Hedge Fund - Wikipedia

4/21/24, 12:29 PM Hedge fund - Wikipedia
Hedge fund
A hedge fund is a pooled investment fund that holds liquid assets and that makes use of complex
trading and risk management techniques to improve investment performance and insulate returns
from market risk. Among these portfolio techniques are short selling and the use of leverage and
derivative instruments.[1] In the United States, financial regulations require that hedge funds be
marketed only to institutional investors and high-net-worth individuals.
Hedge funds are considered alternative investments. Their ability to use leverage and more
complex investment techniques distinguishes them from regulated investment funds available to
the retail market, commonly known as mutual funds and ETFs. They are also considered distinct
from private equity funds and other similar closed-end funds as hedge funds generally invest in
relatively liquid assets and are usually open-ended. This means they typically allow investors to
invest and withdraw capital periodically based on the fund's net asset value, whereas private-equity
funds generally invest in illiquid assets and return capital only after a number of years.[2][3] Other
than a fund's regulatory status, there are no formal or fixed definitions of fund types, and so there
are different views of what can constitute a "hedge fund".
Although hedge funds are not subject to the many restrictions applicable to regulated funds,
regulations were passed in the United States and Europe following the financial crisis of 2007–
2008 with the intention of increasing government oversight of hedge funds and eliminating certain
regulatory gaps.[4] While most modern hedge funds are able to employ a wide variety of financial
instruments and risk management techniques,[5] they can be very different from each other with
respect to their strategies, risks, volatility and expected return profile. It is common for hedge fund
investment strategies to aim to achieve a positive return on investment regardless of whether
markets are rising or falling ("absolute return"). Hedge funds can be considered risky investments;
the expected returns of some hedge fund strategies are less volatile than those of retail funds with
high exposure to stock markets because of the use of hedging techniques.
A hedge fund usually pays its investment manager a management fee (typically, 2% per annum of
the net asset value of the fund) and a performance fee (typically, 20% of the increase in the fund's
net asset value during a year).[1] Hedge funds have existed for many decades and have become
increasingly popular. They have now grown to be a substantial portion of the asset management
industry,[6] with assets totaling around $3.8 trillion as of 2021.[7] Hedge fund managers can have
several billion dollars of assets under management (AUM).
Etymology
The word "hedge", meaning a line of bushes around the perimeter of a field, has long been used as
a metaphor for placing limits on risk.[8] Early hedge funds sought to hedge specific investments
against general market fluctuations by shorting other, similar assets.[9]: 4 Nowadays, however,
many different investment strategies are used, many of which do not "hedge" risk.[9]: 16–34 [10]
History
https://en.wikipedia.org/wiki/Hedge_fund 1/44
During the US bull market of the 1920s, there were numerous private investment vehicles available
to wealthy investors. Of that period, the best known today is the Graham-Newman Partnership,
founded by Benjamin Graham and his long-time business partner Jerry Newman.[11] This was
cited by Warren Buffett in a 2006 letter to the Museum of American Finance as an early hedge
fund,[12] and based on other comments from Buffett, Janet Tavakoli deems Graham's investment
firm the first hedge fund.[13]
The sociologist Alfred W. Jones is credited with coining the phrase "hedged fund"[14][15] and is
credited with creating the first hedge fund structure in 1949.[16] Jones referred to his fund as being
"hedged", a term then commonly used on Wall Street to describe the management of investment
risk due to changes in the financial markets.[17]
In the 1970s, hedge funds specialized in a single strategy with most fund managers following the
long/short equity model. Many hedge funds closed during the recession of 1969–1970 and the
1973–1974 stock market crash due to heavy losses. They received renewed attention in the late
1980s.[15]
During the 1990s, the number of hedge

funds increased significantly with the 1990s
stock market rise,[14] the aligned-interest
compensation structure (i.e., common
financial interests), and the promise of above
average returns[18] as likely causes. Over the
next decade, hedge fund strategies expanded
to include credit arbitrage, distressed debt,
fixed income, quantitative, and multi-
strategy.[15] US institutional investors, such Cumulative hedge fund and other risk asset returns
as pension and endowment funds, began (1997–2012)
allocating greater portions of their portfolios
to hedge funds.[19][20]
During the first decade of the 21st century, hedge funds gained popularity worldwide, and, by
2008, the worldwide hedge fund industry held an estimated US$1.93 trillion in assets under
management (AUM).[21][22] However, the financial crisis of 2007–2008 caused many hedge funds
to restrict investor withdrawals and their popularity and AUM totals declined.[23] AUM totals
rebounded and in April 2011 were estimated at almost $2 trillion.[24][25] As of February 2011, 61%
of worldwide investment in hedge funds came from institutional sources.[26]
In June 2011, the hedge fund management firms with the greatest AUM were Bridgewater
Associates (US$58.9 billion), Man Group (US$39.2 billion), Paulson & Co. (US$35.1 billion),
Brevan Howard (US$31 billion), and Och-Ziff (US$29.4 billion).[27] Bridgewater Associates had
$70 billion in assets under management as of March 2012.[28][29] At the end of that year, the 241
largest hedge fund firms in the United States collectively held $1.335 trillion.[30] In April 2012, the
hedge fund industry reached a record high of US$2.13 trillion total assets under management.[31]
In the middle of the 2010s, the hedge fund industry experienced a general decline in the "old
guard" fund managers. Dan Loeb called it a "hedge fund killing field" due to the classic long/short
falling out of favor because of unprecedented easing by central banks. The US stock market
correlation became untenable to short sellers.[32] The hedge fund industry today has reached a
state of maturity that is consolidating around the larger, more established firms such as Citadel,
Elliot, Millennium, Bridgewater, and others. The rate of new fund start ups is now outpaced by
fund closings.[33]
In July 2017, hedge funds recorded their eighth consecutive monthly gain in returns with assets
under management rising to a record $3.1 trillion.[34]
Notable hedge fund managers

John Meriwether of Long-Term Capital Management, most
successful returns from 27% to 59% through 1993 to 1998
until its collapse and liquidation.
George Soros of Quantum Group of Funds
Ray Dalio of Bridgewater Associates, the world's largest
hedge fund firm with US$160 billion in assets under
management as of 2017[35][36]
Steve Cohen of Point72 Asset Management, formerly
known as founder of SAC Capital Advisors[37][38][39]
John Paulson of Paulson & Co., whose hedge funds as of
December 2015 had $19 billion assets under
management[40]
David Tepper of Appaloosa Management
Paul Tudor Jones of Tudor Investment Corporation
Daniel Och of Och-Ziff Capital Management Group[41][42]
with more than $40 billion in assets under management in
Tom Steyer, hedge-fund manager of
2013[43][44]
NextGen America
Israel Englander of Millennium Management, LLC
Leon Cooperman of Omega Advisors[45]
Michael Platt of BlueCrest Capital Management (UK),
Europe's third-largest hedge-fund firm[46]
James Dinan of York Capital Management[47]
Stephen Mandel of Lone Pine Capital with $26.7 billion
under management at end June 2015[48]
Larry Robbins of Glenview Capital Management with $9.2
billion of assets under management as of July 2014[49]
Glenn Dubin of Highbridge Capital Management[50][51][52]
Paul Singer of Elliott Management Corporation, an activist
hedge fund with more than US$23 billion in assets under
management in 2013,[53][54] and a portfolio worth $8.1
billion as of the first quarter of 2015[55][56][57]
Michael Hintze of CQS with $14.4 billion of assets under
management as of June 2015[58] George Soros, fund manager of
David Einhorn of Greenlight Capital[59][60]
as the top 20 Quantum Group of Funds
billionaire hedge fund managers. [61]
Bill Ackman of Pershing Square Capital Management LP
Kenneth Griffin of Citadel with over $62 billion in assets

