategies
A prospectus from the US

Hedge fund strategies are generally

classified among four major categories:
global macro, directional, event-driven, and
relative value (arbitrage).[62] Strategies
within these categories each entail
characteristic risk and return profiles. A
fund may employ a single strategy or
multiple strategies for flexibility, risk
management, or diversification.[63] The
hedge fund's prospectus, also known as
an offering memorandum, offers potential
investors information about key aspects of
the fund, including the fund's investment
strategy, investment type, and leverage
limit.[64]

The elements contributing to a hedge fund

strategy include: the hedge fund's
approach to the market; the particular
instrument used; the market sector the
fund specializes in (e.g., healthcare); the
method used to select investments; and
the amount of diversification within the
fund. There are a variety of market
approaches to different asset classes,
including equity, fixed income, commodity,
and currency. Instruments used include:
equities, fixed income, futures, options,
and swaps. Strategies can be divided into
those in which investments can be
selected by managers, known as
"discretionary/qualitative", or those in
which investments are selected using a
computerized system, known as
"systematic/quantitative".[65] The amount
of diversification within the fund can vary;
funds may be multi-strategy, multi-fund,
multi-market, multi-manager, or a
combination.
Sometimes hedge fund strategies are
described as "absolute return" and are
classified as either "market neutral" or
"directional". Market neutral funds have
less correlation to overall market
performance by "neutralizing" the effect of
market swings, whereas directional funds
utilize trends and inconsistencies in the
market and have greater exposure to the
market's fluctuations.[63][66]

Global macro …

Hedge funds using a global macro

investing strategy take sizable positions in
share, bond, or currency markets in
anticipation of global macroeconomic
events in order to generate a risk-adjusted
return.[66] Global macro fund managers
use macroeconomic ("big picture")
analysis based on global market events
and trends to identify opportunities for
investment that would profit from
anticipated price movements. While global
macro strategies have a large amount of
flexibility (due to their ability to use
leverage to take large positions in diverse
investments in multiple markets), the
timing of the implementation of the
strategies is important in order to generate
attractive, risk-adjusted returns.[67] Global
macro is often categorized as a directional
investment strategy.[66]

Global macro strategies can be divided

into discretionary and systematic
approaches. Discretionary trading is
carried out by investment managers who
identify and select investments, whereas
systematic trading is based on
mathematical models and executed by
software with limited human involvement
beyond the programming and updating of
the software. These strategies can also be
divided into trend or counter-trend
approaches depending on whether the
fund attempts to profit from following
market trend (long or short-term) or
attempts to anticipate and profit from
reversals in trends.[65]

Within global macro strategies, there are

further sub-strategies including
"systematic diversified", in which the fund
trades in diversified markets, or sector
specialists such as "systematic currency",
in which the fund trades in foreign
exchange markets or any other sector
specialisition.[68]:348 Other sub-strategies
include those employed by commodity
trading advisors (CTAs), where the fund
trades in futures (or options) in commodity
markets or in swaps.[69] This is also known
as a "managed future fund".[66] CTAs trade
in commodities (such as gold) and
financial instruments, including stock
indices. They also take both long and
short positions, allowing them to make
profit in both market upswings and
downswings.[70] Most Global Macro
managers tends to be a CTA from a
regulatory perspective and the main divide
is between systematic and discretionary
strategies. A classification framework for
CTA/Macro Strategies can be found in the
reference.[71]

Directional …
Schematic representation of short selling in two
steps. The short seller borrows shares and
immediately sells them. The short seller then expects
the price to decrease, when the seller can profit by
purchasing the shares to return to the lender.

Directional investment strategies use

market movements, trends, or
inconsistencies when picking stocks
across a variety of markets. Computer
models can be used, or fund managers will
identify and select investments. These
types of strategies have a greater
exposure to the fluctuations of the overall
market than do market neutral
strategies.[63][66] Directional hedge fund
strategies include US and international
long/short equity hedge funds, where long
equity positions are hedged with short
sales of equities or equity index options.

Within directional strategies, there are a

number of sub-strategies. "Emerging
markets" funds focus on emerging
markets such as China and India,[68]:351
whereas "sector funds" specialize in
specific areas including technology,
healthcare, biotechnology,
pharmaceuticals, energy, and basic
materials. Funds using a "fundamental
growth" strategy invest in companies with
more earnings growth than the overall
stock market or relevant sector, while
funds using a "fundamental value" strategy
invest in undervalued companies.[68]:344
Funds that use quantitative and financial
signal processing techniques for equity
trading are described as using a
"quantitative directional" strategy.[68]:345
Funds using a "short bias" strategy take
advantage of declining equity prices using
short positions.[72]
Event-driven …

Event-driven strategies concern situations

in which the underlying investment
opportunity and risk are associated with
an event.[73] An event-driven investment
strategy finds investment opportunities in
corporate transactional events such as
consolidations, acquisitions,
recapitalizations, bankruptcies, and
liquidations. Managers employing such a
strategy capitalize on valuation
inconsistencies in the market before or
after such events, and take a position
based on the predicted movement of the
security or securities in question. Large
institutional investors such as hedge
funds are more likely to pursue event-
driven investing strategies than traditional
equity investors because they have the
expertise and resources to analyze
corporate transactional events for
investment opportunities.[67][74][75]

Corporate transactional events generally

fit into three categories: distressed
securities, risk arbitrage, and special
situations.[67] Distressed securities include
such events as restructurings,
recapitalizations, and bankruptcies.[67] A
distressed securities investment strategy
involves investing in the bonds or loans of
companies facing bankruptcy or severe
financial distress, when these bonds or
loans are being traded at a discount to
their value. Hedge fund managers
pursuing the distressed debt investment
strategy aim to capitalize on depressed
bond prices. Hedge funds purchasing
distressed debt may prevent those
companies from going bankrupt, as such
an acquisition deters foreclosure by
banks.[66] While event-driven investing, in
general, tends to thrive during a bull
market, distressed investing works best
during a bear market.[75]
Risk arbitrage or merger arbitrage includes
such events as mergers, acquisitions,
liquidations, and hostile takeovers.[67] Risk
arbitrage typically involves buying and
selling the stocks of two or more merging
companies to take advantage of market
discrepancies between acquisition price
and stock price. The risk element arises
from the possibility that the merger or
acquisition will not go ahead as planned;
hedge fund managers will use research
and analysis to determine if the event will
take place.[75][76]

Special situations are events that impact

the value of a company's stock, including
the restructuring of a company or
corporate transactions including spin-offs,
share buy backs, security
issuance/repurchase, asset sales, or other
catalyst-oriented situations. To take
advantage of special situations the hedge
fund manager must identify an upcoming
event that will increase or decrease the
value of the company's equity and equity-
related instruments.[77]

Other event-driven strategies include credit

arbitrage strategies, which focus on
corporate fixed income securities; an
activist strategy, where the fund takes
large positions in companies and uses the
ownership to participate in the
management; a strategy based on
predicting the final approval of new
pharmaceutical drugs; and legal catalyst
strategy, which specializes in companies
involved in major lawsuits.

