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A hedge fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than traditional long-only investment funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and the methods of investment it undertakes. Hedge funds, as a class, invest in a broad range of investments including shares, debt and commodities. Some people consider the fund created in 1949 by Alfred Winslow Jones to be the first hedge fund. As the name implies, hedge funds often seek to hedge some of the risks inherent in their investments using a variety of methods, most notably short selling and derivatives. However, the term "hedge fund" has also come to be applied to certain funds that, as well as (or instead of) hedging certain risks, use short selling and other "hedging" methods as a trading strategy to generate a return on their capital. In most jurisdictions hedge funds are open only to a limited range of professional or wealthy investors who meet certain criteria set by regulators, and are accordingly exempted from many regulations that govern ordinary investment funds. The exempted regulations typically cover short selling, the use of derivatives and leverage, fee structures, and the rules by which investors can remove their capital from the fund. Light regulation and the presence of performance fees are the distinguishing characteristics of hedge funds. The net asset value of a hedge fund can run into many billions of dollars, and the gross assets of the fund will usually be higher still due to leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt.
T.Y.B.F.M. An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact,
T.Y.B.F.M. because hedge fund managers make speculative investments, these funds can carry more risk than the overall market. A hedge fund is a term commonly used to describe any fund that isn't a conventional investment fund - that is, any fund using a strategy or set of strategies other than investing long in bonds, equities (mutual funds), and money markets (money market funds). Among these alternative strategies are:
hedging by selling short -- selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop using arbitrage - seeking to exploit pricing inefficiencies between related securities trading options or derivatives - contracts whose values are based on the performance of any underlying financial asset, index or other investment using leverage - borrowing to try to enhance returns investing in out-of-favor or unrecognized undervalued securities (debt or equity) Attempting to take advantage of the spread between the current market price and the ultimate purchase price in event driven situations such as mergers or hostile takeovers.
Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949. Jones believed that price movements of an individual asset could be seen as having a component due to the overall market and a component due to the performance of the asset itself. To neutralize the effect of overall market movement, he balanced his
Once the farmer plants wheat. because. Hedge Funds Basics Investment fund: Money is collected from a group of people and invested. bonds. The market values of wheat and other crops fluctuate constantly as supply and demand for them vary. the farmer might decide that planting wheat is a good idea one season.M. He saw that price movements due to the overall market would be cancelled out. the usual minimum investment amount is US$ 1. If the actual price of wheat rises greatly between 4 . commodities. Examples Hedging an agricultural commodity price A typical hedger might be a commercial farmer. Exclusively favoring the crème de la crème.Y. this became known as a hedge fund. portfolio by buying assets whose price he expected to be stronger than the market and selling short assets he expected to be weaker than the market. the loss on shorted assets would be cancelled by the additional gain on assets bought and vice-versa. he is committed to it for an entire growing season.F. Foreign Institutional Investors (FIIs). With a minimum investment limit: The investors are high net worth individuals.000/ USD 1 million. Because the effect is to 'hedge' that part of the risk due to overall market movements. but the forecast prices are only that — forecasts. Based on current prices and forecast levels at harvest time.T. 000. if the overall market rose.B. with occasional large moves in either direction. currencies etc. Non-Resident Indians (NRIs) and persons of Indian Origin (PIOs) invest in securities in primary and secondary markets in shares.
because he is guaranteed a price by the contract.000 active hedge funds. Beyond the averages. 5 . Facts about Hedge Funds Estimated to be a $2 trillion industry and growing every year. planting and harvest. is not dependent on the direction of the bond or equity markets -. He no longer needs to worry about being ruined by a low wheat price at harvest time. he effectively locks in the price of wheat at that time: the contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. with approximately 10. Most hedge funds are highly specialized. but he also gives up the chance at making extra money from a high wheat price at harvest times. some of which use leverage and derivatives while others are more conservative and employ little or no leverage. he could be ruined. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or derivatives. which are generally 100% exposed to market risk. disciplined and diligent.T.Y.M. particularly relative value strategies. The farmer has hedged his exposure to wheat prices. the farmer stands to make a lot of unexpected money.unlike conventional equity or mutual funds (unit trusts). Performance of many hedge fund strategies. but if the actual price drops by harvest time. If the farmer sells a number of wheat futures contracts equivalent to his crop size at planting time. he no longer cares whether the current price rises or falls. relying on the specific expertise of the manager or management team. Hedge fund managers are generally highly professional.F. there are some truly outstanding performers. Includes a variety of investment strategies.B.
Pension funds. and understand the consequences of. Many. but not all. including many Swiss and other private banks. who have lived through. etc.). Key Characteristics of Hedge Funds • Hedge funds utilize a variety of financial instruments to reduce risk. Hedge funds vary enormously in terms of investment returns. enhance returns and minimize the correlation with equity and bond markets. calls. insurance companies. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns. thus attracting the • • • • • • • 6 .B. Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage. Many hedge funds are flexible in their investment options (can use short selling. Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent. endowments. leverage. Investing in hedge funds tends to be favored by more sophisticated investors.F. Many endowments and pension funds allocate assets to hedge funds. derivatives such as puts. Many hedge funds have the ability to deliver non-market correlated returns. volatility and risk. hedge fund strategies tend to hedge against downturns in the markets being traded. private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns. Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives. options.Y. major stock market corrections.T. futures.M.
B. eliminating the need to correctly time entry and exit from markets. In reality. hedge fund managers usually have their own money invested in their fund. and gold. currencies. commodities. Benefits of Hedge Funds • Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets.T. Most hedge funds use derivatives only for hedging or don't use derivatives at all.F. 7 .that they all use global macro strategies and place large directional bets on stocks. while using lots of leverage. Huge variety of hedge fund investment styles – many uncorrelated with each other – provides investors with a wide choice of hedge fund strategies to meet their investment objectives.M. bonds. best brains in the investment business. Popular Misconception The popular misconception is that all hedge funds are volatile -. Adding hedge funds to an investment portfolio provides • • • • • diversification not otherwise available in traditional investing.Y. Hedge funds provide an ideal long-term investment solution. Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns. less than 5% of hedge funds are global macro funds. and many use no leverage. Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds. In addition.
Includes sector specialist funds such as technology. effective hedging is often not available.S.Moderate Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation and volatile growth. Short selling is not permitted in many emerging markets.T.B. Hedge Fund Styles The predictability of future results shows a strong correlation with the volatility of each strategy. Generally high P/E ratios. and. Profits from the market's lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities.Y.) Results generally not dependent on the direction of the markets. Expected Volatility: Low . Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. debt. (This selling pressure creates the deep discount. Tends to be "long-biased.M. or biotechnology.F. low or no dividends. banking. Expected Volatility: Very High 8 . often smaller and micro cap stocks which are expected to experience rapid growth. Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes. although Brady debt can be partially hedged via U. Future performance of strategies with high volatility is far less predictable than future performance from strategies experiencing low or moderate volatility. Treasury futures and currency markets. or trade claims at deep discounts of companies in or facing bankruptcy or reorganization." Expected Volatility: High Distressed Securities: Buys equity. therefore.
T. risk.B. typically brought about by shifts in government policy that impact interest rates. in turn affecting currency.High Income: Invests with primary focus on yield or current income rather than solely on capital gains.F. Capital preservation is generally an important consideration. can be long convertible bonds and short the underlying issuer’s equity. Funds of Hedge Funds: Mix and match hedge funds and other pooled investment vehicles. capital structure arbitrage. These relative value strategies include fixed income arbitrage. Participates in all major markets -. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. but the leveraged directional investments tend to make the largest impact on performance. currencies and commodities -. mortgage backed securities. For example.Y. Expected Volatility: Low Macro: Aims to profit from changes in global economies. and closed-end fund arbitrage. Utilizes hedging. and bond markets. bonds. Returns.though not always at the same time. Expected Volatility: Very High Market Neutral . Expected Volatility: Low 9 .M. Expected Volatility: Low .Moderate .Arbitrage: Attempts to hedge out most market risk by taking offsetting positions. often in different securities of the same issuer. stock.equities. Volatility depends on the mix and ratio of strategies employed. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. and volatility can be controlled by the mix of underlying strategies and funds. Uses leverage and derivatives to accentuate the impact of market moves. May also use futures to hedge out interest rate risk. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds.
B. Expected Volatility: Variable Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class. sudden price changes often caused by an interim earnings disappointment. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Market Neutral . Market risk is greatly reduced. Usually low or no correlation to the market. Expected Volatility: Variable 10 . Leverage may be used to enhance returns. and other event-driven opportunities. Other strategies may include systems trading such as trend following and various diversified technical strategies. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy.F.Y.and long-term gains.M. Sometimes uses market index futures to hedge out systematic (market) risk. Expected Volatility: Low Market Timing: Allocates assets among different asset classes depending on the manager's view of the economic or market outlook. Relative benchmark index usually T-bills.T. hostile bids. but effective stock analysis and stock picking is essential to obtaining meaningful results. Expected Volatility: High Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs.Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Portfolio emphasis may swing widely between asset classes.
Expected Volatility: Low . Results generally not dependent on direction of market. May involve simultaneous purchase of stock in companies being acquired. hoping to profit from the spread between the current market price and the ultimate purchase price of the company. High risk. May also utilize derivatives to leverage returns and to hedge out interest rate and/or market risk. or leveraged buyouts. Long-term holding. new competition. reorganizations. Expected Volatility: Very High Special Situations: Invests in event-driven situations such as mergers.Y. 11 . or the market. Expected Volatility: Moderate Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth.T. and the sale of stock in its acquirer.F.B. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. or in anticipation of earnings disappointments often due to accounting irregularities. hostile takeovers. Short Selling: Sells securities short in anticipation of being able to rebuy them at a future date at a lower price due to the manager's assessment of the overvaluation of the securities.M. Such securities may be out of favor or underfollowed by analysts.Moderate What is a Fund of Hedge Funds? o A diversified portfolio of generally uncorrelated hedge funds. change of management. patience. and strong discipline are often required until the ultimate value is recognized by the market. etc.
unit trusts or individual hedge funds.B. mutual funds. Provides effective diversification for investment portfolios. Significantly reduces individual fund and manager risk. o o o o o Benefits of a Hedge Fund of Funds o Provides an investment portfolio with lower levels of risk and can deliver returns uncorrelated with the performance of the stock market. Delivers more stable returns under most market conditions due to the fund-of-fund manager’s ability and understanding of the various hedge strategies. endowments. o o o o 12 .M. Seeks to deliver more consistent returns than stock portfolios. strategies and hedge fund managers for one easy-to-administer investment. private banks and highnet-worth families and individuals. Provides more predictable returns than traditional investment funds. insurance companies. Provides access to a broad range of investment styles.T. Preferred investment of choice for many pension funds. Allows for easier administration of widely diversified investments across a large variety of hedge funds.F. or sector or geographically focused.Y. o May be widely diversified. Eliminates the need for time-consuming due diligence otherwise required for making hedge fund investment decisions.