under management as of December 2022.[62][63]
Strategies
Hedge fund strategies are generally classified among four
major categories: global macro, directional, event-driven, and
relative value (arbitrage).[64] Strategies within these categories
each entail characteristic risk and return profiles. A fund may
employ a single strategy or multiple strategies for flexibility,
risk management, or diversification.[65] The hedge fund's
prospectus, also known as an offering memorandum, offers Ray Dalio, fund manager of
potential investors information about key aspects of the fund, Bridgewater Associates
including the fund's investment strategy, investment type, and
leverage limit.[66]
The elements contributing to a hedge fund strategy include

the hedge fund's approach to the market, the particular
instrument use, the market sector the fund specializes in
(e.g., healthcare), the method used to select investments,
and the amount of diversification within the fund. There
are a variety of market approaches to different asset
classes, including equity, fixed income, commodity, and
currency. Instruments used include equities, fixed income,
futures, options, and swaps. Strategies can be divided into
those in which investments can be selected by managers,
known as "discretionary/qualitative", or those in which A prospectus from the US
investments are selected using a computerized system,
known as "systematic/quantitative".[67] The amount of
diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market,
multi-manager, or a combination.
Sometimes hedge fund strategies are described as "absolute return" and are classified as either
"market neutral" or "directional". Market neutral funds have less correlation to overall market
performance by "neutralizing" the effect of market swings whereas directional funds utilize trends
and inconsistencies in the market and have greater exposure to the market's fluctuations.[65][68]
Global macro
Hedge funds using a global macro investing strategy take large positions in share, bond, or
currency markets in anticipation of global macroeconomic events in order to generate a risk-
adjusted return.[68] Global macro fund managers use macroeconomic ("big picture") analysis
based on global market events and trends to identify opportunities for investment that would
profit from anticipated price movements. While global macro strategies have a large amount of
flexibility (due to their ability to use leverage to take large positions in diverse investments in
multiple markets), the timing of the implementation of the strategies is important in order to
generate attractive, risk-adjusted returns.[69] Global macro is often categorized as a directional
investment strategy.[68]
Global macro strategies can be divided into discretionary and systematic approaches.
Discretionary trading is carried out by investment managers who identify and select investments,
whereas systematic trading is based on mathematical models and executed by software with
limited human involvement beyond the programming and updating of the software. These
strategies can also be divided into trend or counter-trend approaches depending on whether the
fund attempts to profit from following market trend (long or short-term) or attempts to anticipate
and profit from reversals in trends.[67]
Within global macro strategies, there are further sub-strategies including "systematic diversified",
in which the fund trades in diversified markets, or sector specialists such as "systematic currency",
in which the fund trades in foreign exchange markets or any other sector specialisation.[70]: 348
Other sub-strategies include those employed by commodity trading advisors (CTAs), where the
fund trades in futures (or options) in commodity markets or in swaps.[71] This is also known as a
"managed future fund".[68] CTAs trade in commodities (such as gold) and financial instruments,
including stock indices. They also take both long and short positions, allowing them to make profit
in both market upswings and downswings.[72] Most global macro managers tends to be a CTA from
a regulatory perspective and the main divide is between systematic and discretionary strategies. A
classification framework for CTA/Macro Strategies can be found in the reference.[73]
Directional
Directional investment strategies use market
movements, trends, or inconsistencies when picking
stocks across a variety of markets. Computer models
can be used, or fund managers will identify and
select investments. These types of strategies have a
greater exposure to the fluctuations of the overall
market than do market neutral strategies.[65][68]
Directional hedge fund strategies include US and
international long/short equity hedge funds, where
long equity positions are hedged with short sales of
equities or equity index options. Schematic representation of short selling in two
steps. The short seller borrows shares and
Within directional strategies, there are a number of immediately sells them. The short seller then
sub-strategies. "Emerging markets" funds focus on expects the price to decrease, when the seller
can profit by purchasing the shares to return to
emerging markets such as China and India,[70]: 351
the lender.
whereas "sector funds" specialize in specific areas
including technology, healthcare, biotechnology,
pharmaceuticals, energy, and basic materials. Funds using a "fundamental growth" strategy invest
in companies with more earnings growth than the overall stock market or relevant sector, while
funds using a "fundamental value" strategy invest in undervalued companies.[70]: 344 Funds that
use quantitative and financial signal processing techniques for equity trading are described as
using a "quantitative directional" strategy.[70]: 345 Funds using a "short bias" strategy take
advantage of declining equity prices using short positions.[74]
Event-driven
Event-driven strategies concern situations in which the underlying investment opportunity and
risk are associated with an event.[75] An event-driven investment strategy finds investment
opportunities in corporate transactional events such as consolidations, acquisitions,
recapitalizations, bankruptcies, and liquidations. Managers employing such a strategy capitalize on
valuation inconsistencies in the market before or after such events, and take a position based on
the predicted movement of the security or securities in question. Large institutional investors such
as hedge funds are more likely to pursue event-driven investing strategies than traditional equity
investors because they have the expertise and resources to analyze corporate transactional events
for investment opportunities.[69][76][77]
Corporate transactional events generally fit into three categories: distressed securities, risk
arbitrage, and special situations.[69] Distressed securities include such events as restructurings,
recapitalizations, and bankruptcies.[69] A distressed securities investment strategy involves
investing in the bonds or loans of companies facing bankruptcy or severe financial distress, when
these bonds or loans are being traded at a discount to their value. Hedge fund managers pursuing
the distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds
purchasing distressed debt may prevent those companies from going bankrupt, as such an
acquisition deters foreclosure by banks.[68] While event-driven investing, in general, tends to
thrive during a bull market, distressed investing works best during a bear market.[77]
Risk arbitrage or merger arbitrage includes such events as mergers, acquisitions, liquidations, and
hostile takeovers.[69] Risk arbitrage typically involves buying and selling the stocks of two or more
merging companies to take advantage of market discrepancies between acquisition price and stock
price. The risk element arises from the possibility that the merger or acquisition will not go ahead
as planned; hedge fund managers will use research and analysis to determine if the event will take
place.[77][78]
Special situations are events that impact the value of a company's stock, including the
restructuring of a company or corporate transactions including spin-offs, share buy backs, security
issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage of special
situations the hedge fund manager must identify an upcoming event that will increase or decrease
the value of the company's equity and equity-related instruments.[79]
Other event-driven strategies include credit arbitrage strategies, which focus on corporate fixed
income securities; an activist strategy, where the fund takes large positions in companies and uses
the ownership to participate in the management; a strategy based on predicting the final approval
of new pharmaceutical drugs; and legal catalyst strategy, which specializes in companies involved
in major lawsuits.
Relative value
Relative value arbitrage strategies take advantage of relative discrepancies in price between
securities. The price discrepancy can occur due to mispricing of securities compared to related
securities, the underlying security or the market overall. Hedge fund managers can use various
types of analysis to identify price discrepancies in securities, including mathematical, technical, or
fundamental techniques.[80] Relative value is often used as a synonym for market neutral, as
strategies in this category typically have very little or no directional market exposure to the market
as a whole.[81] Other relative value sub-strategies include:
Fixed income arbitrage: exploit pricing inefficiencies between related fixed income securities.
Equity market neutral: exploit differences in stock prices by being long and short in stocks
within the same sector, industry, market capitalization, country, which also creates a hedge
against broader market factors.
Convertible arbitrage: exploit pricing inefficiencies between convertible securities and the
corresponding stocks.
Asset-backed securities (fixed-income asset-backed): fixed income arbitrage strategy using
asset-backed securities.
Credit long/short: the same as long/short equity, but in credit markets instead of equity
markets.
Statistical arbitrage: identifying pricing inefficiencies between securities through mathematical
modelling techniques
Volatility arbitrage: exploit the change in volatility, instead of the change in price.
Yield alternatives: non-fixed income arbitrage strategies based on the yield, instead of the
price.
Regulatory arbitrage: exploit regulatory differences between two or more markets.
Risk arbitrage: exploit market discrepancies between acquisition price and stock price.
Value investing: buying securities that appear underpriced by some form of fundamental
analysis.
Miscellaneous
In addition to those strategies within the four main categories, there are several strategies that do
not entirely fit into these categories.
Fund of hedge funds (multi-manager): a hedge fund with a diversified portfolio of numerous
underlying single-manager hedge funds.
Multi-manager: a hedge fund wherein the investment is spread along separate sub-managers
investing in their own strategy.
Multi-strategy: a hedge fund using a combination of different strategies.
130-30 funds: equity funds with 130% long and 30% short positions, leaving a net long position
of 100%.
Risk parity: equalizing risk by allocating funds to a wide range of categories while maximizing
gains through financial leveraging.
AI-driven: using sophisticated machine learning models and sometimes big data.
Risk
For an investor who already holds large quantities of equities and bonds, investment in hedge
funds may provide diversification and reduce the overall portfolio risk.[82] Managers of hedge
funds often aim to produce returns that are relatively uncorrelated with market indices and are
consistent with investors' desired level of risk.[83][84] While hedging can reduce some risks of an
investment it usually increases others, such as operational risk and model risk, so overall risk is
reduced but cannot be eliminated. According to a report by the Hennessee Group, hedge funds
were approximately one-third less volatile than the S&P 500 between 1993 and 2010.[85]
Risk management
Investors in hedge funds are, in most countries, required to be qualified investors who are assumed
to be aware of the investment risks, and accept these risks because of the potential returns relative
to those risks. Fund managers may employ extensive risk management strategies in order to
protect the fund and investors. According to the Financial Times, "big hedge funds have some of
the most sophisticated and exacting risk management practices anywhere in asset
management."[83] Hedge fund managers that hold a large number of investment positions for
short periods are likely to have a particularly comprehensive risk management system in place, and
it has become usual for funds to have independent risk officers who assess and manage risks but
are not otherwise involved in trading.[86] A variety of different measurement techniques and
models are used to estimate risk according to the fund's leverage, liquidity, and investment
strategy.[84][87] Non-normality of returns, volatility clustering and trends are not always accounted
for by conventional risk measurement methodologies and so in addition to value at risk and similar
measurements, funds may use integrated measures such as drawdowns.[88]
In addition to assessing the market-related risks that may arise from an investment, investors
commonly employ operational due diligence to assess the risk that error or fraud at a hedge fund
might result in a loss to the investor. Considerations will include the organization and
management of operations at the hedge fund manager, whether the investment strategy is likely to
be sustainable, and the fund's ability to develop as a company.[89]
Transparency, and regulatory considerations

