University of Phoenix Hedge Fund Investment Essay

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juteno

Economics

University of Phoenix

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 Please write an essay for this project.  

Part one?I think the first part can be changed, maybe rewritten, just briefly describe the history and current situation of hedge fund, and explain the difference between now and before from the perspective of scale, changes in strategy, etc. (How institutions are using hedge funds today). Make a short summary about the disadvantages and advantages of HF. (Without giving examples when describing history). this is one of Part one+Following that, the UNPF wants to know what percentage of the pension fund you think they should allocate to hedge funds, how many hedge funds you think they should invest in, and what strategies or types of hedge you think they should focus on. Feel free to give specific examples of managers that you know of and that you might recommend. Remember, UNPF does not expect you to be a hedge fund expert (after all they know that you are a student) but they want to understand how you think, what you have learned about hedge funds, how you approach your research, what sources of information you would use, and how you would tackle and implement this potential assignment. Please detail some of the key operational issues that hedge funds deal with and outline to the UNPF a potential timeline to build out the hedge fund allocation. Remember, if you are the “winning” proposal, you will mostly likely be hired for this assignment. Due to the size and prestige of the UNPF you can safely assume that they will be able to access virtually any hedge fund they would like to use.This paragraph is mentioned in my guideline but you seem to be missingI think the writer can re-read it and then searching some sources about UNPF and pension fund? ?My idea?this might help you?Start by answering what percentage of the pension fund, and how many hedge funds you think they should invest in. Then find some information about real-life fund examples and strategies used by fund managers. (Follow the guideline given before, writers can play by themselves. But you need to meet the guideline requirements)In the end, This is not a Q&A, it needs to be like an articleSecond part?*Will your hedge fund be modelled after an existing one, if so, explain that clearly*Please detail your industry focus, market cap focus, geographic focusLost these two, I think you need write more about industry focus, market cap focus, geographic focus can be added. For example, which industries are mainly preferred or which ones are not selected, and why (assuming that high-tech, new energy, etc. will develop better in the future, because this fund is better for long-term investment in 5 years. Or avoid some industries) market cap focus (It can be said that thelarge HF funds may be stable, and the small HF funds may have a high volatility ) geographic focus (You can talk about some areas are at war or etc... for example Russia and Ukraine. So we need stay away from these markets.)You can add content about Group members.Like why are there four people (I think there may be more) and what is each of them responsible for? Maybe? some people will do research and collect materials, some people will do trading , some people will management...... For this part, you can look at the descriptions of some other fund teams.Reducing the part about self-recommendation. Just describing some important points.

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THE WORK IS PROVIDED “AS IS.” McGRAW-HILL EDUCATION AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill Education and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill Education nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting there from. McGraw-Hill Education has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill Education and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. 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 settleme...
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Hedge fund
Outline
Part 1

Definition
History of hedge funds
How institutions are using hedge funds today
Advantages that are associated with the use of hedge funds
Disadvantages

Second part

Strategies
References


1

Hedge fund investment

Student’s Name
Instructor’s Name
Course Number
Date

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Hedge fund investment
Definition
A hedge fund is an efficiently managed investment pool, They are private funds
and have limited constraints in terms of risk taken, this allows the engagement of more complex
strategies in the investment, capable of taking a higher risk and therefore used in more risky
ways, hedge funds, therefore, is limited to individuals and institution participants that have a
high net worth.
History of hedge funds
Alfred Winslow Jones is famously given the accreditation of the launch of hedge
funds. Having no Ph.D. in Quantitative Finance, he resolved to work at a tramp steamer, at the
age of forty-eight he collected $100000 and started what is known today as the hedge fund. From
this idea, he generated exemplary profits in the 1950s and 1960s, which led to the creation of an
improvised investment structure that would be used even to this day.
Many investors afterward followed in his footsteps; one of these disciples was
Clifford Asness, Clifford was a highly intellectual individual with a Ph.D. in Quantitative
Finance, before he became a staunch disciple of jones, he was running a $38 billion firm, being
at a younger age he became impatient and lacked the needed skills to run the hedge fund, it was
not until the great mortgage crush of 2007 that he realized to succeed in the business of hedge
fund he had to follow Jones profound improvisation as follows:
Ensure that he kept one-fifth of the investment profits as the performance fee,
these motivated him as well as his staff

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He ensured that he avoided regulatory red tape that could make it difficult for him
to attain flexibility and change from one investment to another
He also ensured that his portfolio was composed of buying promising shares and
short selling of the shares that did not show good prospects. This way he was capable of hedging
against risk.
History teaches us that it is the hedge fund that made Pierpont Morgan
accumulate a wealth of $1.4 billion equated to the modern-day dollars, giving him the nickname
of Jupiter in Wall Street. Individuals could even earn more than banks in the era of the
initialization of hedge funds.
The titans of the great era of the hedge, unluckily, tumbled down in the late
1980s, to the early 1990s and 2000s this was because of inefficient markets.
The modern-day is seen reclaiming the victory that once the hedge funds had, as
per the statistics, Total assets managed grew from about $2.2 trillion in 2012 up to about $3.6
trillion in 2019. The statistics also showed that the hedge funds being operated also grew
considerably in 2015 (Hedge director, 2015).
How institutions are using hedge funds today
The institutionalization of hedge funds has occurred between 2001 and 2007, this
change took place as a result of a changed perception of viewing hedge funds as a means of
getting very high returns to a way of ensuring portfolio diversification, low volatility, and a good
source of alpha. Institutional investors, such as sovereign wealth funds, pension funds, and
insurance corporations, have emerged in the contemporary era. These institutions operate in
environments that need a lot of cash, for them to finance their operations as needed, they engage
in hedge funds to sufficiently finance their costs as well as maintain their assets. They also

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participate in hedge funds to be able to honor their short-term and long-term obligations when
they fall due.
Advantages that are associated with the use of hedge funds


They offer vast investment styles that enhance effective investments



Hedge funds have complete absolute returns this is because they have low

strategy.

risks and they give portfolio alphas


They offer increased returns



The global macro can he...

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