Hedge fund

A hedge fund is an investment fund open to a limited range of investors that is permitted by regulators to undertake a wider range of investment and trading activities than other investment funds and pays a performance fee to its investment manager. Each fund has its own strategy which determines the type of investments and the methods of investment it undertakes. Hedge funds, as a class, invest in a broad range of investments including shares, debt, commodities and so forth.

As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term "hedge fund" has come to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other "hedging" methods to increase rather than reduce risk, with the expectation of increasing return.

Hedge funds are typically open only to a limited range of professional or wealthy investors. This provides them with an exemption in many jurisdictions from regulations governing short selling, derivative contracts, leverage, fee structures and the liquidity of interests in the fund. A hedge fund will typically commit itself to a particular investment strategy, investment types and leverage levels via statements in its offering documentation, thereby giving investors some indication of the nature of the fund.

The net asset value of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt.

History

Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949. Jones believed that price movements of an individual asset could be seen as having a component due to the overall market and a component due to the performance of the asset itself. To neutralize the effect of overall market movement, he balanced his portfolio by buying assets whose price he expected to be stronger than the market and selling short assets he expected to be weaker than the market. He saw that price movements due to the overall market would be cancelled out, because if the overall market rose, the loss on shorted assets would be cancelled by the additional gain on assets bought and vice-versa. Because the effect is to 'hedge' that part of the risk due to overall market movements, this became known as a hedge fund.

Industry size

Estimates of industry size vary widely due to the lack of central statistics; the lack of a single definition of hedge funds; and the rapid growth of the industry. As a general indicator of scale, the industry may have managed around $2.5 trillion at its peak in the summer of 2008. The credit crunch has caused assets under management (AUM) to fall sharply through a combination of trading losses and the withdrawal of assets from funds by investors.

Fees

A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee) from the fund. A typical manager may charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% of the fund's profit.

Management fees

As with other investment funds, the management fee is calculated as a percentage of the fund's net asset value. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. Management fees are usually expressed as an annual percentage but calculated and paid monthly or quarterly.

The business models of most hedge fund managers provide for the management fee to cover the operating costs of the manager, leaving the performance fee for employee bonuses. However, in large funds the management fees may form a significant part of the manager's profit.

Performance fees

Performance fees (or "incentive fees") are one of the defining characteristics of hedge funds. The manager's performance fee is calculated as a percentage of the fund's profits, usually counting both realized and unrealized profits. By incentivising the manager to generate returns, performance fees are intended to align the interests of manager and investor more closely than flat fees do. In the business models of most managers, the performance fee is largely available for staff bonuses and so can be extremely lucrative for managers who perform well. Several publications publish annual estimates of the earnings of top hedge fund managers.

Typically, hedge funds charge 20% of returns as a performance fee. However, the range is wide with highly regarded managers charging higher fees. For example Steven Cohen's SAC Capital Partners charges a 35-50% performance fee, while Jim Simons' Medallion Fund charged a 45% performance fee.

Performance fees have been criticized by many people, including notable investor Warren Buffett, who believe that, by allowing managers to take a share of profit but providing no mechanism for them to share losses, performance fees give managers an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark.

As the hedge fund remuneration structure is highly attractive it has been joked that hedge funds are best viewed "... not as a unique asset class but as a unique ‘fee structure’".

High water marks

A high water mark (or "loss carryforward provision") is often applied to a performance fee calculation. This means that the manager only receives performance fees on increases in the net asset value of the fund in excess of the highest net asset value it has previously achieved. For example, if a fund were launched at a net asset value per share of $100, which then rose to $120 in its first year, a performance fee would be payable on the $20 return for each share. If the next year it dropped to $110, no fee is payable. If in the third year the NAV per share rises to $130, a performance fee will be payable only on the $10 return from $120 (the high water mark) to $130 rather than on the full return during that year from $110 to $130.

This measure is intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. If a high water mark is not used, a fund that ends alternate years at $100 and $110 would generate a performance fee every other year, enriching the manager but not the investors.