Since hedge funds are private entities and have few public disclosure requirements, this is
sometimes perceived as a lack of transparency.[90] Another common perception of hedge funds is
that their managers are not subject to as much regulatory oversight and/or registration
requirements as other financial investment managers, and more prone to manager-specific
idiosyncratic risks such as style drifts, faulty operations, or fraud.[91] New regulations introduced
in the US and the EU as of 2010 required hedge fund managers to report more information,
leading to greater transparency.[92] In addition, investors, particularly institutional investors, are
encouraging further developments in hedge fund risk management, both through internal
practices and external regulatory requirements.[83] The increasing influence of institutional
investors has led to greater transparency: hedge funds increasingly provide information to
investors including valuation methodology, positions, and leverage exposure.[93]
Risks shared with other investment types

Hedge funds share many of the same types of risk as other investment classes, including liquidity
risk and manager risk.[91] Liquidity refers to the degree to which an asset can be bought and sold or
converted to cash; similar to private-equity funds, hedge funds employ a lock-up period during
which an investor cannot remove money.[68][94] Manager risk refers to those risks which arise
from the management of funds. As well as specific risks such as style drift, which refers to a fund
manager "drifting" away from an area of specific expertise, manager risk factors include valuation
risk, capacity risk, concentration risk, and leverage risk.[90] Valuation risk refers to the concern
that the net asset value (NAV) of investments may be inaccurate;[95] capacity risk can arise from
placing too much money into one particular strategy, which may lead to fund performance
deterioration;[96] and concentration risk may arise if a fund has too much exposure to a particular
investment, sector, trading strategy, or group of correlated funds.[97] These risks may be managed
through defined controls over conflict of interest,[95] restrictions on allocation of funds,[96] and set
exposure limits for strategies.[97]
Many investment funds use leverage, the practice of borrowing money, trading on margin, or using
derivatives to obtain market exposure in excess of that provided by investors' capital. Although
leverage can increase potential returns, the opportunity for larger gains is weighed against the
possibility of greater losses.[94]

Hedge funds employing leverage are likely to engage in extensive
risk management practices. [86][90] In comparison with investment banks, hedge fund leverage is
relatively low; according to a National Bureau of Economic Research working paper, the average
leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.[98]
Some types of funds, including hedge funds, are perceived as having a greater appetite for risk,
with the intention of maximizing returns,[94] subject to the risk tolerance of investors and the fund
manager. Managers will have an additional incentive to increase risk oversight when their own
capital is invested in the fund.[86]
Fees and remuneration
Fees paid to hedge funds