Relative value …

Relative value arbitrage strategies take

advantage of relative discrepancies in
price between securities. The price
discrepancy can occur due to mispricing
of securities compared to related
securities, the underlying security or the
market overall. Hedge fund managers can
use various types of analysis to identify
price discrepancies in securities, including
mathematical, technical, or fundamental
techniques.[78] Relative value is often used
as a synonym for market neutral, as
strategies in this category typically have
very little or no directional market
exposure to the market as a whole.[79]
Other relative value sub-strategies include:

Fixed income arbitrage: exploit pricing

inefficiencies between related fixed
income securities.
Equity market neutral: exploit
differences in stock prices by being long
and short in stocks within the same
sector, industry, market capitalization,
country, which also creates a hedge
against broader market factors.
Convertible arbitrage: exploit pricing
inefficiencies between convertible
securities and the corresponding
stocks.
Asset-backed securities (fixed-income
asset-backed): fixed income arbitrage
strategy using asset-backed securities.
Credit long/short: the same as
long/short equity, but in credit markets
instead of equity markets.
Statistical arbitrage: identifying pricing
inefficiencies between securities
through mathematical modeling
techniques
Volatility arbitrage: exploit the change in
volatility, instead of the change in price.
Yield alternatives: non-fixed income
arbitrage strategies based on the yield,
instead of the price.
Regulatory arbitrage: exploit regulatory
differences between two or more
markets.
Risk arbitrage: exploit market
discrepancies between acquisition price
and stock price.
Value investing: buying securities that
appear underpriced by some form of
 fundamental analysis.

Miscellaneous …

In addition to those strategies within the

four main categories, there are several
strategies that do not fit into these
categorizations or can apply across
several of them.

Fund of hedge funds (multi-manager): a

hedge fund with a diversified portfolio of
numerous underlying single-manager
hedge funds.
Multi-strategy: a hedge fund using a
combination of different strategies to
reduce market risk.
Minimum account fund: the minimum
amount to open a hedge fund account is
(say) $10 million (with 25% non-holding)
or $2.5 million withholding.
Multi-manager: a hedge fund wherein
the investment is spread along separate
sub-managers investing in their own
strategy.
Withdraw holding: a hold is placed on all
major withdrawals for 90 days prior to
and after the hedge fund is created and
established.
130-30 funds: equity funds with 130%
long and 30% short positions, leaving a
net long position of 100%.
 Risk parity: equalizing risk by allocating
funds to a wide range of categories
while maximizing gains through
financial leveraging.
AI-driven: using big data and
sophisticated machine learning models
to predict prices.

Risk
For an investor who already holds large
quantities of equities and bonds,
investment in hedge funds may provide
diversification and reduce the overall
portfolio risk.[80] Managers of hedge funds
use particular trading strategies and
instruments with the specific aim of
reducing market risks to produce risk-
adjusted returns that are consistent with
investors' desired level of risk.[81] Hedge
funds ideally produce returns relatively
uncorrelated with market indices.[82] While
"hedging" can be a way of reducing the risk
of an investment, hedge funds, like all
other investment types, are not immune to
risk. According to a report by the
Hennessee Group, hedge funds were
approximately one-third less volatile than
the S&P 500 between 1993 and 2010.[83]

Risk management …
Investors in hedge funds are, in most
countries, required to be qualified
investors who are assumed to be aware of
the investment risks, and accept these
risks because of the potential returns
relative to those risks. Fund managers
may employ extensive risk management
strategies in order to protect the fund and
investors. According to the Financial
Times, "big hedge funds have some of the
most sophisticated and exacting risk
management practices anywhere in asset
management."[81] Hedge fund managers
that hold a large number of investment
positions for short durations are likely to
have a particularly comprehensive risk
management system in place, and it has
become usual for funds to have
independent risk officers who assess and
manage risks but are not otherwise
involved in trading.[84] A variety of different
measurement techniques and models are
used to estimate risk according to the
fund's leverage, liquidity, and investment
strategy.[82][85] Non-normality of returns,
volatility clustering and trends are not
always accounted for by conventional risk
measurement methodologies and so in
addition to value at risk and similar
measurements, funds may use integrated
measures such as drawdowns.[86]
In addition to assessing the market-related
risks that may arise from an investment,
investors commonly employ operational
due diligence to assess the risk that error
or fraud at a hedge fund might result in a
loss to the investor. Considerations will
include the organization and management
of operations at the hedge fund manager,
whether the investment strategy is likely to
be sustainable, and the fund's ability to
develop as a company.[87]

Transparency, and regulatory

considerations
…
Since hedge funds are private entities and
have few public disclosure requirements,
this is sometimes perceived as a lack of
transparency.[88] Another common
perception of hedge funds is that their
managers are not subject to as much
regulatory oversight and/or registration
requirements as other financial investment
managers, and more prone to manager-
specific idiosyncratic risks such as style
drifts, faulty operations, or fraud.[89] New
regulations introduced in the US and the
EU as of 2010 required hedge fund
managers to report more information,
leading to greater transparency.[90] In
addition, investors, particularly
institutional investors, are encouraging
further developments in hedge fund risk
management, both through internal
practices and external regulatory
requirements.[81] The increasing influence
of institutional investors has led to greater
transparency: hedge funds increasingly
provide information to investors including
valuation methodology, positions, and
leverage exposure.[91]

