HEDGE FUND OVERVIEW

In 1996 while hedge funds seemed to be surfacing as fast as new McDonald's franchises, Martin Baker wrote a now famous book titled 'A Fool and His Money', where he used his sarcastic humor to create a formula for creating hedge funds (Baker, 1996):

"Take a speculative cocktail shaker.  Add four parts public ignorance and 33 parts greed.  Toss in a little perceived genius.  If you don't have any freshly ground perceived genius at hand, a little dried genius status will do.  Season generously with mystique. Add apparent publicity shyness to taste.  Serve in opaque tumbler of awed, ill informed media coverage" ⁵.

Though subjective, Mr. Baker's definition is a decent representation to the reputation of the hedge fund industry.  

A hedge fund is a general term describing a unit of trust³ or a pool of investments which utilizes complex hedging and arbitrage methods to make trades in the marketplace¹. Often times, hedge funds are partnerships known to yield high returns and large gains sometimes by exploiting incongruities in the marketplace³. The strategies they use can involve a high degree of risk but exert a large amount of power and influence into the capital markets, while also somehow maintaining a low profile and remaining a commonly misunderstood investment vehicle.   

A hedge fund is not a legal term ¹ and it is not subject to the typical regulations for investment companies such as mutual funds ². In fact, the term hedging refers to the practice of trying to reduce risks, so hedge funds will utilize hedging while simultaneously trying to maximize returns ⁷.  

Typically (especially in European nations ¹), hedge funds are comprised by the world's elite first class by accepting only accredited investors, serving as a commonplace for incredibly wealthy and sophisticated investors ¹. This is likely due to the fact that hedge funds require a very large initial investment ⁷. ‘Membership' into a hedge fund generally requires a minimum subscription level ¹ or a high minimum investment, as well as, dues for any performance related fees to the managers ³.  

The investments are not liquid, as they often have a minimum length of investment of one year or more, ⁷ and there is a seemingly endless limit on the investments from which they can choose from ². Many insurance companies, private banks, pension funds, endowments, families, and high net-worth individuals invest in hedge funds to generate more sizable returns ⁶. Other benefits of investing into a hedge fund include; the ability to generate returns in both rising and falling equity and bond markets, reduce portfolio risk, potentiality to make more choices for strategies used, and to experience an attractive long-term investment solution ⁶.   

Some of the features of hedge funds stem from the first hedge fund, which was created by Alfred W. Jones, dating back to 1949 ². Some of these features include: the efforts to hedge away market risk, utilize leverage to increase returns, the attempt to track down absolute returns ⁴, and the use of certain volatile trading methods, such as arbitrage ⁶, short selling, and derivatives ⁴.  

Other common characteristics include their participation in the process of extensive research to determine which stocks to select and in creating an incentive fee structure. One additional characteristic of many funds today is that they are using management investment, meaning that the owners (i.e. Jones) actually invest their own capital into the fund ⁴. This is thought to help align the objectives of the managers and investors to ensure trust and a true partnership ⁹.  

Hedge funds aim to provide more flexibility to the investors when constructing a portfolio ⁹. The strategies employed vary from one fund to another, which allows them to provide more customized services and investment exposure. This is thought to be one main reason the industry has been successful ⁹. Hedge funds have been introduced into the banking industry and now banks actually help to set up hedge funds, invest in them, and even trade with them ¹. Many new services have developed from this relationship, including a relatively new banking sector called 'prime brokerage', where settling and clearing of hedge funds is combined and execution services are provided ⁴. Many banks also do capital introductions raising capital for hedge funds or they will create incubators to help successful traders set up hedge funds, and train them in working with investors ⁴.  

Some technical groups in large global banks also develop and implement products around hedge funds and specifically hedge fund linked investments and derivatives ⁴. As of December 2009, there are over 8,000 hedge funds in existence ⁹, which combine to manage more than $2 trillion assets and counting ^(4,9). As the industrie's peak, prior to the credit crisis, there wsa an estimated 10,000 headge funds with over $3 trillion in assets. Of course, due to the lack of centralized data, lack of regulation, and the private nature of the funds, specific statistics are difficult to find. Banks have also shown a recent interest in acquiring such funds, i.e. JP Morgan/Highbridge Capital Management⁴.

What is a hedge fund NOT?  

