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CONTENTS
Preface
Acknowledgments
Introduction: Major Themes and Organization of the Book
PART ONE: INTRODUCTION TO HEDGE FUNDS
Chapter 1
What Is a Hedge Fund?
Chapter 2
Regulation of Hedge Funds
Chapter 3
Hedge Fund Organization
Chapter 4
Hedge Fund Service Providers
PART TWO: HEDGE FUND TOOLKIT
Chapter 5
Short Selling and Leverage
Chapter 6
Derivatives: Financial Weapons of Mass Destruction
PART THREE: HISTORY AND OVERVIEW OF THE HEDGE FUND
INDUSTRY
Chapter 7
History of Hedge Funds
Chapter 8
Hedge Funds, Shadow Banking, and Systemic Risk
Chapter 9
Key Events in the Development of Hedge Funds: Long-Term Capital
Management and the Credit and Liquidity Crisis
PART FOUR: HEDGE FUND PERFORMANCE: MOUNTING
CRITICISM AND CHANGING BENCHMARKS
Chapter 10
Mounting Criticism of Hedge Fund Performance
Chapter 11
Is Smaller Better in Hedge Funds?
Chapter 12
Statistical Measures of Performance
Chapter 13
Aggregate Measures of Hedge Fund Performance
Chapter 14
Hedge Fund Returns from the Investors’ Viewpoint
PART FIVE: HEDGE FUND STRATEGIES
Chapter 15
Overview of Hedge Fund Strategies
Chapter 16
Equity Hedge Strategies
Chapter 17
Event-Driven Strategies
Chapter 18
Relative Value Strategies
Chapter 19
Global Macro and Commodity Trading Adviser Strategies
Chapter 20
Hedge Fund of Funds
PART SIX: HEDGE FUNDS AND INVESMENT PORTFOLIOS
Chapter 21
Modern Portfolio Theory and Efficient Market Hypothesis
Chapter 22
Behavioral Critique of Efficient Market Hypothesis
Chapter 23
Institutionalization of Hedge Funds
Chapter 24
Hedge Funds and Retail Investors
PART SEVEN: MANAGING HEDGE FUND PORTFOLIOS
Chapter 25
Manager Selection and Due Diligence
Chapter 26
Risk Management
Chapter 27
Recent Hedge Fund Controversies
Conclusion
Appendix A: Model Due Diligence Questionnaire for Hedge Fund Investors
Appendix B: Overview of Major Hedge Fund Replication Products
Appendix C: Internet Resources for Hedge Fund News and Research
Appendix D: Government Agencies That Oversee Hedge Funds
Glossary
Bibliography
Index
PREFACE
I founded a hedge fund in 1991 and spent the subsequent 20 years in the hedge
fund industry, participating in its amazing transformation. There were fewer than
1,000 hedge funds managing $58 billion in 1991 compared with over 10,000
funds managing $2 trillion today. The dominant hedge fund strategy in 1991 was
“global macro,” which entailed leveraged bets on the direction of global
currency, interest rates, commodities, and stock markets, whereas today the
strategies pursued by hedge funds are diversified and divided between equity,
fixed income, global macro, and others. Finally, the investors in 1991 were
predominantly wealthy individuals while today they are largely institutions,
including pension funds, university endowments, and sovereign wealth funds
(Figure 0.1).
FIGURE 0 – 1
It is fair to say that hedge funds have evolved from marginal investment
It is fair to say that hedge funds have evolved from marginal investment
vehicles for the rich into mainstream investments for the world’s largest
institutional investors, including CalPERS (the largest U.S. pension fund), the
Yale Endowment, State of Massachusetts’ $50 Billion Pension Reserves
Investment Management Board, and the China Investment Corporation.
And yet, most people’s knowledge of hedge funds comes from the news
headlines, which tend to focus on the sensational aspects of the industry: the
incredible wealth of some of its managers; the out-sized gains (i.e., Paulson &
Company, which made billions by correctly predicting the collapse of the U.S.
housing market) and losses (i.e., Long-Term Capital Management, which lost
billions in 1998 and caused a major crisis in the global financial system) of some
of the larger funds; the frauds perpetrated by some managers (frequently
including Bernard Madoff, who was not a hedge fund manager); its lack of
transparency and escape from government regulation; the insider trading
convictions of participants, notably Raj Rajaratnam and Raj Gupta; and the
alleged role of hedge funds in the recent credit crisis.
The simple fact that the great majority of individuals are prohibited from
investing in hedge funds amplifies the lack of widespread knowledge about
hedge funds.
The purpose of the book is to provide an objective roadmap to the complex
and rapidly changing world of hedge funds; to document the state of the industry
today, describing the forces of change; and to provide some insight into its future
direction.
The first edition, written by Robert Jaeger, has become a classic, widely
renowned for its comprehensive description of the hedge fund industry and
insightful analysis of hedge fund strategies. This is an opportune time to publish
a second edition of this book. Hedge funds are inextricably linked to the larger
financial and economic world and changes in the hedge fund industry are a
mirror of global changes that include the credit crisis, the collapse of the
investment banking industry, the global search for higher returns, the Madoff
and insider trading scandals, the deleveraging of the global financial system, and
the evolving regulation of the financial services industry: all have a profound
impact upon—and are in turn affected by—hedge funds.
It is important to state what this book is not. First, it is not a “get rich quick”
or even a “get rich slowly” book. Bookstores and e-books contain tons of
information on how to make money with various investments, including hedge
funds. There is a clear hunger for sure-fire solutions to the predicament faced by
many investors—individual and institutional—of the combination of slowed
economic growth, high debt levels, historically low interest rates, and a
directionless stock market, all of which have made the investment decision
increasingly frustrating. This book does not provide a path out of this bleak
landscape.
This brings up a related point: this book is not a cheerleader or apologist for
hedge funds. Over the years, the hedge fund industry has had an effective mantra
that partially helps explain its extraordinary growth and helps justify its high
fees, which goes something like this: hedge funds provide protection during
market downturns; add diversity to an investment portfolio; produce favorable
risk-adjusted returns compared with traditional stock and bond investments; and
possess the ability to generate investment alpha. They are therefore an essential
component of any investment portfolio.
These arguments are succinctly presented in a 2012 publication of the
Alternative Investment Management Association, a hedge fund industry group,
and KPMG, the consulting firm. The publication—“The Evolution of an
Industry”—also contained a favorable endorsement by Richard H. Baker,
President and Chief Executive Officer of the Managed Funds Association, the
hedge fund industry’s lobbying group.
However, hedge funds also have their critics.
Respected academics such as Burton Malkiel, author of A Random Walk
Down Wall Street,* have long argued that hedge funds provide no benefit to
investors. More recently, Simon Lack, a veteran of the industry, has argued that
hedge funds are primarily a vehicle for siphoning investors’ money into the
pockets of hedge fund managers, leaving very little for investors.† Hedge funds
are also criticized for causing or contributing to market turmoil, including during
the recent credit crisis.
This book does not attempt to advocate, justify, or condemn; it seeks to
document, analyze, and explain. Among the topics that will be treated in detail
are the evolution and growth of hedge funds; the strategies and tools used by
hedge funds; the performance and risk of hedge funds and their role in
investment portfolios; the role of hedge funds in the larger financial markets and
economic system; the industry’s structure and evolution; hedge fund losses and
scandals and government regulation of hedge funds.
WHO SHOULD READ THIS BOOK
While this book will be of interest to most readers, it is organized to present
topics that would primarily be of interest to one of four distinct audiences: the
topics that would primarily be of interest to one of four distinct audiences: the
general reader, institutional investors, retail investors, and industry professionals.
The General Reader
Because of their increasingly important role in the financial and investment
worlds, any informed citizen should know more about hedge funds than what
can be gleaned from the media. The book is organized to systematically explain
them in a nontechnical manner so that the general reader will be able to answer
the questions I inevitably get from friends and neighbors: What is a hedge fund?
How do they work? Can I invest in one? Should I invest in one? Are the
headlines I read true?
Hedge funds are unique in their organization and they use complex and
unfamiliar strategies and techniques. They regularly inhabit new and unusual
markets. In addition, because hedge funds span global markets and interact with
a wide range of actors—including banks, governments, and investors—they
provide important insights on the key issues in the global financial system and
efforts to deal with the ongoing financial crisis.
Finally, general readers will also find interest (and occasional titillation) in
the descriptions of some of the outsized personalities and unique strategies that
are part of the hedge fund world.
Institutional Investors
The hedge fund world is segmented into a “retail” sector dominated by wealthy
investors and, increasingly, average (“retail”) investors, and an “institutional”
sector dominated by pension funds, sovereign wealth funds, and endowments. I
have made an effort to address the differing interests of these segments when
relevant, especially in the latter chapters of the book on the role of hedge funds
in an overall investment portfolio.
Institutional investors manage “other people’s money” and therefore are faced
with fiduciary responsibility to their investors. They invest large amounts of
money with a long-term time horizon under formal regulatory and institutional
mandates. Institutions are concerned with how hedge funds fit into their overall
investment portfolio that, for many institutions, is experiencing a shortfall that
needs to be addressed in a difficult environment.
Institutions view hedge funds in the context of modern portfolio theory, asset
allocation, and risk management. They use such concepts as “alpha,”
allocation, and risk management. They use such concepts as “alpha,”
“alternative beta,” “Sharpe ratio,” and “value at risk,” in evaluating hedge funds
and their potential contributions to their overall investment needs.
Institutional investors are also using their size and sophistication to bring
about the “institutionalization” of hedge funds; changing hedge funds’ modus
operandi by gaining increased transparency into their strategies, operations, and
risks; pressing for a reduction of fees; and ensuring that there is more of an
alignment of the interests of hedge fund managers and investors.