The mechanism does not provide complete protection to investors: a manager who has lost a significant percentage of the fund's value may close the fund and start again with a clean slate, rather than continue working for no performance fee until the loss has been made good. This tactic is dependent on the manager's ability to persuade investors to trust him or her with their money in the new fund.

Hurdle rates

Some managers specify a hurdle rate, signifying that they will not charge a performance fee until the fund's annualized performance exceeds a benchmark rate, such as T-bill yield, LIBOR or a fixed percentage. This links performance fees to the ability of the manager to provide a higher return than an alternative, usually lower risk, investment.

With a "soft" hurdle, a performance fee is charged on the entire annualized return if the hurdle rate is cleared. With a "hard" hurdle, a performance fee is only charged on returns above the hurdle rate. Prior to the credit crisis of 2008, demand for hedge funds tended to outstrip supply, making hurdle rates relatively rare.

Withdrawal/Redemption fees

Some funds charge investors a redemption fee (or "withdrawal fee" or "surrender charge") if they withdraw money from the fund. Where a redemption fee exists, it is often charged only during a certain period of time (typically one year) following the investment, or to withdrawals representing a specified portion of an investment.

The purpose of the fee is to discourage short-term investment in the fund, thereby reducing turnover and allowing the use of more complex, illiquid or long-term strategies. The fee may also dissuade investors from withdrawing funds after periods of poor performance.

Unlike management and performance fees, redemption fees are usually retained by the fund and therefore directly benefit the remaining investors rather than the manager.

Strategies

Hedge funds employ many different trading strategies, which are classified in many different ways, with no standard system used. Each strategy can be said to be built from a number of different elements:

• Style: global macro, directional, event driven, relative value (arbitrage), managed futures (CTA)
• Market: equity, fixed income, commodity, currency
• Instrument: long/short, futures, options,swaps
• Exposure: directional, market neutral
• Sector: emerging market, technology, healthcare etc.
• Method: discretionary/qualitative (where the individual investments are selected by managers), systematic/quantitative (or "quant" - where the investments are selected according to numerical methods using a computerized system)
• Diversification: multi manager, multi strategy, multi fund, multi market

The four main strategy groups are based on the investment style and have their own risk and return characteristics. The most common label for a hedge fund is "long/short equity", meaning that the fund takes both long and short positions in shares traded on public stock exchanges.

Global macro

(Macro, Trading) Anticipate to global macroeconomic events using all markets and instruments.

• Discretionary macro - trading is done by investment managers instead of generated by software.
• Systematic macro - trading is done purely mathematically, generated by software without human intervention.
  • Commodity Trading Advisors (CTA, Managed futures, Trading) - trading in futures (or options contracts) in commodity markets.
  • Systematic diversified - trading in diversified markets.
  • Systematic currency - trading in currency markets.
  • Trend following - profit from long-term or short-term trends.
  • Non-trend following (Counter trend) - profit from trend reversals.
• Multi strategy - combination of discretionary and systematic macro.

Directional

(Equity hedge) Hedged investments with exposure to the equity market.

• Long / short equity (Equity hedge) - long equity positions hedged with short sales of stocks or stock market index options.
• Emerging markets - specialized in emerging markets, such as China, India etc.
• Sector funds - expertise in niche areas such as technology, healthcare, biotechnology, pharmaceuticals, energy, basic materials.
• Fundamental growth - invest in companies with more earnings growth than the broad equity market.
• Fundamental value - invest in undervalued companies.
• Quantitative Directional - equity trading using quantitative techniques.
• Short bias - take advantage of declining equity markets using short positions.
• Multi strategy - diversification through different styles to reduce risk.

Event driven

(Special situations) Exploit pricing inefficiencies caused by anticipated specific corporate events.