Many people also have a misconception that hedge funds operate in the most extreme volatile ways, with only incredibly risky techniques, and while some do, many do not. In fact, the hedge fund industry has generated large returns over time, with less volatility and less risk of loss than equities ¹.  

Distinction between hedge funds and private investment / private equity groups:  

People often erroneously qualify hedge funds with private investment/private equity groups and vice versa, but they have different characteristics, goals, and trends ¹⁰. For this reason, a clear distinction between the two should be made and is highlighted below in the following points:

 

• Both private equity funds and hedge funds currently have more assets and money under management than ever before and they are both constantly looking for new deals so, by nature, the two business' do overlap.

 

• Where private equity companies strive to purchase all of the equity of target companies, hedge funds are not limited to working with only equity investments. In fact, a hedge fund can even invest in the debt of a private equity company.  

 

• The length of investments is different as well. Hedge funds like to see turn around times of 6-18 months, where investments by private equity companies might be held for 7 years or even longer, in some situations ¹⁰.

 

• When investors put their money into a hedge fund, they can usually take their money out much quicker than they would be able to with a private equity company ¹⁰.  

 

• Private equity companies put a large effort into the research of an industry as well as a company and its strategic direction prior to investing in them, than hedge funds do. Hedge funds focus more on hold periods, returns, and hedging strategies ¹⁰.

 

• Hedge funds tend to execute their due diligence much more rapidly than private equity companies who are more detailed and customized in their approach ¹⁰.  

 

• Hedge funds have a more straight forward methodology and strive for a higher level of return in their investments than do private equity companies who normally adjust their rate of return on factors including; market share, profitability, revenue, and valuation statistics ¹⁰.  

 

• Private equity companies will exercise a much greater level of control over many companies which they buy equity of. They will often come in and replace the senior management and/or control the board of directors. In hedge fund investments, management is often left in place while that fund strives toward a position of buy and sell trading in debt or equity ¹⁰.

 

• Volatility is considered potential toward receiving higher rates of return for hedge funds where private equity companies might steer away from making such risky decisions ¹⁰. Both entities charge sizable fees, but these fees are handled a bit differently between the two investment vehicles. Hedge fund fees are calculated for a shorter time frame and more aggressively, where as private equity funds are much more long term and handled later in the process. This is to emphasize the benefits of the longevity of their investment ¹⁰.  

Distinction between hedge funds and mutual funds:  

Though both of these investment vehicles traditionally receive money from investors and invest that money into other initiatives, mutual funds and hedge funds are subject to very different regulations. Infact, until 2005 hedge funds did not even have to register their securities with the Securities Exchange Commission of the United States (SEC)¹. The following points highlight the distinctions between hedge funds and mutual funds:

 

• One regulation is that a mutual fund must price and be liquid on a daily basis, where as hedge funds do not need to maintain constant liquidity.  

 

• Contrary to the requirements for a mutual fund, a hedge fund investor must be an accredited investor in order to invest their money ².

 

• Hedge funds do not need to report their pricing the way mutual funds do. Mutual funds must disclose their asset allocation on a regular basis ².   
  
  

MAIN FUNCTIONS 

The key goal of any hedge fund is to provide attractive returns and diversified portfolios to high-net-worth investors while minimizing risk ⁹ as well as preserving capital ⁹. They have minimal restrictions on investing in any opportunity which it sees as a way to make gains, sometimes with less risk ⁶, and sometimes using more risk ². The limited restrictions also allow the ability to invest in a broad range of investments, including shares, debts, and commodities ² generating greater returns on their investments ². Hedge funds aim to provide more flexibility to the investors when constructing a portfolio ^{(9, 19)}. Investors¹⁹ find this diversification to be the most valued service of a hedge fund.   

BACKGROUND 

The first hedge fund was created in 1949 by Alfred W. Jones ² who, after extensive research in the forecasting of stock prices, became eager to generate profits, while simultaneously minimizing the risk of losses due to the unpredictability of the market⁴. Mr. Jones, once an academic, diplomat, and journalist ⁴, eventually turned the fund into the first multi-manager hedge fund. As other funds started to emerge, Mr. Jones used certain investment techniques such as short-sales, the sale of a security, (usually when prices fall, which the seller does not own but must borrow), and leveraging (which is the practice of using credit to increase the rate of return on an investment¹). He was also known as the first to use the above mentioned techniques in combination.  

