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Hedge fund

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Generally, a hedge fund is a lightly regulated private investment fund sometimes characterized by unconventional strategies (e.g., strategies other than investing long only in bonds, equities or money markets). They are primarily organized as limited partnerships, and previously were often simply called "limited partnerships" and were grouped with other similar partnerships such as those that invested in oil development.

Origin and development

The term Hedge fund dates back to the first such fund founded by Alfred Winslow Jones in 1949. Jones' innovation was to sell short some stocks while buying others, thus some of the market risk was hedged. While most of today's hedge funds still trade stocks both long and short, many do not trade stocks at all.

For U.S.-based managers and investors, hedge funds are simply structured as limited partnerships or limited liability companies. The hedge fund manager is the general partner or manager and the investors are the limited partners or members respectively. The funds are pooled together in the partnership or company and the general partner or manager makes all the investment decisions based on the strategy it outlined in the offering documents.

In return for managing the investors' funds, the hedge fund manager will receive a management fee and a performance or incentive fee. The management fee is computed as a percentage of assets under management, and the incentive fee is computed as a percentage of the fund's profits.

A "high water mark" may be specified, under which the manager does not receive incentive fees unless the value of the fund exceeds the highest value it has achieved. The "high water mark" is intended to encourage fund managers to recoup losses, but is viewed by critics as encouraging laggard funds to close, to the detriment of investors.

The fee structures of hedge funds vary, but the annual management fee is typically 20% of the profits of the fund plus 2% of assets under management. Certain highly regarded managers demand higher fees. In particular, Steven Cohen's SAC Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons' Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its flagship Medallion Fund before returning all investors' capital and running solely on its employees' money.

The typical hedge fund management firm includes both the domestic U.S. hedge fund and the offshore hedge fund. This allows hedge fund managers to attract capital from all over the world. Both funds will trade 'Pari passu' based on the strategy outlined in the offering documents.

Flows and levels

Assets under management of the hedge fund industry totaled $1.225 trillion at the end of the second quarter of 2006 according to the recently released data by Hedge Fund Research Inc. (HFR). This was up 19% on the previous year and nearly twice the total three years earlier. Because hedge funds typically use leverage/gearing or debt to invest, the positions they can take in the financial markets are larger than their assets under management. The number of hedge funds increased 10% during the past year to reach around 9,000 according to HFR. Research conducted by TowerGroup predicts that hedge fund assets will grow at an annualised rate of 15% between 2006 and 2008 while the actual number of hedge funds is likely to remain relatively flat.

At the end of 2004, 55% of the number of hedge funds, managing nearly two-thirds of total hedge fund assets, were registered offshore. The most popular offshore location was the Cayman Islands followed by British Virgin Islands and Bermuda. The U.S. was the most popular onshore location accounting for 34% of the number of funds and 24% of assets. EU countries were the next most popular location with 9% of the number of funds and 11% of assets. Asia accounted for the majority of the remaining assets.

Onshore locations are far more important in terms of the location of hedge fund managers. New York City and the Gold Coast area of Connecticut (particularly Stamford, Connecticut and Greenwich, Connecticut) together are the world's leading location for hedge fund managers with about twice as many hedge fund managers as the next largest centre, London. This is not surprising considering that the US is the source of the bulk of hedge fund investments. London is Europe’s leading centre for the management of hedge funds. At end-2005, three-quarters of European hedge fund investments, totalling $300bn, were managed within the UK, the vast majority from London. Assets managed out of London grew more than four-fold between 2002 and 2005 from $61bn to $225bn. Australia was the most important centre for the management of Asia-Pacific hedge funds. Managers located there accounted for around a quarter of the $115bn in Asia-Pacific hedge funds’ assets in 2005. [1]

Strategies

The bulk of hedge fund assets are invested in funds that employ "long / short" equity strategies. Other hedge funds use alternative strategies such as selling short, arbitrage, trading options or derivatives, using leverage, investing in seemingly undervalued securities, trading commodity and FX contracts, and attempting to take advantage of the spread between current market price and the ultimate purchase price in situations such as mergers. When strategies become extremely complex they may acquire potential and unanticipated risk of catastrophic losses as in the case of Long-Term Capital Management.

