Banking Academy of Vietnam

International School of Business

A Research Report

on

HEDGE FUNDS

Teacher: Trần Thị Xuân Anh

Student:Lê Thị Thu Huyền - CA7-

045

Long Huyền Mai - CA7-058

Nguyễn Hồng Hạnh- CA6-

030

Class: CityU7A

Course: Financial Organization

 Hanoi, 13/04/2021

Table of Contents
Abstract.....................................................................................................................................3
I. Introduction..........................................................................................................................4
1) What is Hedge funds?........................................................................................................4
2) The history of hedge funds................................................................................................4
3) The hedge fund today........................................................................................................5
II. Main features.......................................................................................................................5
1) Characteristics of Hedge Funds.........................................................................................5
2) Overview structures...........................................................................................................6
3) Hedge fund’s strategies......................................................................................................7
4) Advantages and Disadvantages of Hedge Funds.............................................................10
III. Performance.....................................................................................................................11
1. Performance measurement...............................................................................................11
2. Sector-size effect..............................................................................................................12
3. Hedge fund indices...........................................................................................................13
IV. Regulation.........................................................................................................................14
1. United States....................................................................................................................14
2. Europe..............................................................................................................................16
V. Problems of Hedge funds..................................................................................................16
VI. Conclusion........................................................................................................................20
References...............................................................................................................................21

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 Abstract
Along with the development of the stock market, many new types of investment funds have
been introduced to meet the diverse needs of investors. Hedge fund is a potential fund that is
in the stage of strong growth, rapid growth compared to mutual funds. Although they have
the same economic function, hedge funds have more advantages and creativity in investment
strategy and fund management. This research paper introduces a general overview of hedge
funds, analyzes investment structures and strategies, performance measurement, compares
them with mutual funds, and from there identifies the problems that hedge funds are facing.

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I. Introduction
1) What is Hedge funds?
Hedge funds are unregulated pools of money managed by an investment advisor, the hedge
fund manager, who has a great deal of flexibility. In particular, hedge fund managers
typically have the right to have short positions, to make use of derivatives and leverage in
both domestic and international markets with the goal of generating high returns. Put simply,
a hedge fund is a pool of money that takes both short and long positions, buys and sells
equities, initiates arbitrage, and trades bonds, currencies, convertible securities, commodities,
and derivative products to generate returns at reduced risk. As the name suggests, the fund
tries to hedge risks to investor’s capital against market volatility by employing alternative
investment approaches.
2) The history of hedge funds
A former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co.,
launched the world's first hedge fund back in 1949.1 Jones was inspired to try his hand at
managing money while writing an article about investment trends earlier that year. He raised
$100,000 (including $40,000 out of his own pocket) and tried to minimize the risk in holding
long-term stock positions by short-selling other stocks. This investing innovation is now
referred to as the classic long/short equities model. Jones also employed leverage to enhance
returns. In 1952, Jones altered the structure of his investment vehicle, converting it from a
general partnership to a limited partnership and adding a 20% incentive fee as compensation
for the managing partner. As the first money manager to combine short selling, the use of
leverage shared risk through a partnership with other investors and a compensation system
based on investment performance, Jones earned his place in investing history as the father of
the hedge fund.
Hedge funds went on to dramatically outperform most mutual funds in the 1960s and gained
further popularity when a 1966 article in Fortune highlighted an obscure investment that
outperformed every mutual fund on the market by double-digit figures over the previous year
and by high double-digits over the previous five years.
However, as hedge fund trends evolved, in an effort to maximize returns, many funds turned
away from Jones' strategy, which focused on stock picking coupled with hedging and chose
instead to engage in riskier strategies based on long-term leverage. These tactics led to heavy