• Distressed securities (Distressed debt) - specialized in companies trading at discounts to their value because of (potential) bankruptcy.
• Merger arbitrage (Risk arbitrage) - exploit pricing inefficiencies between merging companies.
• Special situations - specialized in restructuring companies or companies engaged in a corporate transaction.
• Multi strategy - diversification through different styles to reduce risk.
• Credit arbitrage - specialized in corporate fixed income securities.
• Regulation D - specialized in private equities.
• Activist - take large positions in companies and use the ownership to be active in the management

Relative value

(Arbitrage, Market neutral) Exploit pricing inefficiencies between related assets that are mispriced.

• Fixed income arbitrage - exploit pricing inefficiencies between related fixed income securities.
• Equity market neutral (Equity arbitrage) - being market neutral by maintaining a close balance between long and short positions.
• Convertible arbitrage - exploit pricing inefficiencies between convertible securities and the corresponding stocks.
• Fixed Income corporate - fixed income arbitrage strategy using corporate fixed income instruments.
• Asset-backed securities (Fixed Income asset backed) - fixed income arbitrage strategy using asset-backed securities.
• Credit long / short - as long / short equity but in credit markets instead of equity markets.
• Statistical arbitrage - equity market neutral strategy using statistical models.
• Volatility arbitrage - exploit the change in implied volatility instead of the change in price.
• Yield alternatives - non fixed income arbitrage strategies based on the yield instead of the price.
• Multi strategy - diversification through different styles to reduce risk.
• Regulatory Arbitrage - the practice of taking advantage of regulatory differences between two or more markets.

Under certain circumstances an investor can completely hedge the risks of an investment, leaving pure profit. For example, at one time it was possible for exchange traders to buy shares of, say, IBM on one exchange and simultaneously sell them on another exchange, leaving pure profit. Competition among investors has leached away such profits, leaving hedge fund managers with trades that are partially hedged, at best. These trades still contain residual risks which can be considerable.

Miscellaneous

• Fund of hedge funds (Multi manager) - a hedge fund with a diversified portfolio of numerous underlying hedge funds to reduce risk.
• Fund of fund of hedge funds (F3, F cube) - ultra diversified by investing in other funds of hedge funds.
• Multi strategy - a hedge fund exploiting a combination of different hedge fund strategies to reduce market risk.
• Multi manager - a hedge fund where the investment is spread along separate sub managers investing in their own strategy.
• 130-30 funds - unhedged equity fund with 130% long and 30% short positions, the market exposure is 100%.
• Long only absolute return funds - partly hedged fund excluding short selling but allow derivatives.

Hedge fund risk

Investing in certain types of hedge fund can be a riskier proposition than investing in a regulated fund, despite a "hedge" being a means of reducing the risk of a bet or investment. Many hedge funds have some of these characteristics:

Leverage - in addition to money invested into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing sums many times greater than the initial investment. If a hedge fund has borrowed $9 for every $1 received from investors, a loss of only 10% of the value of the investments of the hedge fund will wipe out 100% of the value of the investor's stake in the fund, once the creditors have called in their loans. In September 1998, shortly before its collapse, Long Term Capital Management had $125 billion of assets on a base of $4 billion of investors' money, a leverage of over 30 times. It also had off-balance sheet positions with a notional value of approximately $1 trillion.

Short selling - due to the nature of short selling, the losses that can be incurred on a losing bet are theoretically limitless, unless the short position directly hedges a corresponding long position. Therefore, where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns against it. Ordinary funds very rarely use short selling in this way.

Appetite for risk - hedge funds are culturally more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities and collateralized debt obligations based on sub-prime mortgages.

Lack of transparency - hedge funds are secretive entities with few public disclosure requirements. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision.

Lack of regulation - hedge funds are not subject to as much oversight from financial regulators as regulated funds, and therefore some may carry undisclosed structural risks.

Investors in hedge funds are, in most countries, required to be sophisticated investors who will be aware of the risk implications of these factors. They are willing to take these risks because of the corresponding rewards: leverage amplifies profits as well as losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns; secrecy helps to prevent imitation by competitors; and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis.

One approach to diagnosing hedge fund risk is operational due diligence.