Most hedge funds are highly specialized. • • 13 . o Allows access to a broader spectrum of leading hedge funds that may otherwise be unavailable due to high minimum investment requirements. As a general indicator of scale. some of which use leverage and derivatives while others are more conservative and employ little or no leverage. the lack of a single definition of hedge funds and the rapid growth of the industry.Y. The credit crunch has caused assets under management (AUM) to fall sharply through a combination of trading losses and the withdrawal of assets from funds by investors.F. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or through the use of derivatives. Recent estimates find that hedge funds have more than $2 trillion in AUM Facts about the Hedge Fund Industry • Estimated to be a $1 trillion industry and growing at about 20% per year with approximately 8350 active hedge funds.5 trillion at its peak in the summer of 2008.M. Is an ideal way to gain access to a wide variety of hedge fund strategies. the industry may have managed around $2.T.B. Includes a variety of investment strategies. relying on the specific expertise of the manager or management team. o Industry size Estimates of industry size vary widely due to the lack of central statistics. for a relatively modest investment. managed by many of the world’s premier investment professionals.
including many Swiss and other private banks that have lived through. As a result.T. Brevan Howard ($27 billion). major stock market corrections.unlike conventional equity or mutual funds (unit trusts). and Soros Fund Management ($27 billion). is not dependent on the direction of the bond or equity markets -. there are some truly outstanding performers. Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities. particularly relative value strategies. Paulson & Co.7 billion in assets under management as of December 31. particularly arbitrage strategies. Beyond the averages.6 billion). Investing in hedge funds tends to be favored by more sophisticated investors. • • • • • • Largest hedge fund managers The 25 largest hedge fund managers had $519. ($32 billion). disciplined and diligent.F. • Performance of many hedge fund strategies. Fees 14 . are limited as to how much capital they can successfully employ before returns diminish.M. The largest manager is JP Morgan Chase ($53. Hedge fund managers are generally highly professional. 2009.Y. An increasing number of endowments and pension funds allocate assets to hedge funds. many successful hedge fund managers limit the amount of capital they will accept.5 billion) followed by Bridgewater Associates ($43. Many hedge fund strategies. and understand the consequences of. which are generally 100% exposed to market risk.B.
usually counting both realized and unrealized profits. the management fee is calculated as a percentage of the funds net asset value. but calculated and paid monthly or quarterly. the performance fee is largely available for staff bonuses and so can be 15 . leaving the performance fee for employee bonuses. which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% of the fund's profit Management fees As with other investment funds. By incentivizing the manager to generate returns.T.Y. performance fees are intended to align the interests of manager and investor more closely than flat fees do.M. A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee) from the fund. the management fees for large funds may form a significant part of the manager's profits.B. A typical manager may charge fees of "2 and 20". However. with several large public pension funds calling on managers to reduce fees. with 2% being the standard figure. Management fees typically range from 1% to 4% per annum. In the business models of most managers. The manager's performance fee is calculated as a percentage of the fund's profits. Management fees are usually expressed as an annual percentage. Management fees associated with hedge funds have been under much scrutiny. Performance fees Performance fees (or "incentive fees") are one of the defining characteristics of hedge funds.F. The business models of most hedge fund managers provide for the management fee to cover the operating costs of the manager.
performance fees give managers an incentive to take excessive risk rather than targeting high long-term returns. Incentive fees for single manager funds fell to 19. This means that the manager receives 16 .9 percent (versus 8.Y.T. Performance fees have been criticized by many people..6 percent.05 percent in Q1 08). the range is wide with highly regarded managers charging higher fees. while Jim Simons' Medallion Fund charged a 45% performance fee. by allowing managers to take a share of profit but providing no mechanism for them to share losses.M. The average incentive fee for funds launched in 2009 was 17. Ironically. 1. High water marks A high water mark (or "loss carry forward provision") is often applied to a performance fee calculation.. Several publications publish annual estimates of the earnings of top hedge fund managers. including notable investor Warren Buffett.B. fees are usually limited by a high water mark. In an attempt to control this problem. As the hedge fund remuneration structure is highly attractive it has been remarked that hedge funds are best viewed ".2 percent (versus 19. For example Steven Cohen's SAC Capital Partners charges a 35-50% performance fee.6 percent below the broader industry average.F. Average incentive fees have declined since the start of the financial crisis. with the decline being more pronounced in funds of hedge funds (FOFs). Mr. extremely lucrative for managers who perform well. not as a unique asset class but as a unique ‘fee structure’. hedge funds charge 20% of returns as a performance fee. who believe that. Typically. However. Buffett charged incentive fees until his firm was very large.34 percent in Q1 08) while FOFs fell to 6.
M.T. 17 . rather than on the full return during that year from $110 to $130. such as T-bill yield. enriching the manager but not the investors. a performance fee would be payable on the $20 return for each share. If a high water mark is not used. High water marks are intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. LIBOR or a fixed percentage. usually lower risk. no fee would be payable. signifying that they will not charge a performance fee until the fund's annualized performance exceeds a benchmark rate. This links performance fees to the ability of the manager to provide a higher return than an alternative. If the next year it dropped to $110. which then rose to $120 in its first year. rather than continue working for no performance fee until the loss has been made up for. a performance fee would be payable only on the $10 profit from $120 (the high water mark) to $130. If in the third year the NAV per share rose to $130. investment.B.F. The mechanism does not provide complete protection to investors: A manager who has lost a significant percentage of the fund's value may close the fund and start again with a clean slate. if a fund were launched at a NAV per share of $100. a fund that ends alternate years at $100 and $110 would generate a performance fee every other year. This tactic is dependent on the manager's ability to persuade investors to trust him or her with their money in the new fund. Hurdle rates Some managers specify a hurdle rate.Y. performance fees only on increases in the net asset value (NAV) of the fund in excess of the highest net asset value it has previously achieved. For example.
demand for hedge funds tended to outstrip supply. a performance fee is only charged on returns above the hurdle rate. Withdrawal / Redemption fees Some funds charge investors a redemption fee (or "withdrawal fee" or "surrender charge") if they withdraw money from the fund.T. making hurdle rates relatively rare. A hedge fund will typically commit itself to a particular strategy. with no standard system used. Strategies Hedge funds employ many different trading strategies. thereby giving investors some indication of the nature of the particular fund. A redemption fee is often charged only during a specified period of time (typically a year) following the date of investment. or only to withdrawals representing a specified portion of an investment. illiquid or long-term strategies.F. redemption fees are usually retained by the fund and therefore benefit the remaining investors rather than the manager. particular investment types and leverage limits via statements in its offering documentation. With a "hard" hurdle. 18 .Y. a performance fee is charged on the entire annualized return if the hurdle rate is cleared. With a "soft" hurdle. thereby reducing turnover and allowing the use of more complex. which are classified in many different ways. Prior to the credit crisis of 2008. The fee may also dissuade investors from withdrawing funds after periods of poor performance.M. Unlike management and performance fees. The purpose of the fee is to discourage short-term investment in the fund.B.
meaning that the fund takes both long and short positions in shares traded on public stock exchanges. relative value (arbitrage). currency Instrument: long/short.Y. systematic/quantitative (or "quant" where the investments are selected according to numerical methods using a computerized system) Diversification: multi-manager.T. Method: discretionary/qualitative (where the individual investments are selected by managers). options. multi-strategy. technology. fixed income. market neutral Sector: emerging market.B. event-driven. despite a "hedge" being a means of reducing the risk of a bet or investment. managed futures (CTA) Market: equity. healthcare etc. commodity. multimarket • • • • • • The four main strategy groups are based on the investment style and have their own risk and return characteristics. futures. Each strategy can be said to be built from a number of different elements: • Style: global macro. The most common label for a hedge fund is "long/short equity". multi-fund. directional.F.M. Hedge fund risk Investing in certain types of hedge fund can be a riskier proposition than investing in a regulated fund. swaps Exposure: directional. Many hedge funds have some of these characteristics: 19 .
and other factors relevant to an investment decision. In September 1998. unless the short position directly hedges a corresponding long position. distressed securities. once the creditors have called in their loans. 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. It also had offbalance sheet positions with a notional value of approximately $1 trillion. such as high yield bonds. 20 .in addition to money invested into the fund by investors. diversification of the portfolio.M.T.hedge funds are more likely than other types of funds to take on underlying investments that carry high degrees of risk. If a hedge fund has borrowed $9 for every $1 received from investors.Y. Long-Term Capital Management had $125 billion of assets on a base of $4 billion of investors' money.F. shortly before its collapse. Short selling . Ordinary funds very rarely use short selling in this way. the losses that can be incurred on a losing bet are in theory limitless. Leverage . It can therefore be difficult for an investor to assess trading strategies. Appetite for risk .B. a hedge fund will typically borrow money or trade on margin. a leverage of over 30 times.hedge funds are private entities with few public disclosure requirements.due to the nature of short selling. with certain funds borrowing sums many times greater than the initial investment. and collateralized debt obligations based on sub-prime mortgages. Lack of transparency .
The portfolio is managed by the investment manager. Investors in hedge funds are.certain hedge fund strategies involve writing out of the money call or put options. required to be sophisticated investors who are assumed to be aware of these risks. Lack of regulation .B. the functions of a hedge fund are delegated to a number of other service providers. not subject to as much oversight from financial regulators as regulated funds. One approach to diagnosing hedge fund risk is operational due diligence. in some jurisdictions. The fund itself has no employees and no assets other than its investment portfolio and cash.T. secrecy helps to prevent imitation by competitors.M. and therefore some may carry undisclosed structural risks. in most countries. As well as the investment manager. and willing to take these risks because of the corresponding rewards: Leverage amplifies profits as well as losses.Y. Hedge fund structure A hedge fund is a vehicle for holding and investing the money of its investors.hedge fund managers are. Short volatility . If these expire in the money the fund may make large losses. The most common service providers are: 21 .F. and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis. short selling opens up new investment opportunities. which is the actual business and has employees. riskier investments typically provide higher returns.
M. Regulatory considerations will also play a role. this role is taken by the investment manager.F. An investor will still pay tax on any profit it makes when it realizes its investment. Prime brokers are typically parts of large investment banks. Outside of the U.B. particularly in the U. usually based in a major financial centre.the distributor is responsible for marketing the fund to potential investors.S.. some of these functions are performed by the investment manager.. Many hedge funds are established in offshore financial centres so that the fund can avoid paying tax on the increase in the value of its portfolio. and the investment manager. trade execution. lending securities for the purpose of short selling. In some funds. Distributor . The Cayman Islands was the most popular registration 22 . calculates the net asset value of the fund. Frequently. regulations often require this role to be taken by a third party.Y. Administrator – the administrator typically deals with the issue and redemption of interests and shares. Domicile The legal structure of a specific hedge fund – in particular its domicile and the type of legal entity used – is usually determined by the tax environment of the fund’s expected investors. Around 60% of the numbers of hedge funds in 2009 were registered in offshore locations. Prime broker – prime brokerage services include lending money. Many prime brokers also provide custody services.S. will pay tax on the fees that it receives for managing the fund. acting as counterparty to derivative contracts.T. a practice that gives rise to a potential conflict of interest inherent in having the investment manager both determine the NAV and benefit from its increase through performance fees. and performs related back office functions. clearing and settlement.
