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A hedge fund is a private investment fund that charges a performance fee and is typically open to only a limited range of qualified investors. Hedge fund activity in the public securities markets has grown substantially as it constitutes approximately 30% of all U.S. fixed-income security transactions, 55% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, as well as 30% of equity trades. Hedge Funds dominate certain specialty markets such as trading in derivatives with high-yield ratings, and distressed debt.[1]
Alfred Winslow Jones is credited with inventing hedge funds in 1949. [2]
In the United States, in order for an investment fund to be exempt from direct regulation, it must be open to accredited investors only and only a limited number of investors can belong to it. While there is no legal definition of “hedge fund” under U.S. securities laws and regulations, typically they include any investment fund that, because of an exemption from the types of regulation that otherwise apply to mutual funds, brokerage firms or investment advisers can invest in more complex and more risky investments than a public fund might. Hedge funds managed from other countries have similar relationships with their national regulators. As a hedge fund’s investment activities are therefore limited only by the contracts governing the particular fund, it can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.
As their name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term “hedge fund” has come in modern parlance to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other “hedging” methods to increase risk, and therefore return, rather than reduce it.
Hedge funds have acquired a reputation for secrecy. Being outside the regulatory regime that applies to retail funds greatly reduces the information a hedge fund is legally required to make public. Additionally, divulging trading methods and positions would compromise the business interests of many types of hedge fund, tending to limit the information they want to release.[2][3]
The assets under management of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Their sway over markets, whether they succeed or fail, is therefore potentially substantial and there is a continuing debate over whether they should be more thoroughly regulated.Contents [hide]
1 Industry
2 Fees
2.1 Management fees
2.2 Performance fees
2.2.1 High water marks
2.2.2 Hurdle rates
2.3 Withdrawal/Redemption fees
3 Strategies
4 Hedge fund risk
5 Legal structure
5.1 Domicile
5.2 The legal entity
5.3 Open-ended nature
5.4 Listed funds
6 Hedge fund management worldwide
7 Regulatory Issues
7.1 US regulation
7.2 Comparison to private equity funds
7.3 Comparison to U.S. mutual funds
7.4 Offshore regulation
8 Hedge Fund Indices
9 Debates and controversies
9.1 Systemic risk
9.2 Transparency
9.3 Market capacity
9.4 Investigations of illegal conduct
9.5 Performance measurement
9.6 Relationships with analysts
10 Hedge fund data
10.1 Top performing funds
10.2 Highest-earning hedge fund managers
10.3 Notable hedge fund management companies
10.4 Terminology
11 See also
12 References
13 Further reading
13.1 Research Articles
13.2 Research Papers
13.3 Books
14 External links
14.1 Academic research
14.2 Indices
14.3 Trade associations
14.4 Other links
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Industry
In 2005, Absolute Return magazine found there were 196 hedge funds with $1 billion or more in assets, with a combined $743 billion under management - the vast majority of the industry’s estimated $1 trillion in assets.[3] However, according to hedge fund advisory group Hennessee, total hedge fund industry assets increased by $215 billion in 2006 to $1.442 trillion, up 17.5% on a year earlier, an estimate for 2005 seemingly at odds with Absolute Return.[4]
As large institutional investors have entered the hedge fund industry the total asset levels continue to rise. The 2008 Hedge Fund Asset Flows & Trends Report [5] published by HedgeFund.net and Institutional Investor News estimates total industry assets reached $2.68 trillion in Q3 2007. According to the BarclayHedge Monthly Asset Flow Report, hedge funds received only $16 billion in October, the second-lowest inflow in 2007. Year-to-date hedge funds attracted $278.5 billion, three times year-to-date inflow into equity mutual funds.
A major trend in the hedge fund industry is the increasing amount of capital being poured in to the asset class through institutional investments. Single digit returns and underfunded pension plans has led to institutional investors looking beyond traditional investments in stocks and bonds in order to generate the absolute returns needed to close their funding gaps or maintain capital levels. Data taken from the 2008 Preqin Hedge Institutional Investor Directory [6] indicates that throughout 2008 up to $80-90 billion will be invested in hedge funds through institutional commitments alone. The most prolific institutional investors, as identified by Preqin Hedge, are public pension plans, endowments and family offices and foundations.
