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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
commodities. Hedge Funds Basics Investment fund: Money is collected from a group of people and invested. he is committed to it for an entire growing season. but the forecast prices are only that — forecasts.000/ USD 1 million. 000. the usual minimum investment amount is US$ 1.F.T.Y. 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 farmer might decide that planting wheat is a good idea one season. He saw that price movements due to the overall market would be cancelled out. Exclusively favoring the crème de la crème. the loss on shorted assets would be cancelled by the additional gain on assets bought and vice-versa. with occasional large moves in either direction. If the actual price of wheat rises greatly between 4 . currencies etc. Because the effect is to 'hedge' that part of the risk due to overall market movements.B. Based on current prices and forecast levels at harvest time. With a minimum investment limit: The investors are high net worth individuals.M. Foreign Institutional Investors (FIIs). this became known as a hedge fund. if the overall market rose. The market values of wheat and other crops fluctuate constantly as supply and demand for them vary. Once the farmer plants wheat. Non-Resident Indians (NRIs) and persons of Indian Origin (PIOs) invest in securities in primary and secondary markets in shares. because. Examples Hedging an agricultural commodity price A typical hedger might be a commercial farmer. bonds.
Hedge fund managers are generally highly professional. Performance of many hedge fund strategies. the farmer stands to make a lot of unexpected money.Y. he could be ruined. Beyond the averages. 5 .T. he no longer cares whether the current price rises or falls. 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. which are generally 100% exposed to market risk. but he also gives up the chance at making extra money from a high wheat price at harvest times. with approximately 10. Most hedge funds are highly specialized.B. He no longer needs to worry about being ruined by a low wheat price at harvest time.F. but if the actual price drops by harvest time. Facts about Hedge Funds Estimated to be a $2 trillion industry and growing every year. If the farmer sells a number of wheat futures contracts equivalent to his crop size at planting time.000 active hedge funds. relying on the specific expertise of the manager or management team. Includes a variety of investment strategies. The farmer has hedged his exposure to wheat prices. disciplined and diligent. some of which use leverage and derivatives while others are more conservative and employ little or no leverage.unlike conventional equity or mutual funds (unit trusts). Many hedge fund strategies seek to reduce market risk specifically by shorting equities or derivatives. there are some truly outstanding performers. particularly relative value strategies. because he is guaranteed a price by the contract.M. is not dependent on the direction of the bond or equity markets -. planting and harvest.
insurance companies. endowments.Y. enhance returns and minimize the correlation with equity and bond markets.B. calls.F. volatility and risk.). Many. Many hedge funds have the ability to deliver non-market correlated returns. Many endowments and pension funds allocate assets to hedge funds. derivatives such as puts. Many hedge funds are flexible in their investment options (can use short selling. major stock market corrections. Investing in hedge funds tends to be favored by more sophisticated investors. including many Swiss and other private banks. hedge fund strategies tend to hedge against downturns in the markets being traded. thus attracting the • • • • • • • 6 .M. Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives. Hedge funds vary enormously in terms of investment returns. futures. options. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns. Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent. private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns. Key Characteristics of Hedge Funds • Hedge funds utilize a variety of financial instruments to reduce risk. Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage. Pension funds. and understand the consequences of. leverage. etc. who have lived through.T. but not all.
B. commodities.T. 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. while using lots of leverage.Y. less than 5% of hedge funds are global macro funds. bonds. and gold.F. Hedge funds provide an ideal long-term investment solution. 7 . hedge fund managers usually have their own money invested in their fund. eliminating the need to correctly time entry and exit from markets. Popular Misconception The popular misconception is that all hedge funds are volatile -. In reality.that they all use global macro strategies and place large directional bets on stocks. and many use no leverage. currencies. In addition. Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns.M. Adding hedge funds to an investment portfolio provides • • • • • diversification not otherwise available in traditional investing. Most hedge funds use derivatives only for hedging or don't use derivatives at all. Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds. Benefits of Hedge Funds • Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets. best brains in the investment business.
M.F. debt.S. often smaller and micro cap stocks which are expected to experience rapid growth.T. banking. although Brady debt can be partially hedged via U. or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Tends to be "long-biased. Expected Volatility: Very High 8 . Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes. Short selling is not permitted in many emerging markets.Y. Future performance of strategies with high volatility is far less predictable than future performance from strategies experiencing low or moderate volatility. low or no dividends. Includes sector specialist funds such as technology. therefore. 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.Moderate Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation and volatile growth.) Results generally not dependent on the direction of the markets." Expected Volatility: High Distressed Securities: Buys equity. and. Treasury futures and currency markets. Generally high P/E ratios. Hedge Fund Styles The predictability of future results shows a strong correlation with the volatility of each strategy.B. Expected Volatility: Low . effective hedging is often not available. or biotechnology. (This selling pressure creates the deep discount. Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share.
May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. in turn affecting currency. can be long convertible bonds and short the underlying issuer’s equity.F. Volatility depends on the mix and ratio of strategies employed. mortgage backed securities. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. May also use futures to hedge out interest rate risk.Arbitrage: Attempts to hedge out most market risk by taking offsetting positions. Expected Volatility: Low 9 . Uses leverage and derivatives to accentuate the impact of market moves.M. and bond markets. often in different securities of the same issuer.equities. stock. but the leveraged directional investments tend to make the largest impact on performance. Expected Volatility: Very High Market Neutral . currencies and commodities -. Utilizes hedging.B. Funds of Hedge Funds: Mix and match hedge funds and other pooled investment vehicles.though not always at the same time.High Income: Invests with primary focus on yield or current income rather than solely on capital gains.T. Expected Volatility: Low . These relative value strategies include fixed income arbitrage. and closed-end fund arbitrage. Expected Volatility: Low Macro: Aims to profit from changes in global economies. and volatility can be controlled by the mix of underlying strategies and funds. For example. typically brought about by shifts in government policy that impact interest rates. bonds. Returns. capital structure arbitrage. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. Capital preservation is generally an important consideration. risk.Moderate . Participates in all major markets -.Y.
Market risk is greatly reduced. Leverage may be used to enhance returns. Sometimes uses market index futures to hedge out systematic (market) risk. Other strategies may include systems trading such as trend following and various diversified technical strategies.Y. Usually low or no correlation to the market. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy. but effective stock analysis and stock picking is essential to obtaining meaningful results. Portfolio emphasis may swing widely between asset classes. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Relative benchmark index usually T-bills.F. Expected Volatility: Low Market Timing: Allocates assets among different asset classes depending on the manager's view of the economic or market outlook. hostile bids.and long-term gains. Expected Volatility: Variable 10 . Expected Volatility: High Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs.T. and other event-driven opportunities. sudden price changes often caused by an interim earnings disappointment. Market Neutral . Expected Volatility: Variable Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short.B. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class.Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market.M.
M. or leveraged buyouts. reorganizations. Such securities may be out of favor or underfollowed by analysts. Results generally not dependent on direction of market. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. Expected Volatility: Very High Special Situations: Invests in event-driven situations such as mergers. etc. Expected Volatility: Moderate Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth.B. 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. change of management. or the market. Expected Volatility: Low . 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. and strong discipline are often required until the ultimate value is recognized by the market.T. new competition. and the sale of stock in its acquirer.F. or in anticipation of earnings disappointments often due to accounting irregularities. May involve simultaneous purchase of stock in companies being acquired. patience.Y. Long-term holding.Moderate What is a Fund of Hedge Funds? o A diversified portfolio of generally uncorrelated hedge funds. 11 .
insurance companies. o o o o 12 . endowments.B.Y. unit trusts or individual hedge funds. Significantly reduces individual fund and manager risk. Delivers more stable returns under most market conditions due to the fund-of-fund manager’s ability and understanding of the various hedge strategies. Provides effective diversification for investment portfolios.F. Seeks to deliver more consistent returns than stock portfolios. or sector or geographically focused.T. o May be widely diversified.M. private banks and highnet-worth families and individuals. strategies and hedge fund managers for one easy-to-administer investment. 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. Eliminates the need for time-consuming due diligence otherwise required for making hedge fund investment decisions. Preferred investment of choice for many pension funds. Provides access to a broad range of investment styles. Allows for easier administration of widely diversified investments across a large variety of hedge funds. Provides more predictable returns than traditional investment funds. mutual funds.