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losses in 1969-70, followed by a number of hedge fund closures during the bear market of
1973-74. The industry was relatively quiet for more than two decades until a 1986 article in
Institutional Investor touted the double-digit performance of Julian Robertson's Tiger Fund,
once again capturing the public's attention with its stellar performance, investors flocked to
an industry that now offered thousands of funds and an ever-increasing array of exotic
strategies, including currency trading and derivatives such as futures and options. High-
profile money managers deserted the traditional mutual fund industry in droves in the early
1990s, seeking fame and fortune as hedge fund managers. Unfortunately, history repeated
itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds,
including Robertson's, failed in spectacular fashion. Since that era, the hedge fund industry
has grown substantially.
3) The hedge fund today
Today the hedge fund industry is massive—total assets under management in the industry are
valued at more than $3.2 trillion according to the 2018 Preqin Global Hedge Fund Report.
Based on statistics from research firm Barclays hedge, the total number of assets under
management for hedge funds jumped by 2335% between 1997 and 2018.
The number of operating hedge funds has grown as well, at least in some periods. There were
around 2,000 hedge funds in 2002. Estimates vary about the number of hedge funds operating
today. This number had crossed 10,000 by the end of 2015. However, losses and
underperformance led to liquidations. By the end of 2017, there were 9,754 hedge funds
according to research firm Hedge Fund Research. According to Statistica, by 2019, the
number of funds worldwide had reached 11,088.

II. Main features

1) Characteristics of Hedge Funds
Hedge funds are sometimes misunderstood as mutual funds. But they are very different from
the latter.
 Investors
While mutual funds are offered by institutional fund managers with a variety of options for
retail and institutional investors who have a low minimum investment threshold, hedge funds
target high-net-worth investors. Normally these are investors who have a net worth exceeding
$1m or an annual income of over $200,000 maintained for the previous two years (the levels
vary from country to country). The minimum investment amounts for participation in a hedge
fund are typically far higher as a result.

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  Diversification
Hedge funds invest in a wide range of financial markets. Unlike mutual funds that are only
allowed to invest in bonds and stocks, hedge funds can invest in all financial markets such as
real estate, commodities or forex.
 Employ leverage
Hedge funds use several forms of leverage to chase large returns. They purchase securities on
margin, meaning they leverage a broker's money to make larger investments. They invest
using credit lines and hope their returns outpace the interest. Leverage allows hedge funds to
amplify their returns, but can also magnify losses and lead to increased risk of failure if bets
go against them. Hedge funds also trade in derivatives, which they view as having
asymmetric risk; the maximum loss is much smaller than the potential gain.
2) Overview structures
a) Organizational structure
Unique to the investment community, hedge funds are partnerships formed between fund
managers and investors, which is really a two-tiered organization. The most common
structure for hedge funds is the general/limited partnership model.
In this structure, the hedge fund’s general partners are the founders and money managers of
the fund. Their responsibility is to select service providers to market and manage the fund as
well as perform any functions necessary in the normal course of business, assume
responsibility for the operations of the fund. General partners typically use a limited liability
company structure. In exchange for their control, general partners take on unlimited liability
in the fund, which means that their personal assets are at stake if the fund’s liabilities exceed
its assets.
Limited partners can make investments into the partnership and are liable only for that
amount. When investors give their money to the fund manager (a general partner) to invest,
they take a stake in the fund as a business. Limited partners can come in many different
flavors: Individual investors, pension funds, or endowments. The limited partnership has its
drawbacks. Limited partners pay fees to the general partners for their management services.
They have little or no say in the fund’s operations. And the fund may restrict ongoing
communication with the general partners to only a few times per year. But in exchange for
these limitations of control, limited partners just have limited liability. They can lose only the
amount their invest in the fund and no more.
b) Fee structure