Individual High-Net-Worth and “Retail” Investors
As a general rule, this group of investors is interested in a practical and useful
roadmap to a very complicated and, to most, unfamiliar investment world. The
person who is thinking about investing in hedge funds needs solid information
about the strategies and tools used by hedge funds, as well as the potential return
and risks of different types of hedge fund strategies. Most importantly, they need
information to allow them to cut through the hype and decide whether hedge
funds are a suitable investment for their specific needs and objectives.
The book describes in some detail the alternatives available to investors,
starting with the eligibility requirements they need to meet to invest in traditional
hedge fund and hedge fund of fund limited partnerships. In the past several
years, a number of vehicles have been developed for investors that wish to
access hedge fund strategies; notably mutual funds and exchange-traded funds
(ETFs) that adopt some of the strategies and tools of hedge funds such as
leverage, short selling, and derivatives, as well as hedge fund “replicators” who
strive to provide returns comparable to those of hedge funds in a mutual fund or
ETF structure. Finally, SEC-registered funds of hedge funds in the United States
and UCITS-registered funds in Europe have provided investors with another
channel to invest in hedge funds and hedge fund–type programs.
Financial and Hedge Fund Industry Professionals, Regulators,
and Academics
For industry insiders and fellow travelers, the book will analyze the changes in
the hedge fund industry and provide some ideas for future development of
strategies, products, and regulations.
The specific topics covered in this book that will be of special interest to this
audience include:
• Changes in the regulation of hedge funds and the financial services industry
• Changes in the regulation of hedge funds and the financial services industry
and their effect on hedge funds
• Changes in the organization of the financial services industry—for
example, the changing role of investment banks and brokers—and the
impact on the role of hedge funds
• Developments in hedge fund strategies, such as statistical arbitrage and
direct lending
• Changes in the investor mix, including sovereign wealth funds, retail
investors, and, most recently, wealthy investors from China
• Changes in the organization and functioning of hedge funds as they adapt to
the segmentation of their investor base and the very different needs of
“retail” and “institutional” investors
• Changes in the finances, economics, and structure of the hedge fund
industry itself, including the consolidation of the industry; pressure on
hedge fund fees; the changing role of fund of hedge funds; and the
increasing overlap and competition between hedge funds, mutual funds, and
other asset managers
* W.W. Norton & Company, New York, 2011. † The Hedge Fund Mirage: The
Illusion of Big Money and Why It’s Too Good to be True; Wiley, New York,
2012.
ACKNOWLEDGMENTS
I would like to thank Robert Jaeger, the author of the classic All About Hedge
Funds, for providing the foundation upon which this book was built.
I would like to thank Philip L. S. Deely, CAIA, for his extensive and ongoing
research and editorial support in the course of writing this book.
INTRODUCTION
Major Themes and Organization of the Book
While the book covers a wide range of topics, it is also guided by a number of
recurring themes. It is important to make these themes explicit at the start
because they define the major issues confronting hedge funds, their investors,
and their regulators.
HEDGE FUNDS ARE REMARKABLY DIVERSE
Unlike mutual funds, which are constrained by regulation and investor
expectations to conform to rigid and well-defined categories, hedge funds cover
a wide and varied territory. The very fact that hedge funds have the flexibility to
evolve and change their strategy makes it impossible to develop a fixed typology
of the industry.
There are hedge funds that closely resemble mutual funds; they pursue
primarily long-only investment in equities using traditional financial analysis to
identify overvalued and undervalued stocks. In fact, many of the practitioners of
this type of hedge funds came from the “long-only” world. It seems only natural,
therefore, that hedge funds have started long-only mutual funds and mutual
funds have founded vehicles that adopt some of the hedge fund strategies and
tools, notably the use of leverage and short selling.
In sharp contrast are hedge funds such as Steven Cohen’s SAC Capital
Advisors that have a fast-paced, opportunistic orientation to the market, often
driven by trends and movements in the market themselves. “Black box”
quantitative hedge funds, such as Jim Simons’ Renaissance Technologies and
David Shaw’s D.E. Shaw Group, are another distinct hedge fund category, as are
commodity trading advisers such as David Harding’s Winton, many of whom
utilize statistical models to drive their investment decisions.
At another extreme are hedge funds that pursue strategies based on the
discretion of their managers; strategies that can vary widely and change quickly.
discretion of their managers; strategies that can vary widely and change quickly.
Prominent here are the so-called global macro funds—exemplified by George
Soros’ Soros Fund Management, Bruce Kovner’s Caxton Associates, Paul Tudor
Jones’s Tudor Investment Corporation, and Louis Bacon’s Moore Capital
Management—that scour the world for opportunities and adopt strategies and
instruments to suit a variety of markets.
There are “niche” hedge funds that exploit relatively narrow markets and
strategies such as mergers and acquisitions (M&A) arbitrage, convertible bonds,
or specific sectors (i.e., financial, energy, or high tech) or specific countries or
regions (i.e., Brazil, China, Russia, Europe, or Asia).
Finally, a combination of the changes in the financial industry and the “war
chest” accumulated by some of the larger hedge funds has blurred the lines
between hedge funds, investment banks, and private equity firms and caused
hedge funds to provide loans for mergers and acquisitions and initial public
offerings (IPO) and invest in companies with the goal of affecting the companies
structure; a strategy known as “activist” investing practiced by hedge funds,
including Warren Lichtenstein’s Steel Partners and Daniel S. Loeb whose Third
Point LLC’s targets have included Yahoo and Procter & Gamble.
THE HEDGE FUND INDUSTRY IS CHANGING
The hedge fund industry is changing in fundamental ways. The increasing
consolidation and concentration among hedge funds has a parallel in the mutual
fund industry, which went through a similar change in the 1980s. If we project
this trend into the future, hedge funds look likely to mimic mutual funds and
asset management companies in becoming larger, more concentrated, and more
hierarchical. Hedge funds are also increasingly competing with mutual funds and
asset management companies for both institutional and retail customers, causing
changes in their products and organization. It is noteworthy that these changes
coincide with retirement of the first generation of hedge fund managers.
Another area of change is the increased crossover of functions between hedge
funds and other financial firms, notably banks, investment banks, and private
equity firms. The credit crisis (and subsequent regulatory initiatives such as
Dodd–Frank and Basel III) have unmoored the functions of traditional banking
and investment banking and provided a window for hedge funds to assume some
of their functions, notably risk trading and financing of M&A transactions, as
well as providing financing in “special situations” such as distressed company
debt and trade financing. Activist hedge funds are also changing the landscape in
the area of corporate finance and shareholder rights.
the area of corporate finance and shareholder rights.
INSTITUTIONALIZATION OF HEDGE FUNDS
Today’s hedge fund world is not the same as that of the 1990s. Hedge funds
have evolved from small and nimble firms often driven by outsized personalities
catering primarily to the wealthy. The industry is now dominated by increasingly
large hedge funds catering to institutional investors who view hedge funds as an
integral part of their portfolio.
Along with this change has come increased concentration and consolidation
According to PerTrac, a hedge fund industry information company, singlemanager hedge funds with over $1 billion under management account for only
3.9% of all hedge funds, but account for about 60% of all hedge fund assets.‡
In response to their changing investor base and to new government
regulations, hedge funds have beefed up their organization in areas such as risk
management, marketing, operations, and compliance. In a self-fulfilling cycle,
the additional resources needed to service institutional investors and comply
with government regulations have favored the larger hedge funds at the expense
of the smaller ones, in turn further concentrating assets with the larger firms.
FINANCIAL HEADWINDS: LOW INTEREST RATES, SLOW
GROWTH, AND CREDIT CONTRACTION
In the two decades leading up to the credit crisis in 2007, hedge funds— along
with the asset management industry—enjoyed a tailwind of falling interest rates,
economic expansion, and increased tolerance for leverage and derivative
structures. Falling interest rates and easier credit standards led to an increase in
asset valuation in major markets, and also to markets—especially bond markets
—that had pronounced trends. Hedge funds responded to these new
opportunities to devise investment strategies based on leverage and rising
markets.
The current financial landscape is one of low interest rates, a reduction in
leverage and credit, and volatile and unpredictable markets. In this environment,
the expected returns from hedge funds have declined dramatically from double
digit at the start of the decade to the point where an 6% annual return is
considered extremely attractive.
This trend dovetails with the “yield shock” of investors who, faced with
interest rates in the low single digits and volatile equity markets, are desperately
interest rates in the low single digits and volatile equity markets, are desperately
seeking additional return on investment. The need for return is compounded by
the deterioration in the “assets side” of the balance sheet of individuals,
institutions, and governments whereby the growth of debt and expenses are
outpacing the return on their investments.
DEBATE OVER HEDGE FUND BENEFITS
For close to two decades, hedge funds—along with private equity, commodities,
and “real assets—have been presented as “alternative investments”; a necessary
component of a portfolio that also includes stocks and bonds (the so-called
traditional investments). Hedge funds, consultants, and academics claimed that
hedge funds produced risk-adjusted returns superior to traditional investments,
while also offering protection from market crashes and reducing risk through
portfolio diversification. An oft-stated mantra was that anywhere from 5% to
20% of a portfolio should be invested in hedge funds.
However, over the past several years, these assumptions have been
increasingly tested, challenged, and denied on a number of fronts. First, the
underlying data used to analyze the performance of hedge funds has come under
repeated attack, to the point where some critics deny the validity of any
aggregate analysis of hedge fund returns or performance. Second, a number of
analyses of hedge fund performance have indicated that hedge funds do not
provide the additional or “alpha” returns (i.e., returns that come from manager
skill) above traditional investments, especially given the major drag on
performance caused by the unique hedge fund fee structure. A particularly
trenchant criticism of hedge fund performance, which will be described and
analyzed in detail below, has been presented by Simon Lack, who argues that the
overwhelming majority of hedge fund returns have actually gone to the hedge
fund managers, with a meager sliver handed to investors.