Risks shared with other investment

types
…

Hedge funds share many of the same

types of risk as other investment classes,
including liquidity risk and manager
risk.[89] Liquidity refers to the degree to
which an asset can be bought and sold or
converted to cash; similar to private-equity
funds, hedge funds employ a lock-up
period during which an investor cannot
remove money.[66][92] Manager risk refers
to those risks which arise from the
management of funds. As well as specific
risks such as style drift, which refers to a
fund manager "drifting" away from an area
of specific expertise, manager risk factors
include valuation risk, capacity risk,
concentration risk, and leverage risk.[88]
Valuation risk refers to the concern that
the net asset value (NAV) of investments
may be inaccurate;[93] capacity risk can
arise from placing too much money into
one particular strategy, which may lead to
fund performance deterioration;[94] and
concentration risk may arise if a fund has
too much exposure to a particular
investment, sector, trading strategy, or
group of correlated funds.[95] These risks
may be managed through defined controls
over conflict of interest,[93] restrictions on
allocation of funds,[94] and set exposure
limits for strategies.[95]

Many investment funds use leverage, the

practice of borrowing money, trading on
margin, or using derivatives to obtain
market exposure in excess of that
provided by investors' capital. Although
leverage can increase potential returns,
the opportunity for larger gains is weighed
against the possibility of greater losses.[92]
Hedge funds employing leverage are likely
to engage in extensive risk management
practices.[84][88] In comparison with
investment banks, hedge fund leverage is
relatively low; according to a National
Bureau of Economic Research working
paper, the average leverage for investment
banks is 14.2, compared to between 1.5
and 2.5 for hedge funds.[96]
Some types of funds, including hedge
funds, are perceived as having a greater
appetite for risk, with the intention of
maximizing returns,[92] subject to the risk
tolerance of investors and the fund
manager. Managers will have an additional
incentive to increase risk oversight when
their own capital is invested in the fund.[84]

Fees and remuneration

Fees paid to hedge funds …

Hedge fund management firms typically

charge their funds both a management fee
and a performance fee.
Management fees are calculated as a
percentage of the fund's net asset value
and typically range from 1% to 4% per
annum, with 2% being standard.[97][98][99]
They are usually expressed as an annual
percentage, but calculated and paid
monthly or quarterly. Management fees for
hedge funds are designed to cover the
operating costs of the manager, whereas
the performance fee provides the
manager's profits. However, due to
economies of scale the management fee
from larger funds can generate a
significant part of a manager's profits, and
as a result some fees have been criticized
by some public pension funds, such as
CalPERS, for being too high.[100]

The performance fee is typically 20% of

the fund's profits during any year, though
performance fees range between 10% and
50%. Performance fees are intended to
provide an incentive for a manager to
generate profits.[101][102] Performance fees
have been criticized by Warren Buffett,
who believes that because hedge funds
share only the profits and not the losses,
such fees create an incentive for high-risk
investment management. Performance
fee rates have fallen since the start of the
credit crunch.[103]
Almost all hedge fund performance fees
include a "high water mark" (or "loss
carryforward provision"), which means that
the performance fee only applies to net
profits (i.e., profits after losses in previous
years have been recovered). This prevents
managers from receiving fees for volatile
performance, though a manager will
sometimes close a fund that has suffered
serious losses and start a new fund, rather
than attempt to recover the losses over a
number of years without a performance
fee.[104]

Some performance fees include a "hurdle",

so that a fee is only paid on the fund's
performance in excess of a benchmark
rate (e.g., LIBOR) or a fixed percentage.[105]
The hurdle is usually tied to a benchmark
rate such as Libor or the one-year Treasury
bill rate plus a spread.[106] A "soft" hurdle
means the performance fee is calculated
on all the fund's returns if the hurdle rate is
cleared. A "hard" hurdle is calculated only
on returns above the hurdle rate.[107] By
example the manager sets a hurdle rate
equal to 5%, and the fund return 15%,
incentive fees would only apply to the 10%
above the hurdle rate.[106] A hurdle is
intended to ensure that a manager is only
rewarded if the fund generates returns in
excess of the returns that the investor
would have received if they had invested
their money elsewhere.

Some hedge funds charge a redemption

fee (or withdrawal fee) for early
withdrawals during a specified period of
time (typically a year), or when
withdrawals exceed a predetermined
percentage of the original investment.[108]
The purpose of the fee is to discourage
short-term investing, reduce turnover, and
deter withdrawals after periods of poor
performance. Unlike management fees
and performance fees, redemption fees
are usually kept by the fund.
Remuneration of portfolio …

managers

Hedge fund management firms are often

owned by their portfolio managers, who
are therefore entitled to any profits that the
business makes. As management fees are
intended to cover the firm's operating
costs, performance fees (and any excess
management fees) are generally
distributed to the firm's owners as profits.
Funds do not tend to report compensation,
and so published lists of the amounts
earned by top managers tend to be
estimates based on factors such as the
fees charged by their funds and the capital
they are thought to have invested in
them.[109] Many managers have
accumulated large stakes in their own
funds and so top hedge fund managers
can earn extraordinary amounts of money,
perhaps up to $4 billion in a good
year.[110][111]

Earnings at the very top are higher than in

any other sector of the financial
industry,[112] and collectively the top 25
hedge fund managers regularly earn more
than all 500 of the chief executives in the
S&P 500.[113] Most hedge fund managers
are remunerated much less, however, and
if performance fees are not earned then
small managers at least are unlikely to be
paid significant amounts.[112]

In 2011, the top manager earned $3,000m,

the tenth earned $210m, and the 30th
earned $80m.[114] In 2011, the average
earnings for the 25 highest-compensated
hedge fund managers in the United States
was $576 million.[115] while the mean total
compensation for all hedge fund
investment professionals was $690,786
and the median was $312,329. The same
figures for hedge fund CEOs were
$1,037,151 and $600,000, and for chief
investment officers were $1,039,974 and
$300,000, respectively.[116]
Of the 1,226 people on the Forbes World's
Billionaires List for 2012,[117] 36 of the
financiers listed "derived significant
chunks" of their wealth from hedge fund
management.[118] Among the richest 1,000
people in the United Kingdom, 54 were
hedge fund managers, according to the
Sunday Times Rich List for 2012.[119]

A porfolio manager risks losing his past

compensation if he engages in insider
trading. In Morgan Stanley v. Skowron, 989
F. Supp. 2d 356 (S.D.N.Y. 2013), applying
New York's faithless servant doctrine, the
court held that a hedge fund's portfolio
manager engaging in insider trading in
violation of his company's code of
conduct, which also required him to report
his misconduct, must repay his employer
the full $31 million his employer paid him
as compensation during his period of
faithlessness.[120][121][122][123] The court
called the insider trading the "ultimate
abuse of a portfolio manager's
position."[121] The judge also wrote: "In
addition to exposing Morgan Stanley to
government investigations and direct
financial losses, Skowron's behavior
damaged the firm's reputation, a valuable
corporate asset."[121]