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The hedge fund fee structure is one of the main reasons why talented money managers decide
to open their own hedge funds. Not only are the fees paid by investors higher than they are
for mutual funds, where investors typically only pay a management fee., but they also include
some additional fees that mutual funds do not even charge. In a hedge fund, the investors pay
two types of fees to the hedge fund managers, namely management fee and incentive fee
(also called performance fees). The fee charged is mentioned as “2 and 20” which means is a
hedge fund compensation structure consisting of 2% represents a management fee hat is
applied to the total assets under management and 20% performance fee is charged on the
profits that the hedge fund generates. The management fee is a periodic payment that is paid
by investors in a pooled investment fund to the fund’s investment adviser for investment and
portfolio management services. This is paid irrespective of how the fund performs. In some
cases even 2% higher, if the manager is in high demand and has had a very good track record.
The incentive fee is usually in place to tie a manager’s compensation to their level of
performance, more specifically to their level of financial return. The idea of the incentive fee
is to reward the hedge fund manager for good performance, and if the fund's performance is
attractive enough, investors are willing to pay this fee. However, such fees can sometimes
lead to increased levels of risk-taking, as managers attempt to increase incentive levels
through riskier ventures than outlined in a fund’s prospectus
c) Term structure
Subscriptions and Redemptions:
• A subscription is when the investor applies to join a particular fund. Subscription minimums
vary from fund to fund.
• A redemption is when the investor withdraws part or all of their investment from a fund.
• Unlike registered investment companies, hedge funds are not required to have daily
liquidity. Some hedge funds offer subscriptions and redemptions monthly, while others
accept them only quarterly or annually.
Lock-Ups:
• A lock-up is the time period that an initial investment cannot be redeemed from the fund.
The length of time varies based on the fund. The most common lock-up is limited to one
year. It could be a “hard lock”, which prevents the investor from withdrawing funds for the
full-time period. In other cases, an investor can pay a penalty fee to withdraw funds before
the expiration of the lock-up period.
3) Hedge fund’s strategies
 Long-Short Equity Fund