Offshore corporate funds are used for non-U. East coast – principally New York City and the Gold Coast area of Connecticut – this has become the leading location for hedge fund managers. The legal entity Limited partnerships are principally used for hedge funds aimed at USbased investors who pay tax. British Virgin Islands 7% and Bermuda 5%. entities that do not pay tax (such as pension funds). With the bulk of hedge fund investment coming from the U.Y. It was estimated there were 7.S. at the end of 2009. primarily in Ireland and Luxembourg.F. Around 5% of global hedge funds are registered in the EU. Asia.S. with threequarters of European hedge fund investments. as the investors will receive relatively favorable tax treatment in the US. London is Europe’s leading centre for hedge fund managers. Investment manager locations In contrast to the funds themselves. investors and U. is taking on a more important role as a source of funds for the global hedge fund industry. as such investors do not receive the same 23 . It was followed by Delaware (US) 27%.B.000 investment managers in the United States in 2004. location and accounted for 39% of the number of global hedge funds. The UK and the U. investment managers are primarily located onshore in order to draw on the major pools of financial talent and to be close to investors.T. 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. about $400 billion. and more particularly China.S. are leading locations for management of Asian hedge funds' assets with around a quarter of the total each.M.S.
The investment manager. a U. which will have organized the establishment of the hedge fund. limited partnership and a unit trust) to invest into the same master fund. To realize the investment.S. the price of each being the net asset value (“NAV”) per interest/share. Open-ended nature Hedge funds are typically open-ended.F. Founder shares typically have no economic rights and voting rights over only a limited range of issues. which will.Y. allowing an investment manager the benefit of managing the assets of a single entity while giving all investors the best possible tax treatment.T. the type of entity used does not have a significant bearing on the nature of the fund. an offshore corporate fund.g. Therefore. if the value of the underlying investments has increased (and the NAV per interest/share has 24 . Unit trusts are typically marketed to Japanese investors. such as selection of the investment manager. the investor will redeem the interests or shares at the NAV per interest/share prevailing at that time. Many hedge funds are structured as master-feeder funds. tax benefits from investing in a limited partnership. in that the fund will periodically issue additional partnership interests or shares directly to new investors. In such a structure. may retain an interest in the hedge fund. Other than taxation. invest all of its assets into the master fund. This allows several feeder funds (e. the investors will invest into a feeder fund. The fund’s strategic decisions are taken by the board of directors of the fund. in turn.B. which is independent but generally loyal to the investment manager. The assets of the master fund will then be managed by the investment manager in the usual way.M. either as the general partner of a limited partnership or as the holder of “founder shares” in a corporate fund.
If the illiquid assets subsequently turned out to be worth less than expected. which has a limited number of shares which are traded among investors. A side pocket is a mechanism whereby the fund segregates the illiquid assets from the main portfolio of the fund and issues investors with a new class of interests or shares which participate only in the assets in the side pocket.Y. his redemption proceeds could only be obtained by selling the liquid assets of the fund. the fund may employ a "side pocket". This contrasts with a closed-ended fund.M. Side pockets Where a hedge fund holds assets that are hard to value reliably or are relatively illiquid (in comparison to the redemption terms of the fund itself). and which distributes its profits.B. Side pockets therefore allow a fund to ensure that all investors in the fund at the time the relevant assets became illiquid will bear any loss on them equally and allow the fund to continue subscriptions and redemptions in the 25 .F. Side pockets are designed to address issues relating to the need to value an investor's holding in the fund if they choose to redeem. Moreover. Investors do not typically trade shares or interests among themselves and hedge funds do not typically distribute profits to investors before redemption.T. therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Those interests/shares cannot be redeemed by the investor. the fund cannot be confident that the calculation of his redemption proceeds would be accurate. Once the fund is able to sell the side pocket assets. the remaining investors would bear the full loss while the redeemed investor would have borne none. the fund will generally redeem the side pocket interests/shares and pay investors the proceeds. If an investor redeems when certain assets cannot be valued or sold.
applies to subscriptions during the same period.T. as this provides a low level of regulatory oversight that is required by some investors.F. and their cachet in the public imagination is that they straddle multiple definitions and 26 . Once the damage has been assessed. Specific types of fund may also use side pockets in the ordinary course of their business. Regulatory issues Part of what gives hedge funds their competitive edge. inverted. Side pockets are most commonly used by funds as an emergency measure. A similar problem.B. may routinely side pocket securities linked to natural disasters following the occurrence of such a disaster. the IPO of Fortress Investment Group LLC was for the sale of the investment manager. Listing of Hedge Funds Corporate hedge funds sometimes list their shares on smaller stock exchanges. preventing the funds from selling or obtaining a market value for the assets. A fund investing in insurance products. meantime in respect of the main portfolio. They were used extensively following the collapse of Lehman Brothers in September 2008. such as the Irish Stock Exchange.Y. A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an investment manager. when the market for certain types of assets held by hedge funds collapsed. Although widely reported as a "hedgefund IPO".M. Shares in the listed hedge fund are not generally traded on the exchange. the security can again be valued with some accuracy. for example. not of the hedge funds that it managed.
There are other limitations and restrictions placed on public investment company managers. Those exemptions are for funds with 100 or fewer investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7 Fund"). 27 . they have avoided the typical regulations for investment companies because of exceptions in the laws. Securities and Exchange Commission (SEC). investment companies are subject to strict limitations on short-selling and the use of leverage. Although hedge funds are investment companies. The Securities Act of 1933 disclosure requirements apply only if the company seeks funds from the general public. Mutual funds are the most common type of registered investment companies. categories.F. and the quarterly reporting requirements of the Securities Exchange Act of 1934 are only required if the fund has more than 499 investors. U.) A 3(c)1 Fund cannot have more than 100 investors. while others are unregulated or at best quasi-regulated.S.M. A qualified purchaser is an individual with over US$5. including the prohibition on charging incentive or performance fees. Aside from registration and reporting requirements. (Some institutional investors also qualify as accredited investors or qualified purchasers.Y. A 3(c)7 fund with more than 499 investors must register its securities with the SEC.T.000 in investment assets. The two major exemptions are set forth in Sections 3(c) 1 and 3(c) 7 of the Investment Company Act of 1940.000. regulation The typical public investment company in the United States is required to be registered with the U.B. some aspects of their dealings are well-regulated.S. while a 3(c)7 Fund can have an unlimited number of investors.
a minimum income of US$200. hedge funds raise capital via private placement under the Securities Act of 1933. To be a qualified client. The new rule was controversial.000. and.000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1. There are numerous issues surrounding these proposed requirements.F. A client who is charged an incentive fee must be a "qualified client" under Advisers Act Rule 205-3. in June 2006.000 or.T. the U. with two commissioners dissenting.000 with over 14 investors.Y. The requirement. alternatively.000 in invested assets. the exemptions under the Investment Company Act. as investment advisers under the Investment Advisers Act. combined with the restrictions contained in Regulation D.000 in assets invested with the adviser or a net worth in excess of US$1. For banks and corporate entities. with minor exceptions. An accredited investor is an individual person with a minimum net worth of $1. In December 2004. the minimum net worth is $5.000.B. Court of Appeals for the 28 . There have been attempts to register hedge fund investment managers.M. 2006. or be one of certain high-level employees of the investment adviser.000. The rule change was challenged in court by a hedge fund manager. applied to firms managing in excess of US$25. Although it is possible to have non-accredited investors in a hedge fund. an individual must have US$750.S.5 million. In order to comply with 3(c)(1) or 3(c)(7). effectively require hedge funds to be offered solely to accredited investors. and normally the shares sold do not have to be registered under Regulation D. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry.
S. private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. and permit investors to enter or leave the fund.Y. District of Columbia overturned it and sent it back to the agency to be reviewed. See Goldstein v. 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. perhaps requiring some months notice. In November 2009 the House Financial Services Committee passed a bill that would allow states to oversee hedge funds and other investment advisors with $100m or less in assets under management. in 2007 the SEC adopted Rule 206(4)-8. Both are lightly regulated. Hedge funds often invest in private equity companies' acquisition funds. or roughly 710. Rule 206(4)-8. In response to the court decision. some hedge funds adopted 25-month lock-up rules expressly to exempt themselves from the SEC's new 29 . Most hedge funds invest in relatively liquid assets. the President's Working Group on Financial Markets rejected further regulation of hedge funds and said that the industry should instead follow voluntary guidelines.M. In February 2007. the bill would shift 43% of these companies.F. Because the SEC currently regulates advisers with $25m or more under management. Comparison to U.B. unlike the earlier challenged rule. leaving larger investment managers up to the Securities and Exchange Commission. Between 2004 and February 2006. back over to state oversight. private equity funds Hedge funds are similar to private equity funds in many respects. SEC.T. "does not impose additional filing. reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity.
however. there are many differences between the two. 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. Hedge fund investors tolerate these policies because hedge funds are expected to generate higher total returns for their investors versus mutual funds. registration requirements and cause them to fall under the registration exemption that had been intended to exempt private equity funds. while hedge funds are not A hedge fund investor must be an accredited investor with certain exceptions (employees. whereas hedge funds do not have to abide by these terms. money people want to invest). However. Tax W-forms. In addition. Hedge funds also ordinarily do not have daily liquidity.S.S. mutual funds must have a prospectus available to anyone that requests one (either electronically or via U.S.T.) 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. including: • • Mutual funds are regulated by the SEC. mutual funds Like hedge funds.. and must disclose their asset allocation quarterly. 30 . Recently.Y.e. etc. Comparison to U. but for most there is no method of ascertaining pricing on a regular basis. the mutual fund industry has created products with features that have traditionally been found only in hedge funds. through a pass through requiring CPAs and U.M.B.F. mutual funds are pools of investment capital (i. postal mail).