Structure
A hedge fund is an investment vehicle that
is most often structured as an offshore
corporation, limited partnership, or limited
liability company.[124] The fund is
managed by an investment manager in the
form of an organization or company that is
legally and financially distinct from the
hedge fund and its portfolio of
assets.[125][126] Many investment
managers utilize service providers for
operational support.[127] Service providers
include prime brokers, banks,
administrators, distributors, and
accounting firms.
Prime broker …

Prime brokers clear trades, and provide

leverage and short-term financing.[128][129]
They are usually divisions of large
investment banks.[130] The prime broker
acts as a counterparty to derivative
contracts, and lends securities for
particular investment strategies, such as
long/short equities and convertible bond
arbitrage.[131][132] It can provide custodial
services for the fund's assets, and
execution and clearing services for the
hedge fund manager.[133]

Administrator …
Hedge fund administrators are typically
responsible for valuation services, and
often operations and accounting.

Calculation of the net asset value ("NAV")

by the administrator, including the pricing
of securities at current market value and
calculation of the fund's income and
expense accruals, is a core administrator
task, because it is the price at which
investors buy and sell shares in the
fund.[134] The accurate and timely
calculation of NAV by the administrator is
vital.[134][135] The case of Anwar v. Fairfield
Greenwich (SDNY 2015) is the major case
relating to fund administrator liability for
failure to handle its NAV-related
obligations properly.[136][137] There, the
hedge fund administrator and other
defendants settled in 2016 by paying the
Anwar investor plaintiffs $235
million.[136][137]

Administrator back office support allows

fund managers to concentrate on
trades.[138] Administrators also process
subscriptions and redemptions, and
perform various shareholder
services.[139][140] Hedge funds in the
United States are not required to appoint
an administrator, and all of these functions
can be performed by an investment
manager.[141] A number of conflict of
interest situations may arise in this
arrangement, particularly in the calculation
of a fund's net asset value.[142] Some
funds employ external auditors, thereby
arguably offering a greater degree of
transparency.[141]

Distributor …

A distributor is an underwriter, broker,

dealer, or other person who participates in
the distribution of securities.[143] The
distributor is also responsible for
marketing the fund to potential investors.
Many hedge funds do not have
distributors, and in such cases the
investment manager will be responsible
for distribution of securities and
marketing, though many funds also use
placement agents and broker-dealers for
distribution.[144][145]

Auditor …

Most funds use an independent

accounting firm to audit the assets of the
fund, provide tax services, and perform a
complete audit of the fund's financial
statements. The year-end audit is often
performed in accordance with the
standard accounting practices enforced
within the country in which the fund it
established, US GAAP or the International
Financial Reporting Standards (IFRS).[146]
The auditor may verify the fund's NAV and
assets under management (AUM).[147][148]
Some auditors only provide "NAV lite"
services, meaning that the valuation is
based on prices received from the
manager rather than independent
assessment.[149]

Domicile and taxation …

The legal structure of a specific hedge

fund, in particular its domicile and the type
of legal entity in use, is usually determined
by the tax expectations of the fund's
investors. Regulatory considerations will
also play a role. Many hedge funds are
established in offshore financial centers to
avoid adverse tax consequences for its
foreign and tax-exempt investors.[150][151]
Offshore funds that invest in the US
typically pay withholding taxes on certain
types of investment income, but not US
capital gains tax. However, the fund's
investors are subject to tax in their own
jurisdictions on any increase in the value
of their investments.[152][153] This tax
treatment promotes cross-border
investments by limiting the potential for
multiple jurisdictions to layer taxes on
investors.[154]

US tax-exempt investors (such as pension

plans and endowments) invest primarily in
offshore hedge funds to preserve their tax
exempt status and avoid unrelated
business taxable income.[153] The
investment manager, usually based in a
major financial center, pays tax on its
management fees per the tax laws of the
state and country where it is located.[155]
In 2011, half of the existing hedge funds
were registered offshore and half onshore.
The Cayman Islands was the leading
location for offshore funds, accounting for
34% of the total number of global hedge
funds. The US had 24%, Luxembourg 10%,
Ireland 7%, the British Virgin Islands 6%,
and Bermuda had 3%.[156]

Basket options …

Deutsche Bank and Barclays

created special options accounts
for hedge fund clients in the
banks’ names and claimed to
own the assets, when in fact the
hedge fund clients had full
control of the assets and reaped
the profits. The hedge funds
 would then execute trades –
many of them a few seconds in
duration – but wait until just
after a year had passed to
exercise the options, allowing
them to report the profits at a
lower long-term capital gains
tax rate.

— Alexandra Stevenson. July

8, 2015. The New York Times

The US Senate Permanent Subcommittee

on Investigations chaired by Carl Levin
issued a 2014 report that found that from
1998 and 2013, hedge funds avoided
billions of dollars in taxes by using basket
options. The Internal Revenue Service
began investigating Renaissance
Technologies[157] in 2009, and Levin
criticized the IRS for taking six years to
investigate the company. Using basket
options Renaissance avoided "more than
$6 billion in taxes over more than a
decade".[158]

These banks and hedge funds

involved in this case used
dubious structured financial
products in a giant game of 'let’s
pretend,' costing the Treasury
 billions and bypassing
safeguards that protect the
economy from excessive bank
lending for stock speculation.