Hedge fund structure

A hedge fund is a vehicle for holding and investing the money of its investors. The fund itself has no employees and no assets other than its investment portfolio and cash. The portfolio is managed by the investment manager, which is the actual business and has employees. To say that a person works at a hedge fund is not technically correct, as they are employed by the investment manager.

As well as the investment manager, the functions of a hedge fund are delegated to a number of other service providers. The most common service providers are:

Prime broker – prime brokerage services include lending money, acting as counterparty to derivative contracts, lending securities for the purpose of short selling, trade execution, clearing and settlement. Many prime brokers also provide custody services. Prime brokers are typically parts of large investment banks.

Administrator – the administrator typically deals with the issue and redemption of interests and shares, calculates the net asset value of the fund and performs related back office functions. In some funds, particularly in the U.S., some of these functions are performed by the investment manager, a practice that gives rise to a potential conflict of interest inherent in having the investment manager both determine the NAV and benefit from its increase through performance fees. Outside of the U.S. regulations often require this role to be taken by a third party.

Distributor - the distributor is responsible for marketing the fund to potential investors. Frequently this role is taken by the investment manager.

Domicile

The legal structure of a specific hedge fund – in particular its domicile and the type of legal entity used – is usually determined by the tax environment of the fund’s expected investors. Regulatory considerations will also play a role. Many hedge funds are established in offshore financial centres so that the fund can avoid paying tax on the increase in the value of its portfolio. An investor will still pay tax on any profit it makes when it realizes its investment, and the investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund.

At the end of 2008, a half of the number of hedge funds were registered offshore. The most popular offshore location was the Cayman Islands (67% of number of offshore funds), followed by British Virgin Islands (11%) and Bermuda (11%). The other offshore centers are the Isle of Man, Luxembourg and Mauritius. The US was the most popular onshore location (with funds mostly registered in Delaware) accounting for 64% of the number of onshore funds, followed by Europe with 16%.

Investment manager locations

In contrast to the funds themselves, investment managers are primarily located onshore in order to draw on the major pools of financial talent and to be close to investors. With the bulk of hedge fund investment coming from the US East coast – principally New York City and the Gold Coast area of Connecticut – this has become the leading location for hedge fund managers. It was estimated there were 7,000 investment managers in the United States in 2004.

London is Europe’s leading centre for hedge fund managers, with three-quarters of European hedge fund investments, about $300bn, at the end of 2008. Asia, and more particularly China, is taking on a more important role as a source of funds for the global hedge fund industry. The UK and the US are leading locations for management of Asian hedge funds' assets with around a quarter of the total each.

The legal entity

Limited partnerships are principally used for hedge funds aimed at US-based investors who pay tax, as the investors will receive relatively favorable tax treatment in the US. The general partner of the limited partnership is typically the investment manager (though is sometimes an offshore corporation) and the investors are the limited partners. Offshore corporate funds are used for non-US investors and US entities that do not pay tax (such as pension funds), as such investors do not receive the same tax benefits from investing in a limited partnership. Unit trusts are typically marketed to Japanese investors. Other than taxation, the type of entity used does not have a significant bearing on the nature of the fund.

Many hedge funds are structured as master-feeder funds. In such a structure the investors will invest into a feeder fund which will in turn invest all of its assets into the master fund. The assets of the master fund will then be managed by the investment manager in the usual way. This allows several feeder funds (e.g. an offshore corporate fund, a US limited partnership and a unit trust) to invest into the same master fund, allowing an investment manager the benefit of managing the assets of a single entity while giving all investors the best possible tax treatment.

The investment manager, which will have organized the establishment of the hedge fund, may retain an interest in the hedge fund, either as the general partner of a limited partnership or as the holder of “founder shares” in a corporate fund. Founder shares typically have no economic rights, and voting rights over only a limited range of issues, such as selection of the investment manager. The fund’s strategic decisions are taken by the board of directors of the fund, which is independent but generally loyal to the investment manager.