Is an ideal way to gain access to a wide variety of hedge fund strategies. o Industry size Estimates of industry size vary widely due to the lack of central statistics. for a relatively modest investment.F. the industry may have managed around $2. 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.T. o Allows access to a broader spectrum of leading hedge funds that may otherwise be unavailable due to high minimum investment requirements.5 trillion at its peak in the summer of 2008. The credit crunch has caused assets under management (AUM) to fall sharply through a combination of trading losses and the withdrawal of assets from funds by investors. • • 13 . the lack of a single definition of hedge funds and the rapid growth of the industry.Y. As a general indicator of scale. some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Most hedge funds are highly specialized. relying on the specific expertise of the manager or management team. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or through the use of derivatives.B. Includes a variety of investment strategies.M. managed by many of the world’s premier investment professionals.
there are some truly outstanding performers. which are generally 100% exposed to market risk. particularly relative value strategies. including many Swiss and other private banks that have lived through.M. major stock market corrections. many successful hedge fund managers limit the amount of capital they will accept.F.6 billion).B. Many hedge fund strategies. 2009. and Soros Fund Management ($27 billion). Paulson & Co.T. Fees 14 . Brevan Howard ($27 billion). Hedge fund managers are generally highly professional. are limited as to how much capital they can successfully employ before returns diminish. • • • • • • Largest hedge fund managers The 25 largest hedge fund managers had $519. • Performance of many hedge fund strategies.7 billion in assets under management as of December 31.Y. 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. An increasing number of endowments and pension funds allocate assets to hedge funds. The largest manager is JP Morgan Chase ($53. and understand the consequences of.5 billion) followed by Bridgewater Associates ($43. is not dependent on the direction of the bond or equity markets -.unlike conventional equity or mutual funds (unit trusts). Investing in hedge funds tends to be favored by more sophisticated investors. ($32 billion). Beyond the averages. As a result. disciplined and diligent. particularly arbitrage strategies.
with several large public pension funds calling on managers to reduce fees.Y. the management fee is calculated as a percentage of the funds net asset value. Management fees are usually expressed as an annual percentage. performance fees are intended to align the interests of manager and investor more closely than flat fees do. the management fees for large funds may form a significant part of the manager's profits. but calculated and paid monthly or quarterly. In the business models of most managers. usually counting both realized and unrealized profits. 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. Management fees associated with hedge funds have been under much scrutiny. A typical manager may charge fees of "2 and 20". However.F. leaving the performance fee for employee bonuses. with 2% being the standard figure. Performance fees Performance fees (or "incentive fees") are one of the defining characteristics of hedge funds. the performance fee is largely available for staff bonuses and so can be 15 .T. A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee) from the fund.B.M. By incentivizing the manager to generate returns. The business models of most hedge fund managers provide for the management fee to cover the operating costs of the manager. The manager's performance fee is calculated as a percentage of the fund's profits. Management fees typically range from 1% to 4% per annum.
with the decline being more pronounced in funds of hedge funds (FOFs).34 percent in Q1 08) while FOFs fell to 6. Incentive fees for single manager funds fell to 19.6 percent below the broader industry average. High water marks A high water mark (or "loss carry forward provision") is often applied to a performance fee calculation.6 percent. including notable investor Warren Buffett. by allowing managers to take a share of profit but providing no mechanism for them to share losses. the range is wide with highly regarded managers charging higher fees. extremely lucrative for managers who perform well. Performance fees have been criticized by many people.2 percent (versus 19. Ironically..F.. Mr. This means that the manager receives 16 .Y.05 percent in Q1 08). Typically. hedge funds charge 20% of returns as a performance fee. not as a unique asset class but as a unique ‘fee structure’. The average incentive fee for funds launched in 2009 was 17. while Jim Simons' Medallion Fund charged a 45% performance fee. As the hedge fund remuneration structure is highly attractive it has been remarked that hedge funds are best viewed ". 1. For example Steven Cohen's SAC Capital Partners charges a 35-50% performance fee.T.B. fees are usually limited by a high water mark.9 percent (versus 8. Several publications publish annual estimates of the earnings of top hedge fund managers. who believe that.M. performance fees give managers an incentive to take excessive risk rather than targeting high long-term returns. However. In an attempt to control this problem. Average incentive fees have declined since the start of the financial crisis. Buffett charged incentive fees until his firm was very large.
If the next year it dropped to $110. a performance fee would be payable on the $20 return for each share. rather than on the full return during that year from $110 to $130. such as T-bill yield. This tactic is dependent on the manager's ability to persuade investors to trust him or her with their money in the new fund.M. performance fees only on increases in the net asset value (NAV) of the fund in excess of the highest net asset value it has previously achieved. 17 . This links performance fees to the ability of the manager to provide a higher return than an alternative. 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. no fee would be payable.B. High water marks are intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. if a fund were launched at a NAV per share of $100.Y. signifying that they will not charge a performance fee until the fund's annualized performance exceeds a benchmark rate. If a high water mark is not used.T. For example. Hurdle rates Some managers specify a hurdle rate.F. which then rose to $120 in its first year. a fund that ends alternate years at $100 and $110 would generate a performance fee every other year. LIBOR or a fixed percentage. usually lower risk. rather than continue working for no performance fee until the loss has been made up for. investment. enriching the manager but not the investors. 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.
a performance fee is only charged on returns above the hurdle rate. With a "hard" hurdle. redemption fees are usually retained by the fund and therefore benefit the remaining investors rather than the manager.F. thereby giving investors some indication of the nature of the particular fund. a performance fee is charged on the entire annualized return if the hurdle rate is cleared. thereby reducing turnover and allowing the use of more complex.Y. making hurdle rates relatively rare. or only to withdrawals representing a specified portion of an investment. particular investment types and leverage limits via statements in its offering documentation. A hedge fund will typically commit itself to a particular strategy. Unlike management and performance fees. The fee may also dissuade investors from withdrawing funds after periods of poor performance. With a "soft" hurdle. A redemption fee is often charged only during a specified period of time (typically a year) following the date of investment. Prior to the credit crisis of 2008. demand for hedge funds tended to outstrip supply.B. The purpose of the fee is to discourage short-term investment in the fund.M. with no standard system used. illiquid or long-term strategies. which are classified in many different ways. Strategies Hedge funds employ many different trading strategies.T. 18 . Withdrawal / Redemption fees Some funds charge investors a redemption fee (or "withdrawal fee" or "surrender charge") if they withdraw money from the fund.
Method: discretionary/qualitative (where the individual investments are selected by managers). managed futures (CTA) Market: equity. swaps Exposure: directional. despite a "hedge" being a means of reducing the risk of a bet or investment. futures. healthcare etc. fixed income.T. The most common label for a hedge fund is "long/short equity". options.M. directional. systematic/quantitative (or "quant" where the investments are selected according to numerical methods using a computerized system) Diversification: multi-manager. market neutral Sector: emerging market.B. multi-fund. meaning that the fund takes both long and short positions in shares traded on public stock exchanges. Each strategy can be said to be built from a number of different elements: • Style: global macro. Hedge fund risk Investing in certain types of hedge fund can be a riskier proposition than investing in a regulated fund. multi-strategy. relative value (arbitrage). multimarket • • • • • • The four main strategy groups are based on the investment style and have their own risk and return characteristics. technology.F.Y. event-driven. Many hedge funds have some of these characteristics: 19 . currency Instrument: long/short. commodity.
F. Leverage .hedge funds are private entities with few public disclosure requirements. It can therefore be difficult for an investor to assess trading strategies. It also had offbalance sheet positions with a notional value of approximately $1 trillion. once the creditors have called in their loans. such as high yield bonds. the losses that can be incurred on a losing bet are in theory limitless. and other factors relevant to an investment decision. distressed securities. Appetite for risk . shortly before its collapse. unless the short position directly hedges a corresponding long position.T.Y. In September 1998. 20 . a leverage of over 30 times. If a hedge fund has borrowed $9 for every $1 received from investors. with certain funds borrowing sums many times greater than the initial investment.due to the nature of short selling. Lack of transparency .hedge funds are more likely than other types of funds to take on underlying investments that carry high degrees of risk.in addition to money invested into the fund by investors. a loss of only 10% of the value of the investments of the hedge fund will wipe out 100% of the value of the investor's stake in the fund.M. Ordinary funds very rarely use short selling in this way. Short selling . Long-Term Capital Management had $125 billion of assets on a base of $4 billion of investors' money.B. a hedge fund will typically borrow money or trade on margin. and collateralized debt obligations based on sub-prime mortgages. diversification of the portfolio.
M. which is the actual business and has employees.Y. Short volatility . in some jurisdictions. not subject to as much oversight from financial regulators as regulated funds.certain hedge fund strategies involve writing out of the money call or put options.F. the functions of a hedge fund are delegated to a number of other service providers. and therefore some may carry undisclosed structural risks. The most common service providers are: 21 . required to be sophisticated investors who are assumed to be aware of these risks. short selling opens up new investment opportunities. and willing to take these risks because of the corresponding rewards: Leverage amplifies profits as well as losses. If these expire in the money the fund may make large losses. Investors in hedge funds are. in most countries. and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis. secrecy helps to prevent imitation by competitors.hedge fund managers are. One approach to diagnosing hedge fund risk is operational due diligence.T. The portfolio is managed by the investment manager.B. riskier investments typically provide higher returns. The fund itself has no employees and no assets other than its investment portfolio and cash. Lack of regulation . As well as the investment manager. Hedge fund structure A hedge fund is a vehicle for holding and investing the money of its investors.