Risk arbitrage

Main article: Risk arbitrage

One strategy is to buy shares of a company that has announced it is being purchased. When a merger or acquisition is announced, the target company (the one being acquired) and the acquirer (the one buying) disclose deal terms, or the premium that the acquirer will pay for the target. In almost all cases, the target's current share price is below the premium that will be paid for it at the completion of the merger, so arbitragers will buy the target company's now undervalued shares. This strategy is very risky; hence the name. There is no assurance the merger will be finalized and several factors such as regulatory approval, shareholder approval, and the possibility of other acquiring companies entering the picture account to this. As the announced merger's effective date gets closer and the more approval the merger gains, the closer the target's share price will get to the premium offered, so every detail of the merger process is very important. When the acquiring company is offering to buy the target for cash and its own stock, the trader will short sell the stock of the acquiring company, the appropriate number of shares being decided by cash/stock ratio of the deal terms, in addition to buying the stock of the target in order to lock in the spread between the target's current price and the deal terms. This process is called "setting a spread". The reversal of this process is called "unwinding a spread", and is the equivalent of exiting the position. There is also a risk arbitrage strategy of betting against the completion of a merger by selling the target short, and buying the acquirer's shares; traders engaged in this strategy are known as "Reversers".

Most of the early hedge funds employed this strategy. They became very popular as a way of seeing gains better than the investment grade bond market, while still having low risk.

However the side effect of this popularity was to dramatically increase the interest in all of the non-standard investment strategies, and soon other funds were being set up with new strategies aimed primarily at high growth. Although there is no hedging in these cases, the term is still used for these funds as well.

Some people break the hedge fund universe into seven broad classifications: (1) event driven, (2) fixed-income arbitrage, (3) global convertible bond arbitrage, (4) equity market-neutral, (5) long/short equity, (6) global macros, and (7) commodity trading.

Event driven strategies

Event driven strategies are unaffected by the general direction of markets or national policies. The events that drive event-driven funds are specific to enterprises -- chiefly mergers, takeovers, bankruptcies, and the issuance of securities.

Because of its concern with micro triggering events, this family of strategies is also sometimes called bottom up as opposed to top down.

Sometimes an event-driven hedge fund will focus upon one of those bottom-up strategies in particular, in which case it may be referred to as a risk arbitrage, a distressed securities, or a Regulation D fund, whichever name then applies.

But event-driven multi-strategy funds, as the term implies, can keep a finger in each of those pies. This provides diversification and evens out results over the business cycle, because while merger-oriented funds (i.e. risk arbitrageurs) and Regulation D funds (concerns with small-cap securities issuance) are busiest during times of boom, the distressed-securities strategy finds amplest opportunities during times of bust.

U.S. regulation

Investment companies registered with the U.S. Securities and Exchange Commission (SEC) are subject to strict limitations on the short-selling and use of leverage that are essential to many hedge fund strategies. For this and other reasons, hedge funds elect to operate as unregistered investment companies. As a result, interests in a hedge fund cannot be offered or advertised to the general public, and are limited to individuals who are both "accredited investors" (those who have total incomes of over US$200,000 per year or a net worth of over US$1,000,000) and "qualified purchasers" (who own at least US$5,000,000 in qualified investments). Further, any one hedge fund is limited to 499 investors ("limited partners"). For the funds, the trade off is that they have fewer investors to sell to, but they have few government imposed restrictions on their investment strategies. The presumption is that hedge funds are pursuing more risky strategies, which may or may not be true depending on the fund, and that the ability to invest in these funds should be restricted to wealthier investors who are presumed to be more sophisticated and who have the financial reserves to absorb a possible loss.

Recent US regulatory developments

In October 2004, the SEC approved a rule change, finalized in December, final rule and rule amendments, implemented on February 1, 2006, that required most hedge fund advisers to register with the SEC as investment advisers under the Investment Advisers Act. The requirement applied to firms managing in excess of US$25,000,000 with over 15 investors. While there were minor exceptions to the rule, 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 rules was challeged in court by a hedge fund manager, and in June 2006, the U.S. Court of Appeals for the District of Columbia overturned it, and sent it back to the agency to be reviewed. See, Goldstein vs. SEC

Although the SEC is currently examining how it can address the Goldstein decision, commentators have stated that the SEC currently has neither the staff nor expertise to comprehensively monitor the estimated 8,000 U.S. and international hedge funds.See, New Hedge Fund Advisor Rule. One of the Commissioners, Roel Campos, has said that the SEC is forming internal teams that will identify and evaluate irregular trading patterns or other phenomena that may threaten individual investors, the stability of the industry, or the financial world. "It's pretty clear that we will not be knocking on (hedge fund) doors very often,"[citation needed] Campos told several hundred hedge fund managers, industry lawyers and others. And even if it did, "the SEC will never have the degree of knowledge or background that you do."[citation needed]

Recent UK regulatory developments

In recent years, HM Revenue and Customs, formerly Inland Revenue, has adopted interpretations of the tax laws that seem likely to keep many funds offshore. One change was in June 2005, The United Kingdom's Financial Services Authority published two discussion papers about hedge funds -- one concerning systemic risks, the other on consumer protection. Due to the same concerns, later in the year the FSA created an internal team to supervise the management of 25 particularly high-impact hedge funds doing business within the UK.