Hedge fund management firms typically charge their funds both a management fee and a
performance fee.
Management fees are calculated as a percentage of the fund's net asset value and typically range
from 1% to 4% per annum, with 2% being standard.[99][100][101] They are usually expressed as an
annual percentage, but calculated and paid monthly or quarterly. Management fees for hedge
funds are designed to cover the operating costs of the manager, whereas the performance fee
provides the manager's profits. However, due to economies of scale the management fee from
larger funds can generate a significant part of a manager's profits, and as a result some fees have
been criticized by some public pension funds, such as CalPERS, for being too high.[102]
The performance fee is typically 20% of the fund's profits during any year, though performance
fees range between 10% and 50%. Performance fees are intended to provide an incentive for a
manager to generate profits.[103][104] Performance fees have been criticized by Warren Buffett, who
believes that because hedge funds share only the profits and not the losses, such fees create an
incentive for high-risk investment management. Performance fee rates have fallen since the start
of the credit crunch.[105]
Almost all hedge fund performance fees include a "high water mark" (or "loss carryforward
provision"), which means that the performance fee only applies to net profits (i.e., profits after
losses in previous years have been recovered). This prevents managers from receiving fees for
volatile performance, though a manager will sometimes close a fund that has suffered serious
losses and start a new fund, rather than attempt to recover the losses over a number of years
without a performance fee.[106]
Some performance fees include a "hurdle", so that a fee is only paid on the fund's performance in
excess of a benchmark rate (e.g., LIBOR) or a fixed percentage.[107] The hurdle is usually tied to a
benchmark rate such as Libor or the one-year Treasury bill rate plus a spread.[108] A "soft" hurdle
means the performance fee is calculated on all the fund's returns if the hurdle rate is cleared. A
"hard" hurdle is calculated only on returns above the hurdle rate.[109] By example the manager sets
a hurdle rate equal to 5%, and the fund return 15%, incentive fees would only apply to the 10%
above the hurdle rate.[108] A hurdle is intended to ensure that a manager is only rewarded if the
fund generates returns in excess of the returns that the investor would have received if they had
invested their money elsewhere.
Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a
specified period of time (typically a year), or when withdrawals exceed a predetermined percentage
of the original investment.[110] The purpose of the fee is to discourage short-term investing, reduce
turnover, and deter withdrawals after periods of poor performance. Unlike management fees and
performance fees, redemption fees are usually kept by the fund and redistributed to all investors.
Remuneration of portfolio managers

Hedge fund management firms are often owned by their portfolio managers, who are therefore
entitled to any profits that the business makes. As management fees are intended to cover the
firm's operating costs, performance fees (and any excess management fees) are generally
distributed to the firm's owners as profits. Funds do not tend to report compensation, and so
published lists of the amounts earned by top managers tend to be estimates based on factors such
as the fees charged by their funds and the capital they are thought to have invested in them.[111]
Many managers have accumulated large stakes in their own funds and so top hedge fund managers
can earn extraordinary amounts of money, perhaps up to $4 billion in a good year.[112][113]
Earnings at the very top are higher than in any other sector of the financial industry,[114] and
collectively the top 25 hedge fund managers regularly earn more than all 500 of the chief
executives in the S&P 500.[115] Most hedge fund managers are remunerated much less, however,
and if performance fees are not earned then small managers at least are unlikely to be paid
significant amounts.[114]
In 2011, the top manager earned $3 billion, the tenth earned $210 million, and the 30th earned
$80 million.[116] In 2011, the average earnings for the 25 highest-compensated hedge fund
managers in the United States was $576 million[117] while the mean total compensation for all
hedge fund investment professionals was $690,786 and the median was $312,329. The same
figures for hedge fund CEOs were $1,037,151 and $600,000, and for chief investment officers were
$1,039,974 and $300,000, respectively.[118]
Of the 1,226 people on the Forbes World's Billionaires List for 2012,[119] 36 of the financiers listed
"derived significant chunks" of their wealth from hedge fund management.[120] Among the richest
1,000 people in the United Kingdom, 54 were hedge fund managers, according to the Sunday
Times Rich List for 2012.[121]
A portfolio manager risks losing his past compensation if he engages in insider trading. In Morgan
Stanley v. Skowron, 989 F. Supp. 2d 356 (S.D.N.Y. 2013), applying New York's faithless servant
doctrine, the court held that a hedge fund's portfolio manager engaging in insider trading in
violation of his company's code of conduct, which also required him to report his misconduct, must
repay his employer the full $31 million his employer paid him as compensation during his period
of faithlessness.[122][123][124][125] The court called the insider trading the "ultimate abuse of a
portfolio manager's position".[123] The judge also wrote: "In addition to exposing Morgan Stanley
to government investigations and direct financial losses, Skowron's behavior damaged the firm's
reputation, a valuable corporate asset."[123]
Structure
A hedge fund is an investment vehicle that is most often structured as an offshore corporation,
limited partnership, or limited liability company.[126] The fund is managed by an investment
manager in the form of an organization or company that is legally and financially distinct from the
hedge fund and its portfolio of assets.[127][128]

Many investment managers utilize service providers
for operational support. [129] Service providers include prime brokers, banks, administrators,
distributors, and accounting firms.
Prime broker
Prime brokers clear trades and provide leverage and short-term financing.[130][131] They are
usually divisions of large investment banks.[132] The prime broker acts as a counterparty to
derivative contracts, and lends securities for particular investment strategies, such as long/short
equities and convertible bond arbitrage.[133][134] It can provide custodial services for the fund's
assets, and trade execution and clearing services for the hedge fund manager.[135]
Administrator
Hedge fund administrators are typically responsible for valuation services, and often operations,
and accounting.
Calculation of the net asset value ("NAV") by the administrator, including the pricing of securities
at current market value and calculation of the fund's income and expense accruals, is a core
administrator task, because it is the price at which investors buy and sell shares in the fund.[136]
The accurate and timely calculation of NAV by the administrator is vital.[136][137] The case of
Anwar v. Fairfield Greenwich (SDNY 2015) is the major case relating to fund administrator
liability for failure to handle its NAV-related obligations properly.[138][139] There, the hedge fund
administrator and other defendants settled in 2016 by paying the Anwar investor plaintiffs $235
million.[138][139]
Administrator back office support allows fund managers to concentrate on trades.[140]

Administrators also process subscriptions and redemptions and perform various shareholder
services.[141][142] Hedge funds in the United States are not required to appoint an administrator
and all of these functions can be performed by an investment manager.[143] A number of conflict of
interest situations may arise in this arrangement, particularly in the calculation of a fund's net
asset value.[144] Most funds employ external auditors, thereby arguably offering a greater degree of
transparency.[143]
Auditor
An auditor is an independent accounting firm used to perform a complete audit the fund's financial
statements. The year-end audit is performed in accordance with the standard accounting practices
enforced within the country in which the fund it established, typically US GAAP or the
International Financial Reporting Standards (IFRS).[145] The auditor may verify the fund's NAV
and assets under management (AUM).[146][147] Some auditors only provide "NAV lite" services,
meaning that the valuation is based on prices received from the manager rather than an
independent assessment.[148]
Distributor
A distributor is an underwriter, broker, dealer, or other person who participates in the distribution
of securities.[149] The distributor is also responsible for marketing the fund to potential investors.
Many hedge funds do not have distributors, and in such cases, the investment manager will be
responsible for the distribution of securities and marketing, though many funds also use placement
agents and broker-dealers for distribution.[150][151]
Domicile and taxation