Open-ended nature

Hedge funds are typically open-ended, in that the fund will periodically issue additional partnership interests or shares directly to new investors, the price of each being the net asset value (“NAV”) per interest/share. To realize the investment, the investor will redeem the interests or shares at the NAV per interest/share prevailing at that time. Therefore, if the value of the underlying investments has increased (and the NAV per interest/share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Investors do not typically trade shares or interests among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund, which has a limited number of shares which are traded among investors, and which distributes its profits.

Listed funds

Corporate hedge funds sometimes list their shares on smaller stock exchanges, such as the Irish Stock Exchange, as this provides a low level of regulatory oversight that is required by some investors. Shares in the listed hedge fund are not generally traded on the exchange.

A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an investment manager. Although widely reported as a "hedge-fund IPO", the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.

Regulatory issues

Part of what gives hedge funds their competitive edge, and their cachet in the public imagination, is that they straddle multiple definitions and categories; some aspects of their dealings are well-regulated, others are unregulated or at best quasi-regulated.

US regulation

The typical public investment company in the United States is required to be registered with the U.S. Securities and Exchange Commission (SEC). Mutual funds are the most common type of registered investment companies. Aside from registration and reporting requirements, investment companies are subject to strict limitations on short-selling and the use of leverage. There are other limitations and restrictions placed on public investment company managers, including the prohibition on charging incentive or performance fees.

Although hedge funds fall within the statutory definition of an investment company, the limited-access, private nature of hedge funds permits them to operate pursuant to exemptions from the registration requirements. The two major exemptions are set forth in Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940. Those exemptions are for funds with 100 or fewer investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7 Fund"). A qualified purchaser is an individual with over US$5,000,000 in investment assets. (Some institutional investors also qualify as accredited investors or qualified purchasers.) A 3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited number of investors. However, a 3(c)7 fund with more than 499 investors must register its securities with the SEC. Both types of funds can charge performance or incentive fees.

In order to comply with 3(c)(1) or 3(c)(7), hedge funds are sold via private placement under the Securities Act of 1933. Thus interests in a hedge fund cannot be offered or advertised to the general public, and are normally offered under Regulation D. Although it is possible to have non-accredited investors in a hedge fund, the exemptions under the Investment Company Act, combined with the restrictions contained in Regulation D, effectively require hedge funds to be offered solely to accredited investors. An accredited investor is an individual person with a minimum net worth of US $1,000,000 or, alternatively, a minimum income of US$200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. For banks and corporate entities, the minimum net worth is $5,000,000 in invested assets.

The regulatory landscape for Investment Advisors is changing, and there have been attempts to register hedge fund investment managers. There are numerous issues surrounding these proposed requirements. One issue of importance to hedge fund managers is the requirement that a client who is charged an incentive fee must be a "qualified client" under Advisers Act Rule 205-3. To be a qualified client, an individual must have US$750,000 in assets invested with the adviser or a net worth in excess of US$1.5 million, or be one of certain high-level employees of the investment adviser.

For the funds, the tradeoff of operating under these exemptions is that they have fewer investors to sell to, but they have few government-imposed restrictions on their investment strategies. The presumption is that hedge funds are pursuing more risky strategies, which may or may not be true depending on the fund, and that the ability to invest in these funds should be restricted to wealthier investors who are presumed to be more sophisticated and who have the financial reserves to absorb a possible loss.

In December 2004, the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers Act. The requirement, with minor exceptions, applied to firms managing in excess of US$25,000,000 with over 15 investors. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry. The rule change was challenged in court by a hedge fund manager, and in June 2006, the U.S. Court of Appeals for the District of Columbia overturned it and sent it back to the agency to be reviewed. See Goldstein v. SEC.

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

In February 2007, the President's Working Group on Financial Markets rejected further regulation of hedge funds and said that the industry should instead follow voluntary guidelines.

Comparison to private equity funds

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

Between 2004 and February 2006 some hedge funds adopted 25 month lock-up rules expressly to exempt themselves from the SEC's new registration requirements and cause them to fall under the registration exemption that had been intended to exempt private equity funds.