— Carl Levin. 2015. Senate

Permanent Subcommittee on
Investigations

A dozen other hedge funds along with

Renaissance Technologies used Deutsche
Bank's and Barclays' basket options.[158]
Renaissance argued that basket options
were "extremely important because they
gave the hedge fund the ability to increase
its returns by borrowing more and to
protect against model and programming
failures".[158] In July 2015 the United
States Internal Revenue claimed hedge
funds used basket options "to bypass
taxes on short-term trades". These basket
options will now be labeled as listed
transactions that must be declared on tax
returns, and a failure to do would result in
a penalty.[158]

Investment manager locations …

In contrast to the funds themselves,

investment managers are primarily located
onshore. The United States remains the
largest center of investment, with US-
based funds managing around 70% of
global assets at the end of 2011.[156] As of
April 2012, there were approximately 3,990
investment advisers managing one or
more private hedge funds registered with
the Securities and Exchange
Commission.[159] New York City and the
Gold Coast area of Connecticut are the
leading locations for US hedge fund
managers.[160][161]

London was Europe's leading center for

hedge fund managers, but since the Brexit
referendum some formerly London-based
hedge funds have relocated to other
European financial centers such as
Frankfurt, Luxembourg, Paris, and Dublin,
while some other hedge funds have moved
their European head offices back to New
York City.[162][163][164][165][166][167][168] Before
Brexit, according to EuroHedge data,
around 800 funds located in the UK had
managed 85% of European-based hedge
fund assets in 2011.[156] Interest in hedge
funds in Asia has increased significantly
since 2003, especially in Japan, Hong
Kong, and Singapore.[169] After Brexit,
Europe and the US remain the leading
locations for the management of Asian
hedge fund assets.[156]
Legal entity …

Hedge fund legal structures vary

depending on location and the investor(s).
US hedge funds aimed at US-based,
taxable investors are generally structured
as limited partnerships or limited liability
companies. Limited partnerships and
other flow-through taxation structures
assure that investors in hedge funds are
not subject to both entity-level and
personal-level taxation.[133] A hedge fund
structured as a limited partnership must
have a general partner. The general
partner may be an individual or a
corporation. The general partner serves as
the manager of the limited partnership,
and has unlimited liability.[128][170] The
limited partners serve as the fund's
investors, and have no responsibility for
management or investment decisions.
Their liability is limited to the amount of
money they invest for partnership
interests.[170][171] As an alternative to a
limited partnership arrangement, U.S.
domestic hedge funds may be structured
as limited liability companies, with
members acting as corporate
shareholders and enjoying protection from
individual liability.[172]
By contrast, offshore corporate funds are
usually used for non-US investors, and
when they are domiciled in an applicable
offshore tax haven, no entity-level tax is
imposed.[150] Many managers of offshore
funds permit the participation of tax-
exempt US investors, such as pensions
funds, institutional endowments, and
charitable trusts.[170] As an alternative
legal structure, offshore funds may be
formed as an open-ended unit trust using
an unincorporated mutual fund
structure.[173] Japanese investors prefer to
invest in unit trusts, such as those
available in the Cayman Islands.[174]
The investment manager who organizes
the hedge fund may retain an interest in
the fund, either as the general partner of a
limited partnership or as the holder of
"founder shares" in a corporate fund.[175]
For offshore funds structured as corporate
entities, the fund may appoint a board of
directors. The board's primary role is to
provide a layer of oversight while
representing the interests of the
shareholders.[176] However, in practice
board members may lack sufficient
expertise to be effective in performing
those duties. The board may include both
affiliated directors who are employees of
the fund and independent directors whose
relationship to the fund is limited.[176]

Types of funds …

Open-ended hedge funds continue to

issue shares to new investors and allow
periodic withdrawals at the net asset
value ("NAV") for each share.
Closed-ended hedge funds issue a
limited number of tradeable shares at
inception.[177][178]
Shares of Listed hedges funds are
traded on stock exchanges, such as the
Irish Stock Exchange, and may be
 purchased by non-accredited
investors.[179]

Side pockets …

A side pocket is a mechanism whereby a

fund compartmentalizes assets that are
relatively illiquid or difficult to value
reliably.[180] When an investment is side-
pocketed, its value is calculated separately
from the value of the fund's main
portfolio.[181] Because side pockets are
used to hold illiquid investments, investors
do not have the standard redemption
rights with respect to the side pocket
investment that they do with respect to the
fund's main portfolio.[181] Profits or losses
from the investment are allocated on a pro
rata basis only to those who are investors
at the time the investment is placed into
the side pocket and are not shared with
new investors.[181][182] Funds typically
carry side pocket assets "at cost" for
purposes of calculating management fees
and reporting net asset values. This allows
fund managers to avoid attempting a
valuation of the underlying investments,
which may not always have a readily
available market value.[182]

Side pockets were widely used by hedge

funds during the financial crisis of 2007–
2008 amidst a flood of withdrawal
requests. Side pockets allowed fund
managers to lay away illiquid securities
until market liquidity improved, a move
that could reduce losses. However, as the
practice restricts investors' ability to
redeem their investments it is often
unpopular and many have alleged that it
has been abused or applied
unfairly.[183][184][185] The SEC also has
expressed concern about aggressive use
of side pockets and has sanctioned
certain fund managers for inappropriate
use of them.[1]

Regulation
Hedge funds must abide by the national,
federal, and state regulatory laws in their
respective locations. The U.S. regulations
and restrictions that apply to hedge funds
differ from those that apply to its mutual
funds.[186] Mutual funds, unlike hedge
funds and other private funds, are subject
to the Investment Company Act of 1940,
which is a highly detailed and extensive
regulatory regime.[187] According to a
report by the International Organization of
Securities Commissions, the most
common form of regulation pertains to
restrictions on financial advisers and
hedge fund managers in an effort to
minimize client fraud. On the other hand,
U.S. hedge funds are exempt from many of
the standard registration and reporting
requirements because they only accept
accredited investors.[66] In 2010,
regulations were enacted in the US and
European Union which introduced
additional hedge fund reporting
requirements. These included the U.S.'s
Dodd-Frank Wall Street Reform Act[4] and
European Alternative Investment Fund
Managers Directive.[188]

In 2007 in an effort to engage in self-

regulation, 14 leading hedge fund
managers developed a voluntary set of
international standards in best practice
and known as the Hedge Fund Standards
they were designed to create a "framework
of transparency, integrity and good
governance" in the hedge fund
industry.[189] The Hedge Fund Standards
Board was set up to prompt and maintain
these standards going forward, and by
2016 it had approximately 200 hedge fund
managers and institutional investors with
a value of US $3tn investment endorsing
the standards.[190] The Managed Funds
Association is a US-based trade
association, while the Alternative
Investment Management Association is
the primarily European counterpart.[191]
United States …