Finally, the relatively poor performance of hedge funds both during the credit
crisis, when hedge funds in aggregate lost 20%, as well as in subsequent years
has undermined the claims that they offered superior absolute returns that were
uncorrelated to the major stock and bond markets.
HEDGE FUNDS AND THE GLOBAL FINANCIAL SYSTEM
To understand hedge funds, you have to understand how they fit into the overall
financial system. Two features are especially important. First, they are often seen
as part of the so-called shadow banking system of interconnected actors that
as part of the so-called shadow banking system of interconnected actors that
includes bank vehicles, sovereign wealth funds, hedge funds, and private equity
firms and that is “greased” by leverage and collateral. As important consumers
of this leverage, hedge funds have a symbiotic relationship with banks and
brokers and play a key role in this system.
Second, hedge funds are an important factor in most financial markets and
major players in the derivatives world, and their importance will only increase as
trading shifts from banks to hedge funds. This has made hedge funds a target for
government regulation, to the extent that there is a distinct possibility that some
time in the future larger hedge funds may be designated as “systematically
important entities,” which would lead to an additional layer of regulation and
disclosure.
ORGANIZATION OF THIS BOOK
This book is divided into seven major parts, each composed of several chapters.
It is also populated with separate “side boxes” that contain information related to
the main body of the book but whose inclusion in the text would disrupt the
narrative flow. These boxes will include case studies of hedge funds, hedge fund
strategies, and hedge fund managers. They will also include some of the more
technical and mathematical material that needs to be incorporated to gain a
proper understanding of hedge funds, especially when we delve into some the
hedge fund strategies and measures of performance and risk.
Part One: Introduction to Hedge Funds
The introduction provides a roadmap to the world of hedge funds, including the
key characteristics of hedge funds and how they differ from other investment
vehicles, notably mutual funds. Next are the regulations that govern eligibility
for investing in hedge funds and the dos and don’ts that govern hedge fund
behavior under existing and pending regulations, including the provisions of the
Dodd–Frank Act. The following part describes the organization of a typical
hedge fund and hedge fund management company, including the process of
investing in hedge funds: the offering documents involved and fee structures of
investment managers. The final chapter discusses the hedge fund service
providers that are part and parcel of the hedge fund industry.
Part Two: Hedge Fund Toolkit
This part begins by providing readers with an overview of two of the main tools
in the hedge fund toolkit: short selling, which allows managers to wager that
stock prices are going to fall, and leverage, whereby hedge funds borrow monies
to increase the return (and risk) potential of their investments. This part
describes the mechanics by which hedge funds employ these tools, as well as the
risks inherent in each, especially in the face of tail-risk type events, such as the
Credit Crisis, and the failure of Long-Term Capital Management.
The final chapter in this part looks at derivatives, the oftmaligned instruments
whose astronomical growth over the last two decades shows few signs of
slowing. It addresses the growth of the derivatives market, the mechanics of
futures, forwards, options and swaps, and the issues that have arisen as a result
of constantly expanding derivatives market- trading both on exchanges and overthe-counter.
Part Three: History and Overview of the Hedge Fund Industry
This part discusses the origins of hedge funds, how hedge funds evolved as an
industry and how they fit into the larger domestic and global financial system,
especially in the post–credit crisis environment. This part will discuss issues
including the changing client base and the consolidation of the industry, the
valuation of hedge funds and fund of hedge funds in a mergers and acquisitions
context, and tax issues and the concept of the “new power brokers.”
This part also describes the controversy surrounding the “shadow banking”
system, the purported systemic risk that hedge funds pose to the financial system
and their potential benefits to the market. Lastly, this part provides an overview
of the credit crisis, including the role of hedge funds, and dissects one of the
largest hedge fund failures: Long-Term Capital Management.
Part Four: Hedge Fund Performance: Mounting Criticism and
Changing Benchmarks
This part takes on the highly controversial issue of how hedge funds perform and
the equally controversial issue of how to measure hedge fund performance. The
part begins with the problems inherent in hedge fund data, including a number of
biases that are unique to hedge fund data, which is voluntarily provided by hedge
fund managers. Next is a description of various hedge fund indices that attempt
fund managers. Next is a description of various hedge fund indices that attempt
to measure hedge fund performance in the aggregate and for specific strategies,
and a discussion of the differences between investible and non-investible
indices.
The next chapter discusses the debate over the popular theory that smaller
hedge funds outperform their larger brethren. It also addresses an issue that
rarely gets raised: even if (thousands of) small hedge funds in aggregate do
statistically outperform thousands of larger hedge funds, can investors make use
of this knowledge to their economic advantage?
The following chapter provides readers with an overview of the statistical
measures commonly used in the industry to measure performance, and risk,
including standard deviation, the Sharpe and Sortino ratios, and skewness and
kurtosis. The discussion also looks at the tools that investors employ in the tricky
task of separating alpha from beta in an effort to measure manger skill.
The part continues the investigation into hedge fund performance at the
aggregate level, by applying the most commonly used measures of risk and
performance to the overall hedge fund universe and to various strategy groups,
and by delving deeper into the questions surrounding hedge fund alpha.
The final chapter describes the controversy over whether or not hedge funds
provide value to their investors. Related issues are the persistence of returns, the
division of the spoils of hedge fund returns between investors and hedge fund
managers, and the extent to which the interests of hedge fund managers and
investors converge or diverge.
Part Five: Hedge Fund Strategies
This part provides detailed information on the full range of hedge fund
strategies, with special attention to the risk and return of various hedge fund
strategy types. The part is organized to provide a framework that can be used to
describe and evaluate the various strategies. This framework includes, for each
strategy:
• The markets in which a hedge fund operates, by function (i.e., equities,
fixed income, commodities), by sector (i.e., financial services, energy), and
by geographic region (i.e., country, region, or global)
• The tools and techniques used by different strategies, notably the use of
leverage and derivatives, and the extent to which a strategy is “systematic”
(i.e., a result of a quantitative, rule-driven process) or involves discretion on
the part of the managers
the part of the managers
• The historical performance characteristics of different hedge fund strategies
and their behavior in various types of markets
Part Six: Hedge Funds and Investment Portfolios
This part places hedge funds in the context of an investment portfolio that also
includes stocks, bonds, and other assets. This will also place the discussion in the
context of the controversy over modern portfolio theory and the extent to which
markets are or are not efficient. This is especially important for institutional
investors, whose decisions regarding the role of hedge funds are often driven by
overall asset allocation. The part also describes some of the tools that derive
from modern portfolio theory, notably portfolio optimization, and discusses the
industry practices for creating optimal portfolios.
The following two chapters look at behavioral finance, and its challenges
posed to the efficient markets hypothesis, and the growing trends towards
institutionalization of hedge funds, including how institutions such as
endowments and pensions invest.
This part concludes with a look at hybrid products and alternatives to
traditional hedge funds, including mutual funds that contain hedge fund
characteristics, actively managed ETFs, hedge fund “replication” strategies that
attempt to replicate hedge fund performance using liquid futures and options
markets, and SEC-registered fund of hedge funds.
Part Seven: Managing Hedge Fund Portfolios
The last chapters of the book address the crucial areas of risk management,
portfolio construction, and due diligence, areas that have gained in prominence
following large losses by many hedge funds during the credit crisis and the
exposure of the Madoff Ponzi scheme, the Bayou fraud, as well as other
instances of fraud. The discussion will cover issues of manager selection,
various risks present in all hedge funds—such as market risk and operational risk
—and the techniques that are commonly used for measuring and attempting to
manage these risks. The discussion will include an examination of quantitative
risk measurements—such as value at risk—and the limitation of their usefulness
due to the “fat tails” distribution of returns and “black swan” events.
Finally, the discussion turns to notable hedge fund implosions, and the hedge
fund due diligence issues they raise, a topic that has gained special importance
fund due diligence issues they raise, a topic that has gained special importance
following the failure of investors to uncover the Madoff fraud for over 20 years,
as well as more recent insider trading scandals.
Appendices and Resources
Information on hedge funds is not as readily available as for other investment
vehicles. Part six provides a number of resources that will be useful to the reader
including:
• A glossary of hedge fund terms
• Hedge fund due diligence document
• Overview of major hedge fund replication products
• Internet resources for hedge fund news and research
• Index of regulatory agencies overseeing hedge funds worldwide
• Bibliography of hedge fund books and articles
‡ PerTrac’s Annual Database Survey, April 30, 2012.
PART ONE
Introduction to Hedge Funds
CHAPTER 1
What Is a Hedge Fund?
There is no universally accepted definition of a hedge fund, either legal or
industry-wide. The term is believed to have been coined by a journalist in the
1950s to describe a private investment fund managed by Alfred Winslow Jones,
who used long and short equity positions to “hedge” the fund’s overall exposure
to stock market movements. Today, hedge funds are no longer confined to one
market and very often do not “hedge” their portfolio against market movements.
It is much more useful to describe hedge funds by a set of characteristics that
most hedge funds have in common. While some of these characteristics are also
shared by other investment firms and not every hedge fund has all the
characteristics, taken together these features do represent a definable group of
entities that most industry participants would recognize as hedge funds. These
features include the following:
• Hedge funds pool assets from multiple investors in a limited partnership
structure with a general partner and investment manager.