Around 15 years later, it became clear that his fund was outperforming other mutual funds by a tremendous amount because it yielded a much higher rate of return than did those funds ¹. Once hedge funds started forming in the 1950's, they increased in quantity in the 1960's, again in the 1970's and again in, well, each decade since. After the 1980's, different asset classes such as mortgage and derivatives have surfaced and the industry nearly erupted with new funds ⁴. Over time, hedge funds have expanded to encompass other financial instruments and activities. Today, they may still employ incredibly complex hedging techniques, but they are widely recognized for their exclusivity, private status and unregistered investment pools¹.  

While initially hedge funds were comprised almost solely of wealthy individual investors, today's investors into the hedge fund industries are comprised of pensions, universities, charities, and endowments ¹. As previously mentioned, there are over 8,000 hedge funds in existence ⁹ which combine to manage more than $2 trillion assets and counting ^(4,9).  

REGULATION

 

A hedge fund is not a legal term ¹ and it is not subject to the typical regulations for investment companies such as mutual funds ². For example, they do not need to maintain a certain amount of liquidity, fairness is not always assured, their shares need not be redeemable at any time, they do not have as many regulations against conflicts of interest, and they do not have any limit to the amount of leverage they are allowed to use ¹. Most funds are also set up in a way which does not mandate them to have their financial statements audited ¹⁹. Some funds have even moved a large amount of operations off shore which leaves them with limited regulations by their on shore investors ¹⁹. The lack of such regulations allow hedge funds to engage in more risky investment techniques which, in turn, can allow them to receive higher returns than other investment vehicles, such as what mutual funds are able to ¹.  

Hedge funds do, however, need to comply with the anti-fraud laws in accordance with the U.S. federal government ¹. Attempts were made through the ‘Hedge Fund Rule' by the SEC in 2005, to require registration of all shareholders, partners, members, and beneficiaries which was thought to reduce fraud incidence, strengthen compliance, and raise standards ¹. In 2006, courts ruled that the SEC's definition of ‘client' was invalid and that the term 'client' would only refer to the actual funds they manage rather than the investors of those funds. For this reason, hedge fund managers are still excused from registering as long as they do not exceed 15 funds ¹. One regulation, which hedge funds are subject to, states that one must be an accredited investor or a qualified client in order to invest any money ⁹. This regulation is thought to protect middle-class investors.  

INDUSTRY TRENDS

In finance, the trend is simply hedge funds. When considering trends in the financial sector in general, hedge funds are the 'Cadillac' of investment vehicles and seem to be considered the hottest and most 'cutting edge' alternative investment choices.  

Hedge Funds started forming in the 1950's, increasing in quantities in the 1960's, again in the 1970's and again in each decade since.  Of course, due to the lack of centralized data, lack of regulation, and the private nature of the funds, specific statistics are difficult to find. Funds seem to be surfacing all over the world, but have specifically become concentrated in St. James and the Mayfair in London, the Helmsley Building in New York City, and in many parts of Connecticut ⁴.  

After decades of immense growth, the industry showed some decline in late 2008 and the first two quarters in 2009 as the number of assets under management fell by nearly 30%. Most directly, this decline is thought to be a result of massive increases in redemptions, hedge fund liquidations, and negative performance ¹⁹. Some estimates say that as many as 10% of hedge funds have closed their doors in a response to the meltdown ¹⁹. Although they are smaller, hedge funds are thought of as being incredibly resilient and there is not much concern over their continued successes even despite moderate set-backs ⁹. They still remain diversified with a large amount of liquid assets.  

The United States is expected to outperform all other regions in the area of hedge fund management and alternative investments according to a robust survey by Deutsche Bank, while Eastern and Central Europe are projected to perform the poorest ¹⁹. The fee structure for hedge funds can be considered a trend, because although there are certainly differences in the industry, the majority of funds based in the United States charge a standard fee known as the "one-and-twenty". This means that the investor is required to pay 1% of the assets, often broken down into quarterly payments, which is known as the 'management fee', and 20% of the profits incurred, often calculated on an annual basis, which is known as the 'performance fee' ⁹.  

Hedge funds might prosper at unexpected times and there is evidence that they rely far less on the market for returns ⁹ than do other investment vehicles. For example, in the early 1990's, the economy was poor and people were forced to seek returns from areas outside of the traditional investment bank and asset classes while they were not performing to potential. At this time, money began to flow into the hedge funds by investors who had lost faith in the other methods when they noticed that many investment managers were failing to work above the market curve, especially after the costs and fees associated with the trading ⁹.  