The legal structure of a specific hedge fund, in particular its domicile and the type of legal entity in
use, is usually determined by the tax expectations of the fund's investors. Regulatory
considerations will also play a role. Many hedge funds are established in offshore financial centers
to avoid adverse tax consequences for its foreign and tax-exempt investors.[152][153] Offshore funds
that invest in the US typically pay withholding taxes on certain types of investment income, but not
US capital gains tax. However, the fund's investors are subject to tax in their own jurisdictions on
any increase in the value of their investments.[154][155] This tax treatment promotes cross-border
investments by limiting the potential for multiple jurisdictions to layer taxes on investors.[156]
US tax-exempt investors (such as pension plans and endowments) invest primarily in offshore
hedge funds to preserve their tax exempt status and avoid unrelated business taxable income.[155]
The investment manager, usually based in a major financial center, pays tax on its management
fees per the tax laws of the state and country where it is located.[157] In 2011, half of the existing
hedge funds were registered offshore and half onshore. The Cayman Islands was the leading
location for offshore funds, accounting for 34% of the total number of global hedge funds. The US
had 24%, Luxembourg 10%, Ireland 7%, the British Virgin Islands 6%, and Bermuda had 3%.[158]
Hedge funds take advantage of a tax loopole called carried interest to get around paying too much
in taxes by fancy legalistic maneouvres on their part.[159]
Basket options
Deutsche Bank and Barclays created special options accounts for hedge fund clients in the
banks' names and claimed to own the assets, when in fact the hedge fund clients had full
control of the assets and reaped the profits. The hedge funds would then execute trades –
many of them a few seconds in duration – but wait until just after a year had passed to
exercise the options, allowing them to report the profits at a lower long-term capital gains
tax rate.
— Alexandra Stevenson. July 8, 2015. The New York Times
The US Senate Permanent Subcommittee on Investigations chaired by Carl Levin issued a 2014
report that found that from 1998 and 2013, hedge funds avoided billions of dollars in taxes by
using basket options. The Internal Revenue Service began investigating Renaissance
Technologies[160] in 2009, and Levin criticized the IRS for taking six years to investigate the
company. Using basket options Renaissance avoided "more than $6 billion in taxes over more than
a decade".[161]
These banks and hedge funds involved in this case used dubious structured financial
products in a giant game of 'let's pretend,' costing the Treasury billions and bypassing
safeguards that protect the economy from excessive bank lending for stock speculation.
— Carl Levin. 2015. Senate Permanent Subcommittee on Investigations
A dozen other hedge funds along with Renaissance Technologies used Deutsche Bank's and
Barclays' basket options.[161] Renaissance argued that basket options were "extremely important
because they gave the hedge fund the ability to increase its returns by borrowing more and to
protect against model and programming failures".[161] In July 2015, the United States Internal
Revenue claimed hedge funds used basket options "to bypass taxes on short-term trades". These
basket options will now be labeled as listed transactions that must be declared on tax returns, and
a failure to do would result in a penalty.[161]
Investment manager locations

In contrast to the funds themselves, investment managers are primarily located onshore. The
United States remains the largest center of investment with US-based funds managing around 70%
of global assets at the end of 2011.[158] As of April 2012, there were approximately 3,990
investment advisers managing one or more private hedge funds registered with the Securities and
Exchange Commission.[162] New York City and the Gold Coast area of Connecticut are the leading
locations for US hedge fund managers.[163][164]
London was Europe's leading center for hedge fund managers, but since the Brexit referendum
some formerly London-based hedge funds have relocated to other European financial centers such
as Frankfurt, Luxembourg, Paris, and Dublin, while some other hedge funds have moved their
European head offices back to New York City.[165][166][167][168][169][170][171] Before Brexit,
according to EuroHedge data, around 800 funds located in the UK had managed 85% of
European-based hedge fund assets in 2011.[158] Interest in hedge funds in Asia has increased
significantly since 2003, especially in Japan, Hong Kong, and Singapore.[172] After Brexit, Europe
and the US remain the leading locations for the management of Asian hedge fund assets.[158]
Legal entity
Hedge fund legal structures vary depending on location and the investor(s). US hedge funds aimed
at US-based, taxable investors are generally structured as limited partnerships or limited liability
companies. Limited partnerships and other flow-through taxation structures assure that investors
in hedge funds are not subject to both entity-level and personal-level taxation.[135] A hedge fund
structured as a limited partnership must have a general partner. The general partner may be an
individual or a corporation. The general partner serves as the manager of the limited partnership,
and has unlimited liability.[130][173] The limited partners serve as the fund's investors, and have no
responsibility for management or investment decisions. Their liability is limited to the amount of
money they invest for partnership interests.[173][174] As an alternative to a limited partnership
arrangement, U.S. domestic hedge funds may be structured as limited liability companies, with
members acting as corporate shareholders and enjoying protection from individual liability.[175]
By contrast, offshore corporate funds are usually used for non-US investors, and when they are
domiciled in an applicable offshore tax haven, no entity-level tax is imposed.[152] Many managers
of offshore funds permit the participation of tax-exempt US investors, such as pensions funds,
institutional endowments, and charitable trusts.[173] As an alternative legal structure, offshore
funds may be formed as an open-ended unit trust using an unincorporated mutual fund
structure.[176] Japanese investors prefer to invest in unit trusts, such as those available in the
Cayman Islands.[177]
The investment manager who organizes the hedge fund may retain an interest in the fund, either as
the general partner of a limited partnership or as the holder of "founder shares" in a corporate
fund.[178] For offshore funds structured as corporate entities, the fund may appoint a board of
directors. The board's primary role is to provide a layer of oversight while representing the
interests of the shareholders.[179] However, in practice board members may lack sufficient
expertise to be effective in performing those duties. The board may include both affiliated directors
who are employees of the fund and independent directors whose relationship to the fund is
limited.[179]
Types of funds
Open-ended hedge funds continue to issue shares to new investors and allow periodic
withdrawals at the net asset value ("NAV") for each share.
Closed-ended hedge funds issue a limited number of tradeable shares at inception.[180][181]
Shares of Listed hedges funds are traded on stock exchanges, such as the Irish Stock
Exchange, and may be purchased by non-accredited investors.[182]
Side pockets
A side pocket is a mechanism whereby a fund compartmentalizes assets that are relatively illiquid
or difficult to value reliably.[183] When an investment is side-pocketed, its value is calculated
separately from the value of the fund's main portfolio.[184] Because side pockets are used to hold
illiquid investments, investors do not have the standard redemption rights with respect to the side
pocket investment that they do with respect to the fund's main portfolio.[184] Profits or losses from
the investment are allocated on a pro rata basis only to those who are investors at the time the
investment is placed into the side pocket and are not shared with new investors.[184][185] Funds
typically carry side pocket assets "at cost" for purposes of calculating management fees and
reporting net asset values. This allows fund managers to avoid attempting a valuation of the
underlying investments, which may not always have a readily available market value.[185]
Side pockets were widely used by hedge funds during the financial crisis of 2007–2008 amidst a
flood of withdrawal requests. Side pockets allowed fund managers to lay away illiquid securities
until market liquidity improved, a move that could reduce losses. However, as the practice restricts
investors' ability to redeem their investments it is often unpopular and many have alleged that it
has been abused or applied unfairly.[186][187][188] The SEC also has expressed concern about
aggressive use of side pockets and has sanctioned certain fund managers for inappropriate use of
them.[1]
Regulation
Hedge funds must abide by the national, federal, and state regulatory laws in their respective
locations. The U.S. regulations and restrictions that apply to hedge funds differ from those that
apply to its mutual funds.[189] 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.[190] 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.[68]
In 2010, regulations were enacted in the US and European Union which
introduced additional hedge fund reporting requirements. These included the U.S.'s Dodd-Frank
Wall Street Reform Act[4] and European Alternative Investment Fund Managers Directive.[191]
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.[192] 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.[193] The
Managed Funds Association is a US-based trade association, while the Alternative Investment
Management Association is the primarily European counterpart.[194]
United States
Hedge funds within the US are subject to regulatory, reporting, and record-keeping
requirements.[195] 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.[196] 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,[197] and most traditional hedge funds in the United States are offered
effectively as private placement offerings.[198] The Securities Exchange Act of 1934 required a fund
with more than 499 investors to register with the SEC.[199][200][201] The Investment Advisers Act
of 1940 contained anti-fraud provisions that regulated hedge fund managers and advisers, created
limits for the number and types of investors, and prohibited public offerings. The Act also
exempted hedge funds from mandatory registration with the SEC[68][202][203] 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.[204]
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.[205] The SEC stated that it was adopting a "risk-based approach" to monitoring hedge
funds as part of its evolving regulatory regime for the burgeoning industry.[206] The new rule was
controversial, with two Commissioners dissenting,[207] 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.[208] 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.[209] 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.[200] 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.[195]
The U.S.'s Dodd-Frank Wall Street Reform Act was passed in July 2010[4][92] and requires SEC
registration of advisers who manage private funds with more than US$150 million in
assets.[210][211] Registered managers must file Form ADV with the SEC, as well as information
regarding their assets under management and trading positions.[212] Previously, advisers with
fewer than 15 clients were exempt, although many hedge fund advisers voluntarily registered with
the SEC to satisfy institutional investors.[213] Under Dodd-Frank, investment advisers with less
than US$100 million in assets under management became subject to state regulation.[210] This
increased the number of hedge funds under state supervision.[214] Overseas advisers who managed
more than US$25 million were also required to register with the SEC.[215] The Act requires hedge
funds to provide information about their trades and portfolios to regulators including the newly
created Financial Stability Oversight Council.[214] In this regard, most hedge funds and other
private funds, including private-equity funds, must file Form PF with the SEC, which is an
extensive reporting form with substantial data on the funds' activities and positions.[1] Under the
"Volcker Rule", regulators are also required to implement regulations for banks, their affiliates,
and holding companies to limit their relationships with hedge funds and to prohibit these
organizations from proprietary trading, and to limit their investment in, and sponsorship of, hedge
funds.[214][216][217]
Europe
Within the European Union (EU), hedge funds are primarily regulated through their managers.[68]
In the United Kingdom, where 80% of Europe's hedge funds are based,[218] hedge fund managers
are required to be authorised and regulated by the Financial Conduct Authority (FCA).[191] 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.[68]
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.[219] AIFMD requires all EU hedge fund managers to
register with national regulatory authorities[220] 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.[92][191] 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.[92] 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.[221]
Offshore
Some hedge funds are established in offshore centres, such as the Cayman Islands, Dublin,
Luxembourg, Singapore[222] the British Virgin Islands, and Bermuda, which have different
regulations[223] concerning non-accredited investors, client confidentiality, and fund manager
independence.[4][191]
South Africa
In South Africa, investment fund managers must be approved by, and register with, the Financial
Services Board (FSB).[224]
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[225][226] and databases.[227]
One estimate is that the average hedge fund returned 11.4% per year,[228] representing a 6.7%
return above overall market performance before fees, based on performance data from 8,400
hedge funds.[68] 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.[229] However, more recent data show that hedge fund performance declined and
underperformed the market from about 2009 to 2016.[230]
Hedge funds performance is measured by comparing their returns to an estimate of their risk.[231]
Common measures are the Sharpe ratio,[232] Treynor measure and Jensen's alpha.[233] These
measures work best when returns follow normal distributions without autocorrelation, and these
assumptions are often not met in practice.[234]
New performance measures have been introduced that attempt to address some of theoretical
concerns with traditional indicators, including: modified Sharpe ratios;[234][235] the Omega ratio
introduced by Keating and Shadwick in 2002;[236] Alternative Investments Risk Adjusted
Performance (AIRAP) published by Sharma in 2004;[237] and Kappa developed by Kaplan and
Knowles in 2004.[238]
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.[239][240]
Hedge fund indices