• They are offered to a restricted group of investors that meet regulatory
criteria as qualified investors.
• Hedge funds may not market themselves and can offer shares only on the
basis of a private placement memorandum.
• They are largely exempt from the Securities and Exchange Commission
(SEC) regulation governing investment companies, although this has
changed to some extent with the implementation of the new Dodd-Frank
legislation.
• Investors face restrictions on the redemption of their units or shares that
may be as short as three months or as long as several years.
• Hedge funds have high investment minimums.
SEC DEFINITION OF HEDGE FUNDS
The SEC, which has gained considerable supervisory authority over hedge
funds as a result of the Dodd-Frank Act, defines hedge funds as follows:
What are hedge funds?
Like mutual funds, hedge funds pool investors’ money and invest those
funds in financial instruments in an effort to make a positive return.
Many hedge funds seek to profit in all kinds of markets by pursuing
leveraging and other speculative investment practices that may increase
the risk of investment loss. Unlike mutual funds, however, hedge funds
are not required to register with the SEC. Hedge funds typically issue
securities in “private offerings” that are not registered with the SEC
under the Securities Act of 1933. In addition, hedge funds are not
required to make periodic reports under the Securities Exchange Act of
1934. But hedge funds are subject to the same prohibitions against fraud
as are other market participants, and their managers have the same
fiduciary duties as other investment advisers.
What are “funds of hedge funds”?
A fund of hedge funds is an investment company that invests in hedge
funds—rather than investing in individual securities. Some funds of
hedge funds register their securities with the SEC. These funds of hedge
funds must provide investors with a prospectus and must file certain
reports quarterly with the SEC*
• Hedge funds make extensive use of leverage, short selling, and derivatives.
• They are often active traders and speculators seeking to provide “absolute
returns”— i.e., positive returns in up or down markets.
HEDGE FUNDS AND MUTUAL FUNDS
Mutual funds manage approximately $12 trillion in assets compared to around
$2 trillion managed by hedge funds. Unlike hedge funds, mutual funds are open
to all investors and have no minimum investment. As a result, they have a much
wider investor base of both individuals and institutions. As I discuss in greater
detail later in the book, mutual funds are adopting some of the strategies of
detail later in the book, mutual funds are adopting some of the strategies of
hedge funds. However, even these are distinct because of the distinct features of
mutual funds compared to hedge funds.
The SEC describes mutual funds as follows:
• A mutual fund is a company that pools money from many investors and
invests the money in stocks, bonds, short-term money-market instruments
and other securities or assets.
Some of the traditional, distinguishing characteristics of mutual funds include
the following:
• Investors purchase mutual fund shares from the fund itself (or through a
broker of the fund).
• The price that investors pay for mutual fund shares is the fund’s per share
net asset value (NAV) plus any shareholder fees.
• Mutual fund shares are “redeemable,” meaning investors can sell their
shares back to the fund (or to a broker acting for the fund).
• Mutual funds generally create and sell new shares to accommodate new
investors. In other words, they sell their shares on a continuous basis.
• The investment portfolios of mutual funds typically are managed by
separate entities known as “investment advisers” that are registered with the
SEC.
In addition to the rigorous regulation of mutual funds, a key difference with
hedge funds is that mutual fund managers are constrained by their limitation on
short positions and their need to adhere to benchmarks. The limitation on short
positions means that mutual funds will always have a greater correlation to the
markets (stocks, bonds, etc.) than hedge funds. The adherence to benchmarks
place limits on the extent to which mutual fund managers are able to actively
manage their portfolios.
While some mutual funds are identified as “actively managed,” the meaning
is completely different than hedge funds. In broad terms, mutual funds can be
“index” funds, which means that they seek to exactly track a benchmark index
such as the S&P 500. When a mutual fund is described as “active” the manager
seeks to outperform the benchmark index by a relatively small amount.
Take an example of a mutual fund that seeks to replicate the S&P 500 index
and compare it to an “actively managed” mutual fund with the same index
benchmark. Both funds’ returns will closely mirror the returns of the S&P 500.
If the S&P 500 index declines by 20%, the index fund will decline by the same
amount and the index fund will decline by almost the same amount (say between
19% and 21%).
This is significantly different than a hedge fund which would seek to make
money for investors even in the fact of a stock market decline of 20%. The
extent to which they succeed is the topic of a later chapter.
HEDGE FUND ORGANIZATION
There is a widespread mistaken notion about the exact meaning of “hedge fund.”
A hedge fund is a passive investment pool—the vehicle into which the partners
place their money. Hedge funds are established as limited partnerships (typically
in Delaware) or corporation (offshore), which issue units or shares to limited
partners. A hedge fund has no employees or physical presence. A limited
partnership hedge fund vehicle is structured as follows:
• The general partner (GP) (a.k.a. sponsor) is typically the creator of the
fund. The GP usually manages the fund and has broad powers along with
fiduciary responsibilities to the other (limited) partners.
• The limited partners (LP) (a.k.a. investors) contribute capital and receive
some form of ownership or partnership interest.
What is often mistakenly taken as the hedge fund is the investment manager
(a.k.a. investment adviser) hired by the hedge fund (more specifically the GP of
the hedge fund) to actively manage this pool of money on behalf of the
investors. The portfolio managers and decision makers are employees of the
investment manager. However, while the investment manager is hired by the
hedge fund, in practice the GP is normally the investment manager and invests
substantial amounts, often the great majority, of his or her total assets in the
fund. The complex organization of a fund along with its service provider is
diagrammed in Figure 1–1.
FIGURE
1–1 Illustration of a Typical Hedge Fund Structure
PRIVATELY OFFERED TO A RESTRICTED GROUP OF
INVESTORS
Mutual funds are “sponsored” by an organization such as Fidelity or Vanguard.
Shares in mutual funds are typically offered to the general public on the basis of
a prospectus by brokers, investment advisers, financial planners, banks, or
insurance companies. Mutual funds are supported by a significant amount of
marketing and advertising. All this is in the context of compliance with the
relevant investment laws and under the registration and supervision of the SEC.
Hedge funds can only be offered privately to investors who must meet certain
Hedge funds can only be offered privately to investors who must meet certain
legal requirements as “qualified investors” and “accredited investors” based on
their wealth, income, and sophistication, and who can bear the possibility of
large losses. These requirements have limited hedge fund investors to high-networth individuals and institutions. However, there are increasing opportunities
for individuals who do not meet these criteria to invest in hedge fund products,
or in investments that mimic some of the characteristics of hedge funds.
A private offering means that a hedge fund cannot advertise, although that
will change to an unknown extent as a result of the JOBS Act. Investment in a
hedge fund is offered via a document known as a private placement
memorandum (or offering documents), which serves a similar function as the
mutual funds’ prospectus but which, as the name implies, is not registered with
the SEC.
DODD-FRANK ACT AND HEDGE FUND REGULATION
Two overarching laws govern the investment management industry: the
Securities Act of 1933 and the Investment Adviser Act of 1940, along with their
many amendments. Hedge funds (along with other entities such as private equity
firms) are exempt from many of the provisions of these laws. In exchange for
these exemptions, the Congress limited the ability of hedge funds to market to
small investors. In effect, the Congress said we will leave hedge funds largely
unregulated, but they can only cater to wealthy individuals and institutions, and
only reach out to them through private channels and word of mouth.
Under the provisions of the Dodd-Frank Act, hedge funds that have more than
$150 million in assets under management—must register with the SEC and to
file several documents and provide certain information. The Dodd-Frank Act
does not change the fact that investments in hedge funds units (or shares) are not
registered under the Securities Act of 1933, which governs most publicly issued
investment securities.
However, it is important to point out that hedge funds have always been
subject to laws that prevent fraudulent and other illegal activities, as witnessed
by the recent spate of prominent arrests and conviction of hedge fund managers
and employees for insider trading and for running Ponzi schemes.
RESTRICTED REDEMPTION RIGHTS
By law, mutual funds must honor investor redemption requests within seven
By law, mutual funds must honor investor redemption requests within seven
days; although in practice, redemption is made within a day or two. Shareholders
in a mutual fund return their shares to the fund and are paid their share of the
funds’ net asset value. Hedge fund shares or units, on the other hand, may only
be redeemed on a periodic basis, typically either quarterly or annually, although
they can be much longer. Most hedge funds also require notice before the
redemption period. For example, hedge funds that have a three-month restriction
on redemptions may require that investors notify the fund of their intent to
redeem shares a month before the three-month period begins. In effect, this
means that investors must wait four months to see their funds. As discussed at
length below, there are investment considerations that underlay these restrictions
having to do with the economic benefits of allowing hedge fund managers to
invest with the knowledge that they will be able to deploy the funds for a
minimum amount of time. The same considerations are behind the restrictions
imposed by private equity firms, which limit customer access to their funds for
five years or more.
In addition, the GP is normally allowed to suspend redemptions for a variety
of reasons or to place some or even the entire fund in a segregated account called
a “side pocket,” where the portfolio is essentially locked up until the GP decides
to allow redemptions.
MAY USE LEVERAGE, SHORT SELLING, DERIVATIVES
A number of financial techniques and instruments are widely associated with
hedge funds. In fact, hedge funds (along with investment banks) are the primary
users of some of these instruments, especially for speculative purposes. The
industry has had close links to the derivatives world from its earliest days, when
many hedge funds were closely associated with the futures and options
exchanges. The expertise of hedge funds with derivatives and complex financial
structures (futures, forwards, options, swaps, structured products) is now
widespread within the industry. They are a regular feature of hedge funds
involved in the fixed-income markets, which are extensive users of both futures
and swaps, and the equity markets through stock index options and options on
individual securities. In more recent times, this expertise has placed hedge funds
front and center in the mortgage crisis as major users of mortgage-backed
securities and credit default swaps.
