Hedge Funds
A hedge fund is a vehicle for holding and investing the funds of its investors. The fund itself is not a genuine business, having no employees and no assets other than its investment portfolio and a small amount of cash, while its investors are its clients. The portfolio is managed by the investment manager, which has employees and property and which is the actual business. An investment manager is commonly termed a “hedge fund” (e.g. a person may be said to “work at a hedge fund”) but this is not technically correct. An investment manager may have a large number of hedge funds under its management. Although each fund will have 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, from shares, debt and commodities to works of art. The assets under management of a hedge fund can run into many billions of dollars. 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. The net asset value of a fund, or NAV, is the current market value of a fund's holdings, less the fund's liabilities, usually expressed as a per-share amount.
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. Short selling is the practice of selling a financial instrument the seller does not own, in the hope of repurchasing it later at a lower price. Short-sellers attempt to profit from an expected decline in the price of a security. Typically, the short-seller will "borrow" or "rent" the securities to be sold, and later repurchase identical securities for return to the lender. If the security price falls as expected, the short-seller profits from having sold the borrowed securities for more than he later pays for them but if the security price rises, the short seller loses by having to pay more for them than the price at which he sold them. The practice is risky in that prices may rise indefinitely, even beyond the net worth of the short seller. The act of repurchasing is known as "closing" a position. 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.
A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee). Performance fees are closely associated with hedge funds, and are intended to be an incentive for the investment manager to produce the largest returns he can. A typical manager will charge a management fee of 1 to 4% of the fund's net asset value (or "NAV") per annum and a performance fee of 10-50% of the fund's profit (being the increase in its NAV). Performance fees are intended to align the interests of manager and investor better than flat fees that are payable even when performance is poor. However, performance fees have been criticized by many people, including notable investor Warren Buffett for giving managers an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark (This means that the manager only receives performance fees on the value of the fund that exceeds the highest net asset value it has previously achieved) and sometimes limited by a hurdle rate. The mechanism does not provide complete protection to investors: a manager who has lost a significant percentage of the fund's value will often 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.
Some managers charge investors a withdrawal/redemption fee (also known as a surrender charge) if they withdraw money from the fund before a certain period of time has elapsed since the money was invested. The purpose is to encourage long-term investment in the fund: as a fund's investments need to be liquidated to raise cash for withdrawals, the fee allows the fund manager to reduce the turnover of its own investments and invest in more complex, longer-term strategies. The fee also dissuades investors from withdrawing funds after periods of poor performance. The fee is typically known as a "withdrawal fee" where the fund is a limited partnership and a "redemption fee" where the fund is a corporate entity.
Example of popular hedge funds:
* 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 fund 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.
Domicile
The specific legal structure of a 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 tax havens so that the fund can avoid paying tax on the increase in the value of its portfolio. An investor will still pay tax on any profit it makes when it 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 end-2007, 52% of the number of hedge funds were registered offshore. The most popular offshore location was the Cayman Islands (57% of number of offshore funds), followed by British Virgin Islands (16%) and Bermuda (11%). The other offshore centers are the Isle of Man and Mauritius. The US was the most popular onshore location (with funds mostly registered in Delaware) accounting for 65% of the number of onshore funds, followed by Europe with 31%.
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.
Fund Administration
Fund administration is the name given to the set of activities that are carried out in support of the actual process of running a collective investment scheme, whether the scheme is a traditional mutual fund, a hedge fund, Pension fund, unit trust or something in between. Managers of funds often choose to outsource some or all of these activities to external specialist companies; these companies are often known as fund administrators.
These administrative activities would include:
* Calculation of the Net Asset Value (NAV) including the calculation of the funds income and expense accruals
* Preparation of semi-annual and annual accounts
* Maintenance of the fund's financial books and records
* Payment of the funds expenses.
* To reconcile Daily and Monthly Broker Statement
* Settlement of daily Trades, assuring that the proper dividend and interest are received, updating price of securities of client.
* Pricing of Security
* Calculation and payment of dividends and distributions (if required)
* Supervision of the orderly liquidation and dissolution of the fund (if required)
This list is not exhaustive and particularly where a fund manager has chosen to outsource some of these tasks to an external company some or all of the administrative activities of the fund may or may not be described as "fund administration".
Fund Accounting
Fund accounting is the name given to the subset of fund administration activities that are required to or generally expected to be carried out by a qualified professional accountant. Such activities would generally include the valuation of the fund portfolios, calculation of the NAV, preparation of financial statement for audit purposes and the general maintenance of the fund's financial books and records. Local regulations may require that such functions are carried out by a qualified professional, or it may be a requirement of the fund manager or the fund's auditor.
Hedge fund management worldwide
In contrast to the funds themselves, hedge fund managers are primarily located onshore in order to draw on larger pools of financial talent. The US East coast – principally New York City and the Gold Coast area of Connecticut (particularly Stamford and Greenwich) – is the world's leading location for hedge fund managers with approximately double the hedge fund managers of the next largest centre, London.
London is Europe’s leading centre for the management of hedge funds. At the end of 2007, three-quarters of European hedge fund investments, totaling $400bn (£200bn), were managed from London, having grown from $61bn in 2002. Australia was the most important centre for the management of Asia-Pacific hedge funds, with managers located there accounting for approximately a quarter of the $140bn of hedge fund assets managed in the Asia-Pacific region in 2008.
Hedge Funds Vs (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 Securities & Exchange Commission (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
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.
Notable hedge fund management companies
* Amaranth Advisors
* Bridgewater Associates
* Citadel Investment Group
* D.E. Shaw
* Fortress Investment Group
* Goldman Sachs Asset Management
* Long Term Capital Management
* Man Group
* Moore Capital Management
* Renaissance Technologies
* Soros Fund Management
* The Children's Investment Fund Management (TCI)