S. 3417. For example. Several bills have been introduced in the 110th Congress (2007–08). under Section 205(b) of the Investment Advisers Act of 1940.T. Such funds are SEC regulated.B.R. such compensation is limited to so-called "fulcrum fees". where the compensation to the manager is based on the performance of the fund. Grizzly Short Fund (GRZZX). while Arbitrage Fund (ARBFX) specializes in merger arbitrage. Proposed U. fees can be performance-based so long as they increase and decrease symmetrically. the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves. but they offer hedge fund strategies and protection for mutual fund investors. which would establish a Commission on the Tax Treatment of Hedge Funds and Private Equity to investigate imposing regulations. Mutual funds that utilize some of the trading strategies noted above have appeared. However. 681.M. 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. regulation Hedge funds are exempt from regulation in the United States. is always net short. H. a bill to restrict the use of offshore tax havens and abusive tax shelters to inappropriately avoid Federal taxation.F. Under these arrangements. however. a few mutual funds have introduced performance-based fees. for example. within limits and symmetrically.Y. 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. 31 • . Also. However. Among them are: • S. relating to such funds.
and S. a bill to amend the Investment Advisors Act of 1940. • S.F. and are not directly regulated by the UK authorities. 1402. a bill to amend the Internal Revenue Code of 1986 to provide that the exception from the treatment of publicly traded partnerships as corporations for partnerships with passive-type income shall not apply to partnerships directly or indirectly deriving income from providing investment adviser and related asset management services.B. a bill to amend the Commodity Exchange Act to prevent excessive price speculation with respect to energy commodities.M. and punish price manipulation and excessive speculation. S. usually in an offshore location such as the Cayman Islands. 32 . As the UK is part of the European Union. • • None of the bills has received serious consideration yet. The bill would give the federal regulator of futures markets the resources to detect. 3268.Y. UK regulation Hedge funds managed by UK hedge fund managers are always incorporated outside the UK. However. the UK hedge fund industry will also be affected by the EU's Directive on Alternative Investment Fund Managers. 1624. a hedge fund manager based in the UK is required to be authorized and regulated by the UK's Financial Services Authority. prevent. and accordingly the UK hedge fund industry is regulated. with respect to the exemption to registration requirements for hedge funds.T.
heterogeneous and ephemeral. British Virgin Islands. Offshore regulation Many offshore centers are keen to encourage the establishment of hedge funds. their quoted returns may not be available in practice. They are widely accepted as representative. and business-friendly regulation. Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centres. and products such as futures and ETFs provide investable access to them in most developed markets. In traditional equity investment. indices play a central and unambiguous role. To do this they offer some combination of professional services. Luxembourg. with nearly half the industry's estimated $1. and these fall into three main categories.F. Investable indices achieve liquidity at the 33 .B. In their historical order of development they are Non-investable. Investable and Clone.Y.T. which makes it hard to construct a satisfactory index. However hedge funds are illiquid.M. The Cayman Islands have been estimated to be home to about 75% of world’s hedge funds. Major centers include Cayman Islands. due to various biases. Non-investable indices are representative.225 trillion. but. Typical rules concern restrictions on the availability of funds to retail investors (Dublin). protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager. and Bermuda. a favorable tax environment. Dublin. Hedge Fund Indices There are many indices that track the hedge fund industry.
we will overestimate past returns because many of the worstperforming funds have not survived. None of these approaches is wholly satisfactory. and no single database captures all funds. It is likely that funds 34 . median or weighted mean from a hedge fund database. This leads to significant differences in reported performance between different indices. The databases have diverse selection criteria and methods of construction. Non-investable indices Non-investable indices are indicative in nature. which raises the problem of survivorship bias. leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole.F. If we examine only funds that have survived to the present.M.T. When a fund is added to a database for the first time. non-investable indices suffer from a lengthy and largely unavoidable list of biases. and aim to represent the performance of some database of hedge funds using some measure such as mean.B. Although they aim to be representative. expense of limited representativeness. Funds’ participation in a database is voluntary. and the observed association between fund youth and fund performance suggests that this bias may be substantial.Y. The short lifetimes of many hedge funds means that there are many new entrants and many departures each year. all or part of its historical data is recorded ex-post in the database. For example. Clone indices seek to replicate some statistical properties of hedge funds but are not directly based on them. 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.
making an investable index similar in some ways to a fund of hedge funds portfolio.B. Instead of reflecting the performance of actual hedge funds they take a statistical approach to the analysis of historic hedge fund returns. When investors buy these products the index provider makes the investments in the underlying funds. these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. This means that investable indices do not represent the total universe of hedge funds. so that the average performances displayed by the funds during their incubation period are inflated. Hedge Fund Replication The most recent addition to the field approach the problem in a different manner. hedge funds must agree to accept investments on the terms given by the constructor. and use this to construct a model of how hedge fund returns respond to the movements of various investable financial assets. To create an investable index. and most seriously they may under-represent more successful managers. and in principle they can be as representative as the hedge fund database from which they were constructed. This model is then used to construct an investable portfolio of those assets. only publish their results when they are favorable. This makes the index investable. 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 make the index investable. To make the index liquid.M.F.Y.T. 35 .
Some believe that broad hedge fund investment strategies have also become increasingly correlated. thereby further increasing the potential adverse effects of disorderly exits from crowded trades. As replication indices have a relatively short history it is not yet possible to know how reliable this process will be in practice. The excessive leverage (through derivatives) that can be used by hedge funds to achieve their return is outlined as one of the main factors of the hedge funds' contribution to systemic risk. they rely on a statistical modeling process. transparency and fraud that exist in direct hedge fund investments. although initially indications are that much of hedge fund returns can be replicated in this manner without the problems of illiquidity. The ECB (European Central Bank) issued a warning in June 2006 on hedge fund risk for financial stability and systemic risk: ". Debates and Controversies Systemic risk Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital Management (LTCM) in 1998.F.M." However the ECB statement has been disputed by parts of the financial industry. The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge funds in June 2007.B.T.. the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability.. The funds invested in mortgage36 . Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster. Federal Reserve.Y. which necessitated a bailout coordinated (but not financed) by the U. which warrants close monitoring despite the essential lack of any possible remedies. However.S.
An investor in a hedge fund usually has direct access to the investment advisor of the fund. hedge funds are not obliged to disclose their activities to third parties.) and that 5% of return numbers and 5% of NAV numbers were dramatically different. A study was done on two major databases containing hedge fund data. Funds may choose to report some information in the interest of recruiting additional investors. The study noted that 465 common funds had significant differences in reported information (e. Securities and Exchange Commission is investigating. etc. backed securities.000. It was the largest fund bailout since Long Term Capital Management's collapse in 1998. incentive fee. 37 . This is in contrast to a regulated mutual fund (or unit trust). which may cost on the scale of $50. Much of the data available in consolidated databases is self-reported and unverified. returns. this high level of disclosure is not available to non-investors. The U. This may include detailed discussions of risks assumed and significant positions. and may enjoy more personalized reporting than investors in retail investment funds.T. The funds' financial problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside assistance. contributing to hedge funds' reputation for secrecy. management fee.S. which will typically have to meet regulatory requirements for disclosure. while some hedge funds have very limited transparency even to investors.B. investment styles. investors have to do their own research. With these limitations.g. net assets value.Y.M. inception date. Transparency As private. However.F. lightly regulated entities.
which may dilute the talent available in the industry. the remuneration model is attracting more managers.F. and in extreme cases can assist fraud.B. However summaries are occasionally available in various journals. U.S. 38 . Performance measurement Performance statistics are hard to obtain because of restrictions on advertising and the lack of centralized collection. investigations In June 2006. the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance.T. Securities and Exchange Commission (SEC) is also focusing resources on investigating insider trading by hedge funds. mainly American. do not use third parties either as the custodian of their assets or as their administrator (who will calculate the NAV of the fund). though these causes are disputed. Some hedge funds. Kirk Wright of International Management Associates has been accused of mail fraud and other securities violations which allegedly defrauded clients of close to $180 million. While Madoff did not run a hedge fund. Market capacity Alpha appears to have been becoming rarer for two related reasons. This can lead to conflicts of interest. In December 2008.Y. Second. The U.M.S. In a recent example. his case clearly does illustrate the value of independent verification of assets. First. the Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. Bernard Madoff was arrested for running a $50 billion Ponzi scheme.
Traditional indicators (Sharpe. hedge fund returns are not normally distributed. Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004).M.B. making them even less reliable than is suggested by the shortness of the available return series. 39 . Are all hedge funds speculative and risky? A majority of the funds stress on returns. In that case. there is a whole group of funds that emphasizes low volatility. and hedge fund return series are auto correlated. and Kappa by Kaplan and Knowles (2004). risk is represented by the standard deviation. Consequently. At the other extreme.T. Treynor. Jensen) work best when returns follow a symmetrical distribution. Several innovative performance measures have been introduced in an attempt to deal with this problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003). there is no consensus on the most appropriate absolute performance measure.g.F. Omega by Keating and Shadwick (2002). and traditional performance measures are still widely used in the industry. for the highly risk-averse investor. However. traditional performance measures suffer from theoretical problems when they are applied to hedge funds. Unfortunately. E. Some managers do an excellent job of keeping volatility down close to government-bond level but handily beating bond returns.: Relative benchmark index used for Market neutral security hedging is usually T-bills.Y. The question of how performance should be adjusted for the amount of risk that is being taken has led to literature that is both abundant and controversial.
Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in investor portfolios. 2. To demonstrate this. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers. and 3. portfolios offer the highest level of return per unit of risk. and ten hypothetical hedge funds. Kritzman repeated the optimization using an assumption 40 . largely because of the impact of performance fees.T. reducing overall portfolio risk However. Hedge funds are highly individual and it is hard to estimate the likely returns or risks. rational investors will seek to hold portfolios that are mean/variance efficient (that is. Hedge fund returns are reduced considerably by the high fee structures that are typically charged. there are three reasons why one might not wish to allocate a high proportion of assets into hedge funds. Hedge funds’ low correlation with other assets tends to dissipate during stressful market events.B. These reasons are: 1. 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. making them much less useful for diversification than they may appear. a bond index fund. Value in mean/variance efficient portfolios According to Modern Portfolio Theory. 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. and the lowest level of risk per unit of return).F.Y.M. The optimizer found that a mean-variance efficient portfolio did not contain any allocation to hedge funds.
just when an investor needs part of their portfolio to add value. posting losses significantly worse than the average hedge fund.M. even though low average correlations may appear to make hedge funds attractive this may not work in turbulent period. 41 .S. even "dedicated short bias" funds had a return of -6. both residential and commercial.6% in 2008.65% (the HFRI Fund Weighted Composite Index return) was far better than the returns generated by most assets other than cash.T.F.7% and the average Latin America mutual fund plummeted 57. For example. According to Lipper.08% during September 2008. in January-September 2008. domestic equity mutual fund decreased 37. The average sector mutual fund dropped 39. and that was one of the best performing equity indices in the world. hedge funds outperformed many similarly-risky investment options in 2008.3%. Real estate.Y. The average international equity mutual fund declined 45. the Credit Suisse/Tremont Hedge Fund Index was down 9. Hedge funds posted disappointing returns in 2008. also suffered significant drops in 2008. The result from this second optimization was an allocation of 74% to hedge funds.87%. The average China mutual fund declined 52. but the average hedge fund return of -18. Mutual funds also performed much worse than hedge funds in 2008.00% in 2008. The other factor reducing the attractiveness of hedge funds in a diversified portfolio is that they tend to under-perform during equity bear markets. In summary. for example around the collapse of Lehman Brothers in September 2008. According to the same index series.7%. The S&P 500 total return was -37. In other words. the average U. Several equity markets lost more than half their value. Most foreign and domestic corporate debt indices also suffered in 2008.B.8%. that the hedge funds incurred no performance fees.
not terribly predictable.T.Y. macro hedge 42 .E. They can be enormously profitable. I compare macro funds to grizzlies not only to highlight these common aggressive characteristics but to point out that like grizzlies. such funds are not for the faint of heart. and can also produce occasional sudden falls.S. Instead.B. but are volatile. his funds lost 29 percent when the Fed raised interest rates in the U. and using leverage and derivatives to accentuate the impact of market moves. Shaw Fortress Investment Group GLG Partners Long-Term Capital Management Man Group Marshall Wace Renaissance Technologies SAC Capital Advisors Soros Fund Management The Children's Investment Fund Management (TCI) In the hedge-fund kingdom. causing European interest rates to kick up. causing bonds to rise. Aiming to profit from changes in global economies. For example.F.. Notable Hedge Fund Firms • • • • • • • • • • • • • Amaranth Advisors Bridgewater Associates Citadel Investment Group D. during the first quarter of 1994 hedge-fund superstar Michael Steinhardt (whose funds produced an average annual return of 24 percent over several decades) bet European interest rates would decline.M. global macro funds can be compared to grizzlies.