A trademark of hedge funds is their ability to “short” markets either as short
sellers of stocks or through the use of derivatives in fixed income, currency, and
commodity markets. Hedge funds’ active use of shorting has repeatedly brought
commodity markets. Hedge funds’ active use of shorting has repeatedly brought
them into conflict with governments who blame hedge funds shorting for
declines in the value of stocks and currencies. Finally, many hedge fund
strategies and fund of funds vehicles rely on credit from banks and investment
banks to leverage or enhance their returns (and risks) using vehicles such as
repurchase agreements, credit lines, total return swaps, and the leverage inherent
in many derivatives.
ACTIVE MANAGERS SEEKING TO PRODUCE ABSOLUTE
RETURNS
Hedge fund managers are often described as “active managers seeking absolute
return.” In the mutual fund industry, there are broadly two types of funds. Index
funds attempt to replicate the returns of an index (e.g., the S&P 500). Active
managers seek to provide returns higher than a relevant index. However, active
managers typically seek small enhancements to the index and are tightly
constrained in terms of how much they can deviate and the tools (i.e., leverage,
short selling, and derivatives) they can use.
In the hedge fund arena, all managers are active in the sense that their
objective is to deliver a positive return to investors under all economic and
market conditions utilizing all the tools at their disposal. Hedge funds are not
constrained to beat the S&P 500, which has had declines of 40% or more. As
absolute return managers, with the tools to short a market, their objective is to
make money whether the S&P 500 declines or rises. In reality, hedge funds are
judged by some benchmarks and do not always achieve this absolute return.
SPECULATION, TRADING, INVESTMENT, AND GAMBLING
Hedge funds are often said to speculate, with the inference that they take
greater risk with their clients’ money than other investment managers. It
would be useful to deal with this early in the text and clear up some
misconceptions about the related concepts of speculation, trading, and
investment and gambling.
First, trading is merely the selling or buying of any security, and is
therefore a part of any form of any investment strategy, including those of
mutual funds.
Next, there are differences between speculation and gambling:
speculation is taking a calculated risk, where the outcome can be rationally
speculation is taking a calculated risk, where the outcome can be rationally
(if imperfectly and incorrectly) analyzed. On the other hand, the outcome of
gambling is entirely dependent on pure chance and totally random outcome
for results. While hedge funds certainly gamble, they at least attempt to
speculate and put much time and effort into analyzing the potential
outcome of their trading decisions.
It is more difficult to differentiate between investment and speculation.
It would be tempting to neatly distinguish between hedge funds
(speculators) on the one hand and “responsible” investors on the other.
However, even Ben Graham, the noted financial adviser and author of the
classic investment book The Intelligent Investor, finds it difficult to
separate the two. He describes the prototypical investor as “one interested
chiefly in safety plus freedom from bother.” He admits, however, that
“some speculation is necessary and unavoidable, for in many commonstock situations, there are substantial possibilities of both profit and loss,
and the risks therein must be assumed by someone.”
Finally, economic theory ascribes a significant economic and social
benefit to what is commonly thought of as speculation. By buying and
selling instruments, it often provides liquidity in markets that in turn helps
establish realistic prices, narrow spreads between purchase and sales, and
assume risks that enable hedgers to gain certainty in their businesses. The
classic example here is of a farmer who is able to plant a field with greater
certainty because a “speculator” has taken the other side of a futures
contract on the price of wheat.
* “Investor Bulletin: Hedge Funds.”
www.sec.gov/investor/alerts/ib_hedgefunds.pdf (accessed 12/26/12)
CHAPTER 2
Regulation of Hedge Funds
Four main laws govern the investment industry: the Securities Act of 1933, the
Securities and Exchange Act of 1934, the Investment Company Act of 1940, and
the Investment Advisers Act of 1940. As the names imply, the Securities Act of
1933 governs the issuance and trading of securities while the two 1940s acts
govern investment firms and investment advisers. The most recent law, the
Dodd-Frank Act, has changed some fundamental aspects of these laws but kept
many provisions intact.
These laws exempt certain firms—including hedge funds and private equity
firms—from certain provisions, notably those relating to registration and
supervision by the U.S. Securities and Exchange Commission (SEC). However,
hedge funds that qualify for these exemptions must also accept certain
restrictions, especially in the type of investor that can invest in the fund as well
as limitations to their activities in marketing and approaching clients.
In summary, the exemptions provided to hedge funds are as follows:
• Hedge funds are not subject to the Securities Act of 1933 because they do
not engage in public offerings.
• Hedge funds do not fall under the purview of the Securities and Exchange
Act of 1934 because they are not publicly traded companies.
• Hedge funds are not subject to the Investment Company Act of 1940
because (1) hedge funds are not mutual funds that solicit funds from the
public and (2) they offer investment advice only to private clients.
HEDGE FUND EXEMPTIONS FROM SECURITIES
REGULATIONS
Figure 2–1 provides an overview of hedge fund exceptions by the SEC.
FIGURE
2–1 Overview of Hedge Fund SEC Exemptions
Securities Act of 1933
Interest in a hedge fund are “securities”
The Securities Act of 1933 requires that securities be registered with the SEC.
According to the law, an interest in a hedge fund is a security. However, Section
4(2), which provides the most important provision for hedge funds exemption,
states that “[t]he provisions of section 5 shall not apply to transactions by an
issuer not involving any public offering,” which includes hedge funds.
Regulation D “safe harbor”
Regulation D is a “safe harbor” allowing hedge funds to satisfy the Section 4(2)
exemption noted above (i.e., that they do not make public offerings) provided
that they do not “use general solicitation or advertising to market the securities,”
and that all but 35 investors in the fund are “accredited investors,” as defined by
Rule 506.
Rule 506: accredited investors
Rule 506 defines an accredited investor as a natural person that has:
1. $1 million net worth
2. $200,000 in income in last 2 years; $300,000 when combined with spouse
Institutions that are accredited investors must have a minimum of $5,000,000
in invested assets (not net worth) to qualify as accredited investors.
No general advertising
Prohibition on advertising by hedge funds includes no newspaper ads or radio or
television shows.
Securities and Exchange Act of 1934
Funds with 500 investors and $10 million in equity must register with the
SEC
The Securities Exchange Act of 1934 requires a company to register with the
SEC if it has more than $10 million in assets and more than 500 investors.
Registration subjects funds to annual and other periodic reporting requirements.
Hedge funds with more than $10 million in equity can opt out of this reporting
requirement if they have no more than 499 investors.
Investment Company Act of 1940
Hedge funds exempted under Sections 3(c)(1) and 3(c)(7)
The Investment Company Act of 1940 requires that an investment company must
disclose its financial condition and investment policies to investors on a regular
basis. However, hedge funds qualify for exclusion from the definition of
investment company under the act’s 3(c)(1) and 3(c)(7) provisions.
1. Section 3(c)(1) excludes any issuer whose outstanding securities are
beneficially owned by not more than 100 investors and is not making
public offerings of its securities.
2. Section 3(c)(7) excludes any issuer whose outstanding securities are owned
by “qualified purchasers” and is not making public offerings of its
securities.
securities.
Investment Advisers Act of 1940
Requires investment advisers to register with the SEC
The Advisers Act defines an investment adviser as “any person who, for
compensation, engages in the business of advising others, either directly or
through publications or writings, as to the value of securities or as to the
advisability of investing in, purchasing, or selling securities, or who, for
compensation and as part of a regular business, issues or promulgates analyses
or reports concerning securities.”
Exemption under Section 203(b)(3) for advisers who have less than 15
clients over a 12-month period
Hedge funds that have had fewer than 15 clients during the preceding 12-month
period are not required to register as investment advisers under Section 203(b)
(3).
Commodities Exchange Act CPO and CTA Registration
The Commodity Exchange Act (CEA) may subject hedge funds that trade
financial and commodity futures to register as a commodity pool operator (CPO)
or a commodity trading adviser (CTA), which requires disclosure, record
keeping, and periodic reporting in compliance with the Commodity Futures
Trading Commission rules. Hedge funds can claim exemption from registration
as a CPO or CTA. Rule 4.13(a)(3) of the CEA exempt asset pools from
registering as CPOs if they privately place ownership interests to accredited
investors (as defined in Rule 501 of Regulation D). The CEA also contains Rule
4.13(a)(4), which exempts pools from registering as CPOs if they place
ownership interests to certain highly sophisticated persons, including qualified
purchasers (as defined in Section 2(a)(51) of the Investment Company Act).
Hedge fund advisers can also be exempt from CTA registration under Section
4m(1) of the CEA, which provides exemption for CTAs with 15 or fewer clients.
“Blue Sky” Laws
The above security laws are enforced by the SEC and other exchanges or
agencies at the federal level. There are also “blue sky” laws, which are the
agencies at the federal level. There are also “blue sky” laws, which are the
securities laws of the individual states and enforced by the state’s securities
administrator. Generally, a state requires that hedge funds make a “blue sky
filing” if an investor resides there. In addition, small hedge funds (generally
those with less than $25 million in assets) are exempt from registration under the
Investment Advisor Act (under Section 203(b)(3)) but may still need to register
under state regulation, which varies from state to state.
RECENT CHANGES UNDER THE DODD-FRANK ACT
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank
Act), passed largely in response to the credit crisis, represents the most
comprehensive securities legislation since the New Deal laws, and includes
provisions for the regulation of hedge funds. Title IV of the Act “Regulation of
Advisers to Hedge Funds and Others” mandates that hedge funds with between
$25 million and $150 million in assets under management (AUM) will be
required to register with the state in which they operate, while hedge funds that
operate in over 15 states or have over $150 million in AUM will be required to
register with the SEC.