Another regulatory body, the Takeover Panel, is reportedly concerned about the use by hedge funds of instruments known as contracts for difference, which it worries may have opaque effects on mergers and acquisitions.

Funds of funds

Main article: Fund of funds

There is a special type of investment fund called a fund of funds, which invests only in other investment funds (e.g., hedge funds) rather than trading assets directly. Because some U.S. funds of funds may be specially registered with the SEC, they can accept investments from individuals who are not accredited investors or "financially sophisticated individuals" (defined term by the SEC, which subjectively includes those individuals whose financial sophistication allows them to make investment decisions without the protection of registration under Section 5), and often have lower investment minimums (sometimes as low as $25,000).

Funds of funds carry an additional layer of fees, typically a 1% management fee and, optionally, a 10% incentive (performance) fee, in return for their due diligence on a selection of hedge fund managers. Besides lower mininum investment hurdles and diversification, some funds of funds also add value (or "justify" the extra layer of performance fee) by dynamic allocation to different hedge funds strategies, such as Long/Short Equities, Event Driven, Distressed Debt, Convertible Arbitrage, Statistical Arbitrage, Macro and Multi-Strategies.

Fund of Hedge Fund management companies either invest directly into the hedge funds by buying shares or offer investors access to managed accounts which mirror the performance of the hedge fund. Managed or segregated accounts have grown in popularity because they provide investors with daily risk reporting and help protect the assets if the hedge fund goes into liquidation.

Comparison to private equity funds

Hedge funds are similar to private equity funds, such as venture capital funds, in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in very liquid assets, and permit investors to enter or leave the fund easily. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund.

Hedge funds often invest in private equity companies' acquisition funds.

Between 2004 and February 2006, some U.S. hedge funds adopted 25 month lock-up rules expressly to exempt themselves from the SEC's new registration requirements. They now fall under the registration exemption drafted to exempt private equity funds.

Comparison to U.S. mutual funds

Like hedge funds, mutual funds are pools of investment capital. However, mutual funds are highly regulated by the SEC. One consequence of this regulation is that mutual funds cannot compensate managers based on the performance of the fund, which many believe dilutes the incentive of the fund managers to perform.

Traditionally, hedge funds also distinguished themselves from mutual funds by the strategies noted above. Recently, however, mutual funds have appeared which utilize these strategies. Grizzly Short Fund (GRZZX), for example, is always net short, while Arbitrage Fund (ARBFX) specializes in merger arbitrage. Such funds are SEC regulated, but they offer hedge fund strategies and protection for mutual fund investors.

Hedge fund privacy

As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to third parties. This is in contrast to a fully regulated mutual fund (or unit trust) which will typically have to meet regulatory requirements for disclosure. The hedge funds are typically domiciled in an offshore jurisdiction, such as Bermuda, Cayman Islands, British Virgin Islands, where regulation of investment funds permits wider powers of investment (the Cayman Islands have been estimated to be home to about 75% of world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM[1]). Hedge funds have to file accounts and conduct their business in compliance with the less stringent requirements of these offshore centres. Investors in hedge funds enjoy a higher level of disclosure than investors in mutual funds including detailed discussions of risks assumed, significant positions, and investors usually have direct access to the investment advisors of the funds. This high level of disclosure is not available to non-investors, hence the notion of privacy attached to hedge funds.

A byproduct of this privacy and the lack of regulation is that there are no official hedge fund statistics. An industry consulting group, HFR (hfr.com), reported at the end of the second quarter 2003 there are 5660 hedge funds world wide managing $665 billion. To put that in perspective, at the same time the US mutual fund sector held assets of $7.818 trillion (according to the Investment Company Institute).

The combination of privacy and rich investors means that hedge funds are a target for criticism whenever markets move against some group's interests. For example, hedge funds were widely blamed for the speculative run-up in the bond market that preceded the global bond crisis of 1994, although the major players in the bond spree were actually large commercial and investment banks.

Top earners

Institutional Investor magazine annually ranks top-earning hedge fund managers. Earnings from a hedge fund are simply 100% of the capital gains on the manager's own equity stake in the fund plus 20% to 50% (depending on policy) of the gains on the other investors' capital.

The 2004 top earner was Edward Lampert of ESL Investments Inc. who earned $1.02 billion during the year (PR Newswire link).