S. calculates the net asset value of the fund. and performs related back office functions.B. usually based in a major financial centre.F. Administrator – the administrator typically deals with the issue and redemption of interests and shares. this role is taken by the investment manager. Many prime brokers also provide custody services. and the investment manager. Prime broker – prime brokerage services include lending money. trade execution. acting as counterparty to derivative contracts. Outside of the U.. particularly in the U.. Distributor .M.T. 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.Y. Frequently. 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. some of these functions are performed by the investment manager.S. 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. In some funds.the distributor is responsible for marketing the fund to potential investors. Around 60% of the numbers of hedge funds in 2009 were registered in offshore locations. The Cayman Islands was the most popular registration 22 . lending securities for the purpose of short selling. regulations often require this role to be taken by a third party. An investor will still pay tax on any profit it makes when it realizes its investment. Regulatory considerations will also play a role. will pay tax on the fees that it receives for managing the fund. Prime brokers are typically parts of large investment banks. clearing and settlement.
about $400 billion. Around 5% of global hedge funds are registered in the EU.S. British Virgin Islands 7% and Bermuda 5%. With the bulk of hedge fund investment coming from 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. and more particularly China. investors and U.S. 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. London is Europe’s leading centre for hedge fund managers. with threequarters of European hedge fund investments. East coast – principally New York City and the Gold Coast area of Connecticut – this has become the leading location for hedge fund managers. primarily in Ireland and Luxembourg. location and accounted for 39% of the number of global hedge funds.B.M. It was followed by Delaware (US) 27%.T. as the investors will receive relatively favorable tax treatment in the US. The legal entity Limited partnerships are principally used for hedge funds aimed at USbased investors who pay tax. entities that do not pay tax (such as pension funds). Offshore corporate funds are used for non-U.000 investment managers in the United States in 2004. is taking on a more important role as a source of funds for the global hedge fund industry. are leading locations for management of Asian hedge funds' assets with around a quarter of the total each.F. at the end of 2009.S. as such investors do not receive the same 23 . Investment manager locations In contrast to the funds themselves. Asia.Y. It was estimated there were 7.S. The UK and the U.
limited partnership and a unit trust) to invest into the same master fund.g. which will have organized the establishment of the hedge fund. The fund’s strategic decisions are taken by the board of directors of the fund. which will. the investor will redeem the interests or shares at the NAV per interest/share prevailing at that time.B. the investors will invest into a feeder fund. The assets of the master fund will then be managed by the investment manager in the usual way.F. either as the general partner of a limited partnership or as the holder of “founder shares” in a corporate fund.S. the price of each being the net asset value (“NAV”) per interest/share. Unit trusts are typically marketed to Japanese investors. tax benefits from investing in a limited partnership. Other than taxation. in turn. Open-ended nature Hedge funds are typically open-ended. an offshore corporate fund.M. To realize the investment. if the value of the underlying investments has increased (and the NAV per interest/share has 24 . The investment manager. the type of entity used does not have a significant bearing on the nature of the fund. invest all of its assets into the master fund. in that the fund will periodically issue additional partnership interests or shares directly to new investors. Therefore. In such a structure. a U.T. allowing an investment manager the benefit of managing the assets of a single entity while giving all investors the best possible tax treatment. This allows several feeder funds (e.Y. Founder shares typically have no economic rights and voting rights over only a limited range of issues. such as selection of the investment manager. may retain an interest in the hedge fund. Many hedge funds are structured as master-feeder funds. which is independent but generally loyal to the investment manager.
Once the fund is able to sell the side pocket assets. 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.M. his redemption proceeds could only be obtained by selling the liquid assets of the fund. 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 . and which distributes its profits. Moreover. the fund may employ a "side pocket". the fund cannot be confident that the calculation of his redemption proceeds would be accurate. Those interests/shares cannot be redeemed by the investor. If an investor redeems when certain assets cannot be valued or sold.B. 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. If the illiquid assets subsequently turned out to be worth less than expected.T. the fund will generally redeem the side pocket interests/shares and pay investors the proceeds. the remaining investors would bear the full loss while the redeemed investor would have borne none.F. which has a limited number of shares which are traded among investors.Y. Investors do not typically trade shares or interests among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund. therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. 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).
not of the hedge funds that it managed. for example.M. may routinely side pocket securities linked to natural disasters following the occurrence of such a disaster.T. meantime in respect of the main portfolio. A similar problem. Regulatory issues Part of what gives hedge funds their competitive edge. the security can again be valued with some accuracy. They were used extensively following the collapse of Lehman Brothers in September 2008. Once the damage has been assessed. as this provides a low level of regulatory oversight that is required by some investors. Specific types of fund may also use side pockets in the ordinary course of their business. preventing the funds from selling or obtaining a market value for the assets. such as the Irish Stock Exchange. when the market for certain types of assets held by hedge funds collapsed. inverted. A fund investing in insurance products. applies to subscriptions during the same period. Listing of Hedge Funds Corporate hedge funds sometimes list their shares on smaller stock exchanges.Y.B. Although widely reported as a "hedgefund IPO". the IPO of Fortress Investment Group LLC was for the sale of the investment manager. Side pockets are most commonly used by funds as an emergency measure.F. A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an investment manager. and their cachet in the public imagination is that they straddle multiple definitions and 26 . Shares in the listed hedge fund are not generally traded on the exchange.
some aspects of their dealings are well-regulated.F. There are other limitations and restrictions placed on public investment company managers. Mutual funds are the most common type of registered investment companies. investment companies are subject to strict limitations on short-selling and the use of leverage. while others are unregulated or at best quasi-regulated.) A 3(c)1 Fund cannot have more than 100 investors. The Securities Act of 1933 disclosure requirements apply only if the company seeks funds from the general public. The two major exemptions are set forth in Sections 3(c) 1 and 3(c) 7 of the Investment Company Act of 1940. and the quarterly reporting requirements of the Securities Exchange Act of 1934 are only required if the fund has more than 499 investors. A qualified purchaser is an individual with over US$5. Although hedge funds are investment companies.Y. they have avoided the typical regulations for investment companies because of exceptions in the laws.000 in investment assets. 27 . Aside from registration and reporting requirements. Securities and Exchange Commission (SEC). U.000. (Some institutional investors also qualify as accredited investors or qualified purchasers.S. 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").B. A 3(c)7 fund with more than 499 investors must register its securities with the SEC. regulation The typical public investment company in the United States is required to be registered with the U.S. while a 3(c)7 Fund can have an unlimited number of investors. categories. including the prohibition on charging incentive or performance fees.T.M.
The new rule was controversial. the minimum net worth is $5.000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. In December 2004. The rule change was challenged in court by a hedge fund manager.000 or.000. the exemptions under the Investment Company Act. or be one of certain high-level employees of the investment adviser. For banks and corporate entities.Y. an individual must have US$750. The requirement. There are numerous issues surrounding these proposed requirements. the U.000 in invested assets. in June 2006.M. In order to comply with 3(c)(1) or 3(c)(7).000. a minimum income of US$200. Although it is possible to have non-accredited investors in a hedge fund.000 in assets invested with the adviser or a net worth in excess of US$1. alternatively. 2006. effectively require hedge funds to be offered solely to accredited investors. with minor exceptions.B.S. combined with the restrictions contained in Regulation D. as investment advisers under the Investment Advisers Act.000 with over 14 investors.F. Court of Appeals for the 28 . applied to firms managing in excess of US$25.5 million. and. and normally the shares sold do not have to be registered under Regulation D. with two commissioners dissenting. hedge funds raise capital via private placement under the Securities Act of 1933. There have been attempts to register hedge fund investment managers. An accredited investor is an individual person with a minimum net worth of $1. the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1. 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. A client who is charged an incentive fee must be a "qualified client" under Advisers Act Rule 205-3.000. To be a qualified client.T.
Rule 206(4)-8. private equity funds Hedge funds are similar to private equity funds in many respects. perhaps requiring some months notice. private pools of capital that invest in securities and compensate their managers with a share of the fund's profits.S. In response to the court decision.F. In February 2007. Both are lightly regulated.Y.T. See Goldstein v. and permit investors to enter or leave the fund. unlike the earlier challenged rule. Between 2004 and February 2006. District of Columbia overturned it and sent it back to the agency to be reviewed.M. back over to state oversight. the bill would shift 43% of these companies. the President's Working Group on Financial Markets rejected further regulation of hedge funds and said that the industry should instead follow voluntary guidelines. Comparison to U. Hedge funds often invest in private equity companies' acquisition funds. or roughly 710. in 2007 the SEC adopted Rule 206(4)-8. reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity.B. some hedge funds adopted 25-month lock-up rules expressly to exempt themselves from the SEC's new 29 . "does not impose additional filing. 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. Most hedge funds invest in relatively liquid assets. Because the SEC currently regulates advisers with $25m or more under management. leaving larger investment managers up to the Securities and Exchange Commission. SEC. 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.