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Fees
Usually the hedge fund manager will receive both a management fee and a performance fee (also known as an incentive fee). Performance fees are closely associated with hedge funds, and are intended to incentivize the investment manager to produce the largest returns they can. A typical hedge fund fee is “2 and 20″, which refers to management fees of 2% and performance fees of 20%. See below for an explanation of each.
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Management fees
As with other investment funds, the management fee is calculated as a percentage of the net asset value of the fund at the time when the fee becomes payable. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. Therefore, if a fund has $1 billion of assets at the year end and charges a 2% management fee, the management fee will be $20 million in total. Management fees are usually calculated annually and paid monthly.
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Performance fees
Performance fees, which give a share of positive returns to the manager, are one of the defining characteristics of hedge funds. In contrast to retail investment firms, performance fees are prohibited in the U.S. for stock brokers.[citation needed] A hedge fund’s performance fee is calculated as a percentage of the fund’s profits, counting both unrealized profits and actual realized trading profits. Performance fees exist because investors are usually willing to pay managers more generously when the investors have themselves made money. For managers who perform well the performance fee is extremely lucrative.
Typically, hedge funds charge 20% of gross returns as a performance fee, but again the range is wide, with highly regarded managers demanding 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.[citations needed]
Managers argue that performance fees help to align the interests of manager and investor better than flat fees that are payable even when performance is poor. However, performance fees have been criticized by many people, including notable investor Warren Buffett, for giving managers an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark and sometimes by a hurdle rate. Alternatively, the investment manager might be required to return performance fees when the value of the fund drops. This provision is sometimes called a ‘claw-back.’
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High water marks
A “High water mark” is often applied to a performance fee calculation.[7] This means that the manager does not receive performance fees unless the value of the fund exceeds the highest net asset value it has previously achieved. For example, if a fund was launched at a net asset value (NAV) per share of $100, which then rose to $130 in its first year, a performance fee would be payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If in the third year the NAV per share rises to $143, a performance fee will be payable only on the extra $13 return from $130 to $143 rather than on the full return from $120 to $143.
This measure is intended to link the manager’s interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. If a high water mark is not used, a fund that ends alternate years at $100 and $110 would generate performance fee every other year, enriching the manager but not the investors. However, this mechanism does not provide complete protection to investors: a manager who has lost money may simply decide to close the fund and start again with a clean slate — provided that he can persuade investors to trust him with their money. A high water mark is sometimes referred to as a “Loss Carryforward Provision.”
Poorly performing funds frequently close down rather than work without fees, as would be required by their high water mark policies. [8]
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Hurdle rates
Some funds also specify a hurdle rate, which signifies that the fund will not charge a performance fee until its annualized performance exceeds a benchmark rate, such as T-bills or a fixed percentage, over some period. This links performance fees to the ability of the manager to do better than the investor would have done if he had put the money elsewhere.
Funds which specify a soft hurdle rate charge a performance fee based on the entire annualized return. Funds which use a hard hurdle rate only charge a performance fee on returns above the hurdle rate.
Though logically appealing, this practice has diminished as demand for hedge funds has outstripped supply and hurdles are now rare.[citations needed]
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Withdrawal/Redemption fees
Some hedge funds charge investors a fee if they withdraw money from the fund before a certain period of time has elapsed since the money was invested. The purpose of the “surrender charge” is to moderate the outflow of assets, which can allow the fund manager to reduce the turnover of investments, as investments do not need to be liquidated to raise cash for the withdrawal, and invest in more complex, longer-term strategies. The fee also dissuades investors from withdrawing funds after periods of poor performance. The fee is typically known as a “withdrawal fee” where the fund is a limited partnership and a “redemption fee” where the fund is a corporate entity.