Indices play a central and unambiguous role in traditional asset markets, where they are widely
accepted as representative of their underlying portfolios. Equity and debt index fund products
provide investable access to most developed markets in these asset classes.
Hedge fund indices are more problematic. The typical hedge fund is not traded on exchange, will
accept investments only at the discretion of the manager, and does not have an obligation to
publish returns. Despite these challenges, Non-investable, Investable, and Clone indices have been
developed.
Non-investable indices
Non-investable indices are indicative in nature and aim to represent the performance of some
database of hedge funds using some measure such as mean, median, or weighted mean from a
hedge fund database. The databases have diverse selection criteria and methods of construction,
and no single database captures all funds. This leads to significant differences in reported
performance between different indices.
Although they aim to be representative, non-investable indices suffer from a lengthy and largely
unavoidable list of biases. Funds' participation in a database is voluntary, leading to self-selection
bias because those funds that choose to report may not be typical of funds as a whole. For example,
some do not report because of poor results or because they have already reached their target size
and do not wish to raise further money.
The short lifetimes of many hedge funds mean that there are many new entrants and many
departures each year, which raises the problem of survivorship bias. If we examine only funds that
have survived to the present, we will overestimate past returns because many of the worst-
performing funds have not survived, and the observed association between fund youth and fund
performance suggests that this bias may be substantial.
When a fund is added to a database for the first time, all or part of its historical data is recorded ex-
post in the database. It is likely that funds only publish their results when they are favorable, so
that the average performances displayed by the funds during their incubation period are inflated.
This is known as "instant history bias" or "backfill bias".
Investable indices
Investable indices are an attempt to reduce these problems by ensuring that the return of the index
is available to shareholders. To create an investable index, the index provider selects funds and
develops structured products or derivative instruments that deliver the performance of the index.
When investors buy these products the index provider makes the investments in the underlying
funds, making an investable index similar in some ways to a fund of hedge funds portfolio.
To make the index investable, hedge funds must agree to accept investments on the terms given by
the constructor. To make the index liquid, these terms must include provisions for redemptions
that some managers may consider too onerous to be acceptable. This means that investable indices
do not represent the total universe of hedge funds. Most seriously, they under-represent more
successful managers, who typically refuse to accept such investment protocols.
Hedge fund replication