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One of the most commonly used strategies for startup hedge funds is the long/short equity
strategy. As the name suggests, this strategy is an investing strategy that takes long positions
in stocks that are expected to appreciate and short positions in stocks that are expected to
decline. Funds using a long/short strategy employ a wide range of fundamental and
quantitative techniques to make investment decisions. The fund manager buys and holds the
stocks which he expects to perform well in the future. He also short-sell the shares which are
assumed to achieve less than the expectations. Thus, he deals in both types of equity funds to
reduce the risk. Long/short funds tend to invest primarily in publicly traded equity and their
derivatives and tend to be long-biased. It tends to have reasonably straightforward investment
fund terms. Basically, equity hedge is an extension of pairs trading, in which investors go
long and short on two competing companies in the same industry based on their relative
valuations. It is a relatively low-risk leveraged bet on the manager’s stock-picking skill. The
purpose of a long/short equity hedge fund is to provide absolute returns by investing in stocks
with superior return characteristics, and by disinvesting in or "shorting" stocks with inferior
return profiles.
Net exposure is the difference between a hedge fund’s long positions and its short positions.
Net exposure can be contrasted with a fund's gross exposure. A fund has a net long exposure
if the percentage amount invested in long positions exceeds the percentage amount invested
in short positions, and has a net short position if short positions exceed long positions. If the
percentage invested in long positions equals the amount invested in short positions, the net
exposure is zero.
A hedge fund manager will adjust the net exposure following their investment outlook—
bullish, bearish, or neutral. Being net long reflects a bullish strategy; being net short, a
bearish one. Net exposure of 0% is a market-neutral strategy.
 Global macro
A global macro strategy is an investment and trading strategy that is based on the
interpretation of large macroeconomic events on the national, regional, and global scale.
Global macro hedge funds are market bets around economic events. For the successful
implementation of a global macro strategy, fund managers analyze various macroeconomic
and political factors. These include interest rates, currency exchange rates, levels of
international trade, political events, and international relations. They use financial
instruments to create short or long positions based on the outcomes they predict as a result of
their research. Unlike many other investment strategies, a global market strategy focuses on
the systematic risks of markets. Global macro strategies can be divided into discretionary and
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systematic approaches. Discretionary trading is carried out by investment managers who
identify and select investments, whereas systematic trading is based on mathematical models
and executed by software with limited human involvement beyond the programming and
updating of the software
 Convertible arbitrage
Convertible arbitrage is a trading strategy that typically involves taking a long position (buy)
in convertible security and a short position (sell) in the underlying common stock.
Convertible securities are often bonds that have the option to be converted into stock .
Managers try to maintain a delta-neutral position, in which the bond and stock positions
offset each other as the market fluctuates. To preserve delta-neutrality, traders must increase
their hedge, or sell more shares short if the price goes up and buy shares back to reduce the
hedge if the price goes down. This forces them to buy low and sell high. The goal of the
convertible arbitrage strategy is to capitalize on pricing inefficiencies between the convertible
and the stock. The more the shares bounce around, the more opportunities arise to adjust the
delta-neutral hedge and book trading profits. Funds thrive when volatility is high or
declining, but struggle when volatility spikes—as it always does in times of market stress.
However, convertible arbitrage is not without risks, and multiple steps are involved in
implementing the strategy. If an issuer becomes a takeover target, the conversion premium
collapses before the manager can adjust the hedge, resulting in a significant loss.
 Event-driven
Event-driven strategies are equity-oriented strategies involving investments, long or short, in
the securities of corporations undergoing significant change such as spin-offs, mergers,
liquidations, bankruptcies, and other corporate events. This strategy exploits the tendency of
a company's stock price to suffer during a period of change. This kind of strategy works well
during periods of economic strength when corporate activity tends to be high. With an event-
driven strategy, hedge funds buy the debt of companies that are in financial distress or have
already filed for bankruptcy. Substantial profits may be generated by managers who correctly
analyze the impact of the anticipated corporate event, predict the course of restructuring, and
take positions accordingly. Depending on the nature of the corporate event, either relative
value or directional positions will be taken. Event-driven strategies are therefore intimately
linked to the level of corporate activity. Despite a correlation between corporate activity and
stock market performance, both investors and managers aim to capture consistent absolute
levels of returns. Investors in event-driven funds need to be able to take on some risk and also
be patient. Corporate reorganizations don't always happen the way managers plan, and, in
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some cases, they may play out over months or even years, during which the troubled
company’s operations may deteriorate. Changing financial-market conditions can also affect
the outcome – for better or for worse. Event driven strategies allows managers to capture
short-term fluctuations but they must act quickly before official information is available.
 A fund of hedge funds
A fund of hedge funds (FOF)—also known as a multi-manager investment—is a pooled
investment fund that invests in other hedge funds with the goal of greater diversification,
gains broad exposure to the hedge fund industry. In other words, its portfolio contains
different underlying portfolios of other funds. These holdings replace any investing directly
in bonds, stocks, and other types of securities.
Hedge fund managers will invest with the view of selecting the best possible securities for
their portfolio. A Hedge Fund of Funds manager will select actual hedge funds with the
combination of the best performance and management. Funds of hedge funds generally
charge a fee for their services, always in addition to the hedge fund's management and
performance fees, which can be 1.5% and 15-30%, respectively. Fees can reduce an investor's
profits.
Hedge Fund of Funds are typically regarded as less fundamental and quantitative as typical
hedge funds because analysts at FOF’s not doing security analysis, they are diversifying
capital across a variety of hedge funds.
4) Advantages and Disadvantages of Hedge Funds
a) Advantages
Hedge funds offer some worthwhile benefits over traditional investment funds. Some notable
benefits of hedge funds include:
+ Investment strategies that can generate positive returns in both rising and falling equity and
bond markets
+ The reduction of overall portfolio risk and volatility in balanced portfolios
+ An increase in returns
+ A variety of investment styles that provide investors the ability to precisely customize an
investment strategy
+ Access to some of the world's most talented investment managers
b) Disadvantages
Hedge funds, of course, are not without risk as well:
+ Concentrated investment strategy exposes them to potentially huge losses.

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+ Hedge funds tend to be much less liquid than mutual funds because they typically require
investors to lock up money for a period of years.
+ The use of leverage or borrowed money can turn what would have been a minor loss into a
significant loss.