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Strategies
Hedge funds are no longer a homogeneous class. Under certain circumstances, an investor or hedge fund can completely hedge the risks of an investment, leaving pure profit.[citation needed] For example, at one time it was possible for exchange traders to buy shares of, say, IBM on one exchange and simultaneously sell them on another exchange, leaving pure profit.[citation needed] Competition among investors has leached away such profits, leaving hedge fund managers with trades that are partially hedged, at best. These trades still contain residual risks which can be considerable. Some styles of hedge fund investing, such as global macro investing, may involve no hedging at all. Strictly speaking, it is not accurate to call such funds hedge funds, but that is current usage.
The bulk of hedge funds describe themselves as long / short equity, but many different approaches are used taking different exposures, exploiting different market opportunities, using different techniques and different instruments:
Global macro – seeking related assets that have deviated from some anticipated relationship.
Arbitrage – seeking assets that are mispriced relative to related assets.
Convertible arbitrage – between a convertible bond and the same company’s equity.
Fixed income arbitrage – between related bonds.
Risk arbitrage – between securities whose prices appear to imply different probabilities for one event.
Statistical arbitrage (or StatArb) – between securities that have deviated from some statistically estimated relationship.
Derivative arbitrage – between a derivative and its security.
Long / short equity – generic term covering all hedged investment in equities.
Short bias – emphasizing or solely using short positions.
Equity market neutral – maintaining a close balance between long and short positions.
Event driven – specialized in the analysis of a particular kind of event.
Distressed securities – companies that are or may become bankrupt.
Regulation D – distressed companies issuing securities.
Merger arbitrage - arbitrage between an acquiring public company and a target public company.
Other – the strategies below are sometimes considered hedge strategies, although in several cases usage of the term is debatable.
Emerging markets- this usually means unhedged, long positions in small overseas markets.
Fund of hedge funds - unhedged, long only positions in hedge funds (though the underlying funds, of course, may be hedged). Additional leverage is sometimes used.[citation needed]
F3 or F cube - unhedged, long only positions in fund of hedge funds. Leads to ultra diversified exposure to hedge funds (300 or more hedge funds on look through basis).
Quantitative
130-30 funds - Through leveraging, 130% of the money invested in the fund is used to buy stocks. 30% of the money invested in the fund is used to short stock.
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Hedge fund risk
Investing in certain types of hedge fund can be a riskier proposition than investing in a regulated fund, despite the traditional notion of a “hedge” being a means of reducing the risk of a bet or investment. The following are some of the primary reasons for the increased risk in hedge funds as an industry, though by no means all hedge funds have all or any of these characteristics:
Leverage - in addition to putting money into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing sums many times greater than the initial investment. Where a hedge fund has borrowed $9 for every $1 invested, a loss of only 10% of the value of the investments of the hedge fund will wipe out 100% of the value of the investor’s stake in the fund, once the creditors have called in their loans. At the beginning of 1998, shortly before its collapse, Long Term Capital Management had borrowed over $26 for each $1 invested.
Short selling - due to the nature of short selling, the losses that can be incurred on a losing bet are theoretically limitless, unless the short position directly hedges a corresponding long position. Therefore, where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns against it.
Appetite for risk - hedge funds are culturally more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities and collateralised debt obligations based on sub-prime mortgages.
Lack of transparency - hedge funds are secretive entities. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision.
Lack of regulation - hedge funds are not subject to as much oversight from financial regulators, and therefore some may carry undisclosed structural risks.
Investors in hedge funds are willing to take these risks because of the corresponding rewards. Leverage amplifies profits as well as losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns; secrecy helps to prevent imitation by competitors; and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis.
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Legal structure
A hedge fund is a vehicle for holding and investing the funds of its investors. The fund itself is not a genuine business, having no employees and no assets other than its investment portfolio and a small amount of cash, and its investors being its clients. The portfolio is managed by the investment manager, which has employees and property and which is the actual business. An investment manager is commonly termed a “hedge fund” (e.g. a person may be said to “work at a hedge fund”) but this is not technically correct. An investment manager may have a large number of hedge funds under its management.