Hedge funds also ordinarily do not have daily liquidity. money people want to invest).S.T. postal mail). Recently. and must disclose their asset allocation quarterly.F. registration requirements and cause them to fall under the registration exemption that had been intended to exempt private equity funds.M. mutual funds must have a prospectus available to anyone that requests one (either electronically or via U. mutual funds are pools of investment capital (i. However. however. Comparison to U.e. mutual funds Like hedge funds.S.) Mutual funds must price and be liquid on a daily basis • Some hedge funds that are based offshore report their prices to the Financial Times. but 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. 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.Y.S. In addition. while hedge funds are not A hedge fund investor must be an accredited investor with certain exceptions (employees. but for most there is no method of ascertaining pricing on a regular basis. whereas hedge funds do not have to abide by these terms.. there are many differences between the two. etc. Tax W-forms.B. 30 . Hedge fund investors tolerate these policies because hedge funds are expected to generate higher total returns for their investors versus mutual funds. including: • • Mutual funds are regulated by the SEC.
within limits and symmetrically. Under these arrangements. which would establish a Commission on the Tax Treatment of Hedge Funds and Private Equity to investigate imposing regulations.Y. the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves. while Arbitrage Fund (ARBFX) specializes in merger arbitrage. 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.S.F. However. such compensation is limited to so-called "fulcrum fees". 31 • . a bill to restrict the use of offshore tax havens and abusive tax shelters to inappropriately avoid Federal taxation. Such funds are SEC regulated. Among them are: • S. regulation Hedge funds are exempt from regulation in the United States. For example. Also. 3417. Proposed U.B. H. Mutual funds that utilize some of the trading strategies noted above have appeared. is always net short. a few mutual funds have introduced performance-based fees. for example. However. Several bills have been introduced in the 110th Congress (2007–08). under Section 205(b) of the Investment Advisers Act of 1940. relating to such funds. Grizzly Short Fund (GRZZX). but they offer hedge fund strategies and protection for mutual fund investors. where the compensation to the manager is based on the performance of the fund. 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. 681.T.R. however. fees can be performance-based so long as they increase and decrease symmetrically.M.
32 . and S. UK regulation Hedge funds managed by UK hedge fund managers are always incorporated outside the UK. a hedge fund manager based in the UK is required to be authorized and regulated by the UK's Financial Services Authority. and are not directly regulated by the UK authorities.Y. prevent. As the UK is part of the European Union. 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. 3268. • S. S. • • None of the bills has received serious consideration yet.F.M. a bill to amend the Commodity Exchange Act to prevent excessive price speculation with respect to energy commodities. and punish price manipulation and excessive speculation. However. a bill to amend the Investment Advisors Act of 1940. the UK hedge fund industry will also be affected by the EU's Directive on Alternative Investment Fund Managers.B. 1624. with respect to the exemption to registration requirements for hedge funds. and accordingly the UK hedge fund industry is regulated. The bill would give the federal regulator of futures markets the resources to detect. 1402.T. usually in an offshore location such as the Cayman Islands.
with nearly half the industry's estimated $1. In traditional equity investment.Y. which makes it hard to construct a satisfactory index. indices play a central and unambiguous role. and these fall into three main categories. Non-investable indices are representative. British Virgin Islands. heterogeneous and ephemeral. Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centres. In their historical order of development they are Non-investable. Investable indices achieve liquidity at the 33 .225 trillion. and Bermuda. their quoted returns may not be available in practice. To do this they offer some combination of professional services. Major centers include Cayman Islands. The Cayman Islands have been estimated to be home to about 75% of world’s hedge funds. Dublin. and business-friendly regulation. a favorable tax environment. They are widely accepted as representative. and products such as futures and ETFs provide investable access to them in most developed markets. Investable and Clone. Offshore regulation Many offshore centers are keen to encourage the establishment of hedge funds. protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager.B.M. but. due to various biases. Typical rules concern restrictions on the availability of funds to retail investors (Dublin). Hedge Fund Indices There are many indices that track the hedge fund industry.F. Luxembourg. However hedge funds are illiquid.T.
This leads to significant differences in reported performance between different indices. leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. When a fund is added to a database for the first time. None of these approaches is wholly satisfactory. Although they aim to be representative.Y.B. For example. and no single database captures all funds. It is likely that funds 34 . Non-investable indices Non-investable indices are indicative in nature. If we examine only funds that have survived to the present. and the observed association between fund youth and fund performance suggests that this bias may be substantial. The databases have diverse selection criteria and methods of construction. The short lifetimes of many hedge funds means that there are many new entrants and many departures each year. which raises the problem of survivorship bias.T. expense of limited representativeness. we will overestimate past returns because many of the worstperforming funds have not survived. and aim to represent the performance of some database of hedge funds using some measure such as mean. 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.F. all or part of its historical data is recorded ex-post in the database.M. Clone indices seek to replicate some statistical properties of hedge funds but are not directly based on them. non-investable indices suffer from a lengthy and largely unavoidable list of biases. median or weighted mean from a hedge fund database. Funds’ participation in a database is voluntary.
F. Investable indices Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. and use this to construct a model of how hedge fund returns respond to the movements of various investable financial assets. When investors buy these products the index provider makes the investments in the underlying funds.M. and in principle they can be as representative as the hedge fund database from which they were constructed. To make the index investable.B.Y. 35 . To make the index liquid. To create an investable index. This is known as "instant history bias” or “backfill bias”. Hedge Fund Replication The most recent addition to the field approach the problem in a different manner. This makes the index investable. and most seriously they may under-represent more successful managers. so that the average performances displayed by the funds during their incubation period are inflated. only publish their results when they are favorable. Instead of reflecting the performance of actual hedge funds they take a statistical approach to the analysis of historic hedge fund returns. these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. making an investable index similar in some ways to a fund of hedge funds portfolio. hedge funds must agree to accept investments on the terms given by the constructor. This model is then used to construct an investable portfolio of those assets.T. This means that investable indices do not represent the total universe of hedge funds.
M.. 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.T. The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge funds in June 2007. As replication indices have a relatively short history it is not yet possible to know how reliable this process will be in practice. Federal Reserve. The funds invested in mortgage36 ." However the ECB statement has been disputed by parts of the financial industry. The ECB (European Central Bank) issued a warning in June 2006 on hedge fund risk for financial stability and systemic risk: ".F. transparency and fraud that exist in direct hedge fund investments.S. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster. 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.B. Some believe that broad hedge fund investment strategies have also become increasingly correlated. they rely on a statistical modeling process. the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability. However. which necessitated a bailout coordinated (but not financed) by the U.Y. which warrants close monitoring despite the essential lack of any possible remedies. thereby further increasing the potential adverse effects of disorderly exits from crowded trades. although initially indications are that much of hedge fund returns can be replicated in this manner without the problems of illiquidity..
S. this high level of disclosure is not available to non-investors. With these limitations. while some hedge funds have very limited transparency even to investors. investors have to do their own research.Y.) and that 5% of return numbers and 5% of NAV numbers were dramatically different. The study noted that 465 common funds had significant differences in reported information (e. Much of the data available in consolidated databases is self-reported and unverified. etc.M. An investor in a hedge fund usually has direct access to the investment advisor of the fund. A study was done on two major databases containing hedge fund data. inception date. Funds may choose to report some information in the interest of recruiting additional investors. investment styles. This is in contrast to a regulated mutual fund (or unit trust).T. The funds' financial problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside assistance.000.B. returns.g. 37 . net assets value. Transparency As private. However.F. management fee. It was the largest fund bailout since Long Term Capital Management's collapse in 1998. hedge funds are not obliged to disclose their activities to third parties. This may include detailed discussions of risks assumed and significant positions. Securities and Exchange Commission is investigating. contributing to hedge funds' reputation for secrecy. which will typically have to meet regulatory requirements for disclosure. lightly regulated entities. which may cost on the scale of $50. and may enjoy more personalized reporting than investors in retail investment funds. backed securities. The U. incentive fee.
M.B. The U. However summaries are occasionally available in various journals. the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. which may dilute the talent available in the industry. Performance measurement Performance statistics are hard to obtain because of restrictions on advertising and the lack of centralized collection.S. 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. do not use third parties either as the custodian of their assets or as their administrator (who will calculate the NAV of the fund). While Madoff did not run a hedge fund.T.F. the remuneration model is attracting more managers. Second. Securities and Exchange Commission (SEC) is also focusing resources on investigating insider trading by hedge funds. Some hedge funds. In December 2008. investigations In June 2006. U. Market capacity Alpha appears to have been becoming rarer for two related reasons. 38 . First. mainly American. the Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. though these causes are disputed.S. This can lead to conflicts of interest.Y. In a recent example. his case clearly does illustrate the value of independent verification of assets. Bernard Madoff was arrested for running a $50 billion Ponzi scheme. and in extreme cases can assist fraud.
Some managers do an excellent job of keeping volatility down close to government-bond level but handily beating bond returns. Consequently. In that case. risk is represented by the standard deviation. making them even less reliable than is suggested by the shortness of the available return series.M. and traditional performance measures are still widely used in the industry. and Kappa by Kaplan and Knowles (2004). traditional performance measures suffer from theoretical problems when they are applied to hedge funds. E. Unfortunately. Treynor.: Relative benchmark index used for Market neutral security hedging is usually T-bills. Omega by Keating and Shadwick (2002). for the highly risk-averse investor. However.F. Jensen) work best when returns follow a symmetrical distribution. and hedge fund return series are auto correlated. Several innovative performance measures have been introduced in an attempt to deal with this problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003). Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004). Traditional indicators (Sharpe. 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. hedge fund returns are not normally distributed. Are all hedge funds speculative and risky? A majority of the funds stress on returns.Y. At the other extreme. there is no consensus on the most appropriate absolute performance measure. there is a whole group of funds that emphasizes low volatility.B.g. 39 .T.