III. Performance
1. Performance measurement.
Performance statistics for individual hedge funds are difficult to obtain, as the funds have
historically not been required to report their performance to a central repository, and
restrictions against public offerings and advertisement have led many managers to refuse to
provide performance information publicly. However, summaries of individual hedge fund
performance are occasionally available in industry journals and databases.
One estimate is that the average hedge fund returned 11.4% per year, representing a 6.7%
return above overall market performance before fees, based on performance data from 8,400
hedge funds. Another estimate is that between January 2000 and December 2009 hedge funds
outperformed other investments and were substantially less volatile, with stocks falling an
average of 2.62% per year over the decade and hedge funds rising an average of 6.54% per
year; this was an unusually volatile period with both the 2001-2002 dot-com bubble and a
recession beginning mid-2007. However, more recent data show that hedge fund performance
declined and underperformed the market from about 2009 to 2016.
Hedge fund's performance is measured by comparing their returns to an estimate of their risk.
Common measures are the Sharpe ratio, Treynor measure, and Jensen's alpha. These
measures work best when returns follow normal distributions without autocorrelation, and
these assumptions are often not met in practice.
New performance measures have been introduced that attempt to address some of the
theoretical concerns with traditional indicators, including modified Sharpe ratios; the Omega
ratio introduced by Keating and Shadwick in 2002; Alternative Investments Risk-Adjusted
Performance (AIRAP) published by Sharma in 2004, and Kappa developed by Kaplan and
Knowles in 2004.

1.1. The Sharpe ratio

In finance, the Sharpe ratio (also known as the Sharpe index, the Sharpe measure, and

the reward-to-variability ratio) measures the performance of an investment (e.g., a security or
portfolio) compared to a risk-free asset, after adjusting for its risk. It is defined as the
difference between the returns of the investment and the risk-free return, divided by

11
the standard deviation of the investment (i.e., its volatility). It represents the additional
amount of return that an investor receives per unit of increase in risk.

The Sharpe ratio = (Portfolio Return – Risk-Free Rate) / Standard Deviation

1.2. Absolute returns

The absolute return is measure of the gain or loss on an investment portfolio expressed as a
percentage of invested capital.

Absolute return differs from relative return because it is concerned with the return of a
particular asset and does not compare it to any other measure or benchmark.

1.3. Jensen’s alpha

Jensen's alpha is a statistic that is commonly used in empirical finance to assess the
marginal return associated with unit exposure to a given strategy. Generalizing the above
definition to the multifactor setting, Jensen's alpha is a measure of the marginal return
associated with an additional strategy that is not explained by existing factors.
Jensen’s alpha = Portfolio Return – Benchmark Portfolio Return
Where: Benchmark Return (CAMP) = Risk-free Rate of Return + Beta (Return of Market –
Risk-free Rate of Return)
1.4. Treynor ratio

The Treynor reward to volatility model (sometimes called the reward-to-volatility

ratio or Treynor measure) is a measurement of the returns earned in excess of that which
could have been earned on an investment that has no diversifiable risk (e.g., Treasury bills or
a completely diversified portfolio), per unit of market risk assumed.

The Treynor ratio relates excess return over the risk-free rate to the additional risk taken;
however, systematic risk is used instead of total risk. The higher the Treynor ratio, the better
the performance of the portfolio under analysis.

Treynor ratio = (Portfolio Return – Risk-free Rate ) / Beta

2. Sector-size effect
There is a debate over whether alpha (the manager's skill element in performance) has been
diluted by the expansion of the hedge fund industry. Two reasons are given. First, the
increase in traded volume may have been reducing the market anomalies that are a source of
hedge fund performance. Second, the remuneration model is attracting more managers, which
may dilute the talent available in the industry.

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3. Hedge fund indices.
3.1. Non-invetable indices

Non-investable indices are indicative in nature and aim to represent the performance of some
database of hedge funds using some measure such as mean, median, or weighted mean from a
hedge fund database. The databases have diverse selection criteria and methods of
construction, and no single database captures all funds. This leads to significant differences in
reported performance between different indices.