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Domicile
The specific legal structure of a hedge fund – in particular its domicile and the type of entity used – is usually determined by the tax environment of the fund’s expected investors. Regulatory considerations will also play a role. Many hedge funds are established in offshore tax havens so that the fund can avoid paying tax on the increase in the value of its portfolio. An investor will still pay tax on any profit it makes when it realises its investment, and the investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund.
At the end of 2004 55% of the world’s hedge funds, accounting for nearly two-thirds of total hedge fund assets, were established offshore. The most popular offshore location was the Cayman Islands, followed by the British Virgin Islands, Bermuda and the Bahamas. The US was the most popular onshore location, accounting for 34% of funds and 24% of assets. EU countries were the next most popular location with 9% of funds and 11% of assets. Asia accounted for the majority of the remaining assets.[citations needed]
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The legal entity
Limited partnerships are principally used for hedge funds aimed at US-based investors who pay tax, as the investors will receive relatively favorable tax treatment in the US. The general partner of the limited partnership is typically the investment manager (though is sometimes an offshore corporation) and the investors are the limited partners. Offshore corporate funds are used for non-US investors and US entities that do not pay tax (such as pension funds), as such investors do not receive the same tax benefits from investing in a limited partnership. Unit trusts are typically marketed to Japanese investors. Other than taxation, the type of entity used does not have a significant bearing on the nature of the fund.[9]
Many hedge funds are structured as master/feeder funds. In such a structure the investors will invest into a feeder fund which will in turn invest all of its assets into the master fund. The assets of the master fund will then be managed by the investment manager in the usual way. This allows several feeder funds (e.g. an offshore corporate fund, a US limited partnership and a unit trust) to invest into the same master fund, allowing an investment manager the benefit of managing the assets of a single entity while giving all investors the best possible tax treatment.
The investment manager, which will have organized the establishment of the hedge fund, may retain an interest in the hedge fund, either as the general partner of a limited partnership or as the holder of “founder shares” in a corporate fund. Founder shares typically have no economic rights, and voting rights over only a limited range of issues, such as selection of the investment manager – most of the fund’s decisions are taken by the board of directors of the fund, which is self-appointing and independent but invariably loyal to the investment manager.
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Open-ended nature
Hedge funds are typically open-ended, in that the fund will periodically issue additional partnership interests or shares directly to new investors, the price of each being the net asset value (“NAV”) per interest/share. To realise the investment, the investor will redeem the interests or shares at the NAV per interest/share prevailing at that time. Therefore, if the value of the underlying investments has increased (and the NAV per interest/share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Investors do not typically trade shares among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund, which has a limited number of shares which are traded among investors, and which distributes its profits.
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Listed funds
Corporate hedge funds often list their shares on smaller stock exchanges, such as the Irish Stock Exchange, in the hope that the low level of quasi-regulatory oversight will give comfort to investors and to attract certain funds, such as some pension funds, that have bars or caps on investing in unlisted shares. Shares in the listed hedge fund are not traded on the exchange, but the fund’s monthly net asset value and certain other events must be publicly announced there.
A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an investment manager. Although widely reported as a “hedge-fund IPO”[10], the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.[11]
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Hedge fund management worldwide
In contrast to the funds themselves, hedge fund managers are primarily located onshore in order to draw on larger pools of financial talent. The US East coast – principally New York City and the Gold Coast area of Connecticut (particularly Stamford and Greenwich) – is the world’s leading location for hedge fund managers with approximately double the hedge fund managers of the next largest centre, London. With the bulk of hedge fund investment coming from the US, this distribution is natural.
London is Europe’s leading centre for the management of hedge funds. At the end of 2006, three-quarters of European hedge fund investments, totalling $400bn (£200bn), were managed from London, having grown from $61bn in 2002. Australia was the most important centre for the management of Asia-Pacific hedge funds, with managers located there accounting for approximately a quarter of the $140bn of hedge fund assets managed in the Asia-Pacific region in 2006.[12]