Hedge Fund Association Founded in 1995. lawyers. administrators.B. funds are only one species in a wide universe – and that they differ from other hedge funds as much as grizzlies differ from other animals. it is easily made when viewed in the context of tools used. With the maturity and institutionalization of the global hedge fund industry. global financial institutions with hedge fund offerings including retail and private banks. commodities. when global hedge fund assets were just approaching the $250 billion mark. public and private pension funds. practitioners and investors who are shaping the way business is conducted in the global hedge fund industry. innovators.that they all use global macro strategies and place large directional bets on stocks. auditors. bonds. and gold. investors including funds of hedge funds. high net worth individuals. technologists and third party marketers.T.like leverage and short selling. endowments and foundations. while using lots of leverage. and the industry’s service providers including prime brokers. Membership in the HFA includes hedge fund firms.F. risk managers. The Hedge Fund Association™ (HFA) is a not-for-profit international group of industry professionals with a mission to provide a forum for thought leaders.Y. Even though the inference of gambling is not usually correct. regulators and legislators. by Dion Friedland. Traditional Assets The normal view is that hedge funds are highly risky . custodians. the media. allocators. the HFA advocates for the industry by giving voice to the issues affecting the industry through the education of investors. Risk & Reward Comparisons Hedge Funds vs. These are perceived by most investors as purely speculative tools. currencies. family offices. asset management firms and broker dealers. 43 .M.
Its borrowing in the 1997 alone averaged between 50 and 100 times its asset base.T. on the theories espoused by his partners. John Meriwether. Advantages of Hedge Funds vs. LTCM had nearly $1 trillion in bad investments. engaged in arbitraging pricing differentials in the bond markets. through betting on convergence in the prices of similar assets. The theory worked very well .B. and history is full of people who thought they had found the alchemist's stone .Y. But there is a wide range of outcomes.000 and 5. LTCM was a hedge fund. Measured against major equity and bond indices. in 1998. and it borrowed from the biggest of banks and brokerage houses in the world.but when differentials blew out. the firm's highly leveraged positions quickly lost money. and many use no leverage. like Quantum. global hedge fund indices do indeed appear more attractive. Mutual Funds Hedge funds are extremely flexible in their investment options because they use financial instruments generally beyond the reach of mutual funds. thereby endangering a banking system already rocked by losses in Russia and the Far East. bet his firm. The reality is that less than 5% of hedge funds are global macro funds causing speculative waves and contagions. and lost. But many hedge funds successfully employ them to increase performance while actively managing risk. Tiger. 44 . but only $2 billion in assets that it could sell to pay off its debts.000 active hedge funds in this industry.M. necessitating an eventual bail-out by a group of banks.F. the Nobel prize-winning economists. and Strome. the anti-hero of Michael Lewis' book Liars Poker.some magical ingredient that turns dross into gold. Estimated to be growing at about 20% per year.for a time . there are between 4. Robert Merton and Myron Scholes. founded by Meriwether in 1994. Indeed. with lower volatility and higher return. Long Term Capital Management (LTCM). Most hedge funds use derivatives only for hedging or don't use derivatives at all.
Unlike many mutual fund managers. This incentive fee structure tends to attract many of Wall Street’s best practitioners and other financial experts to the hedge fund industry.Y. regardless of performance. In the last nine years. 45 .M.T. hedge fund managers are usually heavily invested in a significant portion of the funds they run and share the rewards as well as risks with the investors. gives hedge funds the ability to best manage investment risks. Where is Investcorp Bank BSC in the Hedge Funds market? Investcorp. This flexibility. and derivatives.B. "Incentive fees" remunerate hedge fund managers only when returns are positive. their growth reflects the importance of this alternative investment category for institutional investors and wealthy individual investors. Currently. whereas mutual funds pay their financial managers according to the volume of assets managed. has won the Hedge Fund of Funds Leader of the Year award at the prestigious Alternative Investment News hedge fund industry awards organized by the international Publication Institutional Investor. The strong results can be linked to performance incentives in addition to investment flexibility. the asset manager specializing in alternative investments. leverage. While the number and size of hedge funds are small relative to mutual funds. which have SEC regulations and disclosure requirements that largely prevent them from using short selling. concentrated investments. there are estimated to be approximately 8350 hedge funds managing $1 trillion. the number of hedge funds has risen by about 20 percent per year and the rate of growth in hedge fund assets has been even more rapid. which includes use of hedging strategies to protect downside risk. Investcorp's hedge fund team beat four other highly regarded fund of funds on the short list.F.
7 billion is proprietary investment. of which $1. Investcorp is one of the leading institutional investors in hedge funds with approximately $4. co-heads of Asset Management at Investcorp. institutional market.M. This is testament to the long term achievements of Investcorp's hedge fund business over the past nine years and our success in building a strong business. Hedge Fund Market Structure: i) Operational Structure: Hedge funds are usually not operated in-house by their employees. we set up a single manager platform and have already partnered with two high profile groups.S.B. Deepak Gurnani and Ibrahim Gharghour. both expressed their delight at receiving this recognition. Deepak Gurnani said: "It is a great tribute to be recognized by our industry peers as well as by the premier awards in the hedge fund industry. They are just investment vehicles owned by investors and sponsors (or limited 46 .T. Interlachen Capital Group and Cura Capital Management. in order to provide our investors greater variety and access to leading specialist funds. where we have attracted substantial US institutional money into our programme. Goldman Sachs and Bear Stearns.6 billion under management.F. The judges cited Investcorp's penetration of the U.' Ibrahim Gharghour added: 'This award also recognizes our substantial recent progress in the United States. its growth in assets under management and its new single manager platform as the critical success factors. In addition.Y. last year. The awards were judged by a panel of experts from leading institutions including JP Morgan. The award was presented in New York this week at a ceremony that celebrated the achievements of the hedge fund industry. not least in establishing leading risk management processes to set us apart from other providers.
6. hedge funds establish relationships with all the necessary industry service providers: 1.The Investment Adviser: The role of investment advisor is simply to give professional advice on the funds investment in a way that is consistent with the funds investment objectives and policies.M. and general parents) and rely on external service providers to conduct the funds day-to-day business. the investment adviser may be a part of the same overall organization as the hedge fund he serves.The Custodian: 47 . 3.F. that is as we talked early (page 1) the sponsor will be the general partner and the investor will be the limited partner. 2.The sponsors and the investors: The sponsor is the creator of the fund and he will typically hold a member of the founder shares in the fund.B. So for this type of operation structure.T.Y.The Manager or Management Company: He/she is responsible for office overhead. and is usually established in a major onshore financial center as London or New York. or he may be unrelated to it. 4-The board of directors: The board of directory is responsible for monitoring the overall operations of the fund. 5-The fund administrator: His primary task is to ensure accurate calculation of the net asset value at regular time interval called break periods. including managing the fund portfolio and providing administrative services.
and to verify the annual financial statement. 1.The registrar and transfer agent: He/she keeps and updates a register of shareholders of the hedge fund. 7. 9. clearing and settlings all trades and monitoring corporate actions such as dividend payments and proxy-related information.Side-by-side and master/feeders: 48 .The legal advisor or lawyer: The legal adviser or lawyer assists the hedge fund with any tax code and/or legal matters. as well as for the payment of any dividends and distributions.T.Clearing the trades. and ensure compliance with domestic investment regulations as well as with regulations of countries where the fund is distributed.M.B.F.Y. . 8.The Prime Broker: The role of prime brokers goes beyond just replacing the hedge funds back office. The custodian’s primary responsibilities include safekeeping of the fund’s assets. if any. they should be seen as full service providers across the core functions of execution and operation for example: .Acting as global custodian.The auditors: The auditors’ role is to ensure that the hedge fund is in compliance with\ accounting practices and any applicable laws.Securities lending.Margin financing. Rather. . He also processes and takes necessary actions for subscriptions and withdrawals of shares in the fund. ii) Organization Structure: Hedge funds also need to set up efficient organizational structures. 10. .
e. A combination of statutory provisions and rules under the 1933 Act and the Investment Company Act for private rather than public offerings allow for them — and the securities they issue to investors 49 . In this structure a series of funds (called feeders) sell shares to investors under the 12 terms of their prospectus and contribute their respective proceeds to another fund (called the master fund) rather than investing directly. and the cloning process essentially consists in facilitating bunched trades among the cloned funds and rebalancing cloned funds that have experienced different cash flows. that there are between 6.F. portfolio managers and a custodian or administrator. however. the assets invested in hedge funds will exceed $1 trillion.Managed accounts. several funds having identical or substantially similar investment policies invest in parallel in a group of cloned portfolio.Umbrella funds.Y.Hedge Fund Market Size: If we are going to talk about how big is the hedge fund industry.6 1. The master/feeder structure is an efficient alternative to side-by-side funds.T. These portfolios usually share a common investment adviser.Multiclass/Multiseries Funds. also called mirror funds or clone funds. And that is wonder us to know why hedge fund is exempt from SEC regulations. 3.M. 2.000 funds that manage approximately $600 to $650 billion in assets. the answer is simply is of the hedge funds are only offered to wealthy individuals and institutions. In side by side structures. 4.000 and 7. The report predicts that in the next five to 10 years.B. then it will definitely a question without an accurate answer because as we know that SEC doesn’t regulate hedge fund i. hedge fund are not required to register but the SEC estimates.
2. US Pensions.US Insurance. Europe insurance.F. Wealthy individual: Wealthy individuals (High Net Worth Individuals or HNWI) – individuals with assets in excess of US$ 1 million .B. Many funds use the safe harbor in the 1933 Act that allows them to sell to "accredited investors. buyers of hedge funds and provider of hedge funds. But in Europe – London 50 . And it is divided as follows: . a) Buyers of Hedge Funds: Current ownership is divided between Wealthy individuals (High Net Worth Individuals or HNWI) and institutions.000 or more.Very high fees and very high profitability.000 or more. married couples with a joint income of $300.M.The vast majority of hedge fund managers are located in North America – largely in the New York and Los Angeles areas. Europe Pensions and US non-profit. The typical hedge fund manager charges a management fee in excess of 1% (versus 40-50 bp on the typical long only portfolio) and usually is entitled to 20% of the profit if a certain target return is exceeded.account for over 60% of the approximately $600bn invested in hedge funds. . 2.US HNWI and Europe HNWI. Now let us have a close look for wealthy individual.Y.T.Key Players We can divide the key players in two categories. b) Provider of Hedge Funds: 1. or individuals with a net worth of $1 million. — To remain unregistered." These are individuals with an annual income of $200. There are signs that hedge funds are becoming a standard element in HNWI – not just super wealthy – portfolios.