Hedge funds within the US are subject to

regulatory, reporting, and record-keeping
requirements.[192] Many hedge funds also
fall under the jurisdiction of the
Commodity Futures Trading Commission,
and are subject to rules and provisions of
the 1922 Commodity Exchange Act, which
prohibits fraud and manipulation.[193] The
Securities Act of 1933 required companies
to file a registration statement with the
SEC to comply with its private placement
rules before offering their securities to the
public,[194] and most traditional hedge
funds in the United States are offered
effectively as private placement
offerings.[195] The Securities Exchange Act
of 1934 required a fund with more than
499 investors to register with the
SEC.[196][197][198] The Investment Advisers
Act of 1940 contained anti-fraud
provisions that regulated hedge fund
managers and advisers, created limits for
the number and types of investors, and
prohibited public offerings. The Act also
exempted hedge funds from mandatory
registration with the SEC[66][199][200] when
selling to accredited investors with a
minimum of US$5 million in investment
assets. Companies and institutional
investors with at least US$25 million in
investment assets also qualified.[201]

In December 2004, the SEC began

requiring hedge fund advisers, managing
more than US$25 million and with more
than 14 investors, to register with the SEC
under the Investment Advisers Act.[202]
The SEC stated that it was adopting a
"risk-based approach" to monitoring hedge
funds as part of its evolving regulatory
regime for the burgeoning industry.[203]
The new rule was controversial, with two
Commissioners dissenting,[204] and was
later challenged in court by a hedge fund
manager. In June 2006, the U.S. Court of
Appeals for the District of Columbia
overturned the rule and sent it back to the
agency to be reviewed.[205] In response to
the court decision, in 2007 the SEC
adopted Rule 206(4)-8, which unlike the
earlier-challenged rule, "does not impose
additional filing, reporting or disclosure
obligations" but does potentially increase
"the risk of enforcement action" for
negligent or fraudulent activity.[206] Hedge
fund managers with at least
US$100 million in assets under
management are required to file publicly
quarterly reports disclosing ownership of
registered equity securities and are
subject to public disclosure if they own
more than 5% of the class of any
registered equity security.[197] Registered
advisers must report their business
practices and disciplinary history to the
SEC and to their investors. They are
required to have written compliance
policies, a chief compliance officer, and
their records and practices may be
examined by the SEC.[192]

The U.S.'s Dodd-Frank Wall Street Reform

Act was passed in July 2010[4][90] and
requires SEC registration of advisers who
manage private funds with more than
US$150 million in assets.[207][208]
Registered managers must file Form ADV
with the SEC, as well as information
regarding their assets under management
and trading positions.[209] Previously,
advisers with fewer than 15 clients were
exempt, although many hedge fund
advisers voluntarily registered with the
SEC to satisfy institutional investors.[210]
Under Dodd-Frank, investment advisers
with less than US$100 million in assets
under management became subject to
state regulation.[207] This increased the
number of hedge funds under state
supervision.[211] Overseas advisers who
managed more than US$25 million were
also required to register with the SEC.[212]
The Act requires hedge funds to provide
information about their trades and
portfolios to regulators including the newly
created Financial Stability Oversight
Council.[211] In this regard, most hedge
funds and other private funds, including
private-equity funds, must file Form PF
with the SEC, which is an extensive
reporting form with substantial data on the
funds' activities and positions.[1] Under the
"Volcker Rule," regulators are also required
to implement regulations for banks, their
affiliates, and holding companies to limit
their relationships with hedge funds and to
prohibit these organizations from
proprietary trading, and to limit their
investment in, and sponsorship of, hedge
funds.[211][213][214]

Europe …

Within the European Union (EU), hedge

funds are primarily regulated through their
managers.[66] In the United Kingdom,
where 80% of Europe's hedge funds are
based,[215] hedge fund managers are
required to be authorised and regulated by
the Financial Conduct Authority (FCA).[188]
Each country has its own specific
restrictions on hedge fund activities,
including controls on use of derivatives in
Portugal, and limits on leverage in
France.[66]

In the EU, managers are subject to the EU's

Directive on Alternative Investment Fund
Managers (AIFMD). According to the EU,
the aim of the directive is to provide
greater monitoring and control of
alternative investment funds.[216] AIFMD
requires all EU hedge fund managers to
register with national regulatory
authorities[217] and to disclose more
information, on a more frequent basis. It
also directs hedge fund managers to hold
larger amounts of capital. AIFMD also
introduced a "passport" for hedge funds
authorised in one EU country to operate
throughout the EU.[90][188] The scope of
AIFMD is broad and encompasses
managers located within the EU as well as
non-EU managers that market their funds
to European investors.[90] An aspect of
AIFMD which challenges established
practices in the hedge funds sector is the
potential restriction of remuneration
through bonus deferrals and clawback
provisions.[218]

Other …

Some hedge funds are established in

offshore centres such as the Cayman
Islands, Dublin, Luxembourg, the British
Virgin Islands, and Bermuda, which have
different regulations[219] concerning non-
accredited investors, client confidentiality,
and fund manager independence.[4][188]

In South Africa, investment fund managers

must be approved by, and register with, the
Financial Services Board (FSB).[220]

Performance

Measurement …

Performance statistics for individual

hedge funds are difficult to obtain, as the
funds have historically not been required
to report their performance to a central
repository, and restrictions against public
offerings and advertisement have led
many managers to refuse to provide
performance information publicly.
However, summaries of individual hedge
fund performance are occasionally
available in industry journals[221][222] and
databases.[223]

One estimate is that the average hedge

fund returned 11.4% per year,[224]
representing a 6.7% return above overall
market performance before fees, based on
performance data from 8,400 hedge
funds.[66] Another estimate is that between
January 2000 and December 2009 hedge
funds outperformed other investments
and were substantially less volatile, with
stocks falling an average of 2.62% per year
over the decade and hedge funds rising an
average of 6.54% per year; this was an
unusually volatile period with both the
2001-2002 dot-com bubble and a
recession beginning mid 2007.[225]
However, more recent data show that
hedge fund performance declined and
underperformed the market from about
2009 to 2016.[226]

Hedge funds performance is measured by

comparing their returns to an estimate of
their risk.[227] Common measures are the
Sharpe ratio,[228] Treynor measure and
Jensen's alpha.[229] These measures work
best when returns follow normal
distributions without autocorrelation, and
these assumptions are often not met in
practice.[230]

New performance measures have been

introduced that attempt to address some
of theoretical concerns with traditional
indicators, including: modified Sharpe
ratios;[230][231] the Omega ratio introduced
by Keating and Shadwick in 2002;[232]
Alternative Investments Risk Adjusted
Performance (AIRAP) published by
Sharma in 2004;[233] and Kappa developed
by Kaplan and Knowles in 2004.[234]