The most recent addition to the field approaches the problem in a different manner. Instead of
reflecting the performance of actual hedge funds, they take a statistical approach to the analysis of
historic hedge fund returns and use this to construct a model of how hedge fund returns respond to
the movements of various investable financial assets. This model is then used to construct an
investable portfolio of those assets. This makes the index investable, and in principle, they can be
as representative as the hedge fund database from which they were constructed. However, these
clone indices rely on a statistical modelling process. Such indices have too short a history to state
whether this approach will be considered successful.
Closures
In March 2017, HFR – a hedge fund research data and service provider – reported that there were
more hedge-fund closures in 2016 than during the 2009 recession. According to the report, several
large public pension funds pulled their investments in hedge funds, because the funds' subpar
performance as a group did not merit the high fees they charged.
Despite the hedge fund industry topping $3 trillion for the first time ever in 2016, the number of
new hedge funds launched fell short of levels before the financial crisis of 2007–2008. There were
729 hedge fund launches in 2016, fewer than the 784 opened in 2009, and dramatically fewer than
the 968 launches in 2015.[241]
Debates and controversies
Systemic risk
Systemic risk refers to the risk of instability across the entire financial system, as opposed to within
a single company. Such risk may arise following a destabilizing event or events affecting a group of
financial institutions linked through investment activity.[242] Organizations such as the European
Central Bank have charged that hedge funds pose systemic risks to the financial sector,[243][244]
and following the failure of hedge fund Long-Term Capital Management (LTCM) in 1998 there was
widespread concern about the potential for systemic risk if a hedge fund failure led to the failure of
its counterparties. (As it happens, no financial assistance was provided to LTCM by the US Federal
Reserve, so there was no direct cost to US taxpayers,[245] but a large bailout had to be mounted by
a number of financial institutions.)
However, these claims are widely disputed by the financial industry,[246] who typically regard
hedge funds as "small enough to fail", since most are relatively small in terms of the assets they
manage and operate with low leverage, thereby limiting the potential harm to the economic system
should one of them fail.[228][247] Formal analysis of hedge fund leverage before and during the
financial crisis of 2007–2008 suggests that hedge fund leverage is both fairly modest and counter-
cyclical to the market leverage of investment banks and the larger financial sector.[98] Hedge fund
leverage decreased prior to the financial crisis, even while the leverage of other financial
intermediaries continued to increase.[98] Hedge funds fail regularly, and numerous hedge funds
failed during the financial crisis.[248] In testimony to the US House Financial Services Committee
in 2009, Ben Bernanke, the Federal Reserve Board Chairman said he "would not think that any
hedge fund or private-equity fund would become a systemically critical firm individually".[249]
This does leave the possibility that hedge funds collectively might contribute to systemic risk if they
exhibit herd or self-coordinating behavior,[250] perhaps because many hedge funds make losses in
similar trades. This coupled with the extensive use of leverage could lead to forced liquidations in a
crisis.
Hedge funds are also closely connected to their prime brokers, typically investment banks, which
could contribute to their instability in a crisis, though this works both ways and failing
counterparty banks can freeze hedge funds assets, as Lehman brothers did in 2008.[251]
An August 2012 survey by the Financial Services Authority concluded that risks were limited and
had reduced as a result, inter alia, of larger margins being required by counterparty banks, but
might change rapidly according to market conditions. In stressed market conditions, investors
might suddenly withdraw large sums, resulting in forced asset sales. This might cause liquidity and
pricing problems if it occurred across a number of funds or in one large highly leveraged fund.[252]
Transparency
Hedge funds are structured to avoid most direct regulation (although their managers may be
regulated), and are not required to publicly disclose their investment activities, except to the extent
that investors generally are subject to disclosure requirements. This is in contrast to a regulated
mutual fund or exchange-traded fund, which will typically have to meet regulatory requirements
for disclosure. An investor in a hedge fund usually has direct access to the investment adviser of
the fund, and may enjoy more personalized reporting than investors in retail investment funds.
This may include detailed discussions of risks assumed and significant positions. However, this
high level of disclosure is not available to non-investors, contributing to hedge funds' reputation
for secrecy, while some hedge funds have very limited transparency even to investors.[253]
Funds may choose to report some information in the interest of recruiting additional investors.
Much of the data available in consolidated databases is self-reported and unverified.[254] A study
was done on two major databases containing hedge fund data. The study noted that 465 common
funds had significant differences in reported information (e.g., returns, inception date, net assets
value, incentive fee, management fee, investment styles, etc.) and that 5% of return numbers and
5% of NAV numbers were dramatically different.[255] With these limitations, investors have to do
their own research, which may cost on the scale of US$50,000 for a fund that is not well-
established.[256]
A lack of verification of financial documents by investors or by independent auditors has, in some

cases, assisted in fraud.[257] In the mid-2000s, Kirk Wright of International Management
Associates was accused of mail fraud and other securities violations[258][259] which allegedly
defrauded clients of close to US$180 million.[260] In December 2008, Bernard Madoff was
arrested for running a US$50 billion Ponzi scheme[261] that closely resembled a hedge fund and
was incorrectly[262] described as one.[263][264][265] Several feeder hedge funds, of which the largest
was Fairfield Sentry, channeled money to it. Following the Madoff case, the SEC adopted reforms
in December 2009 that subjected hedge funds to an audit requirement.[266]
The process of matching hedge funds to investors has traditionally been fairly opaque, with
investments often driven by personal connections or recommendations of portfolio managers.[267]
Many funds disclose their holdings, strategy, and historic performance relative to market indices,
giving investors some idea of how their money is being allocated, although individual holdings are
often not disclosed.[268] Investors are often drawn to hedge funds by the possibility of realizing
significant returns, or hedging against volatility in the market. The complexity and fees associated
with hedge funds are causing some to exit the market – CalPERS, the largest pension fund in the
US, announced plans to completely divest from hedge funds in 2014.[269] Some services are
attempting to improve matching between hedge funds and investors: HedgeZ is designed to allow
investors to easily search and sort through funds;[270] iMatchative aims to match investors to
funds through algorithms that factor in an investor's goals and behavioral profile, in hopes of
helping funds and investors understand the how their perceptions and motivations drive
investment decisions.[271]
Links with analysts

In June 2006, prompted by a letter from Gary J. Aguirre, the U.S. Senate Judiciary Committee
began an investigation into the links between hedge funds and independent analysts. Aguirre was
fired from his job with the SEC when, as lead investigator of insider trading allegations against
Pequot Capital Management, he tried to interview John Mack, then being considered for chief
executive officer at Morgan Stanley.[272] The Judiciary Committee and the US Senate Finance
Committee issued a scathing report in 2007, which found that Aguirre had been illegally fired in
reprisal[273] for his pursuit of Mack, and in 2009 the SEC was forced to re-open its case against
Pequot. Pequot settled with the SEC for US$28 million, and Arthur J. Samberg, chief investment
officer of Pequot, was barred from working as an investment advisor.[274] Pequot closed its doors
under the pressure of investigations.[275]
The systemic practice of hedge funds submitting periodic electronic questionnaires to stock
analysts as a part of market research was reported by The New York Times in July 2012. According
to the report, one motivation for the questionnaires was to obtain subjective information not
available to the public and possible early notice of trading recommendations that could produce
short-term market movements.[276]
Value in a mean/variance efficient portfolio