Anecdotal evidence suggests US managers are opening in larger scale in London. According to the survey conducted by an American hedge fund research company. the size of hedge fund market--which was worth US$324 billion in early 2000--exceeded US$1 trillion for the first time by early January 2005. There are signs that with the amount of institutional money facing the market. to be viable. standards and expectations on managers are falling.a large number of companies are starting up. Also we can consider the players in the previous section as key player in Hedge fund even though some of them are not directly involved in such things.T. 3. a further 12 months on. If performance is good the fund reopens 12 months later and grows to $60-100m. Top 100 Hedge Funds The market’s horrors of 2008 gave way to the pleasures of 2009. particularly.F. 3-Competitive Positioning The hedge fund market has been growing dramatically in recent years. The investment managers must have considerable experience and those with good reputations can raise $250m at launch. had to raise about $20m.B.Most advisors noted a specific life cycle for hedge funds. New start ups. But in practice few funds grow beyond the $25-30m size. If performance is sustained. Experience in short selling is critical as are robust risk control measures. John Paulson’s Paulson Credit Opportunities fund has gained a phenomenal 123% annually over the past three years. 4-The credibility of the investment decision making process is critical to fundraising. the fund can re-open and grow to $300-600m. The worst-performing member of Barron’s Top 100 has returned roughly five times what the average hedge 51 .Y.M.
F. 52 . GBP and Euro) refer to specific currency classes of a fund.Y. Currencies (USD.T.B.M. fund has risen.
Y. 53 .B.T.M.F.
Y.F. 54 .B.M.T.
M.Y.T.F.B. FINANCIAL CRISIS AND HEDGE FUNDS 55 .
and the subsequent turbulence that swept the world’s financial markets over the next 12-18 months. The Committee also made a reference to the role played by some hedge funds complex trading strategies involving futures were thought by some authorities to have exerted a destabilizing influence on market performance in their jurisdictions. has been significant not only in terms of the financial. LTCM built its positions on sophisticated arbitrage trading strategies. East Asian Crisis The impact of the East Asian crisis which materialized in the middle of 1997. operation and regulation of the international financial system. it used a 56 . In spite of difference of views. the roles played by some of the large hedge funds have often been associated with major financial crisis that took place in the 90’s. In addition.T. Causes of the crisis remain among the most contentious issues and continue to be debated at the academic as well as policy level. attributed the negative public perception of the role of hedge fund managers in crisis partly to the limited information available about what they actually do.Y. Long Term Capital Management (LTCM) Another major financial crisis involving a large hedge fund was that of the huge loss (US $ 4 billion) suffered by LTCM in 1998. subsequent research could not produce robust evidence implicating the hedge funds for precipitating the crisis.B. However.M. but also in terms of drawing the world’s attention to outstanding issues concerning the structure.F. Currency speculators pursued a so-called “double play” aimed at playing off the Hong Kong currency board system against the administrations stock and futures markets. economic and social consequences that these events wrought on emerging market economies. however. The Emerging Markets Committee of IOSCO identified multiple causes of the East Asian crisis. Researchers have.
he also asserted that it was too soon to tell whether LTCM’s investment strategies represent the norm in the hedge funds industry or.M. LP (LTCM). can provide benefits to global financial markets. resulting in losses for other participants in those markets. In August. However. it became clear to LTCM that many of the assumptions inherent in the arbitrage positions it held were incorrect. recommended strong and prudent risk management processes at the regulated firms with which the HLIs trade. the Technical Committee of the IOSCO formed a special Task Force on Hedge Funds and Other Highly Leveraged Institutions to address regulatory issues relating to the activities of highly leveraged institutions (HLIs) or hedge funds. The Committee in its report underlined that HLIs. Liquidation of LTCM’s positions could have potentially disrupted the financial markets. Finally. and the legal and other uncertainties arising out of the extensive operations in offshore centers posing particular challenges which need to be managed carefully in order to avoid risks to the financial system. 57 . as well as the proper role that regulators should play with respect to those activities. Due to LTCM’s leverage (which at one point has exceeded 50 to 1).Y. a consortium of banks worked out a rescue plan facilitated by the Federal Reserve Bank of New York. In response to the near collapse of Long-Term Capital Management.F. as the global financial crisis worsened.T.B. It also highlighted the combination of characteristics typically associated with HLIs such as significant leverage. as a defense against systemic risk in the market . whether LTCM was an overly aggressive player among otherwise responsible market participants. and September of 1998. those incorrect assumptions resulted in substantial losses for the firm and eroded its capital base5. The committee. significant degree of leverage to increase its expected return. like other institutional investors. acknowledged that LTCM’s potential impact on the world’s financial markets raises legitimate questions about the activities of hedge funds in general.
which invested in publicly traded Indian securities. through its predecessor company.S. such perceived misdemeanors by certain hedge funds have been considered more as occasional aberrations than general industry wide behaviour. 2nd Hedge Fund .B. It ran an investment fund. homeland security and other strategic sectors. started as an investment advisory firm in 2005.HFG India Continuum Fund: Hudson Fairfax Group (HFG) is an investment partnership focused on India’s aerospace. During the operation of its fund. It is based in New York with an advisory office in New Delhi.M.Y.Avatar Investment Management: 58 .T. The Committee also highlighted the importance of transparent disclosure by the regulated entities dealing with HLIs and HLIs themselves on a voluntary basis. HFG was a Registered Investment Advisor (RIA) with the U. List of Hedge Funds in India 1st Hedge Fund . as a means to maintain market integrity.F. In spite of occasional negative perception about the role of hedge funds. the HFG India Continuum Fund. This is also corroborated by the fact that many jurisdictions are gradually opening up their markets for hedge funds to establish and market their products. Its team has five decades of focused experience in the sector combining investment and industry expertise. Securities & Exchange Commission and a Foreign Institutional Investor (FII) with the Securities & Exchange Board of India. defense. Hudson Fairfax Group. for the purpose of this paper it must be emphasized here that allowing access to offshore hedge funds to invest in India through FII route will not provide any opportunity to them to build up leveraged position onshore as borrowing by FIIs are not allowed under the terms of RBIs general permission. Further.
family offices and high net-worth individuals. the India Deep Value Fund was launched in April 2006. Headquartered in Mauritius. Avatar Investment Management is the investment advisor to three funds. LLC was founded by Robin Rodriguez and Raj Agarwal in 2006 to pursue the number of significant investment opportunities presented by the burgeoning Indian capital and real estate markets. The principals have a combined over 30 years of experience in researching and investing in India. As a result. In July 2003.India Capital Fund: 59 . 4th Hedge Fund . India was formed in 2002 to provide boutique fund management services to institutions.B.India Deep Value Fund: India Investment Advisors. India launched the India Absolute Return Fund (IARF). 5th Hedge Fund . In order to meet the approval of various regulatory bodies around the world. the funds are focused on the Indian public and private equity markets. India has a research presence in Mumbai. foundations. It seek absolute. 3rd Hedge Fund .Y.Fair value: Fair Value Capital is a highly specialized and exclusive Investment Advisory Firm focused on Deep Value Investment opportunities primarily in Indian equity markets. India.T.India Capital Pvt Ltd India Capital Pvt. The Fund's Managers seek to achieve long-term capital gains by acting as pro-active deep value investors in publicly-traded Indian stocks. Fair Value specializes in Deep Value Investments in the Indian equity markets. only accredited investors may apply to invest. Ltd (India) is a Singapore based investment advisor. 6th Hedge Fund . In addition to the Singapore office. long-term returns for its investments while minimizing investment risks using a Value oriented approach towards our investments.F. a directional fund investing in India and Indian companies globally.M.
From diversified proprietary fund portfolios to customized programs for a full range of global institutional investors. India Capital Fund SM is an open-ended Investment Company incorporated in Mauritius which has invested in India since 1994. Our wealth of experience has guided us in offering attractive riskadjusted. LLC: Monsoon Capital is the adviser to onshore and offshore private investment partnerships and specializes in equity investments in India. 7th Hedge Fund .B. alphaseeking India Focused products including long-only equity and long-short products.Atyant Capital Karma Capital Management LLC is an organization with dedicated professionals engaged in providing specialist.T.Monsoon Capital Equity Value Fund: India Capital Fund SM is an open-ended Investment Company incorporated in Mauritius which has invested in India since 1994. Prior to 60 .M. specifically how management operates with its minority shareholders in mind. Shares of the India Capital Fund 8th Hedge Fund .Y.F. advisor to the Atyant Capital India Fund. His mission is to consistently identify the best 10-15 investment ideas from among the thousands of publicly-traded Indian corporations.Karma Capital Management. fundamentally based. In the last 10 years he’s managed money exclusively in the Indian markets. our capabilities and product offerings address the various investment needs of investors around the world. Rahul’s value-based investment philosophy stands apart due to his belief in the paramount importance of corporate governance. 10th Hedge Fund Atlantis India Opportunities Fund: Rahul leads Atyant Capital Advisors. 9th Hedge Fund . performance-driven products that take advantage of market opportunities and meet specific client objectives.
Considering the existing limit being only US $ 25.Y. on account of limited convertibility. Recently.F. advise clients or undertake the management of portfolio of securities or funds of the client. Therefore regulatory issues related to investor protection have not been considered for this Report.000 per year for any current or capital account transaction. no information about any hedge funds domiciled in India. Indian market may not be attractive to hedge fund product marketing. generating a 430% absolute return for the firm’s high net worth clients.B.T. The liberalized scheme will allow Indian individual investors to explore the possibility of investing in offshore financial products. do not seem to be excited to access investment from Indian investors in India. Rahul spent four years leading Meridian Investments. 61 . offshore hedge funds have yet to offer their products to Indian investors within India.000 per year. In the same year SEBI. Further.M. Atyant.000 or higher. REGULATORY ISSUE FOR ALLOWING FOREIGN HEDGE FUNDS IN INDIA Hedge Funds in India With the notification of SEBI (Mutual Fund) Regulations 1993. also notified Regulations and Rules governing Portfolio Managers who pursuant to a contract or arrangement with clients. We have however. by virtue of their minimum investment limit being $ 100. allowed resident individuals to remit up to US $ 25. It may be clearly understood that the suggestions put forth in the following paragraphs are in no way aimed at allowing foreign hedge funds to mobilize investment from India by offering their products to Indian investors. As long as there will be restriction on capital account convertibility. the asset management business under private sector took its root in India. foreign hedge funds. RBI through liberalized remittance scheme.