Hedge funds’ low correlation with other assets tends to dissipate during stressful market events. Hedge fund returns are reduced considerably by the high fee structures that are typically charged. Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in investor portfolios. 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. a bond index fund.T. there are three reasons why one might not wish to allocate a high proportion of assets into hedge funds. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers. rational investors will seek to hold portfolios that are mean/variance efficient (that is. 2. largely because of the impact of performance fees. and the lowest level of risk per unit of return). portfolios offer the highest level of return per unit of risk. Kritzman repeated the optimization using an assumption 40 . To demonstrate this. Hedge funds are highly individual and it is hard to estimate the likely returns or risks. and ten hypothetical hedge funds. These reasons are: 1. and 3. The optimizer found that a mean-variance efficient portfolio did not contain any allocation to hedge funds.M. Value in mean/variance efficient portfolios According to Modern Portfolio Theory. reducing overall portfolio risk However.F. making them much less useful for diversification than they may appear.B. 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.Y.
for example around the collapse of Lehman Brothers in September 2008.S.T. the average U. that the hedge funds incurred no performance fees. even "dedicated short bias" funds had a return of -6.7%. Hedge funds posted disappointing returns in 2008. For example. The S&P 500 total return was -37. According to the same index series.Y. and that was one of the best performing equity indices in the world. 41 .00% in 2008.65% (the HFRI Fund Weighted Composite Index return) was far better than the returns generated by most assets other than cash. Several equity markets lost more than half their value.7% and the average Latin America mutual fund plummeted 57. According to Lipper. the Credit Suisse/Tremont Hedge Fund Index was down 9. just when an investor needs part of their portfolio to add value. The average international equity mutual fund declined 45. In summary. The average China mutual fund declined 52. but the average hedge fund return of -18.8%. domestic equity mutual fund decreased 37. The result from this second optimization was an allocation of 74% to hedge funds. posting losses significantly worse than the average hedge fund.08% during September 2008.87%.F. hedge funds outperformed many similarly-risky investment options in 2008. The average sector mutual fund dropped 39. In other words. Most foreign and domestic corporate debt indices also suffered 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. Real estate.B. also suffered significant drops in 2008.6% in 2008.3%.M. Mutual funds also performed much worse than hedge funds in 2008. even though low average correlations may appear to make hedge funds attractive this may not work in turbulent period. in January-September 2008. both residential and commercial.
causing bonds to rise. Notable Hedge Fund Firms • • • • • • • • • • • • • Amaranth Advisors Bridgewater Associates Citadel Investment Group D.B. 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. 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. not terribly predictable. Aiming to profit from changes in global economies. but are volatile. global macro funds can be compared to grizzlies.M. For example. Instead.T.E. I compare macro funds to grizzlies not only to highlight these common aggressive characteristics but to point out that like grizzlies.F. causing European interest rates to kick up.S. 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. They can be enormously profitable. and can also produce occasional sudden falls.Y. macro hedge 42 .. such funds are not for the faint of heart.
commodities. lawyers. allocators. asset management firms and broker dealers. by Dion Friedland. and the industry’s service providers including prime brokers. Risk & Reward Comparisons Hedge Funds vs. Hedge Fund Association Founded in 1995. 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. and gold. endowments and foundations. 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. global financial institutions with hedge fund offerings including retail and private banks. currencies. high net worth individuals. technologists and third party marketers. public and private pension funds. bonds. the media. risk managers.Y. while using lots of leverage.like leverage and short selling. family offices. practitioners and investors who are shaping the way business is conducted in the global hedge fund industry.that they all use global macro strategies and place large directional bets on stocks. the HFA advocates for the industry by giving voice to the issues affecting the industry through the education of investors. investors including funds of hedge funds. regulators and legislators.T. With the maturity and institutionalization of the global hedge fund industry. Traditional Assets The normal view is that hedge funds are highly risky . These are perceived by most investors as purely speculative tools.M.B. custodians. innovators. administrators. when global hedge fund assets were just approaching the $250 billion mark. auditors. Membership in the HFA includes hedge fund firms. it is easily made when viewed in the context of tools used. 43 .F. Even though the inference of gambling is not usually correct.
Measured against major equity and bond indices. But many hedge funds successfully employ them to increase performance while actively managing risk. global hedge fund indices do indeed appear more attractive. But there is a wide range of outcomes.some magical ingredient that turns dross into gold. John Meriwether.000 and 5. Mutual Funds Hedge funds are extremely flexible in their investment options because they use financial instruments generally beyond the reach of mutual funds. but only $2 billion in assets that it could sell to pay off its debts. Its borrowing in the 1997 alone averaged between 50 and 100 times its asset base. founded by Meriwether in 1994.F.but when differentials blew out. through betting on convergence in the prices of similar assets.T. and it borrowed from the biggest of banks and brokerage houses in the world. The reality is that less than 5% of hedge funds are global macro funds causing speculative waves and contagions. Advantages of Hedge Funds vs. Long Term Capital Management (LTCM). LTCM was a hedge fund. in 1998.000 active hedge funds in this industry. Robert Merton and Myron Scholes. bet his firm.for a time . LTCM had nearly $1 trillion in bad investments. Estimated to be growing at about 20% per year. The theory worked very well . on the theories espoused by his partners. necessitating an eventual bail-out by a group of banks. and Strome. like Quantum. 44 . engaged in arbitraging pricing differentials in the bond markets. Tiger. Most hedge funds use derivatives only for hedging or don't use derivatives at all. there are between 4. the anti-hero of Michael Lewis' book Liars Poker. and lost.Y. Indeed. and many use no leverage. thereby endangering a banking system already rocked by losses in Russia and the Far East.B. with lower volatility and higher return. the Nobel prize-winning economists. and history is full of people who thought they had found the alchemist's stone .M. the firm's highly leveraged positions quickly lost money.
and derivatives. there are estimated to be approximately 8350 hedge funds managing $1 trillion. leverage. regardless of performance.F. which includes use of hedging strategies to protect downside risk. which have SEC regulations and disclosure requirements that largely prevent them from using short selling. 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. This incentive fee structure tends to attract many of Wall Street’s best practitioners and other financial experts to the hedge fund industry.B. Investcorp's hedge fund team beat four other highly regarded fund of funds on the short list. This flexibility.T. the asset manager specializing in alternative investments. 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. their growth reflects the importance of this alternative investment category for institutional investors and wealthy individual investors.M.Y. Currently. whereas mutual funds pay their financial managers according to the volume of assets managed. 45 . In the last nine years. "Incentive fees" remunerate hedge fund managers only when returns are positive. Unlike many mutual fund managers. Where is Investcorp Bank BSC in the Hedge Funds market? Investcorp. gives hedge funds the ability to best manage investment risks. The strong results can be linked to performance incentives in addition to investment flexibility. concentrated investments. While the number and size of hedge funds are small relative to mutual funds. 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.
S. In addition. not least in establishing leading risk management processes to set us apart from other providers. 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. Goldman Sachs and Bear Stearns. institutional market. Deepak Gurnani and Ibrahim Gharghour. both expressed their delight at receiving this recognition.7 billion is proprietary investment.6 billion under management. co-heads of Asset Management at Investcorp. its growth in assets under management and its new single manager platform as the critical success factors. The award was presented in New York this week at a ceremony that celebrated the achievements of the hedge fund industry.Y. Investcorp is one of the leading institutional investors in hedge funds with approximately $4. The judges cited Investcorp's penetration of the U. Hedge Fund Market Structure: i) Operational Structure: Hedge funds are usually not operated in-house by their employees. They are just investment vehicles owned by investors and sponsors (or limited 46 . 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. The awards were judged by a panel of experts from leading institutions including JP Morgan.B. Interlachen Capital Group and Cura Capital Management.F. of which $1. where we have attracted substantial US institutional money into our programme. last year.T.' Ibrahim Gharghour added: 'This award also recognizes our substantial recent progress in the United States. we set up a single manager platform and have already partnered with two high profile groups.M. in order to provide our investors greater variety and access to leading specialist funds.
