HEDGE FUNDS  

What is a Hedge Fund ?

The SEC's definition is the following:

"Hedge fund" is a general, non-legal term that was originally used to describe a type of private and unregistered investment pool that employed sophisticated hedging and arbitrage techniques to trade in the corporate equity markets. Hedge funds have traditionally been limited to sophisticated, wealthy investors”.

Over time, the activities of hedge funds broadened into other financial instruments and activities. Today, the term "hedge fund" refers not so much to hedging techniques, which hedge funds may or may not employ, as it does to their status as private and unregistered investment pools. All the partner's capital amounts are pooled together for the purpose of trading in securities. All hedge funds follow some sort of trading strategy and are pretty much free to use any financial instrument they wish. Some hedge funds do not utilize leverage and the rest utilize leverage at an average of 2:1. In rare cases, hedge funds like Long-Term Capital Management manage to exceed the 2:1 ratio.

Hedge funds are similar to mutual funds in that they both are pooled investment vehicles that accept investors’ money and generally invest it on a collective basis. Hedge funds differ significantly from mutual funds, however, because hedge funds are not required to register under the federal securities laws. They are not required to register because they generally only accept financially sophisticated investors and do not publicly offer their securities. In addition, some, but not all, types of hedge funds are limited to no more than 100 investors.

A hedge fund is a private investment limited partnership that invests in a variety of securities. There are two types of partners in a hedge fund, a general partner and limited partners. The term hedge fund is misleading in that a hedge fund does not necessarily have to hedge. The term "hedge fund" now means any type of private investment partnership.

The general partner is the individual or entity who started the hedge fund. The general partner also handles all of the trading activity and day to day operations of running a hedge fund. The limited partners supply most of the capital but do not participate in the trading or day to day activities of running the hedge fund. Are also Hedge Funds, all forms of investment funds, companies and private partnerships that:

                                        1. use derivatives for directional investing

                                                2. and/or are allowed to go short

3. and/or use significant leverage through borrowing.   

Because they tend not to correlate with equities or bonds, hedge funds often enhance a traditional portfolio. As a result, they have become increasingly popular in the last few years, and hedge fund managers are estimated to manage at least USD 1,889 billion in assets. Estimates of industry growth in 2007 put new hedge fund assets at more than USD 407 billion, (Source: HFR Year End 2007 Industry Report, 2007).

How does the general partner get compensated ?

For all the services that the general partner provides, he will normally receive an incentive fee. The incentive fee is usually 20% of the net profits of the partnership. The incentive fee determination will vary from hedge fund to hedge fund. Determination of the incentive is dictated by the partnership agreement. The general partner will also normally charge an administrative fee, this fee is usually 1% of the year's net asset value. This fee is also dictated by the partnership agreement. Hedge fund managers are only rewarded for performance. If they make money they do well, if they are flat or lose money they will receive little or no money. The management fee will usually not cover the expenses of operating a hedge fund.

How are gains/losses and expenses allocated to all the partners ?

The remainder of the profits/losses are allocated to all the partners in the partnership based on their percentage ownership.  

Hedge Funds are prohibited from advertising, that's why there is little information about particular hedge funds. Hedge funds will raise money through the use of consultants or word of mouth, the consultants will have accredited or qualified purchaser clients that they solicit various hedge funds to. The consultants in some cases will conduct background checks as well as due diligence for their clients on the hedge fund managers. this means that on behalf of the potential investors, the consultant will visit the hedge funds, gather background information, gather references, collect performance data, conduct statistical and analytical reviews of the funds. They will then have a database of reviewed funds that they can present to their clients.

Key characteristics of Hedge Funds

                                                (The following key characteristics are common to most or all hedge funds)

1. Free choice of asset classes: Hedge funds are not by definition restricted to one specific asset class. Whereas some hedge funds may retrict their investment policy to one asset class (e.g. equity, interest rates, currencies, commodities), others enjoy greater freedom (e.g. macro hedge funds).
2. Free choice of markets: many hedge funds do not focus on one specific market but invest according to available opportunities in all kinds  of geographic locations (US, Europe, Japan, emerging markets.)
3. Free choice of trading style: Whereas some hedge funds confine themselves to one specific trading style, others apply whichever is most convenient. Examples of trading strategies commonly used include; discretionnary, systematic, technical trend following, contrarian, top down, bottom up. Some of these strategies are based on marco or micro economic research, others are more statistically or technically oriented.
4. Free choice of instruments: The majority of hedge funds invest in both cash and derivative products. Instruments may be exchange of over-the-counter (OTC) traded, and securitized or non-securitized.
5. Since most hedge funds are sold on a private basis and many are incorporated offshore, their transparency is very restricted. Even basic data concerning monthly performance, asset size or investment policy is often discolsed exclusively to existing investors.
6. For regulatory and administrative reasons, high minimum investment levels are often required.
7. Infrequent subscription and redemption possibilities with long notification periods have become standards for the industry
8. A common feature is the performance oriented incentive fee. Also, due to the nature of the business, high total fee and cost loads are charged.
9. Many managers invest with their own capital in their fund.
10. Hedge funds are marketed as being oriented towards absolute performance (performance above zero) instead of performance relative to a certain benchmark or refernce index. This is explained by the lack of meaningful benchmarks resulting from the flexibility of the funds and the possibility of going long and short.
11. Most hedge funds show low correlation to traditional markets.