During the discussions they have requested whether India. On the basis of market value. Through this route hedge funs can derive economic benefit of investing in Indian securities without directly entering the Indian market as FIIs or their sub-accounts. Relevant Provisions of FII Regulations: 62 . 2004. Through recent amendments to the FII Regulations (Regulation 15A and 20 A). the following approach may be considered for allowing the well-established hedge funds to invest in Indian markets as a registered entity under the SEBI (Foreign Institutional Investors) Regulations. are Rs. Robust economic fundamentals. In this context. As at the end of March.F. 8050 crores which represents about 8% total net equity investments of all FIIs. the regulatory regime has been further strengthened and periodic disclosures regime has been introduced. Investors all over the world are keen to come to Indian market. the hedge funds account for about 5% of the market value of the total assets held by the FIIs in India.B. In the offshore derivative instruments (PNs) against Indian equity. strong corporate earnings and improvement in market micro structure are driving the FII interest in India.Y. total investment by hedge funds. From informal discussions with institutional investors including some reputed and well established hedge funds.M. The current fiscal year (2003-2004) has seen a spectacular increase in FII activities in Indian market. Till this report is filed FIIs have already invested US $ 10 bn. Some hedge funds have invested in offshore derivative instruments (PNs) issued by FIIs against underlying Indian securities. like other Asian emerging markets. 1995. one could gauge the extent of interest they have about Indian markets. during this year alone which is a record.T. can provide a regulatory framework that will allow them to directly invest in Indian market in a transparent manner.
Since granting of registration to FII/sub-accounts is based on the disclosure of details and on the undertaking given by the applicant in the application form. However.accounts.M.T. on whose behalf investments are proposed to be made in India by a foreign institutional investor”. or portfolios. Identifying Hedge Funds 63 . it must be remembered that all sub-accounts have to be sponsored by registered FIIs who are required to be regulated entities by the relevant regulators in their home countries. However. by virtue of not being regulated by securities regulators in their place of incorporation or operations . based on (an internal administrative decision) if an applicant indicates in the application that it is a hedge fund.F. whether incorporated or not.B. Hedge Funds of almost all variations can meet the requirements of sub-accounts if they are ‘fit and proper’ persons. Further. the consideration of the application is withheld. established outside India. cannot come as FII under the present provisions of SEBI (FII) Regulations. however. it could be possible that a few entities who described their activities in the application form in terms other than hedge funds could have already got registration as sub. The FII Regulations allow sub-accounts sponsored by registered FIIs to invest in India.Y. established or incorporated outside India and those funds. Regulation 6 (i) (b) of the FII Regulations require an FII applicant to be a regulated entity in its place of incorporation or operations. 1995 they are . Regulation 2 (k) defines “sub-account” which “includes foreign corporate or foreign individuals and those institutions. provisions of the regulation 13 lay down the conditions and procedure for granting registration to a sub-account of an FII. Though hedge funds are not an excluded category of foreign institutional investors under the SEBI (FII) Regulations.
F. e.M. iv) Often significant ‘own’ funds are invested by manager. iii) Investors are typically permitted to redeem their interests periodically. semi-annually or annually. such as long/short exposures. Investment limits applicable to FIIs: Chapter II of the SEBI (Foreign Institutional Investors) Regulations. and many (but not all) hedge funds use high levels of leverage. it might be appropriate to also consider the investment strategy followed by particular funds. which are typically included in Mutual Fund Regulation are not applied.B. 1995 interalia list out the instruments in which an FII/sub-account can invest.Y. The regulation does not include currency or commodities as eligible instruments for investment for the FIIs. currency trading or 64 . The distinguishing characteristics of hedge funds are not limited to this and the list may need to adapt depending on the changing market dynamics. Therefore. it will be possible to identify an applicant as a hedge fund. identifying a hedge fund is the first challenge that a regulator faces. hedge funds do not have any universally accepted definition. ii) Significant performance fees (often in the form or percentage of profits) are paid to the manager in addition to an annual management fees. as suggested by IOSCO is to look at the kinds of characteristics of fund management strategies employed by institutions. often for speculative purposes.T. Therefore. leverage and / or hedging and arbitrage techniques. and there is ability to short sell securities. Hedge funds would at least exhibit some of the following characteristics: i) Borrowing and leverage restrictions. An approach for identifying hedge funds. Further. As mentioned in earlier paragraphs. quarterly. On the basis of these characteristics.g. v) Derivatives are used. vi) More diverse risks or complex underlying products are involved.
F. Thus. investment in commodity related financial products will not be an option for any hedge funds under the present FII Regulations. 1995 also lays down scrip-wise and fund wise maximum limits a fund can invest. scrip wise 65 . The SEBI (Foreign Institutional Investors) Regulations. The provisions of Chapter III (Regulation 15 (3) (a)) disallows short selling by FIIs and stipulates that all trades by FIIs are delivery based. clear that existing provisions in the FII Regulations include several checks and balances which can keep our market safe from potential market abuse and manipulation. it might be time to provide a limited window to this growing segment of asset management industry within the existing framework of the SEBI (Foreign Institutional Investors) Regulations. the approach adopted in formulating the following policy suggestions has been that of transparent and regulated access with abundant caution. position limits for investment by FIIs in derivatives has been advised.Y. through circular no. The provision will clearly keep the hedge funds if allowed to invest as FIIs out of short selling at least in the cash segment.M. SMD/DC/CIR-11/02 dated February 12.B. While opening up our market one cannot be oblivious to the special concerns associated with the creative fund management strategies used by these funds.T. It is therefore. Additional Regulatory Concerns: In view of the increasing popularity among the institutions as well as their increasing interest in the Indian market. Further. short selling. Para 4. 1995 and the Guidelines issued by SEBI which an address\ the concerns related to currency speculations.4 of this section has already outlined the existing provisions in the SEBI (Foreign Institutional Investors) Regulations. 2004 issued by Secondary Market Department. 2002 and SEBI/DNAD/CIR-21/2004/03/09 dated March 9. These limits will help diversify the foreign hedge fund investments and will help in jettisoning concentration in any specific scrip.
4. Further.T. The fund manager or investment adviser must have experience of at least 3 years of managing funds with similar investment strategy that the applicant fund has adopted. university funds. institutional investors may help fund managers to take a long term perspective of the market. The investment adviser to the hedge funds should be a regulated investment advisor under the relevant Investor Advisor Act or the fund is registered under Collective Investment Fund Regulations or Investment Companies Act.M. Hedge funds as a whole are becoming an important segment of the asset management industry and gaining popularity from investors particularly 66 . keep our markets insulated from the possible adverse effects of ‘trial and errors’ by uninitiated rookies.F.B. endowments. concentration in the cash market and excessive positions in the derivative segment of our market. As mentioned earlier.Y. charitable trusts or societies. The fund should be a broad based fund in terms of the SEBI (Foreign Institutional Investors) Regulations. The presence of institutional investors in the fund is expected to ensure better governance on the part of the fund manager and fund administrators. At least 20% of the corpus of the fund should be contributed by the investors such as pension funds. 2. particularly in terms of the explanation to Regulation 6 (1) (d). This provision is expected to allow well managed funds to access our market and at the same time. these types of funds raise special regulatory concerns which are necessary to be addressed with special regulatory provisions. 3. banks and insurance companies. In this context. following additional provisions have been suggested with respect to hedge funds seeking registration as FII: 1.
The alternative investment pools if allowed to investment in Indian markets will be a source of additional liquidity and will also diversify the pool of foreign investments in Indian market. pension funds. All hedge funds are not necessarily speculative funds though most of them provide an alternative investment options for the investors through innovative investment strategy. most willing to take risks in anticipation of explosive reward. particularly investment in hedge funds. good information disclosure standards. They are class of investors who believe in the finance mantra . Presence of systematic institutional framework for hedging. endowments.for those with an appetite for risks.higher risk. Yes. charitable funds.F. The asset under management of the hedge funds are growing on a double digit rate. wealthy individuals or families and big institutions.Y. rapid reforms. higher opportunity investments and higher rewards. liberalized stable economy. Investment in hedge funds in India has been gaining momentum post 2001-2002. Two fast growing emerging markets. universities. Investment in hedge funds is a cynosure of interest for sophisticated investors. investment in India focused hedge funds . India and China are keenly observed for new investment propositions. insurance and other institutional investors. democratic set-up. from the high net worth investors. In addition. better return on capital have rather favored India score over China as a superior place for investment in hedge funds. the suggestions also provide for adequate safety measures to address legitimate concerns associated with these funds.M. The issues discussed and suggestions placed above are intended to widen the FII window to allow these alternatives invest pools to our securities markets in a transparent and orderly manner. a well-developed capital economy. To invest in hedge 67 . regulatory factors.B.T.
Vikram Panditfounded Old Lane.Y. funds in India. Renaissance Technologies. The early entrants into the Indian markets have recorded encouraging returns which in turn attracted other hedge fund players to step in. India Capital Fund. • • • • • • • • • • • • • • India Capital Pvt. India Deep Value Fund Absolute India Fund (AIF) Fair Value Naissance Jaipur (India) Fund Avatar Investment Management Passport India Fund HFG India Continuum Fund Monsoon Capital Equity Value Fund Karma Capital Management. DE Shaw. Overview of Hedge funds in India Financial experts opine that India has tremendous potential for attracting global investments in hedge funds. Och-Ziff Capital Management are some reputed international hedge funds firms in India.F. LLC Vasishta South Asia Fund Limited Atyant Capital Atlantis India Opportunities Fund Typical Hedge Fund Investment • Investor chooses and decides hedge fund investment 68 . Here is a list of hedge funds operating in India.B.M. you need to first understand what they are and how it works. Ltd.T.
its implications.M.F. • Read blogs. Investment manager instructs custodian to move funds to prime broker for investment in market. amount allocated for investment. refer commercial directories or databases. financial magazines. the operational risks. Fund administrator instructs issue of share to investor. • During the process the prime broker and custodian are in direct contact with fund administrator. websites. The age of hedge fund industry. Account for your investment goals. the pros and cons of investing in hedge funds etc • Identify potential hedge funds. preferably interact 69 . their worth.Y. the key players. how business is run in India all helps. risk tolerance level. news articles.T. Custodian confirms receipt of payment to fund administrator. Guide to investing in Hedge Funds in India • Prior to finalizing investment. take couple of months to know about the hedge fund industry in India. • Get to understand the ground realities of regulatory factors.B. white papers on hedge funds in India. • • • • • Subscription amount is paid to the custodian. Talk to personnel. Fund administrator issues reports on hedge fund performance.