The SEC attempted to require the registration of hedge funds by
administrative edict in 2004. However, the courts overturned this attempt in
2006 in the case of Goldstein, et al. v. Securities Exchange Commission. The
Dodd-Frank Act makes registration a legal requirement.
Title IV: Regulation of Advisers to Hedge Funds and Others
Section (1) of the title requires hedge funds and private equity advisors to
register with the SEC as investment advisers and provide information about their
trades and portfolios. The information is primarily gathered to be shared with the
Financial Stability Oversight Council (FSOC), a group comprising the major
regulatory agencies with the mandate of determining the sources of systemic
risk. The inclusion of hedge funds, private equity firms, and other members of
the “shadow banking” system were deemed essential for the FSOC to be able to
gauge the potential for systemic risk.
Hedge funds that register under Dodd-Frank are required to provide
information on Form PF (Reporting Form for Investment Advisers to Private
Funds and Certain Commodity Pool Operators and Commodity Trading
Advisors). Form PF is formidable and calls for extensive information on the
funds’ AUM; leverage and sources of financing; use of derivatives; fund
funds’ AUM; leverage and sources of financing; use of derivatives; fund
strategies and risks; their largest market positions; the types of investors in the
fund; and their “gatekeepers”—auditors, prime brokers, and marketers that
service the funds.
Registered funds will also be required to have a compliance officer and set up
policies to avoid conflicts of interest.
Under the new rules, advisers with AUM between $150 million and $1.5
billion will have to report on an annual basis. Advisers with AUM of $1.5 billion
or greater will be required to file quarterly. Large hedge fund advisers (those
with $1.5 billion or more in AUM) will have to file within 60 days after their
quarter end. Smaller advisers and large private equity fund advisers will have to
file within 120 days after their fiscal year.
Section (3) of the title exempts from registration advisers to private funds
with AUM of less than $150 million as well as advisers to “family offices.” A
number of large hedge funds, notably that of George Soros, have converted to
family offices partly to avoid the registration and disclosure requirements of
Dodd-Frank.
Another provision of Dodd-Frank greatly restricts the role of banks in their
ability to invest and/or sponsor hedge funds and private equity funds. Banks may
constitute no more than 3% of the NAV of a hedge fund, and may have no more
than 3% of their Tier 1 capital invested in private funds.
JOBS Act and Hedge Fund Advertising
Congress passed the Jump start Our Business Startups (JOBS) Act in 2012. The
Act will greatly increase the ability of hedge funds to market their services. As
described above, hedge funds are allowed to solicit funds under the exemption
provided by Rule 506, which allows for the offering of securities primarily to
accredited investors so long as such offering is not accomplished through
general solicitation or general advertising (e.g., publishing an advertisement in a
newspaper or on TV, or announcing the new fundraiser on the sponsor’s website
or at a public seminar).
However, the JOBS Act lifts the Rule 506 restriction on general solicitation
and general advertising so long as the sponsor has taken reasonable steps to
verify that all purchasers are accredited investors. Once rules go into effect,
hedge funds will be permitted to market new funds through print, broadcast, and
Internet advertisements; notices posted on their websites; and media interviews.
It also allows presentations at seminars and other forms of interaction with
potential investors. However, the antifraud provisions contained in the
potential investors. However, the antifraud provisions contained in the
Investment Advisers Act of 1940 and in the rules promulgated thereunder will
continue to apply, which include (in the case of registered investment advisers)
prohibitions on the use of testimonials and specific requirements when listing
past performance information in connection with the offer and sale of private
fund securities.
The effect of the JOBS act, however, may be limited in practice—at least in
the immediate future—for a number of reasons: First, the larger and more
established hedge funds do not need to advertise to solicit funds; in fact, many
have turned away prospective investors. Second, the hedge fund industry has
developed a network that connects investors with funds throughout the world.
The network is built on personal relationships, events that bring together
investors and funds, databases that allow investors to evaluate some aspects of
hedge fund performance, and professional marketers that have extensive contacts
among investors. This network does not depend on advertising. Third, hedge
funds have an incentive to maintain a relatively low profile to avoid the adverse
publicity they sometimes generate among regulators or the general public.
Finally, hedge funds may be eager to maintain their “brand name” with wealthy
investors and especially institutions that may view mass media advertising as a
diminution of that brand.
EUROPEAN ALTERNATIVE INVESTMENT FUND MANAGERS
DIRECTIVE
While the focus of hedge fund regulation has centered on the Dodd-Frank
legislation, a regulation proposed for the European Union (EU)—the
Alternative Investment Fund Managers Directive (AIFMD)—is likely to
have far greater impact on hedge funds. The directive, which will become
law in July 2013, addresses the following issues:
1. Domicile—Depending on how the legislation is implemented, there is
a real possibility that hedge funds and hedge fund managers may have
to establish domicile in Europe in order to market their products
within the EU.
2. Reporting—Managers will have to register with their national
regulator (essentially the Financial Services Authority in the United
Kingdom since 80% of EU-based hedge funds are in London) and
provide information on investment strategy and the instruments and
leverage they will utilize. The added operational and software
leverage they will utilize. The added operational and software
capability this reporting will require will favor larger hedge funds
with deeper pockets.
3. Depository Requirements—All hedge funds will have to appoint a
single independent depository (custodian or prime broker) to
safeguard the funds. Non-EU funds may have a depository either
within the EU or in their “home country” (main location) or country
of domiciliation. However, the non-EU depository must be subject to
the same level of EU regulation in the “home” jurisdiction as they
would be in the EU, which may present a problem for some hedge
funds.
4. Leverage—The directive adopts restrictions on leverage as well as a
revised measurement of hedge funds whose overall effect will be to
reduce hedge fund leverage to the degree that it may change the
model of traditional hedge funds.
5. Valuation Policy—The AIFMD mandates that all assets of a fund will
be independently valued either by an independent entity (i.e., an
administrator) or by the hedge fund—as long as it is not valued by the
portfolio management function or the area that sets remuneration
policy for the fund. The overall effect may be to make it less
attractive for hedge funds to invest in potentially illiquid investments.
EUROPEAN REGULATORS MAY LIMIT HEDGE FUND
COMPENSATION
The European Securities and Markets Authority (ESMA) has stated that it
expects national EU regulators to extend to hedge funds bonus restrictions
that are already imposed on banks. ESMA’s guidance suggests that hedge
funds would have to defer between 40% and 60% of bonuses over several
years, and that at least half of the bonuses would have to be paid in equitylinked instruments related to the fund rather than outright cash bonuses.
Part of the proposed regulation would include a “clawback” provision that
would allow a hedge fund to cancel a bonus or an equity-linked instrument
if the recipient lost money for the fund in subsequent years. The motivation
for the regulation is to align the interests of hedge fund managers and their
investors at least insofar as it should deter hedge funds from pursuing shortterm strategies that may provide them with an immediate bonus payout but
come back and harm investors in the longer term. A classic example would
come back and harm investors in the longer term. A classic example would
be a short option or an option-like strategy that paid the hedge fund an
immediate premium but may incur large losses in the future.
WHO ARE HEDGE FUND INVESTORS?
Because hedge funds are exempt from a wide variety of securities and
investment adviser regulations, hedge funds historically have been available only
to accredited investors and large institutions, and have limited their investors
through high investment minimums. The specific regulatory limitations on hedge
fund investors vary according to the legal organization of each hedge fund.
Subscription documents that investors sign to purchase hedge fund units
generally ask investors to provide the information needed to assure they meet the
investor requirements for the fund. However, in general, hedge fund investors
must fall into one of two categories, each with its own investor limitations.
Section 3(c)(1) and Regulation D Rule 506 Exempt Funds
Hedge funds established as Section 3(c)(1) funds under the Investment Adviser
Act of 1940 are limited to 99 investors. Furthermore, each investor must be an
accredited investor, which is defined as an individual (or individual and spouse)
with a net worth of at least $1 million and an income of more than $200,000 (or
$300,000 with spouse) in each of the preceding two years. (A Rule 506 fund
may have an unlimited number of accredited investors and up to 35
nonaccredited investors.)
Section 3(c)(7) Exemption Funds
These funds are limited to 499 investors (recently changed to 1,999), all of
whom are qualified purchasers, defined as a natural person who (with their
spouse) “owns not less than $5,000,000 in investments.” Also allowed are
certain trusts, foundations, and family offices, as well as advisers that manage
more than $25,000,000 in investments on behalf of qualified purchasers.
FIDUCIARY AND LEGAL DUTIES OF HEDGE FUND
MANAGERS
The standard description one finds of hedge funds inevitably claims that hedge
funds are “unregulated” or “largely unregulated.” This presents an impression of
an out-of-control industry able to operate without restrictions or prohibitions,
accountable to no one but their investors (if even those), to the extent their
investors know what they are doing and are in a position to redeem their funds or
influence the managers.
This is not the case. In fact, even before the passage of the Dodd-Frank Act,
the SEC stated that:
Like mutual funds, hedge funds pool investors’ money and invest those funds
in financial instruments in an effort to make a positive return. Many hedge
funds seek to profit in all kinds of markets by pursuing leveraging and other
speculative investment practices that may increase the risk of investment loss.
Unlike mutual funds, however, hedge funds are not required to register with
the SEC. Hedge funds typically issue securities in “private offerings” that are
not registered with the SEC under the Securities Act of 1933. In addition,
hedge funds are not required to make periodic reports under the Securities
Exchange Act of 1934. But hedge funds are subject to the same prohibitions
against fraud as are other market participants, and their managers have the
same fiduciary duties as other investment advisers.