3.2. Investable indices

Investable indices are an attempt to reduce these problems by ensuring that the return of the
index is available to shareholders. To create an investable index, the index provider selects
funds and develops structured products or derivative instruments that deliver the performance
of the index. When investors buy these products the index provider makes the investments in
the underlying funds, making an investable index similar in some ways to a fund of hedge
funds portfolio.

Hedge funds in Europe

Europe is the second-largest region in terms of hedge fund activity across the globe, and at
$657bn accounts for 20% of assets under management (AUM) held by the industry. Europe-
based institutional investors account for 1,053 of the 5,156 institutional investors tracked by
Preqin’s Hedge Fund Online database, and the 1,006 Europe-based fund managers represent
18% of the 5,557 total firms. The European industry has, however, faced some challenges in
recent years. AUM held by managers in Europe fell over the course of 2016 from $674bn to
$657bn, as investors’ concerns about performance and fees – common to the whole industry
– put pressure on fund managers. More significantly, over recent years Europe-based
investors have accounted for a decreasing proportion of capital allocated to hedge funds by
institutional investors worldwide, as some have pulled back from investing in the asset class
and investors in other regions have increased their activity. Europe-based institutions
accounted for 32% of institutional capital invested in hedge funds in December 2011; this
figure has fallen to 21% as of December 2016. The amount of capital invested in hedge funds
by these investors peaked at $444bn in December 2014 and has since decreased to $387bn.
Nevertheless, with this figure representing over a fifth of institutional capital invested in
hedge funds, Europe remains a major centre for the industry. Hedge fund activity also varies
hugely between the different countries. Although the UK is still the dominant market for

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hedge funds in Europe, accounting for 53% of the total number of fund managers and 39% of
investors, other countries have their own specialities

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

In 2007 in an effort to engage in self-regulation, 14 leading hedge fund managers developed a

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

1. United States
Hedge funds within the US are subject to regulatory, reporting and record keeping
requirements. Many hedge funds also fall under the jurisdiction of the Commodity Futures
Trading Commission and are subject to rules and provisions of the 1922 Commodity
Exchange Act which prohibits fraud and manipulation. The Securities Act of 1933 required
companies to file a registration statement with the SEC to comply with its private
placement rules before offering their securities to the public. The Securities Exchange Act
of 1934 required a fund with more than 499 investors to register with the SEC.

14
The Investment Advisers Act of 1940 contained anti-fraud provisions that regulated hedge
fund managers and advisers, created limits for the number and types of investors, and
prohibited public offerings. The Act also exempted hedge funds from mandatory registration
with the US Securities and Exchange Commission (SEC) when selling to accredited
investors with a minimum of US$5 million in investment assets. Companies and institutional
investors with at least US$25 million in investment assets also qualified.

In December 2004, the SEC began requiring hedge fund advisers, managing more than
US$25 million and with more than 14 investors, to register with the SEC under the
Investment Advisers Act. The SEC stated that it was adopting a "risk-based approach" to
monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning
industry. The new rule was controversial, with two commissioners dissenting, and was later
challenged in court by a hedge fund manager. In June 2006, the U.S. Court of Appeals for the
District of Columbia overturned the rule and sent it back to the agency to be reviewed. In
response to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the
earlier challenged rule, "does not impose additional filing, reporting or disclosure
obligations" but does potentially increase "the risk of enforcement action" for negligent or
fraudulent activity. Hedge fund managers with at least US$100 million in assets under
management are required to file publicly quarterly reports disclosing ownership of registered
equity securities and are subject to public disclosure if they own more than 5% of the class of
any registered equity security. Registered advisers must report their business practices and
disciplinary history to the SEC and to their investors. They are required to have written
compliance policies, a chief compliance officer and their records and practices may be
examined by the SEC.