Sector-size effect …

There is a debate over whether alpha (the

manager's skill element in performance)
has been diluted by the expansion of the
hedge fund industry. Two reasons are
given. 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.[235][236]
Hedge fund indices …

Indices that track hedge fund returns are,

in order of development, called Non-
investable, Investable, and Clone. They
play a central and unambiguous role in
traditional asset markets, where they are
widely accepted as representative of their
underlying portfolios. Equity and debt
index fund products provide investable
access to most developed markets in
these asset classes. Hedge funds,
however, are actively managed, so that
tracking is impossible. Non-investable
hedge fund indices on the other hand may
be more or less representative, but returns
data on many of the reference group of
funds is non-public. This may result in
biased estimates of their returns. In an
attempt to address this problem, clone
indices have been created in an attempt to
replicate the statistical properties of
hedge funds without being directly based
on their returns data. None of these
approaches achieves the accuracy of
indices in other asset classes for which
there is more complete published data
concerning the underlying returns.[237]

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

mean that there are many new entrants
and many departures each year, which
raises the problem of survivorship bias. If
we examine only funds that have survived
to the present, we will overestimate past
returns because many of the worst-
performing funds have not survived, and
the observed association between fund
youth and fund performance suggests that
this bias may be substantial.

When a fund is added to a database for

the first time, all or part of its historical
data is recorded ex-post in the database. It
is likely that funds only publish their
results when they are favorable, so that the
average performances displayed by the
funds during their incubation period are
inflated. This is known as "instant history
bias" or "backfill bias".

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. Most seriously, they
under-represent more successful
managers, who typically refuse to accept
such investment protocols.

Hedge fund replication …

The most recent addition to the field

approaches the problem in a different
manner. Instead of reflecting the
performance of actual hedge funds, they
take a statistical approach to the analysis
of historic hedge fund returns and use this
to construct a model of how hedge fund
returns respond to the movements of
various investable financial assets. This
model is then used to construct an
investable portfolio of those assets. This
makes the index investable, and in
principle, they can be as representative as
the hedge fund database from which they
were constructed. However, these clone
indices rely on a statistical modelling
process. Such indices have too short a
history to state whether this approach will
be considered successful.
Closures …

In March 2017, HFR – a hedge fund

research data and service provider –
reported that there were more hedge-fund
closures in 2016 than during the 2009
recession. According to the report, several
large public pension funds pulled their
investments in hedge funds, because the
funds’ subpar performance as a group did
not merit the high fees they charged.

Despite the hedge fund industry topping

$3 trillion for the first time ever in 2016,
the number of new hedge funds launched
fell short of levels before the financial
crisis of 2007–2008. There were 729
hedge fund launches in 2016, fewer than
the 784 opened in 2009, and dramatically
fewer than the 968 launches in 2015.[238]

Debates and controversies

Systemic risk …

Systemic risk refers to the risk of

instability across the entire financial
system, as opposed to within a single
company. Such risk may arise following a
destabilizing event or events affecting a
group of financial institutions linked
through investment activity.[239]
Organizations such as the European
Central Bank have charged that hedge
funds pose systemic risks to the financial
sector,[240][241] and following the failure of
hedge fund Long-Term Capital
Management (LTCM) in 1998 there was
widespread concern about the potential
for systemic risk if a hedge fund failure led
to the failure of its counterparties. (As it
happens, no financial assistance was
provided to LTCM by the US Federal
Reserve, so there was no direct cost to US
taxpayers,[242] but a large bailout had to be
mounted by a number of financial
institutions.)
However, these claims are widely disputed
by the financial industry,[243] who typically
regard hedge funds as "small enough to
fail", since most are relatively small in
terms of the assets they manage and
operate with low leverage, thereby limiting
the potential harm to the economic
system should one of them fail.[224][244]
Formal analysis of hedge fund leverage
before and during the financial crisis of
2007–2008 suggests that hedge fund
leverage is both fairly modest and counter-
cyclical to the market leverage of
investment banks and the larger financial
sector.[96] Hedge fund leverage decreased
prior to the financial crisis, even while the
leverage of other financial intermediaries
continued to increase.[96] Hedge funds fail
regularly, and numerous hedge funds
failed during the financial crisis.[245] In
testimony to the US House Financial
Services Committee in 2009, Ben
Bernanke, the Federal Reserve Board
Chairman said he "would not think that any
hedge fund or private-equity fund would
become a systemically critical firm
individually".[246]

Nevertheless, although hedge funds go to

great lengths to reduce the ratio of risk to
reward, inevitably a number of risks
remain.[247] Systemic risk is increased in a
crisis if there is "herd" behaviour, which
causes a number of similar hedge funds to
make losses in similar trades. In addition,
while most hedge funds make only
modest use of leverage, hedge funds differ
from many other market participants, such
as banks and mutual funds, in that there
are no regulatory constraints on their use
of leverage, and some hedge funds seek
large amounts of leverage as part of their
market strategy. The extensive use of
leverage can lead to forced liquidations in
a crisis, particularly for hedge funds that
invest at least in part in illiquid
investments. The close
interconnectedness of the hedge funds
with their prime brokers, typically
investment banks, can lead to domino
effects in a crisis, and indeed failing
counterparty banks can freeze hedge
funds. These systemic risk concerns are
exacerbated by the prominent role of
hedge funds in the financial markets.

An August 2012 survey by the Financial

Services Authority concluded that risks
were limited and had reduced as a result,
inter alia, of larger margins being required
by counterparty banks, but might change
rapidly according to market conditions. In
stressed market conditions, investors
might suddenly withdraw large sums,
resulting in forced asset sales. This might
cause liquidity and pricing problems if it
occurred across a number of funds or in
one large highly leveraged fund.[248]

Transparency …

Hedge funds are structured to avoid most

direct regulation (although their managers
may be regulated), and are not required to
publicly disclose their investment
activities, except to the extent that
investors generally are subject to
disclosure requirements. This is in
contrast to a regulated mutual fund or
exchange-traded fund, which will typically
have to meet regulatory requirements for
disclosure. An investor in a hedge fund
usually has direct access to the
investment adviser 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.[249]