Hedge funds were traditionally very specialized when it came to method and focus. Over the last two decades ², many hedge funds have broadened their scope in order to allow more options and styles when working with capital as well as serving a wider client base. The funds label themselves as 'multi-strategy' hedge funds⁴. Historically, funds have been all about numbers, but more recently, technology is becoming more important than ever before as systems must be up-to-date and efficient to allow for efficient high trading volumes. According to a survey by Deutsche Bank, the Macro strategy is expected to be the most widely used strategy with the best performance this year, after it was one of the few strategies that yielded positive returns in 2008 ¹⁹.  

 

CORPORATE STRUCTURE 

 

Hedge funds are unique investment vehicles in that there is very little structure or hierarchy in many of them, and the organizational structure in place is mostly a function of the assets that firm has and how many people it will take to manage them ¹¹. Though there will be some functions which hedge funds will need to cover no matter what, the roles of the employees and their titles will differ greatly in each company ³. In some smaller companies, one employee might handle the tasks of more than one or even two employees in a company with larger trading volume ². For these reasons, it would not be accurate to describe specific career trajectory but rather, some common positions.

In each hedge fund company, there will be at least one President/Partner or Principle who is/are either the founder(s) or owners of that company. This person is also known as the Hedge Fund Manager and is in charge of overseeing everything that takes place in the company, including; the portfolio itself, the investment and transactional decisions, the hiring and training of employees, monitoring the risk of the company's portfolio, and any other duties necessary to ensure the business is running effectively ².

Underneath the Hedge Fund Manager, there are usually portfolio managers, risk managers, financial officers, and operations officers. Portfolio Managers will make important investment decisions for the company and create strategies for managing the money and buying and selling securities ². Research Analysts and Traders will usually report to Portfolio Managers. Analysts will usually create reports and do analysis of the market and work with traders to make educated decisions regarding trades. Traders are the employees who actually buy and sell the financial instruments including (for a hedge fund) stocks, bonds, derivatives, equity, and debt.

Risk Managers can work on their own when in a smaller company but they often manage a group of people to analyze and monitor the fund and ensure that each potential risk is identified and properly planned for. This group is paramount to the hedge fund-investor relationship because it reduces the likelihood of any errors or losses and keeps investors happy and confident in the institution holding their money.

When there is a larger risk group, there are usually Risk Associates who would report to the Manager, as well as Risk Analysts who would be the most junior employees in the team. These employees will do more support monitoring for the risk department. As responsibilities increase, one will utilize a strong analytical knowledge base and sound knowledge in financial products and common risks.

Financial Officers usually manage a team of Analysts and Accountants and is in charge of the company's budget, planning, and record-keeping of the finances while also sometimes getting involved in the balance sheets and the financial risk of the company. Operations Officers also traditionally manage a team of operations employees and work to maintain relationships between the brokers, the banks, and the company ². Operations staff and technical staff work with limited resources to utilize them in the most efficient way, maintaining and monitoring staffing practices, and prioritize requirements ².

Technology is often also in this division and is responsible for developing and implementing the trading systems and applications used to execute the trades. The information technology staff is key to the performance of a hedge fund. Typically, the faster a trade is processed or the highter the frequency of a trading system, the more trades a company will be able to make in one business day, and consequently the more effectively the firm might take advantage of market opportunities.

HEDGE FUND STRATEGIES

 

Hedge funds are traditionally very specialized when it comes to method and focus. Over the last two decades ², many hedge funds have broadened their scope in order to allow more options and styles when working with capital as well as serving a wider client base. The funds label themselves as 'multi-strategy' hedge funds ⁴ and they aim to provide more flexibility to the investors when constructing a portfolio ⁹.

The strategies employed vary from one fund to another which allows them to provide the most customized services and investment exposure. This is thought to be one main reason the industry has been successful ⁹. Each hedge fund has its own investment strategies which establishes the types of investments it will work with and the methods it will employ ². There are currently more than one dozen distinct investment strategies in use by hedge funds, each differing in the degrees of risk, investment returns, and volatility as described below ^(1,6). It is imperative that hedge fund managers and investors are aware of all of the different strategies being used. A successful fund will recognize these differences in order to take advantage of diverse investment opportunities by blending different strategies and asset classes ⁶.