Comparison to U.S. mutual funds

Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to invest). However, there are many differences between the two, including:

• Mutual funds are regulated by the SEC, while hedge funds are not
• A hedge fund investor must be an accredited investor with certain exceptions (employees, etc.)
• Mutual funds must price and be liquid on a daily basis

Some hedge funds that are based offshore report their prices to the Financial Times, but for most there is no method of ascertaining pricing on a regular basis. Additionally, mutual funds must have a prospectus available to anyone that requests one (either electronically or via US postal mail), and must disclose their asset allocation quarterly, while hedge funds do not have to abide by these terms.

Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time where the total returns are generated (net of fees) for their investors and then returned when the term ends, through a passthrough requiring CPAs and US Tax W-forms. Hedge fund investors tolerate these policies because hedge funds are expected to generate higher total returns for their investors versus mutual funds.

Recently, however, the mutual fund industry has created products with features that have traditionally only been found in hedge funds.

Mutual funds have appeared which utilize some of the trading strategies noted above. Grizzly Short Fund (GRZZX), for example, is always net short, while Arbitrage Fund (ARBFX) specializes in merger arbitrage. Such funds are SEC regulated, but they offer hedge fund strategies and protection for mutual fund investors.

Also, a few mutual funds have introduced performance-based fees, where the compensation to the manager is based on the performance of the fund. However, under Section 205(b) of the Investment Advisers Act of 1940, such compensation is limited to so-called "fulcrum fees". Under these arrangements, fees can be performance-based so long as they increase and decrease symmetrically.

For example, the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves, within limits and symmetrically, similarly to a hedge fund "0 and 50" fee: A 0% management fee coupled with a 50% performance fee if the fund outperforms its benchmark index. However, the 125 bp base fee is reduced (but not below zero) by 50% of underperformance and increased (but not to more than 250 bp) by 50% of outperformance.

Offshore regulation

Many offshore centers are keen to encourage the establishment of hedge funds. To do this they offer some combination of professional services, a favorable tax environment, and business-friendly regulation. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin Islands and Bermuda. The Cayman Islands have been estimated to be home to about 75% of world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM.

Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centres. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager.

Many offshore hedge funds, such as the Soros funds, are structured as mutual funds rather than as limited partnerships.

Proposed US regulation

Hedge funds are exempt from regulation in the United States. Several bills have been introduced in the 110th Congress (2007-08), however, relating to such funds. Among them are:

• S. 681, a bill to restrict the use of offshore tax havens and abusive tax shelters to inappropriately avoid Federal taxation;
• H.R. 3417, which would establish a Commission on the Tax Treatment of Hedge Funds and Private Equity to investigate imposing regulations;
• S. 1402, a bill to amend the Investment Advisors Act of 1940, with respect to the exemption to registration requirements for hedge funds; and
• S. 1624, a bill to amend the Internal Revenue Code of 1986 to provide that the exception from the treatment of publicly traded partnerships as corporations for partnerships with passive-type income shall not apply to partnerships directly or indirectly deriving income from providing investment adviser and related asset management services.
• S. 3268, a bill to amend the Commodity Exchange Act to prevent excessive price speculation with respect to energy commodities. The bill would give the federal regulator of futures markets the resources to detect, prevent, and punish price manipulation and excessive speculation.

None of the bills has received serious consideration yet.

Hedge fund indices

There are many indices that track the hedge fund industry, and these fall into three main categories. In their historical order of development they are Non-investable, Investable and Clone.

In traditional equity investment, indices play a central and unambiguous role. They are widely accepted as representative, and products such as futures and ETFs provide investable access to them in most developed markets. However hedge funds are illiquid, heterogenous and ephemeral, which makes it hard to construct a satisfactory index. Non-investable indices are representative, but due to various biases their quoted returns may not be available in practice. Investable indices achieve liquidity at the expense of limited representativeness. Clone indices seek to replicate some statistical properties of hedgefunds but are not directly based on them. None of these approaches is wholly satisfactory.