In addition, hedge fund managers that are general partners owe the fund and
the fund’s limited partners a fiduciary responsibility of placing the fund’s and
limited partner’s interest ahead of their own. Fiduciary duties are not the same as
laws; however, they do place duties and restrictions on hedge fund managers’
behavior and, while not enforceable in the same way as laws, may lead to
lawsuits on the part of investors if these duties are violated.
While there is no fixed definition of fiduciary responsibility, there is a broad
consensus in the investment industry that investment managers owe their
investors a set of duties that include at least the following:
• To manage the hedge fund in the best interest of the fund and its investors
• To place the interest of the limited partners before those of the general
partner
• To disclose all conflicts of interest.
Hedge Funds under the Investment Advisers Act of 1940
The new regulations will be become more meaningful by the regulators’ access
The new regulations will be become more meaningful by the regulators’ access
to hedge fund activities gained through the registration requirement of the new
legislation, which places registered hedge funds under the regulation of the
Investment Advisers Act of 1940. Again, the SEC has stated that:
The Securities and Exchange Commission is adopting a new rule that
prohibits advisers to pooled investment vehicles from making false or
misleading statements to, or otherwise defrauding, investors or prospective
investors in those pooled vehicles. This rule is designed to clarify, in light of
a recent court opinion, the Commission’s ability to bring enforcement actions
under the Investment Advisers Act of 1940 against investment advisers who
defraud investors or prospective investors in a hedge fund or other pooled
investment vehicle.
CHAPTER 3
Hedge Fund Organization
This chapter covers certain organizational issues of hedge funds, including the
types of documents associated with hedge funds, issues of redemptions and fees,
and the important issue of the alignment (or misalignment) of interest between
hedge fund managers and investors.
OFFERING DOCUMENTS
Before investing in a hedge fund, investors are presented with a variety of
documents, each with a specific purpose. Investors need to keep in mind that
these documents are written by attorneys to protect the interests of the general
partner and/or the investment company. As such, a primary purpose of these
documents is to ensure that their legal liability has been reduced as much as
possible through the use of disclaimers. This is not to say, however, that they do
not include valuable information about the fund, its strategy, and its risks.
Hedge funds normally also provide potential investors with several types of
marketing materials, including PowerPoint presentations, newsletters, and other
documents, as well as making representations at meetings and in phone
conversations.
It is important that all these documents and discussions are viewed as a whole
since each document addresses different points and has a different purpose.
Many investors, especially institutional investors, retain attorneys to review the
documents and may be able to negotiate concessions in some of the agreements.
Private Placement Memorandum
Section 3(c)(1) of the U.S. Investment Company Act of 1940, which established
the terms under which hedge funds are exempt from SEC registration, states that
funds must issue a private placement memorandum (PPM) as a prospectus to
potential investors when raising capital, either initially when launching the fund
or on an ongoing basis to new investors or investors looking to purchase new
or on an ongoing basis to new investors or investors looking to purchase new
units.
The PPM is also referred to as an offering circular, offering memorandum, or
private offering memorandum for the interest of shares of a hedge fund. The
PPM is required to disclose all material terms of the interests of shares being
offered to investors, the details of the general partner or the members of an
offshore hedge fund’s board of directors, information about the investment
adviser and the management agreement, material risks factors for an investment
in the hedge fund, regulatory matters, tax aspects, and information about the
administrator and the fees it charges.
A hedge fund may only seek investment from potential investors with whom
it has a preexisting relationship. To legally solicit an individual investor, the
hedge fund must establish this relationship before sending the PPM on for
consideration. Another avenue is for a hedge fund to work with a third-party
marketer or broker-dealer, who must be registered with the SEC, and are allowed
to solicit their own established relationships on behalf of the hedge fund.
In broad terms, these documents are similar to a mutual fund prospectus and
provide detailed discussions of the following topics:
• The investment program, including any limitations to the investment
manager’s discretion in terms of instruments or position limits
• The structural terms such as the relationship of the fund to the general
partner, investment manager, and, importantly, the key service providers,
including broker, administrator, custodian, auditor, and attorneys
• Information on the management company and the managers
• Information on how the market and economic situation affected past
performance
• The fees and expenses that investors would have to pay out of financial
results
• The alert to investors that they may lose all or part of their investments
• The alert to investors that past performance does not guarantee future
success of the fund
A private placement often provides detailed information on the hedge fund’s
proposed strategy, including the types of investments it will make and
instruments it will use, and the fund’s allowable leverage capacity or level.
PPMs also address potential conflicts of interest between the general and limited
PPMs also address potential conflicts of interest between the general and limited
partners. The PPM also describes in detail how fees are calculated and charged.
In order to arrive at fees, it also describes the method for calculating the fund’s
net asset value (NAV).
PPM Table of Contents
A typical Table of Contents for a PPM indicates the topics that are treated:
• Investment objective and policies
• Risk factors
• Fees and expenses
• Management of the fund
• The manager
• The investment adviser
• The prime broker and custodian
• The subadministrator
• Brokerage
• Net asset value
• Tax considerations
• Subscription and redemption of shares
• Distribution and selling restrictions
• Dividends and distributions
• Shareholder reports
• Legal counsel and auditors
• Anti-money laundering regulations
Limited Partnership Agreement
To invest in a limited partnership, investors need to sign a Limited Partnership
Agreement (LPA), also known as the governing legal document. The LPA
covers the relationship between the general partner and the limited partners,
covers the relationship between the general partner and the limited partners,
delineating their respective powers and responsibilities. The LPA is used by
partners in a business to establish the rights and liabilities of the general
partner(s) who actively manages affairs of the business and the limited partner(s)
who are passive investors and have no role in management. In practice, the role
of limited partners is severely restricted; they have no role in the operation of the
partnership. However, the general partner’s authority is restricted by the fact that
he or she owes a fiduciary duty to the limited partners to place the interest of the
fund and of the limited partners ahead of his own. The LPA also describes issues
such as the formation of the partnership, name and place of business, terms of
partnership, and contributions of capital.
Subscription Documents
The actual purchase of units in a hedge fund is done by submitting a signed
limited partner “subscription agreement” along with sending the investment
funds to the administrator. A subscription agreement details the amount of
capital the applicant will contribute to the partnership as well as his or her
responsibilities and authority in the company. The agreement establishes the
partnership’s expectations of the new member and defines his role within the
existing management structure. All limited partners must be approved by the
general partner.
This document describes the amount of money the investor is investing in the
hedge fund and the number of “units” that this amount purchases. The
subscription agreement also details the terms under which an investor can
purchase additional units as well as the procedure for the redemption of shares.
The subscription agreement typically includes questions about an investor’s
financial background, especially their qualification and suitability for exemption
under the SEC securities regulations as “qualified purchasers” or as an
“accredited investor.”
Side Letters
Side letters between a hedge fund and certain investors are relatively common in
the industry. They typically provide for preferential treatment to the investor in
the form of lowered fees, lesser redemption restrictions, and increased
transparency into the fund’s operation. They are typically given to early
investors or particularly large investors in a fund.
HEDGE FUND REDEMPTIONS AND REDEMPTION GATES
Investors in a typical hedge fund can only redeem funds on a quarterly,
semiannual, annual, or longer basis. The period during which an investor is
unable to redeem their shares is known as the “lockup” period. In practice, there
are many variations of redemption rights. For example, some funds allow for an
early redemption upon the payment of a penalty fee, typically around 3–5% of
the amount being redeemed.
Hedge fund general partners typically give themselves wide discretion in their
ability to suspend or restrict redemption. These restrictions are generally written
in broad terms in the offering documents in order to give the general partner
wide latitude as to when and how they impose these restrictions. During the
credit crisis, scores of hedge funds made liberal use of this power. This became
so prevalent that BusinessWeek was driven to declare “Hedge Funds Frozen
Shut” (March 4, 2008). During the crisis, the hedge funds that suspended
redemption to one degree or another included such leading names as Tudor,
Fortress, Highbridge Capital Management, Permal Group, Centaurus Capital,
Goldman Sachs, D.E. Shaw, Farallon Capital Management, Deephaven, GLG,
and many others.*
A typical clause in the PPM addressing the issue of redemptions reads as
follows:
“The General Partner, in its sole and absolute discretion, has the right to
suspend withdrawals by Limited Partners under certain circumstances
specified in the Partnership Agreement including, without limitation, when,
as a result of political, economic, military or monetary events, the existence
of a natural disaster, force majeure, act of war or terrorist attack or other
circumstances outside the responsibility of the General Partner, disposal of
the assets of the Partnership is not reasonably or normally practicable,
without being seriously detrimental, in the judgment of the General Partner,
to the interests of the Partners.” (Hedge Fund Law Report, July 29, 2009)
There are several types of redemption restrictions (in addition to the initial
“lockup”) that many hedge funds have, including:
• Redemption restrictions are the most common form of limit on the partners.
They are outright limitations on redemptions and may be partial (i.e.,
investors can redeem a portion of their assets) or total (i.e., allowing for no
redemptions).
• Redemption gates allow the manager to suspend redemptions once they
have reached a predetermined percentage of the fund’s overall assets,
typically between 10% and 25% of the fund’s assets. The gate may be
discretionary on the part of the manager, or automatically imposed once the
percentage trigger has been reached.