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.[250] 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.[251] With these limitations,
investors have to do their own research,
which may cost on the scale of US$50,000
for a fund that is not well-established.[252]
A lack of verification of financial
documents by investors or by independent
auditors has, in some cases, assisted in
fraud.[253] In the mid-2000s, Kirk Wright of
International Management Associates was
accused of mail fraud and other securities
violations[254][255] which allegedly
defrauded clients of close to US$180
million.[256] In December 2008, Bernard
Madoff was arrested for running a US$50
billion Ponzi scheme[257] that closely
resembled a hedge fund and was
incorrectly[258] described as
one.[259][260][261] Several feeder hedge
funds, of which the largest was Fairfield
Sentry, channeled money to it. Following
the Madoff case, the SEC adopted reforms
in December 2009 that subjected hedge
funds to an audit requirement.[262]

The process of matching hedge funds to

investors has traditionally been fairly
opaque, with investments often driven by
personal connections or
recommendations of portfolio
managers.[263] Many funds disclose their
holdings, strategy, and historic
performance relative to market indices,
giving investors some idea of how their
money is being allocated, although
individual holdings are often not
disclosed.[264] Investors are often drawn to
hedge funds by the possibility of realizing
significant returns, or hedging against
volatility in the market. The complexity and
fees associated with hedge funds are
causing some to exit the market – Calpers,
the largest pension fund in the US,
announced plans to completely divest
from hedge funds in 2014.[265] Some
services are attempting to improve
matching between hedge funds and
investors: HedgeZ is designed to allow
investors to easily search and sort through
funds;[266] iMatchative aims to match
investors to funds through algorithms that
factor in an investor's goals and behavioral
profile, in hopes of helping funds and
investors understand the how their
perceptions and motivations drive
investment decisions.[267]

Links with analysts …

In June 2006, prompted by a letter from

Gary J. Aguirre, the U.S. Senate Judiciary
Committee began an investigation into the
links between hedge funds and
independent analysts. Aguirre was fired
from his job with the SEC when, as lead
investigator of insider trading allegations
against Pequot Capital Management, he
tried to interview John Mack, then being
considered for chief executive officer at
Morgan Stanley.[268] The Judiciary
Committee and the US Senate Finance
Committee issued a scathing report in
2007, which found that Aguirre had been
illegally fired in reprisal[269] for his pursuit
of Mack, and in 2009 the SEC was forced
to re-open its case against Pequot. Pequot
settled with the SEC for US$28 million, and
Arthur J. Samberg, chief investment officer
of Pequot, was barred from working as an
investment advisor.[270] Pequot closed its
doors under the pressure of
investigations.[271]

The systemic practice of hedge funds

submitting periodic electronic
questionnaires to stock analysts as a part
of market research was reported by The
New York Times in July 2012. According to
the report, one motivation for the
questionnaires was to obtain subjective
information not available to the public and
possible early notice of trading
recommendations that could produce
short-term market movements.[272]

Value in a mean/variance efficient

portfolio
…

According to modern portfolio theory,

rational investors will seek to hold
portfolios that are mean/variance efficient
(that is, portfolios that offer the highest
level of return per unit of risk). One of the
attractive features of hedge funds (in
particular market neutral and similar
funds) is that they sometimes have a
modest correlation with traditional assets
such as equities. This means that hedge
funds have a potentially quite valuable role
in investment portfolios as diversifiers,
reducing overall portfolio risk.[105]

However, there are three reasons why one

might not wish to allocate a high
proportion of assets into hedge funds.
These reasons are:
 Hedge funds are highly individual, and it
is hard to estimate the likely returns or
risks.
Hedge funds' low correlation with other
assets tends to dissipate during
stressful market events, making them
much less useful for diversification than
they may appear.
Hedge fund returns are reduced
considerably by the high fee structures
that are typically charged.

Several studies have suggested that hedge

funds are sufficiently diversifying to merit
inclusion in investor portfolios, but this is
disputed for example by Mark Kritzman
who performed a mean-variance
optimization calculation on an opportunity
set that consisted of a stock index fund, a
bond index fund, and ten hypothetical
hedge funds.[273][274] The optimizer found
that a mean-variance efficient portfolio did
not contain any allocation to hedge funds,
largely because of the impact of
performance fees. To demonstrate this,
Kritzman repeated the optimization using
an assumption that the hedge funds took
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
perform poorly during equity bear markets,
just when an investor needs part of their
portfolio to add value.[105] For example, in
January–September 2008, the Credit
Suisse/Tremont Hedge Fund Index was
down 9.87%.[275] 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 a turbulent period, for
example around the collapse of Lehman
Brothers in September 2008.

See also
Activist shareholder
Alternative investment
Board of directors
Corporate governance
Fund governance
Investment banking
List of hedge funds
Vulture fund

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Further reading
Thomas P. Lemke, Gerald T. Lins,
Kathryn L. Hoenig & Patricia S. Rube,
Hedge Funds and Other Private Funds:
Regulation and Compliance (Thomson
West 2014 ed.).
Thomas P. Lemke & Gerald T. Lins,
Regulation of Investment Advisers
(Thomson West 2014 ed.).
Thomas P. Lemke, Gerald T. Lins & A.
Thomas Smith III, Regulation of
Investment Companies (Matthew Bender
2014 ed.).
Partnoy, Frank; Thomas, Randall S. (20
September 2006). "Gap Filling, Hedge
Funds, and Financial Innovation".
Brookings-Nomura Papers on Financial
Services. SSRN 931254 .
Marcel Kahan & Edward B. Rock, 'Hedge
Funds in Corporate Governance and
Corporate Control' (2007) 155 University
of Pennsylvania Law Review 1021
Makrem Boumlouka, 'Regulation and
Transparency in US OTC Derivative
Markets', Original Thoughts Series #1,
August 2010, Hedge Fund Society
Hedge Fund Society
Boyson, Nicole M.; Stahel, Christof W.;
Stulz, Rene M. (2010). "Hedge Fund
Contagion and Liquidity Shocks". The
Journal of Finance. 65 (5): 1789–1816.
doi:10.1111/j.1540-6261.2010.01594.x .
S2CID 17421154 .
 Stowell, David (2010). An Introduction to
Investment Banks, Hedge Funds, and
Private Equity: The New Paradigm.
Academic Press.
Strachman, Daniel A. (2014). The
Fundamentals of Hedge Fund
Management: How to Successfully
Launch and Operate a Hedge Fund,
Second Edition. Wiley.

External links
Archive of articles on hedge funds
controversies in the 21st century ,
Naked Capitalism
Retrieved from
"https://en.wikipedia.org/w/index.php?
title=Hedge_fund&oldid=1022096720"

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