The 2005 top earner was James Harris Simons with an earning of $1.5 billion according to Alpha magazine.[2] However, Trader Monthly reported that Simons only earned about $1 billion and that the top earner was instead T. Boone Pickens with an estimated earning of over $1.5 billion during the year.[3]

The full top 10 list of hedge fund earners according to Trader Monthly includes:

  • 1. T.Boone Pickens - estimated 2005 earnings $1.5bn +
  • 2. Stevie Cohen, SAC Capital Advisers - $1bn +
  • 3. James Simons, Renaissance Technologies Corp. - $900m - $1bn
  • 4. Paul Tudor Jones, Tudor Investment Corp. - $800m - $900m
  • 5. Stephen Feinberg, Cerberus Capital Management - $500 - $600m
  • 6. Bruce Kovner, Caxton Associates - $500m - $600m
  • 7. Eddie Lampert, ESL Investments - $500m - $600m
  • 8. David Shaw, D.E. Shaw & Co - $400m - $500m
  • 9. Jeffrey Gendell, Tontine Partners - $300m - $400m
  • 10. Louis Bacon, Moore Capital Management - $300m - $350m
  • 10. Stephen Mandel, Lone Pine Capital - $300m - $350m

Criticism

Questionable propriety

The U.S. Senate Judiciary Committee began an investigation into the propriety of Hedge Funds on June 28, 2006. The hearings have been recently reported on by CNBC, Bloomberg, and Marketwatch after a New York Times article exposed an investigation by Gary Aguirre, an investigating attorney, who was recently fired by the SEC. [2] [3]

Systemic risk

Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital Management (LTCM) in 1998, which necessitated a bailout coordinated by the U.S. Federal Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster.

The ECB (European Central Bank) has issued a warning on hedge fund risk for financial stability and systematic risk:

"... the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability which warrants close monitoring despite the essential lack of any possible remedies. This risk is further magnified by evidence that broad hedge fund investment strategies have also become increasingly correlated, thereby further increasing the potential adverse effects of disorderly exits from crowded trades." ECB Financial Stability Review June 2006, p. 142

The Times wrote about this review:

"In one of the starkest warnings yet from an official institution over the role of the burgeoning but secretive industry, the ECB sounded a note of alarm over the possible repercussions from any collapse of a hedge fund, or group of funds." Gary Duncan, Economics Editor, June 02, 2006

Poor performance

Critics also maintain that hedge fund performance has suffered as aggregate asset sizes have climbed.

In 2005, Princeton University professor and noted financial theorist Burton G. Malkiel published a paper maintaining that hedge funds systematically underperform the market averages[4]. Malkiel contended that hedge fund indexes, particularly prior to 1995, were often statistically faulty and overstated hedge fund performance. Hedge funds, however, contested Malkiel's findings.[5]

Recent evidence suggests the myth of good performance in all markets is somewhat shaky even for fund of hedge funds. (Source:[6]).

High fees

Criticism was also heaped upon hedge funds by investigative journalist Gary Weiss, in his caustic 2006 book Wall Street Versus America. The book contends that hedge funds have evolved into little more than high-fee mutual funds.

Performance-based management fees have been criticised by people including investor Warren Buffett for rewarding managers for high variability, rather than high long-term returns. A fund that may gain $100M in one year and lose $100M in the next year may pay its managers a performance fee of $30M or more for the profitable year, although the nominal return is zero, and the real return after fees is negative.

Hedge fund data

Notable hedge funds

Top 30 Funds of funds

Ranked by December 2005 Assets Under Management

InvestmentSeek.com has a listing of most fund of funds managers with their links ([35])

Managed Account Platforms

Hedge fund strategies

Terminology

References

  1. ^ Institutional Investor, 15 May 2006, Article Link, although statistics in the Hedge Fund industry are notoriously speculative
  2. ^ "$363M is average pay for top hedge fund managers". Institutional Investor, Alpha magazine (USA TODAY article, 26 May, 2005). Retrieved May 27. {{cite web}}: Check date values in: |accessdate= (help); Unknown parameter |accessyear= ignored (|access-date= suggested) (help)
  3. ^ Traders Monthly. Top Hedge Fund Earners of 2005. 
4. Hedge Fund Amaranth wiped out by unhedged gas position losing $5+ billion

5. "Hedge" Fund Amaranth to Close After loss of $6.5 of 9 billion on Unhedged Gas Bet

Further reading

  • Lhabitant, François-Serge, Hedge Funds: Quantitative Insights, John Wiley & Sons, 2004. ISBN 0-470-85667-X
  • Ineichen, Alexander M., Absolute Returns - Risk and Opportunities of Hedge Fund Investing, New York: John Wiley & Sons, 2003. ISBN 0-471-25120-8
  • Ineichen, Alexander M., Asymmetric Returns - The Future of Active Asset Management, New York: John Wiley & Sons, 2006, forthcoming. ISBN 0-470-04266-4
  • Weiss, Gary, Wall Street Versus America: The Rampant Greed and Dishonesty That Imperil Your Investments, New York: Portfolio, 2006. Argues that hedge funds tend to underperform market indexes and are excessively hyped by the media. ISBN 1-59184-094-5
  • Hedge Fund Flameout

Trade associations

Indices

Hedge fund research

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