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. 3.F.M.Y.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. 5-The fund administrator: His primary task is to ensure accurate calculation of the net asset value at regular time interval called break periods. 4-The board of directors: The board of directory is responsible for monitoring the overall operations of the fund.The Custodian: 47 . and general parents) and rely on external service providers to conduct the funds day-to-day business. hedge funds establish relationships with all the necessary industry service providers: 1. or he may be unrelated to it. including managing the fund portfolio and providing administrative services. and is usually established in a major onshore financial center as London or New York. 2. the investment adviser may be a part of the same overall organization as the hedge fund he serves. 6. So for this type of operation structure.B.The Manager or Management Company: He/she is responsible for office overhead.T. that is as we talked early (page 1) the sponsor will be the general partner and the investor will be the limited partner.
if any.F. .Clearing the trades. clearing and settlings all trades and monitoring corporate actions such as dividend payments and proxy-related information. .M. and to verify the annual financial statement.The Prime Broker: The role of prime brokers goes beyond just replacing the hedge funds back office.Margin financing.Acting as global custodian.The registrar and transfer agent: He/she keeps and updates a register of shareholders of the hedge fund. .The auditors: The auditors’ role is to ensure that the hedge fund is in compliance with\ accounting practices and any applicable laws. The custodian’s primary responsibilities include safekeeping of the fund’s assets.Side-by-side and master/feeders: 48 . Rather. 7. 9. 1.Y.B. 8. He also processes and takes necessary actions for subscriptions and withdrawals of shares in the fund.T. ii) Organization Structure: Hedge funds also need to set up efficient organizational structures. as well as for the payment of any dividends and distributions. 10. and ensure compliance with domestic investment regulations as well as with regulations of countries where the fund is distributed. they should be seen as full service providers across the core functions of execution and operation for example: .Securities lending.The legal advisor or lawyer: The legal adviser or lawyer assists the hedge fund with any tax code and/or legal matters.
T. 3.B.e.000 funds that manage approximately $600 to $650 billion in assets. however.6 1. These portfolios usually share a common investment adviser.Managed accounts. The master/feeder structure is an efficient alternative to side-by-side funds. the assets invested in hedge funds will exceed $1 trillion. hedge fund are not required to register but the SEC estimates.Y.F. then it will definitely a question without an accurate answer because as we know that SEC doesn’t regulate hedge fund i. several funds having identical or substantially similar investment policies invest in parallel in a group of cloned portfolio. that there are between 6.000 and 7. The report predicts that in the next five to 10 years.Umbrella funds. In this structure a series of funds (called feeders) sell shares to investors under the 12 terms of their prospectus and contribute their respective proceeds to another fund (called the master fund) rather than investing directly. In side by side structures. also called mirror funds or clone funds. and the cloning process essentially consists in facilitating bunched trades among the cloned funds and rebalancing cloned funds that have experienced different cash flows. And that is wonder us to know why hedge fund is exempt from SEC regulations. 2.M. 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 .Hedge Fund Market Size: If we are going to talk about how big is the hedge fund industry. 4. the answer is simply is of the hedge funds are only offered to wealthy individuals and institutions.Multiclass/Multiseries Funds. portfolio managers and a custodian or administrator.
US Insurance. Europe Pensions and US non-profit.B. — To remain unregistered. 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.000 or more. And it is divided as follows: . b) Provider of Hedge Funds: 1. Europe insurance. Now let us have a close look for wealthy individual.account for over 60% of the approximately $600bn invested in hedge funds. Many funds use the safe harbor in the 1933 Act that allows them to sell to "accredited investors.000 or more. There are signs that hedge funds are becoming a standard element in HNWI – not just super wealthy – portfolios.Y. 2. a) Buyers of Hedge Funds: Current ownership is divided between Wealthy individuals (High Net Worth Individuals or HNWI) and institutions. buyers of hedge funds and provider of hedge funds. Wealthy individual: Wealthy individuals (High Net Worth Individuals or HNWI) – individuals with assets in excess of US$ 1 million . married couples with a joint income of $300. or individuals with a net worth of $1 million.The vast majority of hedge fund managers are located in North America – largely in the New York and Los Angeles areas.US HNWI and Europe HNWI. But in Europe – London 50 .M." These are individuals with an annual income of $200.F.Very high fees and very high profitability.Key Players We can divide the key players in two categories. 2. . US Pensions.T.
The investment managers must have considerable experience and those with good reputations can raise $250m at launch. to be viable. 3-Competitive Positioning The hedge fund market has been growing dramatically in recent years. 3. New start ups.a large number of companies are starting up.Most advisors noted a specific life cycle for hedge funds. standards and expectations on managers are falling. If performance is good the fund reopens 12 months later and grows to $60-100m. But in practice few funds grow beyond the $25-30m size. Top 100 Hedge Funds The market’s horrors of 2008 gave way to the pleasures of 2009. 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. 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. Anecdotal evidence suggests US managers are opening in larger scale in London.F. 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. There are signs that with the amount of institutional money facing the market. particularly. a further 12 months on. the fund can re-open and grow to $300-600m.T.B.M. had to raise about $20m. The worst-performing member of Barron’s Top 100 has returned roughly five times what the average hedge 51 . 4-The credibility of the investment decision making process is critical to fundraising. If performance is sustained. According to the survey conducted by an American hedge fund research company.Y.
T. GBP and Euro) refer to specific currency classes of a fund.Y. Currencies (USD.B. fund has risen.M. 52 .F.
B.M.F. 53 .Y.T.
B.Y.T.F.M. 54 .
T.M. FINANCIAL CRISIS AND HEDGE FUNDS 55 .B.Y.F.
LTCM built its positions on sophisticated arbitrage trading strategies. Researchers have. operation and regulation of the international financial system. The Emerging Markets Committee of IOSCO identified multiple causes of the East Asian crisis. but also in terms of drawing the world’s attention to outstanding issues concerning the structure.T. 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. East Asian Crisis The impact of the East Asian crisis which materialized in the middle of 1997.F.M. however.B. 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. 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. subsequent research could not produce robust evidence implicating the hedge funds for precipitating the crisis. 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. However. 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. In spite of difference of views. economic and social consequences that these events wrought on emerging market economies.Y. In addition. and the subsequent turbulence that swept the world’s financial markets over the next 12-18 months. Causes of the crisis remain among the most contentious issues and continue to be debated at the academic as well as policy level. has been significant not only in terms of the financial. it used a 56 .
as the global financial crisis worsened. those incorrect assumptions resulted in substantial losses for the firm and eroded its capital base5. In response to the near collapse of Long-Term Capital Management. as a defense against systemic risk in the market . 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 . resulting in losses for other participants in those markets. However. 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. it became clear to LTCM that many of the assumptions inherent in the arbitrage positions it held were incorrect. can provide benefits to global financial markets. Liquidation of LTCM’s positions could have potentially disrupted the financial markets.F. and September of 1998. Finally. LP (LTCM). The Committee in its report underlined that HLIs. a consortium of banks worked out a rescue plan facilitated by the Federal Reserve Bank of New York.M. he also asserted that it was too soon to tell whether LTCM’s investment strategies represent the norm in the hedge funds industry or. like other institutional investors. Due to LTCM’s leverage (which at one point has exceeded 50 to 1). whether LTCM was an overly aggressive player among otherwise responsible market participants.B.T. The committee. It also highlighted the combination of characteristics typically associated with HLIs such as significant leverage. significant degree of leverage to increase its expected return.Y. recommended strong and prudent risk management processes at the regulated firms with which the HLIs trade. In August. as well as the proper role that regulators should play with respect to those activities. acknowledged that LTCM’s potential impact on the world’s financial markets raises legitimate questions about the activities of hedge funds in general.
Further. Securities & Exchange Commission and a Foreign Institutional Investor (FII) with the Securities & Exchange Board of India. as a means to maintain market integrity. The Committee also highlighted the importance of transparent disclosure by the regulated entities dealing with HLIs and HLIs themselves on a voluntary basis. 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. 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. HFG was a Registered Investment Advisor (RIA) with the U. which invested in publicly traded Indian securities.F.T. the HFG India Continuum Fund. homeland security and other strategic sectors. It ran an investment fund. 2nd Hedge Fund . List of Hedge Funds in India 1st Hedge Fund . through its predecessor company. During the operation of its fund.Y.B. defense.S. Hudson Fairfax Group. In spite of occasional negative perception about the role of hedge funds.M. It is based in New York with an advisory office in New Delhi. such perceived misdemeanors by certain hedge funds have been considered more as occasional aberrations than general industry wide behaviour.Avatar Investment Management: 58 . 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.
India was formed in 2002 to provide boutique fund management services to institutions. In addition to the Singapore office.India Deep Value Fund: India Investment Advisors.Y. long-term returns for its investments while minimizing investment risks using a Value oriented approach towards our investments. the India Deep Value Fund was launched in April 2006. a directional fund investing in India and Indian companies globally. Ltd (India) is a Singapore based investment advisor. 4th Hedge Fund .T. India has a research presence in Mumbai.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. foundations. 3rd Hedge Fund . 5th Hedge Fund . India. The principals have a combined over 30 years of experience in researching and investing in India. Avatar Investment Management is the investment advisor to three funds.India Capital Pvt Ltd India Capital Pvt. Fair Value specializes in Deep Value Investments in the Indian equity markets.India Capital Fund: 59 . As a result.M. 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. In order to meet the approval of various regulatory bodies around the world. In July 2003. India launched the India Absolute Return Fund (IARF).B. The Fund's Managers seek to achieve long-term capital gains by acting as pro-active deep value investors in publicly-traded Indian stocks. the funds are focused on the Indian public and private equity markets. 6th Hedge Fund . family offices and high net-worth individuals. It seek absolute.F. only accredited investors may apply to invest. Headquartered in Mauritius.