• Notice annual events like Hedge funds world India to gain an assessment of the burgeoning Indian hedge fund industry. or any other complaint in general that doesn't confirm with regulations. Know your rights.Y.B. keep track of trends. securities broker or licensed investment consultant for advice on hedge fund investments in India. with hedge fund managers involved with hedge fund investments and those who have already invested in hedge funds. where to seek help in terms of a dissatisfied hedge fund investment operation. remittance.F. Engage in data mining. • Ensure your activities are that of an accredited investor (with a net worth of more than $1 million). short-term hedge funds. withdrawal and redemption fees. 70 . Receive and file monthly or quarterly updates. • Check the pros and cons of long-term hedge funds vs. management fee and performance fee.M. • • • • • • Maintain direct communication with hedge fund manager. • Understand terms related to hedge funds. Check with accountant with regard to tax reporting and implications.T. • Approach wealth manager in wealth management companies. • Involve financial advisor in the process of investing in hedge funds in India. Check if diverse hedge fund strategies and techniques are put to use.
liquidity risks. aggregate losses from hedge fund fraud seem relatively small. The SEC brought 51 hedge fund fraud cases from 2000 to 2004. Getmansky.T. and Lo.B. roughly 10 percent of hedge funds die. they make securities transactions. Securities and Exchange Commission (2003) estimates the damages in these cases to amount to $1. The Securities and Exchange Commission wanted to force registration of hedge fund managers because hedge fund collapses had generated large losses for their investors. an outcome that is almost inconceivable for a mutual fund. Each year. arguably indicating a need for greater investor protection. from February 1994 to August 2004. risks to financial institutions. 71 . The U. We review and evaluate these reasons in turn. However. the average annualized standard deviation of the monthly returns of fixed income arbitrage hedge funds was 7. Banking regulators are concerned that hedge funds may create risks to financial institutions. However. or slightly more than half the standard deviation of the Standard & Poor’s 500 return over the 1994–2005 period (Chan. Haas. 2006). Hedge funds create credit exposures for financial institutions in several ways: they borrow. The Long Term Capital Fund had lower volatility than the S&P 500 for almost all its existence.76 percent.S. but this low volatility did not prevent it from losing most of its capital in the span of a month. Do Hedge Funds Pose Significant Risks for the Economy? Many hedge funds appear at first glance to have low return volatility compared to an investment in the stock market. For instance. Because of leverage. even funds with a history of low volatility can end up losing most of their money.M. and excess volatility risks.F.Y. Regulators are concerned about the risks of hedge funds for at least four reasons: investor protection. and they are often counterparties in derivatives trades.1 billion. Some funds disappear because fraud or misreporting becomes apparent. A fund might die because the investors withdraw funds following significant losses.
hedge funds that rely on trading quickly to control their risks cannot do so. the Amaranth losses led to calls for regulation of hedge funds. a hedge fund might get in trouble if its assets experience a sharp drop and the market for these assets lacks liquidity so that the fund cannot exit its positions. when hedge funds use leverage.B. they may not all be able to exit their positions at the same time. in some instances. into concrete proposals for Congress to enact. the Federal Reserve Bank of New York organized a rescue by private banks to avoid possible widespread damage from a possible disorderly liquidation or bankruptcy of the fund. With low liquidity. the New York Times (2006) published an editorial stating that “regulators need to act now to translate their various calls for hedge-fund oversight into enforceable rules and. For instance. As a result. However. which could make matters worse.F. Hence. If too many funds have set up the same trades. which increases threats to financial institutions and can lead to further overreaction in prices as financial institutions have to reduce their positions as well. such hedge funds become more risky.M. adverse shocks could lead hedge funds to dump securities and cash out precisely when things are going poorly.Y. they cannot just ride out a serious adverse shock.T. The collapse of a hedge fund could have far-reaching implications if the fund is large enough. which raises an issue of liquidity risk. Nonetheless. In that case. they must reduce their exposures to satisfy the banks from which they borrowed. When the Long Term Capital Fund lost more than $4 billion in August and September 1998.”Hedge funds rely on their ability to move out of trades quickly when prices turn against them. instead. Further. two adverse developments can ensue: prices may have to overreact and liquidity may fall sharply. 72 . the debacle at the hedge fund Amaranth in late 2006 had only a trivial impact on the markets.
T.Y.B.F.M. Finally, hedge funds could lead prices to overreact by making trades that push prices away from fundamental values and lead to excess volatility risks. Though hedge funds have certainly been accused of creating volatility, the case that they have done so is far from ironclad. For example, hedge funds were net buyers during the stock market crash of 1987, so that they helped stabilize markets at that time (Presidential Task Force on Market Mechanisms, 1998). During the Asian currency crisis of 1997, the prime minister of Malaysia attacked George Soros for causing the crisis. However, an IMF study concluded that hedge fund positions were too small to have much of an impact on emerging markets (Eichengreen et al., 1998). Earlier, the same George Soros had apparently taken a $10 billion bet against the British pound, which effectively forced the British pound out of the European exchange rate mechanism, and won $1 billion in the process. There is some evidence that hedge funds did not sell Internet stocks when their valuations were high (Brunnermeier and Nagel, 2004), but the evidence is not completely clear because the data available does not include various hedges that hedge funds might have used. How concerned should one be about these four types of risks that hedge funds supposedly create? Investor protection should not motivate the SEC to regulate the hedge fund industry, because the small investors who are supposedly the focus of the SEC are already blocked from investing in hedge funds. There is no reason to believe that the occasional hedge fund losses of savvy and well-to-do investors, however painful they may be to these investors, have a social cost. These investors can choose not to invest in a fund, and they also have legal recourse against acts of fraud. The risks posed to financial institutions are real, though often overstated. Brokers and banks have greatly improved their systems to evaluate their exposures to hedge funds in recent years. Derivatives contracts are much
T.Y.B.F.M. better designed for defaults than they were in the past. Financial institutions are already regulated. Moreover, a bank that takes on too much risk through a hedge fund could also take on too much risk with an individual or a proprietary trading desk that employs hedge fund strategies; in either case, the problem is not specifically a hedge fund issue, but rather involves the regulation of financial institutions. Liquidity risk is a serious issue. Though adverse shocks may force hedge funds to contract, hedge funds have strong incentives not to be caught in a situation in which they would have to make distress sales of securities. Empirically, hedge funds do not have their worst performance when large shocks affect capital markets (Boyson, Stahel, and Stulz, 2006). It is not clear how well banks monitor concentration risks in the positions of investment managers they deal with—be they hedge funds or other investors. Regulators could encourage them to monitor more actively. There is no reason to believe that regulation of hedge funds would be a more efficient approach. The fact that hedge funds can cause volatility in prices is a potentially valid concern, but needs to be based on facts and experience. Hedge funds often profit by providing liquidity to the markets—by buying securities that are temporarily depressed because of market disruptions. The role of hedge funds in making markets more liquid and in reducing market inefficiencies makes it necessary for those who want to restrict their activities to have a compelling case that their possible adverse impact on market volatility outweighs their positive effects. So far, this case has not been made. At the same time, one should not overstate the extent to which hedge funds make markets efficient. Though hedge funds do well at eliminating small discrepancies in prices that can be arbitraged, the liquidity they provide may disappear quickly in the presence of a systemic shock—and this
T.Y.B.F.M. liquidity withdrawal may worsen the shock. Further, if asset prices depart systemically from fundamentals, one cannot count on hedge funds to bring them back to fundamentals.
The Future of Hedge Funds
Over recent years, the hedge fund industry has grown sharply and regulatory concerns about the industry have increased. In this section, we examine the implications of these developments for the industry. We expect: 1) the hedge fund industry as a whole will perform less well over the next ten years than over the last ten; 2) the hedge fund industry will become more institutionalized; and 3) the hedge fund industry will become more regulated. These changes will reduce the gap between mutual funds and hedge funds, but not for all hedge funds. Some hedge funds will choose their investors and how they organize themselves so that they will be less affected by the increasing institutionalization and regulation of the industry.
Will Hedge Funds Become More Regulated?
Both Europe and the United States have experienced substantial pressure for increased regulation of hedge funds, for a number of reasons. We earlier discussed the systemic risk concerns and the investor protection concerns of regulators. In addition, mutual funds often lobby for more constraints on hedge funds. As more money is invested in hedge funds, managers have to branch out in new strategies, some of which may increase pressure for regulation of hedge funds.
F.Y. such activism has led to demands for regulation. Large funds seem to have performed somewhat better. Again. suppose that the value-weighted alpha for hedge funds is 4 percent. In some countries. During their sample period.T. However. regulatory authorities are unlikely to allow unregulated hedge funds to compete with regulated banks. Thus.B. Regulations may be enacted to prevent such actions. For the performance of hedge funds to generate 4 percent net of fees for investors. 76 . the skills of hedge fund managers were contributing on average $10 billion a year to investors. much concern has arisen from the fact that hedge funds borrow shares to vote in corporate control contests without bearing the risks of stock ownership (Hu and Black. Finally. regulated financial institutions seem certain to express concerns about the lack of a level playing field. the yearly average size of the hedge fund industry is $262 billion according to one consulting firm. How Will the Hedge Fund Industry Perform Over the Next Ten Years? As discussed earlier. but the lender keeps the price risk of the shares. over the last few years. the skills of hedge fund managers have to produce an additional $20 billion of alpha. As a rough estimate. Some hedge funds have also specialized in lending.M. Recently. 2006)—when a fund borrows shares and holds them to vote. net of fees. strong forces will push them to become more like financial institutions. The industry is now at least three times as large. Ibbotson and Chen (2005) estimate the average alpha of the hedge fund industry to be above 3 percent per year. we saw that as hedge funds succeed. as hedge fund management companies compete with regulated financial institutions. it pays a fee to the lender. For example. more hedge funds have become activist investors.
the strategy becomes less profitable because the funds push the price up.com/2296/hedge_fund. or new managers.M.F.B.com/ http://www. additional money entering hedge funds in the future will typically not find average returns as high as in the past.hedgefundintelligence. leading to smaller profits for the funds. More hedge funds chasing the same price discrepancies means that these discrepancies get eliminated faster.investopedia. Hence. the increase in convertible arbitrage funds. new strategies that typically cannot be as good as the ones already implemented.asp http://www. Bibliography Websites:http://en.com/ http://www.com/terms/h/hedgefund. as more money enters the hedge fund industry. However. from 26 in 1994 to 145 in 2003 according to one database.thehedgefundjournal.thehedgefundjournal. eventually led to poor performance and a drop in the number of such funds.html http://www.T.com/ http://hedgefundproductions. Not surprisingly.org/wiki/Hedge_fund http://www.com/ http://www.hedgefund-index.wikipedia.hedgefund.com/ 77 .hedgefundtools.aspx http://www.asp http://www.magnum. The typical trade for a convertible arbitrage fund is to buy convertible bonds issued by a firm and to hedge the purchase with short sales of the stock of the firm. it either funds existing strategies. so that the performance of this strategy falls.thehfa.org/ http://www.Y.com/hedgefunds/abouthedgefunds.com/ http://www.investorwords. As more funds buy convertible bonds.net/hfn_public/default.net/hedgeducation/hedge-fund-articles/ http://www. A clear example of this problem is the recent performance of convertible arbitrage funds.hedgeco.
Y.F. Logue 3) Investment Strategies of Hedge Funds by Filippo Stefanini 78 . Books:1) All About Hedge Funds: The Easy Way To Get Started by Robert Jaeger 2) Hedge Funds For Dummies by Ann C.T.M.B.
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