How do Hedge funds differ from mutual funds?

-  Mutual funds are operated by investment companies, regulated by the SEC, the IRS and other agencies and entities.

- Money for the funds is raised from the public. Usually, very little of the investment company's own money is actually invested.

-  Investors share equally in gains and losses proportionate to their investment.

-  Mutual Funds offer investors professional management and usually offer investment diversification.

- Mutual funds' choices of investments are more limited and restricted than those of hedge funds.

- Domestic Mutual Funds have disclosure requirements and are otherwise heavily regulated. These regulations restrict the fund from purchasing many types of derivative instruments, leveraging, short-selling, real estate and commodities.

What is a fund of funds?

Simply put, a fund of funds is a one that invests in other hedge funds. By it's very nature it does not make direct investments, and it is therefore known as a "look through" vehicle. Ordinarily, a fund of funds is set up (structured) as a limited partnership which can afford the investor in a fund of funds certain advantages. One such advantage is due diligence. The fund of funds manager spends considerable time evaluating, identifying strategies and selecting the hedge funds to implement them. Depending on the expertise of the fund of funds manager, this can yield superior investment results. Moreover, the fund of funds can control risk by achieving manager diversity. They accomplish this by diversifying in the strategies those managers employ. To the investor, this allows them to participate in a unique asset allocation mechanism while hopefully limiting downside risk.

Fund of funds are not without disadvantages, however, and we would be remiss not to discuss them. The most notable of these is that an investor in a fund of funds is required to pay an additional layer of fees. Usually, these fees range from 1 to 2 percent of assets, but some fund of funds charge a performance fee, too. However, the SEC limits the number of fees an investor can pay. Furthermore, it is wise to remember that a fund of funds is only as good as it's manager and the underlying funds it invests in.

Technically, any fund that acts as a pool of capital and uses two or more submanagers to invest that capital whether it is debt, equity, commodities, derivatives, or currencies, is a fund of funds. Any combination of the above instruments may be used depending on the objectives of the fund. Because of the looseness of the definition, a pension fund or an endowment fund can be considered a fund of funds. But for clarity, the discussion here is limited to a fund of funds in and how they relate to hedge funds.

Figure 1 -- Fund of Funds with Combined Strategies.

This theoretical example illustrates how the fund of funds manager is able to create a fund with a balanced risk posture. Many fund of funds utilize a multi - strategy approach with many managers.

Note: Under each listed strategy the number of hedge fund managers implementing each one is in brackets.

Figure 2 -- A theoretical Fund of Funds following a Dedicated Strategy approach.

In this theoretical example, the Fund of Funds manager is investing in a "dedicated strategy" approach which involves placing money with various hedge fund managers who, in turn, invest in various sectors of the U.S. equities market. Manager #1 is investing in growth stocks while the other managers are involved with specific sectors of the stock market, financial stocks, or technology, etc...

Hedging Techniques

With all this talk of hedging, it might help to provide a definition of what is meant so those who are unaware can get up to speed. Hedging is simply an investment strategy that is designed to offset investment risk. Depending on the type of investing, various hedge strategies can be employed. In theory, a perfect hedge is one that offsets gains and losses, therefore being completely neutral.

Direct Hedge: this is accomplished by hedging one asset, such as common stock, with another asset that shares similar price movements; trades in a similar fashion. An example: hedging a common stock position with call options.

Cross Hedge: involves hedging an instrument with an unlike instrument. An example of a strategy that failed in the crash of 1987 will exemplify the concept. This involved buying (long) preferred stocks and hedging the position with Treasury futures. Interest rates drive Treasury futures, and there are times when these two instruments track one another -- about 85% of the time. In the 1987 scenario, the value of the preferred stock fell and the Treasury futures rose. Since this strategy involved shorting the futures, it proved unsuccessful on both sides.

Dynamic Hedge: involves changing the amount of puts in a position over time, according to the market environment. This can protect against the downside risk associated with a long position.

Static Hedge: involves hedging out every dollar of a portfolio. In this way, it strives to eliminate risk.

Downside Proctection

Glossary