In the last 10 years he’s managed money exclusively in the Indian markets. fundamentally based.Atyant Capital Karma Capital Management LLC is an organization with dedicated professionals engaged in providing specialist.M. advisor to the Atyant Capital India Fund. Our wealth of experience has guided us in offering attractive riskadjusted. our capabilities and product offerings address the various investment needs of investors around the world. Prior to 60 . Shares of the India Capital Fund 8th Hedge Fund . From diversified proprietary fund portfolios to customized programs for a full range of global institutional investors. LLC: Monsoon Capital is the adviser to onshore and offshore private investment partnerships and specializes in equity investments in India. 10th Hedge Fund Atlantis India Opportunities Fund: Rahul leads Atyant Capital Advisors.F. 9th Hedge Fund .Karma Capital Management.B. India Capital Fund SM is an open-ended Investment Company incorporated in Mauritius which has invested in India since 1994. performance-driven products that take advantage of market opportunities and meet specific client objectives. 7th Hedge Fund .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. specifically how management operates with its minority shareholders in mind. alphaseeking India Focused products including long-only equity and long-short products.T. His mission is to consistently identify the best 10-15 investment ideas from among the thousands of publicly-traded Indian corporations. Rahul’s value-based investment philosophy stands apart due to his belief in the paramount importance of corporate governance.Y.
generating a 430% absolute return for the firm’s high net worth clients.T.Y.F.M. the asset management business under private sector took its root in India. Recently. Rahul spent four years leading Meridian Investments.000 per year for any current or capital account transaction. no information about any hedge funds domiciled in India.000 or higher. on account of limited convertibility. Therefore regulatory issues related to investor protection have not been considered for this Report. also notified Regulations and Rules governing Portfolio Managers who pursuant to a contract or arrangement with clients. allowed resident individuals to remit up to US $ 25. Atyant. In the same year SEBI.B. RBI through liberalized remittance scheme. Further. Considering the existing limit being only US $ 25. As long as there will be restriction on capital account convertibility. advise clients or undertake the management of portfolio of securities or funds of the client. offshore hedge funds have yet to offer their products to Indian investors within India. The liberalized scheme will allow Indian individual investors to explore the possibility of investing in offshore financial products. by virtue of their minimum investment limit being $ 100. 61 . We have however. 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.000 per year. Indian market may not be attractive to hedge fund product marketing. foreign hedge funds. REGULATORY ISSUE FOR ALLOWING FOREIGN HEDGE FUNDS IN INDIA Hedge Funds in India With the notification of SEBI (Mutual Fund) Regulations 1993. do not seem to be excited to access investment from Indian investors in India.
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. 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. during this year alone which is a record. the hedge funds account for about 5% of the market value of the total assets held by the FIIs in India.B. Till this report is filed FIIs have already invested US $ 10 bn. Relevant Provisions of FII Regulations: 62 . are Rs. the regulatory regime has been further strengthened and periodic disclosures regime has been introduced. On the basis of market value.M. 2004. strong corporate earnings and improvement in market micro structure are driving the FII interest in India. 1995. 8050 crores which represents about 8% total net equity investments of all FIIs. can provide a regulatory framework that will allow them to directly invest in Indian market in a transparent manner. The current fiscal year (2003-2004) has seen a spectacular increase in FII activities in Indian market. In the offshore derivative instruments (PNs) against Indian equity. Through recent amendments to the FII Regulations (Regulation 15A and 20 A). During the discussions they have requested whether India. Investors all over the world are keen to come to Indian market. one could gauge the extent of interest they have about Indian markets.T. total investment by hedge funds. Some hedge funds have invested in offshore derivative instruments (PNs) issued by FIIs against underlying Indian securities.Y. Robust economic fundamentals. like other Asian emerging markets. As at the end of March. From informal discussions with institutional investors including some reputed and well established hedge funds.F. In this context.
provisions of the regulation 13 lay down the conditions and procedure for granting registration to a sub-account of an FII. on whose behalf investments are proposed to be made in India by a foreign institutional investor”. established outside India. the consideration of the application is withheld.T. Though hedge funds are not an excluded category of foreign institutional investors under the SEBI (FII) Regulations. Identifying Hedge Funds 63 . Hedge Funds of almost all variations can meet the requirements of sub-accounts if they are ‘fit and proper’ persons. 1995 they are . by virtue of not being regulated by securities regulators in their place of incorporation or operations . cannot come as FII under the present provisions of SEBI (FII) Regulations. 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. Regulation 2 (k) defines “sub-account” which “includes foreign corporate or foreign individuals and those institutions. or portfolios.accounts.F. However.Y. 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. However. Further. Regulation 6 (i) (b) of the FII Regulations require an FII applicant to be a regulated entity in its place of incorporation or operations.B. 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.M. based on (an internal administrative decision) if an applicant indicates in the application that it is a hedge fund. The FII Regulations allow sub-accounts sponsored by registered FIIs to invest in India. whether incorporated or not. established or incorporated outside India and those funds.
which are typically included in Mutual Fund Regulation are not applied. ii) Significant performance fees (often in the form or percentage of profits) are paid to the manager in addition to an annual management fees. An approach for identifying hedge funds. Investment limits applicable to FIIs: Chapter II of the SEBI (Foreign Institutional Investors) Regulations. and there is ability to short sell securities. The regulation does not include currency or commodities as eligible instruments for investment for the FIIs.T.Y. it might be appropriate to also consider the investment strategy followed by particular funds. 1995 interalia list out the instruments in which an FII/sub-account can invest. On the basis of these characteristics. it will be possible to identify an applicant as a hedge fund. currency trading or 64 . and many (but not all) hedge funds use high levels of leverage. As mentioned in earlier paragraphs. The distinguishing characteristics of hedge funds are not limited to this and the list may need to adapt depending on the changing market dynamics. identifying a hedge fund is the first challenge that a regulator faces. vi) More diverse risks or complex underlying products are involved. e. often for speculative purposes.F.M. v) Derivatives are used. hedge funds do not have any universally accepted definition. Therefore. Further. iii) Investors are typically permitted to redeem their interests periodically. quarterly. as suggested by IOSCO is to look at the kinds of characteristics of fund management strategies employed by institutions. leverage and / or hedging and arbitrage techniques. such as long/short exposures. Therefore. Hedge funds would at least exhibit some of the following characteristics: i) Borrowing and leverage restrictions. iv) Often significant ‘own’ funds are invested by manager.B.g. semi-annually or annually.
through circular no. These limits will help diversify the foreign hedge fund investments and will help in jettisoning concentration in any specific scrip. SMD/DC/CIR-11/02 dated February 12.F. 2004 issued by Secondary Market Department.B. 1995 also lays down scrip-wise and fund wise maximum limits a fund can invest. scrip wise 65 . 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.Y.M. While opening up our market one cannot be oblivious to the special concerns associated with the creative fund management strategies used by these funds. 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. 1995 and the Guidelines issued by SEBI which an address\ the concerns related to currency speculations. investment in commodity related financial products will not be an option for any hedge funds under the present FII Regulations. short selling. position limits for investment by FIIs in derivatives has been advised. Para 4. The provision will clearly keep the hedge funds if allowed to invest as FIIs out of short selling at least in the cash segment. 2002 and SEBI/DNAD/CIR-21/2004/03/09 dated March 9.T. Additional Regulatory Concerns: In view of the increasing popularity among the institutions as well as their increasing interest in the Indian market. Further. the approach adopted in formulating the following policy suggestions has been that of transparent and regulated access with abundant caution. It is therefore. Thus.4 of this section has already outlined the existing provisions in the SEBI (Foreign Institutional Investors) Regulations. The SEBI (Foreign Institutional Investors) Regulations.
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. The fund should be a broad based fund in terms of the SEBI (Foreign Institutional Investors) Regulations. Hedge funds as a whole are becoming an important segment of the asset management industry and gaining popularity from investors particularly 66 . 3. keep our markets insulated from the possible adverse effects of ‘trial and errors’ by uninitiated rookies. As mentioned earlier. particularly in terms of the explanation to Regulation 6 (1) (d).F. 4. 2. concentration in the cash market and excessive positions in the derivative segment of our market. banks and insurance companies. endowments.M. university funds.T. In this context. following additional provisions have been suggested with respect to hedge funds seeking registration as FII: 1. This provision is expected to allow well managed funds to access our market and at the same time.B. these types of funds raise special regulatory concerns which are necessary to be addressed with special regulatory provisions. At least 20% of the corpus of the fund should be contributed by the investors such as pension funds. 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. charitable trusts or societies.Y. The presence of institutional investors in the fund is expected to ensure better governance on the part of the fund manager and fund administrators. Further.