According to modern portfolio theory, rational investors will seek to hold portfolios that are
mean/variance efficient (that is, portfolios that offer the highest level of return per unit of risk).
One of the attractive features of hedge funds (in particular market neutral and similar funds) is
that they sometimes have a modest correlation with traditional assets such as equities. This means
that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers,
reducing overall portfolio risk.[107]
However, there are at least three reasons why one might not wish to allocate a high proportion of
assets into hedge funds. These reasons are:
Hedge funds are highly individual, making it hard to estimate the likely returns or risks.
Hedge funds' correlation with other assets tends to rise during stressful market events, making
them much less useful for diversification in bad times than they may appear in good times.
Hedge fund returns are reduced considerably by the high fees that are typically charged.
Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in
investor portfolios, but this is disputed for example by Mark Kritzman who performed a mean-
variance optimization calculation on an opportunity set that consisted of a stock index fund, a
bond index fund, and ten hypothetical hedge funds.[277][278] The optimizer found that a mean-
variance efficient portfolio did not contain any allocation to hedge funds, largely because of the
impact of performance fees. To demonstrate this, Kritzman repeated the optimization using an
assumption that the hedge funds took no performance fees. The result from this second
optimization was an allocation of 74% to hedge funds.
Hedge funds tend to perform poorly during equity bear markets, just when an investor needs part
of their portfolio to add value.[107] For example, in January–September 2008, the Credit
Suisse/Tremont Hedge Fund Index returned -9.87%.[279] According to the same index series, even
"dedicated short bias" funds returned −6.08% in September 2008, when Lehman Brothers
collapsed.
See also
Activist shareholder
Alternative investment
Naked Capitalism
Corporate governance
Fund governance
Investment banking
List of hedge funds
Vulture fund
Notes
1. Gerald T. Lins, Thomas P. Lemke, Kathryn L. Hoenig & Patricia Schoor Rube, Hedge Funds
and Other Private Funds: Regulation and Compliance § 5:23 (2013–2014 ed.).
2. "Alternative Funds Are Not Your Typical Mutual Funds" (https://web.archive.org/web/20140514
055052/http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/MutualFunds/P278033).
finra.org. Financial Industry Regulatory Authority. 11 June 2013. Archived from the original (htt
p://www.finra.org/certainInvestors/ProtectYourself/InvestorAlerts/MutualFunds/P278033) on 14
May 2014. Retrieved 16 April 2014.
3. Stowell, David (2012). Investment Banks, Hedge Funds, and Private Equity (https://books.goog
le.com/books?id=B5624MOzmHwC&pg=PA237). Academic Press. p. 237. ISBN 978-0-12-
404632-0. Archived (https://web.archive.org/web/20160809195442/https://books.google.com/b
ooks?id=B5624MOzmHwC&pg=PA237) from the original on 9 August 2016. Retrieved 18 April
2014.
4. Ismail, Netty (21 February 2011). "Institutions Damp Hedge Fund 'Startup Spirit,' Citi's Roe
Says" (https://web.archive.org/web/20110225001817/http://www.businessweek.com/news/2011
-02-21/institutions-damp-hedge-fund-startup-spirit-citi-s-roe-says.html). Bloomberg
Businessweek. Archived from the original (http://www.businessweek.com/news/2011-02-21/inst
itutions-damp-hedge-fund-startup-spirit-citi-s-roe-says.html) on 25 February 2011. Retrieved
9 January 2015.
5. The President's Working Group on Financial Markets (April 1999). "Hedge Funds, Leverage,
and the Lessons of Long-Term Capital Management" (http://www.treasury.gov/resource-center/
fin-mkts/Documents/hedgfund.pdf) (PDF). U.S. Department of the Treasury. Archived (https://w
eb.archive.org/web/20131007175449/http://www.treasury.gov/resource-center/fin-mkts/Docum
ents/hedgfund.pdf) (PDF) from the original on 7 October 2013. Retrieved 27 September 2013.
6. Lemke, Lins, Hoenig & Rube, Hedge Funds and Other Private Funds: Regulation and
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Further reading
Thomas P. Lemke, Gerald T. Lins, Kathryn L. Hoenig & Patricia S. Rube, Hedge Funds and
Other Private Funds: Regulation and Compliance (Thomson West 2014 ed.).
Thomas P. Lemke & Gerald T. Lins, Regulation of Investment Advisers (Thomson West 2014
ed.).
Thomas P. Lemke, Gerald T. Lins & A. Thomas Smith III, Regulation of Investment Companies
(Matthew Bender 2014 ed.).
Partnoy, Frank; Thomas, Randall S. (20 September 2006). "Gap Filling, Hedge Funds, and
Financial Innovation". Brookings-Nomura Papers on Financial Services. SSRN 931254 (https://
papers.ssrn.com/sol3/papers.cfm?abstract_id=931254).
Marcel Kahan & Edward B. Rock, 'Hedge Funds in Corporate Governance and Corporate
Control' (2007) 155 University of Pennsylvania Law Review 1021
Makrem Boumlouka, 'Regulation and Transparency in US OTC Derivative Markets', Original
Thoughts Series #1, August 2010, Hedge Fund Society Hedge Fund Society (https://web.archi
ve.org/web/20100705112958/http://hedgefundsregulation.com/)
Boyson, Nicole M.; Stahel, Christof W.; Stulz, Rene M. (2010). "Hedge Fund Contagion and
Liquidity Shocks". The Journal of Finance. 65 (5): 1789–1816. doi:10.1111/j.1540-
6261.2010.01594.x (https://doi.org/10.1111%2Fj.1540-6261.2010.01594.x). S2CID 17421154
(https://api.semanticscholar.org/CorpusID:17421154).
Stowell, David (2010). An Introduction to Investment Banks, Hedge Funds, and Private Equity:
The New Paradigm. Academic Press.
Strachman, Daniel A. (2014). The Fundamentals of Hedge Fund Management: How to
Successfully Launch and Operate a Hedge Fund, Second Edition. Wiley.
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4/21/24, 12:29 PM Hedge fund - Wikipedia

During the 1990s, the number of hedge

Notable hedge fund managers

Bill Ackman of Pershing Square Capital Management LP

Kenneth Griffin of Citadel with over $62 billion in assets

The elements contributing to a hedge fund strategy include

Transparency, and regulatory considerations

Risks shared with other investment types

possibility of greater losses.[94]

Fees and remuneration

Fees paid to hedge funds

Remuneration of portfolio managers

hedge fund and its portfolio of assets.[127][128]

Administrator back office support allows fund managers to concentrate on trades.[140]

Domicile and taxation

— Alexandra Stevenson. July 8, 2015. The New York Times

— Carl Levin. 2015. Senate Permanent Subcommittee on Investigations

Investment manager locations

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

Hedge fund indices

Hedge fund replication

Debates and controversies

A lack of verification of financial documents by investors or by independent auditors has, in some

Links with analysts

Value in a mean/variance efficient portfolio

50. The World's Billionaires: Glenn Dubin (https://www.forbes.com/profile/glenn-dubin/) Archived (h

78. "Understanding Merger Arbitrage" (http://www.barclayhedge.com/research/educational-articles/

127. Business Knowledge for IT in Hedge Funds (https://books.google.com/books?id=uI-cJ0ZAf5sC

142. Vishwanath, Ramanna; Krishnamurti, Chandrasekhar (2009). Investment Management: A

156. Muraleedharan, D. (2009). Modern Banking: Theory and Practice (https://books.google.com/bo

179. Lhabitant, François-Serge (2007). Handbook of Hedge Funds (https://books.google.com/book

193. "History" (http://www.hfsb.org/about-us/history/). Hedge Fund Standards Board. Archived (http

269. "Will entrepreneurs save the hedge fund industry" (http://www.hedgeweek.com/2015/03/09/219

Retrieved from "https://en.wikipedia.org/w/index.php?title=Hedge_fund&oldid=1216951111"

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