The U.S.'s Dodd-Frank Wall Street Reform Act was passed in July 2010 and requires SEC
registration of advisers who represented funds with more than US$150 million in assets, and
funds with more than 15 US clients, and investors managing US$25 million. Registered
managers must file information regarding their assets under management and trading
positions. Previously, advisers with fewer than 15 clients were exempt, although many hedge
fund advisers voluntarily registered with the SEC to satisfy institutional investors. Under
Dodd-Frank, hedge fund managers with less than US$100 million in assets under
management became subject to state regulation. This increased the number of hedge funds
under state supervision. Overseas funds with more than 15 US clients and investors who
managed more than US$25 million were also required to register with the SEC. The Act

15
requires hedge funds to provide information about their trades and portfolios to regulators
including the newly created Financial Stability Oversight Council. Under the "Volcker Rule",
regulators are also required to implement regulations for banks, their affiliates and holding
companies to limit their relationships with hedge funds and to prohibit these organizations
from proprietary trading, and limit their investment in, and sponsorship of hedge funds.

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

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

V. Problems of Hedge funds

Hedge funds often have a high degree of risk, but that is also a feature that attracts investors
because high risks also promise higher returns.

1. Regulatory and Transparency

Hedge funds are private entities with relatively less public disclosure requirements. This, in
turn, is perceived as a ‘lack of transparency’ in the immense interest of the community.
Another common perception is that in comparison to various other financial investment
managers, the hedge fund managers are not subjected to regulatory oversight and rigid
Registration requirements. Such features expose the funds to fraudulent activities, faulty
operations, mismatch of handling the Fund in case of multiple managers, etc.

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  There is a push by the U.S. Government and E.U. authorities to report additional
information improving transparency such as the 2008 Financial crisis and the 2010
E.U. fall.

2. Investment Risks (Liquidity)

Hedge funds share several risks as other investment classes are broadly classified as Liquidity
Risk and Manager Risk. Liquidity refers to how quickly security can be converted into cash.
Funds generally employ a lock-up period during which an investor cannot withdraw money
or exit the Fund. This can block possible liquidity opportunities during the lock-up period,
which can range from 1-3 years. Another massive risk for all hedge fund investors is the risk
of losing their entire investment. The hedge fund's risk comes from the managers of the
hedge fund being paid a percentage of the profits from the fund, but not paying a percentage
when the fund is at a loss.

3. Performance Issues

Since the 2008 Financial crisis, the charm of the hedge fund industry is said to have waned
out a bit. This is due to various factors related to interest rate formation, credit spreads, stock
market volatility, leverage, and government intervention creating various hurdles that reduce
opportunities for even the most skillful fund managers. The deterioration in performance can
be pinned to the overabundance of investors. The hedge fund investors have now become
very cautious in their approach and opt to preserve their capital even in the worse of
conditions. As the number of hedge funds has swelled, making it a $3 trillion industry, more
investors are participating. Still, the overall performance has shrunk since more hedge fund
managers have entered the market, reducing the effect of multiple strategies that were
traditionally considered speculative.

4. Rising Fees & Prime Broker Dynamism

Fund managers are now beginning to feel the effects of bank regulations, which have been
strengthened post the 2008 financial crisis, especially the Basel III regulations. These updated
rules require banks to hold more capital through a capitalization rate, which blocks money
towards regulatory requirements, leverage constraints, and increasing focus on liquidity,
impacting the capacity and economics of banks. It has also resulted in an evolving shift in
how the Prime broker’s view hedge fund relationships. Prime brokers have started demanding
higher fees from the hedge fund managers for providing their services, which in turn has an

17
impact on the performance of the hedge fund and, in turn making them less lucrative in an
already squeezing margin business.

This has caused fund managers to evaluate how they obtain their financing or, if required, to
make radical changes to their strategies. This has made the investors jittery, especially for
those whose investments are in the “lock-up” period.

5. Mismatch or Incomplete Information

The fund managers must reveal the performance of the Fund regularly. However, the results
can be fabricated to match the directions of the fund manager since the offering documents
are not reviewed or approved by the state or federal authorities. A hedge fund may have little
or no operating history or performance and hence may use hypothetical measures of
execution, which may not necessarily reflect the actual trading done by the manager or
advisor. Hedge fund investors should do a careful vetting of the same and question possible
discrepancies. A hedge fund may not provide any transparency regarding its underlying
investments (including sub-funds in a Fund of Funds structure) to the investors, which in turn
will be difficult for the investors to monitor.