India and China are keenly observed for new investment propositions. insurance and other institutional investors. most willing to take risks in anticipation of explosive reward. Yes. The asset under management of the hedge funds are growing on a double digit rate. charitable funds.higher risk.for those with an appetite for risks. regulatory factors. democratic set-up. Investment in hedge funds is a cynosure of interest for sophisticated investors. investment in India focused hedge funds . To invest in hedge 67 . Investment in hedge funds in India has been gaining momentum post 2001-2002. from the high net worth investors. liberalized stable economy.M. better return on capital have rather favored India score over China as a superior place for investment in hedge funds. In addition. Presence of systematic institutional framework for hedging. particularly investment in hedge funds.Y. 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. endowments. rapid reforms. 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.T. All hedge funds are not necessarily speculative funds though most of them provide an alternative investment options for the investors through innovative investment strategy.F. pension funds. higher opportunity investments and higher rewards. wealthy individuals or families and big institutions. Two fast growing emerging markets.B. They are class of investors who believe in the finance mantra . universities. the suggestions also provide for adequate safety measures to address legitimate concerns associated with these funds. good information disclosure standards. a well-developed capital economy.
The early entrants into the Indian markets have recorded encouraging returns which in turn attracted other hedge fund players to step in. you need to first understand what they are and how it works. Renaissance Technologies. Here is a list of hedge funds operating in India. funds in India. LLC Vasishta South Asia Fund Limited Atyant Capital Atlantis India Opportunities Fund Typical Hedge Fund Investment • Investor chooses and decides hedge fund investment 68 . DE Shaw. 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. India Capital Fund.F. Overview of Hedge funds in India Financial experts opine that India has tremendous potential for attracting global investments in hedge funds. Vikram Panditfounded Old Lane.T.M. Och-Ziff Capital Management are some reputed international hedge funds firms in India.B. Ltd.Y. • • • • • • • • • • • • • • India Capital Pvt.
the key players. white papers on hedge funds in India. Investment manager instructs custodian to move funds to prime broker for investment in market. Custodian confirms receipt of payment to fund administrator.M. financial magazines. • • • • • Subscription amount is paid to the custodian. Talk to personnel. Guide to investing in Hedge Funds in India • Prior to finalizing investment. Account for your investment goals. the operational risks.F. • During the process the prime broker and custodian are in direct contact with fund administrator.B. Fund administrator instructs issue of share to investor. their worth. amount allocated for investment. news articles. refer commercial directories or databases. how business is run in India all helps. websites. Fund administrator issues reports on hedge fund performance. its implications.T. the pros and cons of investing in hedge funds etc • Identify potential hedge funds. risk tolerance level.Y. • Read blogs. take couple of months to know about the hedge fund industry in India. preferably interact 69 . • Get to understand the ground realities of regulatory factors. The age of hedge fund industry.
Check with accountant with regard to tax reporting and implications. Check if diverse hedge fund strategies and techniques are put to use. • Involve financial advisor in the process of investing in hedge funds in India. • Ensure your activities are that of an accredited investor (with a net worth of more than $1 million). Engage in data mining. remittance. keep track of trends. securities broker or licensed investment consultant for advice on hedge fund investments in India. • Check the pros and cons of long-term hedge funds vs.T.F. or any other complaint in general that doesn't confirm with regulations. withdrawal and redemption fees. • Approach wealth manager in wealth management companies. short-term hedge funds.M. • • • • • • Maintain direct communication with hedge fund manager. Receive and file monthly or quarterly updates.Y. Know your rights.B. 70 . with hedge fund managers involved with hedge fund investments and those who have already invested in hedge funds. • Notice annual events like Hedge funds world India to gain an assessment of the burgeoning Indian hedge fund industry. • Understand terms related to hedge funds. where to seek help in terms of a dissatisfied hedge fund investment operation. management fee and performance fee.
Getmansky. even funds with a history of low volatility can end up losing most of their money.S. However. roughly 10 percent of hedge funds die.1 billion. and Lo. Securities and Exchange Commission (2003) estimates the damages in these cases to amount to $1. Regulators are concerned about the risks of hedge funds for at least four reasons: investor protection. or slightly more than half the standard deviation of the Standard & Poor’s 500 return over the 1994–2005 period (Chan. Hedge funds create credit exposures for financial institutions in several ways: they borrow. Haas.Y.B. We review and evaluate these reasons in turn. aggregate losses from hedge fund fraud seem relatively small. an outcome that is almost inconceivable for a mutual fund. The SEC brought 51 hedge fund fraud cases from 2000 to 2004.F. arguably indicating a need for greater investor protection. The U. 2006). However. but this low volatility did not prevent it from losing most of its capital in the span of a month. they make securities transactions. 71 . The Securities and Exchange Commission wanted to force registration of hedge fund managers because hedge fund collapses had generated large losses for their investors.76 percent. and excess volatility risks.T. from February 1994 to August 2004. A fund might die because the investors withdraw funds following significant losses. and they are often counterparties in derivatives trades. Some funds disappear because fraud or misreporting becomes apparent. Banking regulators are concerned that hedge funds may create risks to financial institutions. Each year. 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. liquidity risks.M. Because of leverage. risks to financial institutions. The Long Term Capital Fund had lower volatility than the S&P 500 for almost all its existence. the average annualized standard deviation of the monthly returns of fixed income arbitrage hedge funds was 7.
they cannot just ride out a serious adverse shock. 72 . the Amaranth losses led to calls for regulation of hedge funds. When the Long Term Capital Fund lost more than $4 billion in August and September 1998. adverse shocks could lead hedge funds to dump securities and cash out precisely when things are going poorly. 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. which could make matters worse. the debacle at the hedge fund Amaranth in late 2006 had only a trivial impact on the markets. the New York Times (2006) published an editorial stating that “regulators need to act now to translate their various calls for hedge-fund oversight into enforceable rules and. in some instances.F.”Hedge funds rely on their ability to move out of trades quickly when prices turn against them. when hedge funds use leverage. Hence. instead. two adverse developments can ensue: prices may have to overreact and liquidity may fall sharply.T. If too many funds have set up the same trades. Nonetheless. such hedge funds become more risky.Y. which increases threats to financial institutions and can lead to further overreaction in prices as financial institutions have to reduce their positions as well. For instance. As a result. 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.B. which raises an issue of liquidity risk. hedge funds that rely on trading quickly to control their risks cannot do so. into concrete proposals for Congress to enact. However. they must reduce their exposures to satisfy the banks from which they borrowed. The collapse of a hedge fund could have far-reaching implications if the fund is large enough. With low liquidity. In that case.M. they may not all be able to exit their positions at the same time. Further.
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.
the skills of hedge fund managers were contributing on average $10 billion a year to investors.B. regulatory authorities are unlikely to allow unregulated hedge funds to compete with regulated banks. Some hedge funds have also specialized in lending. During their sample period. more hedge funds have become activist investors. Regulations may be enacted to prevent such actions. 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. For the performance of hedge funds to generate 4 percent net of fees for investors. net of fees. Thus. strong forces will push them to become more like financial institutions.T. For example.M. we saw that as hedge funds succeed. Again. 2006)—when a fund borrows shares and holds them to vote. Recently. As a rough estimate.F. 76 . over the last few years.Y. as hedge fund management companies compete with regulated financial institutions. Ibbotson and Chen (2005) estimate the average alpha of the hedge fund industry to be above 3 percent per year. the skills of hedge fund managers have to produce an additional $20 billion of alpha. but the lender keeps the price risk of the shares. the yearly average size of the hedge fund industry is $262 billion according to one consulting firm. suppose that the value-weighted alpha for hedge funds is 4 percent. Finally. regulated financial institutions seem certain to express concerns about the lack of a level playing field. In some countries. The industry is now at least three times as large. it pays a fee to the lender. However. How Will the Hedge Fund Industry Perform Over the Next Ten Years? As discussed earlier. Large funds seem to have performed somewhat better. such activism has led to demands for regulation.
com/terms/h/hedgefund.investorwords.org/wiki/Hedge_fund http://www.F. More hedge funds chasing the same price discrepancies means that these discrepancies get eliminated faster. as more money enters the hedge fund industry.hedgefund. However.magnum. As more funds buy convertible bonds. from 26 in 1994 to 145 in 2003 according to one database.asp http://www.com/ http://www. so that the performance of this strategy falls.hedgefundtools.investopedia. new strategies that typically cannot be as good as the ones already implemented. the strategy becomes less profitable because the funds push the price up.thehfa. Bibliography Websites:http://en.com/ http://www. or new managers.net/hedgeducation/hedge-fund-articles/ http://www. A clear example of this problem is the recent performance of convertible arbitrage funds.T.com/2296/hedge_fund. it either funds existing strategies.asp http://www.org/ http://www. 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. the increase in convertible arbitrage funds. leading to smaller profits for the funds.thehedgefundjournal. eventually led to poor performance and a drop in the number of such funds.com/ http://www.net/hfn_public/default.aspx http://www. Hence.wikipedia.com/hedgefunds/abouthedgefunds.B.com/ http://hedgefundproductions.html http://www.com/ http://www.Y.thehedgefundjournal.hedgeco. Not surprisingly.hedgefundintelligence.com/ 77 .hedgefund-index. additional money entering hedge funds in the future will typically not find average returns as high as in the past.M.
B.M.Y.T.F. Books:1) All About Hedge Funds: The Easy Way To Get Started by Robert Jaeger 2) Hedge Funds For Dummies by Ann C. Logue 3) Investment Strategies of Hedge Funds by Filippo Stefanini 78 .
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