Non-investable indices

Non-investable indices are indicative in nature, and aim to represent the performance of some database of hedgefunds using some measure such as mean, median or weighted mean from a hedge fund database. The databases have diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different indices.

Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list of biases.

Funds’ participation in a database is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money.

The short lifetimes of many hedge funds means that there are many new entrants and many departures each year, which raises the problem of survivorship bias. If we examine only funds that have survived to the present, we will overestimate past returns because many of the worst-performing funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial.

When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favorable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias” or “backfill bias”.

Investable indices

Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. To create an investable index, the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. When investors buy these products the index provider makes the investments in the underlying funds. This makes an investable index similar in some ways to a fund of hedge funds portfolio.

Only Hedge Funds that agree to accept investments on terms acceptable to the constructor of the index are included in the index, so that the provider can sell products based on it. This guarantees that the indices are investable, which is an attractive property for an index because it makes the index more relevant to the choices available to investors in practice.

However, investable indices do not represent the total universe of hedge funds. Most seriously they may under-represent the more successful managers because these may find the index terms unattractive, for example due to reduced fees or onerous redemption terms being demanded by the provider.

Clone indices

The most recent addition to the field approach the problem in a different manner. Instead of reflecting the performance of actual hedgefunds they take a statistical approach to the analysis of historic hedgefund returns, and use this to construct a model of how hedgefund returns respond to the movements of various investable financial assets. This model is then used to construct an investable portfolio of those assets. This makes the index investable, and in principle they can be as representative as the hedgefund database from which they were constructed.

Unfortunately they rely on a statistical modelling process. As clone indices have are relatively short history it is not yet possible to know how reliable this process will be in practice.

Debates and controversies

Systemic risk

Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital Management (LTCM) in 1998, which necessitated a bailout coordinated (but not financed) by the U.S. Federal Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster. The excessive leverage (through derivatives) that can be used by hedge funds to achieve their return is outlined as one of the main factors of the hedge funds' contribution to systemic risk.

The ECB (European Central Bank) issued a warning in June 2006 on hedge fund risk for financial stability and systemic risk: "... the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability which warrants close monitoring despite the essential lack of any possible remedies. This risk is further magnified by evidence that broad hedge fund investment strategies have also become increasingly correlated, thereby further increasing the potential adverse effects of disorderly exits from crowded trades." However the ECB statement has been disputed by parts of the financial industry.

The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge funds in June 2007. The funds invested in mortgage-backed securities. The funds' financial problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside assistance. It was the largest fund bailout since Long Term Capital Management's collapse in 1998. The U.S. Securities and Exchange commission is investigating.

Transparency

As private, lightly regulated entities, hedge funds are not obliged to disclose their activities to third parties. This is in contrast to a regulated mutual fund (or unit trust) which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment advisor of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, while several hedge funds are offer very limited transparency even to investors.

Some hedge funds, mainly American, do not use third parties either as the custodian of their assets or as their administrator (who will calculate the NAV of the fund). This can lead to conflicts of interest, and in extreme cases can assist fraud. In a recent example, Kirk Wright of International Management Associates has been accused of mail fraud and other securities violations which allegedly defrauded clients of close to $180 million. In December 2008, Bernard Madoff was arrested for running a $50 billion Ponzi scheme.

Market capacity

The rather disappointing hedge fund performance of the past five years calls into question the alternative investment industry's value proposition. Alpha appears to have been becoming rarer for two related reasons. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more managers, which may dilute the talent available in the industry, though these causes are disputed.

U.S. investigations

In June 2006, the Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts.

The SEC is also focusing resources on investigating insider trading by hedge funds.

Performance measurement

Performance statistics are hard to obtain because of restrictions on advertising and the lack of centralised collection. However summaries are occasionally available in various journals.