6. Taxation

Hedge funds are generally taxed as Partnerships to avoid instances of “Double Taxation” and
the Profits and Losses being passed on to the investors. These gains, losses, and deductions
are allocated to the investors for the respective fiscal year as determined by the General
Partner. This is detrimental to the investors since they will be the ones to bear the tax
liabilities and not the hedge fund.

7. Leverage

Higher borrowing increases the fund's exposure to changes in asset values. Large losses can
lead to margin calls from lenders and redemptions from investors, both of which can require
the manager to liquidate the portfolio at “fire sale” prices. Moreover, lenders may implicitly
or explicitly require a minimum level of risk management in contractual agreements or legal
covenants. Therefore, funds using more leverage would benefit from good risk management.

Famous Hedge Funds Withdrawn From The Market

All major funds are susceptible to collapse, however, in the case of Hedge Funds this is more
frequent and the losses tend to be substantially higher. It is therefore quite informative to

18
understand some of the spectacular Hedge Fund losses. We now describe some Hedge Funds
that were previously available on the market but have now ceased trading.
George Soros’s Quantum Fund
Perhaps the most famous Hedge Fund investor is Soros, who in 1 day made US$1 billion on
September 6, 1992, by short-selling the British pound. In 1992, Britain was part of the ERM
(European Exchange Rate Mechanism) and Soros was able to anticipate the currency
devaluation of the British Pound. Consequently, by employing the Global/Macro investment
strategy, Soros managed to net a profit of US$1 billion in 1 day. However, years later, his
fund suffered massive losses; in 1998 Russia’s defaulting crisis created a loss of US $2
billion.
Long Term Capital Management (LTCM)
Perhaps the most notorious Hedge Fund collapse was in September 1998; LTCM announced
it had lost 44% of its investors’ capital in August alone (US$2.1 Billion). LTCM began
trading with over $1 billion of investor capital. LTCM applied the Hedge Fund strategy of
market-neutral investment; LTCM used the method of fixed income arbitrage, taking
advantage of temporary changes in prices. The market-neutral strategy was successful from
1994-98 but in 1998 Russian financial markets fell into crisis. However, LTCM speculated
that the situation would quickly return back to normal again, so LTCM took large, unhedged
positions. Unfortunately, Russia began defaulting on its debts in August 1998, causing
LTCM to experience losses approaching $4 billion as it was significantly exposed to Russian
government bonds. The US Federal Government then devised a rescue plan for LTCM to
avert a major US financial crisis and panic.
Robertson’s Tiger Management Fund
Robertson’s Hedge Fund invested by going long on undervalued stocks whilst
simultaneously short-selling what he considered overvalued stocks. For years this strategy
was extremely successful, giving annual returns of 43% from 1980-86, so he continued
applying this strategy during the technology boom. During the tech boom, Robertson rightly
considered many stocks to be overvalued and so began short selling such stocks with the
expectation that overvalued stocks would eventually fall. Yet during the tech boom, a
speculation bubble formed, causing the overvalued stocks to continue to rise beyond
expectation. Consequently, Robertson’s fund collapsed in 2000 after heavy losses, just before
the speculative bubble itself collapsed.

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VI. Conclusion
Hedge Funds are clearly a complex and unique investment product that can produce
extraordinary gains as well as losses. Unlike most mutual funds and exchange-traded funds,
hedge funds may invest money in a wide array of investments and use non-traditional
investing strategies. The fees for these funds are high, usually combining a management fee
and a performance fee. Hedge funds are an important part of the financial economy as they
help in coupling both risk reduction and high returns although sometimes they can pose
higher risks for higher returns.
Thus coupled with all the factors the future of hedge funds is bright and secure in the hands
of the investors. Hedge funds concentrate almost exclusively on the speculative role of
investment management, that is, the attempt to outperform the market average by superior
security valuation and successful trading strategies. At a minimum, hedge funds have brought
innovative investment strategies and a new sense of excitement to the investment community.

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