• Establishing side pockets is another common form of restriction on
redemptions, especially for funds that have assets that have become highly
illiquid, such as owning bonds of bankrupt companies or countries or when
exchange regulations prevent remitting the assets, as happened during the
Russian debt crisis in 1998. In recent years, side pockets were extensively
used to segregate mortgage-backed securities that the manager felt could
only be sold at “fire sale” prices, well below their “fair value” because of
temporary market conditions, but that will increase in value once these
conditions are gone. In practice, side pockets are established when a fund is
split into liquid and illiquid share class with investors holding a stake in
both share classes. Redemptions can continue on the liquid part (as well as
new money through subscriptions), while redemptions are suspended on the
illiquid shares.
• Liquidation refers to unwinding a fund and returning remaining assets to
the investors. This is normally only done when redemption requests are too
high to continue the fund or the manager decides to wind up the fund. This
was a regular occurrence during the credit crisis, as in the case of Peloton, a
$2 billion hedge fund that suffered fatal losses in mortgage-backed
securities.
Some Limitations on Redemption Restrictions
While most hedge funds provide their managers with broad authority to suspend
redemptions, there are, in practice, limitations to this power. First, the manager,
as general partner, owes the traditional fiduciary duties of loyalty and care to the
limited partnership (i.e., the fund) and its limited partners/investors. In practice,
this limits the actions of the general partner to those that do not breach these
duties and provide a boundary to the manager’s behavior. This has sometimes
been expanded to the manager’s duty to act “in the best interest of the fund.”
Second, redemption restrictions are normally implemented so that no class of
investors is unfairly affected compared with other investors.
Justification for Restrictions on Redemptions
While the presumptive power of general partners to suspend redemptions may
seem onerous, there is actually an economic rationale for at least some
discretionary authority as a benefit to all the partners in a fund. Redemption
restrictions are sometimes justified with the argument that they allow the fund to
“live to fight another day” by preventing forced liquidation. They are also
justified as a mechanism to prevent investors from self-inflicted damage. This
argument was presented by Professor Marcus K. Brunnermeier in an influential
paper written in 2005 called “Predatory Trading,” which Professor Brunnermeier
explains as follows:
Predatory trading is “trading that induces and/or exploits the need of other
investors to reduce their positions … If one trader needs to sell, others also
sell … This leads to price overshooting and a reduced liquidation value for
the distressed trader. Hence, the market is illiquid when liquidity is most
needed. Further, a trader profits from triggering another trader’s crisis, and
the crisis can spill over across traders and across markets.
The point here is that every investor has an incentive to flee the fund first to
avoid being stuck in the crowd as all investors attempt to flee at once through a
narrow door. Another often-used analogy is that of someone yelling “fire!” in a
crowded theater and the need for an orderly exit strategy to prevent harm.
Redemption restrictions are a way of controlling predatory trading by allowing
the general partner to act in the interest of the investors despite their instinct to
flee.
As described above, a related rationale for redemption gates is often used in
the case of a hedge fund that holds illiquid securities in its portfolio, that is,
those that can only be sold at a steep discount to their “real” value or whose sale
would have a negative impact on the price of the security. In extreme cases,
there may be no market for a security.
In addition, redemption limits are sometimes justified as a matter of fairness
to all the investors in a fund. The logic here is as follows: If a large group of
investors redeem their shares or units in a portfolio that includes illiquid
securities or in a volatile environment, the manager would be forced to liquidate
the more liquid securities first, leaving the remaining investors “holding the bag”
with a portfolio of the more illiquid securities. Here, a redemption limit could be
said to be fair to all the investors.
Finally, redemption restrictions are justified as a matter of aligning the
strategy of a fund with its funding source. If a fund’s strategy is dependent on
making investments that may take a certain amount of time to reach fruition, it
seems reasonable that the funding for the strategy (i.e., the investors) be matched
to the needed time. In fact, there is a correlation between the limits on
redemptions and the liquidity of the underlying hedge fund investments. For
example, hedge funds that invest in highly liquid instruments (i.e., high cap
stocks, U.S. Treasury or high-grade corporate bonds, liquid futures contracts)
typically offer relatively short redemption periods (as short as two or three
months), while hedge funds that invest in distressed company debt may have
redemption restrictions of one year or more.
HEDGE FUND MANAGEMENT AND INCENTIVE
(PERFORMANCE) FEES
While the hedge fund industry has come under pressure to reduce their
traditional fee structure, especially from institutional investors, the standard in
the industry is still a management fee of between 1% and 2% of the assets under
management (AUM), and an additional 20% of the returns earned by the fund on
the AUM (Figure 3–1). (In fact, a study by Bank of America Merrill Lynch
shows that management fees have actually crept up over the years, with average
fees of 1.8% for funds launched in 2011.) This fee structure is often referred to
as 1 and 20 or 2 and 20. (In addition, expenses related to the operation of a
hedge fund, including administrative, brokerage, legal, etc., are deducted from
the asset pool.)
FIGURE
3–1 Average Management Fee by Launch Date
Typically, the management fee of 1–2% of AUM is taken out of the fund’s
assets by the administrator at the beginning of each month on the basis of the
administrator’s calculation of AUM. Thus, a fund with $100 million in AUM
would charge investors an annual management fee of between $1 and $2 million.
Except for exceptional situations, management fees are paid regardless of the
fund’s performance.
Incentive fees are typically 20% of returns earned by the fund (after
deducting the management fee and other fund expenses) and normally paid by
investors to the general partner (or more accurately taken by the manager from
the fund) on a quarterly basis. The amount of incentive fee is often (but not
always) contingent on two factors.
Hurdle Rates
Many hedge funds only start to accumulate an incentive fee once the funds’
earning or profits have passed a hurdle rate, typically a short-term Treasury bill
rate. The logic here is that the investor has the alternative to place their assets in
a risk-free investment rather than a hedge fund, and the hedge fund should be
able to return at least this risk-free rate. For example, a hedge fund with a hurdle
rate of 2% will only start to pay incentive fees to the manager once the returns of
rate of 2% will only start to pay incentive fees to the manager once the returns of
the fund have gone above 2%.
High-Water Mark
If a hedge fund losses money in its management of client assets, it must first
make up this loss before it can earn any new incentive fees. The level the fund
must reach before it can start to earn incentive fees is known as the “high-water
mark.” In practice, many funds ceased earning incentive fees after severe losses
in 2008 and 2009. Many of these hedge funds are still below their high-water
mark today. Figure 3.2 shows that a whopping 62% of hedge funds were below
their high-water mark in 2011.
FIGURE
3–2 U.S.-Based Funds Above/Below Their HWMs by Year
As an example, a hedge fund managing $100 million that earns a return of
10% during a year (i.e., $10 million)—an excellent return in this environment—
would pay the fund manager $2 million in incentive fee. If there is a hurdle rate
of 3%, the amount eligible for incentive fee would be $7 million (i.e., 7%) and
the manager’s incentive compensation would be $1.4 million.
Assume that the manager had lost 10% ($10 million) in a given year on an
investment pool of $100 million. The manager would then only be eligible for
incentive compensation after he recouped the $10 million. To see the hardship
imposed by the high-water mark calculation, note that in order to earn $10
million on the remaining $90 in assets, the manager must now make 11.11% on
the remaining assets under management.
It should be noted that some highly successful and desirable hedge funds
charge a management fee of up to 5% and an incentive fee of up to 50%. This is
not really a concern for most investors since these funds tend to be either closed
to new investors or allow new investors to enter on rare occasions.
The impact of hedge fund fees and hurdle rates on the experience of an
investor are shown in Table 3–1.
TABLE
3–1 Fee Calculations
THE ALIGNMENT (AND MISALIGNMENT) OF HEDGE FUND
MANAGER AND INVESTOR INTEREST
One of the ongoing debates in the hedge fund world is the extent to which
the interests of the hedge fund manager are the same as those of investors.
(This is actually a problem, known as the “agency problem,” whenever the
management of a company differs from its owners, as for example in the
case of corporations). The issue of hedge fund fees is one of the
battlegrounds for this debate. The argument runs as follows: when a hedge
battlegrounds for this debate. The argument runs as follows: when a hedge
fund is relatively small, the management fee would normally only be
sufficient to cover the expenses of running the fund, which means that the
manager must earn an incentive fee to make a “reasonable” income.
However, when a hedge fund becomes large, the management fee can be
large enough so that a manager can make a comfortable living without
taking much risk. The economics favor the manager in this scenario
because hedge funds have economies of scale, which means that expenses
do not grow nearly as quickly as AUM. In other words, if the AUM
doubles (along with the management fee), the fund may only need to
increase its expenses (i.e., personnel, space, technology, etc.) by 20%. In
this situation, the interests of the hedge fund manager (i.e., to grow the
assets of the fund) may diverge from those of the investors, who are
interested in a return on investment.
It may occur to the reader that managers whose returns have become
mediocre as they become more interested in collecting management fee
than incentive fees face the risk that investors would pull out their money.
However, in case of large, formerly successful, hedge funds, there is an
inertia among investors that keeps assets stable, or even increasing, so that
many managers are willing to take that chance. They can take comfort from
the many mutual funds that have underperformed their indices for years or
decades but still retain their investors.
* It is important to check if there are any “side letters” between the fund and an
investor that modifies the terms of the fund for that investor, including lockup
and redemption terms.
CHAPTER 4
Hedge Fund Service Providers
Hedge funds survive because of a network of service providers—prime brokers,
administrators, custodians, auditors, and attorneys—that cater to their complex
needs and requirements. In turn, hedge funds have been instrumental in shaping
the service providers. In fact, some features of the modern financial world—
notably shorting, repurchase agreements, and prime brokerage—have grown to
the extent they have as a direct result of the need to service hedge funds.
ACCESS TO MARKETS AND CONSOLIDATION OF
TRADING ACTIVITIES
In broad terms, the prime broker acts as a conduit between hedge funds and the
financial marketplace by providing transaction execution, clearing and
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