 

Some strategies hedge funds will employ are incredibly volatile which makes it difficult to predict the fund’s performance as a result of their use.

Emerging Markets: The fund invests in either equity or debt in markets that are less established and happen to have unpredictable inflation and growth. This can be a risky strategy because hedging is often not available since short selling is not permitted in many of the emerging markets ⁶.

Macro: This style seeks to generate higher revenue as a result of changes in the global economy. Some changes of interest here are alterations in government policy which impact interest rates, in turn, effecting financial markets such as currency, stocks, and bonds ⁶. Leverage and derivatives are used here as is hedging, but the performance is best indicated by those investments which have been leveraged ⁶. The trades are based on computer generated trading signals, market price changes and are focused on speculative, leveraged bets on currencies, commodities, stocks, and interest rates ⁴.

Short Selling: A commonly implemented and very risky strategy where securities are sold short with intent to buy them back later at a lower price in the future. This happens as a result of a Manager's assessment of the overvaluation of the securities or market, or when lower earnings are anticipated in result of accounting abnormalities, new competition, or new management ¹. This is also often used when bear markets are predicted ⁶.

Other highly volatile strategies, though not as much so as those described above, include aggressive growth and market timing. Moderately volatile strategies are known as special situations, value, and distressed securities.

Aggressive Growth: The fund invests in equities which are expected to see rapid growth in earnings-per-share. Hedging is used by shorting equities where lower earnings are expected and stock indexes have shortened Market Timing: This style allocates assets to varied asset classes by recognizing that Fund Manager's opinion on the outlook of the economy or market at that given time. This will differ within asset classes. Because the market will never be entirely predictable, it is difficult to use this strategy without knowing the timing of entering and exiting markets ⁶.

Special Situations: These funds will invest as a result of a timely events such as a merger, hostile takeover, reorganization, or leveraged buyout, in hopes of benefiting from this when the company's decision has increased their stock price ⁶. These funds will need knowledge of regulations, legal documentation, and sometimes even insider information. This style can also be associated with lengthy investment periods ⁴.

Value: Investments will be made into those securities which are selling at a discounted price and their worth is seen to have potential. This is often a long-term strategy and the securities of interest are normally not historically favored nor are those which have received less attention from analysts ⁶.

 

Distressed Securities: In this case, the fund will buy equity, debt, or trade claims of companies which are performing poorly at discount prices or facing bankruptcy at a discount in hopes of benefiting from the company's true value and the lack of understanding by the general market ^(1,6). Contrary to some popular belief ^{(3, 5)}, some strategies employed by hedge funds have minimal volatility.

Income: Investments are made with intent to yield on current income instead of only on capital gains. This style might use leverage to help them increase potential profit ⁶.

Market Neutral- Arbitrage: This style is used to hedge out market risk by assuming offsetting positions, usually for varied securities within the same issuer in order to capitalize on inefficiencies in the marketplace ⁴. Relative strategies within this category include fixed-income arbitrage, mortgage backed securities, and closed-end fund arbitrage ⁶.

Market Neutral- Securities Hedging: A fund invests equally in both long and short equity portfolios, most often in the same market sectors. This will minimize market risk when done carefully and can also employ leverage ⁶. Strategies can also have a varied level of volatility - at times they will be volatile and at times they will pose little risk on the fund to employ them.

Funds of Hedge Funds: This technique will mix different hedge funds and investment vehicles with varied strategies and asset classes to enable a more stable and timeless investment return on any of the funds individually. This and volatility can actually be controlled with such a mixture. There are registered fund-of-fund companies who are closed end investment companies who pool their money into hedge funds or other pooled investment vehicles. Fund-of-Funds are also associated with more diversification, wider exposure to more hedge funds, and more stable returns and more long term investments.

Opportunistic: This is when the investment theme can vary from one strategy to another as opportunities surface to allow a profit from events such as IPO's and other events.

Multi-Strategy: This approach is diversified because it utilizes multiple different strategies at the same time. Funds broaden their scope in order to allow more options and styles when working with capital and to serve a wider client base ⁶. According to a survey by Deutsche Bank, the Macro strategy is expected to be the most widely used strategy with the best performance this year, after it was one of the few strategies that yielded positive returns in 2008 ¹⁹.