The question of how performance should be adjusted for the amount of risk that is being taken has led to literature that is both abundant and controversial. Traditional indicators (Sharpe, Treynor, Jensen) work best when returns follow a symmetrical distribution. In that case, risk is represented by the standard deviation. Unfortunately, hedge fund returns are not normally distributed, and hedge fund return series are autocorrelated. Consequently, traditional performance measures suffer from theoretical problems when they are applied to hedge funds, making them even less reliable than is suggested by the shortness of the available return series.

Several innovative performance measures have been introduced in an attempt to deal with this problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003), Omega by Keating and Shadwick (2002), Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004), and Kappa by Kaplan and Knowles (2004). However, there is no consensus on the most appropriate absolute performance measure, and traditional performance measures are still widely used in the industry.

Value in mean/variance efficient portfolios

According to Modern Portfolio Theory, rational investors will seek to hold portfolios that are mean/variance efficient (that is, portfolios offer the highest level of return per unit of risk, and the lowest level of risk per unit of return). One of the attractive features of hedge funds (in particular market neutral and similar funds) is that they sometimes have a modest correlation with traditional assets such as equities. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers, reducing overall portfolio risk.

However, there are three reasons why one might not wish to allocate a high proportion of assets into hedge funds. These reasons are:

1. Hedge funds are highly individual and it is hard to estimate the likely returns or risks;
2. Hedge funds’ low correlation with other assets tends to dissipate during stressful market events, making them much less useful for diversification than they may appear; and
3. Hedge fund returns are reduced considerably by the high fee structures that are typically charged.

Several studies have suggested that hedgefunds are sufficiently diversifying to merit inclusion in investor portfolios, but this is disputed for examply by Mark Krtitzman who performed a mean-variance optimization calculation on an opportunity set that consisted of a stock index fund, a bond index fund, and ten hypothetical hedge funds. The optimizer found that a mean-variance effient portfolio did not contain any allocation to hedge funds, largely because of the impact of performance fees. To demonstrate this, Kritzman repeated the optimization using an assumption that the hedge funds incurred no performance fees. The result from this second optimization was an allocation of 74% to hedge funds.

The other factor reducing the attractiveness of hedge funds in a diversified portfolio is that they tend to under-perform during equity bear markets, just when an investor needs part of their portfolio to add value. For example, in January-September 2008, the Credit Suisse/Tremont Hedge Fund Index was down 9.87%. According to the same index series, even "dedicated short bias" funds had a return of -6.08% during September 2008. In other words, even though low average correlations may appear to make hedge funds attractive this may not work in turbulent period, for example around the collapse of Lehman Brothers in September 2008.

Hedge funds posted disappointing returns in 2008, but the average hedge fund return of -18.65% (the HFRI Fund Weighted Composite Index return) was far better than the returns generated by most assets other than cash. The S&P 500 total return was -37.00% in 2008, and that was one of the best performing equity indices in the world. Several equity markets lost more than half their value. Most foreign and domestic corporate debt indices also suffered in 2008, posting losses significantly worse than the average hedge fund. Mutual funds also performed much worse than hedge funds in 2008. According to Lipper, the average US domestic equity mutual fund decreased 37.6% in 2008. The average international equity mutual fund declined 45.8%. The average sector mutual fund dropped 39.7%. The average China mutual fund declined 52.7% and the average Latin America mutual fund plummeted 57.3%. Real estate, both residential and commercial, also suffered significant drops in 2008. In summary, hedge funds outperformed many similarly-risky investment options in 2008.

Notable hedge fund firms

• Amaranth Advisors
• Bridgewater Associates
• Citadel Investment Group
• D.E. Shaw
• Fortress Investment Group
• Long-Term Capital Management
• Man Group
• Renaissance Technologies
• Soros Fund Management
• The Children's Investment Fund Management (TCI)

External links

• Center for International Securities and Derivatives Markets at the University of Massachusetts Amherst is a research center specializing in hedge fund research
• Hedge Fund Research Initiative of the International Center for Finance at the Yale School of Management
• The Hedge Fund Journal - covers the European hedge fund industry; from London, UK