Hedge fund

A hedge fund is an investment fund structured to avoid direct regulation and taxation in major
countries and which charges a performance fee based on the increase of the value of the fund's
assets. The assets of a hedge fund will usually be managed by an investment management firm
based in a major financial centre. As a hedge fund is largely unregulated, its investment manager
is able to deploy a wider range of investment strategies and tactics than it could for a regulated
fund, and investing in a hedge fund is therefore considered to carry more risk.

As a hedge fund's investment activities are limited only by the contracts governing the particular
fund, it can make greater use of complex investment strategies such as short selling, entering into
futures, swaps and other derivative contracts and leverage. A hedge fund will often seek to
generate returns that are not closely correlated to those of the broader financial markets by
hedging its investments against adverse moves in those markets.

For the purposes of consumer protection, in most countries hedge funds are prohibited from
marketing to investors who are not professional investors or individuals with sufficient private
wealth, unlike retail funds. They therefore have little incentive to release information to the
general public voluntarily and have acquired a reputation for secrecy.

Since hedge fund assets can run into many billions of dollars and will usually be multiplied by
leverage, their sway over markets, whether they succeed or fail, is potentially substantial and
there is a continuing debate over whether they should be more thoroughly regulated.

Fees

Usually the hedge fund manager will receive both a management fee and a performance fee. As
with other investment funds, the management fee is computed as a percentage of assets under
management. Management fees typically range from 1.5% to 4.0%.

[edit] Performance fees

Performance fees, which give a share of positive returns to the manager, are one of the defining
characteristics of hedge funds. The performance fee is computed as a percentage of the fund's
profits, counting both unrealized profits and actual realized trading profits. Performance fees
exist because investors are usually willing to pay managers more generously when the investors
have themselves made money. For managers who perform well the performance fee is extremely
lucrative.
Typically, hedge funds charge 20% of gross returns as a performance fee, but again the range is
wide, with highly regarded managers demanding higher fees. In particular, Steven Cohen's SAC
Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons'
Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its
flagship Medallion Fund before returning all investors' capital and running solely on its
employees' money.[citations needed]

Managers argue that performance fees help 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 risk, possibly excessive risk, as opposed to high long-term returns. In an
attempt to control these problems, fees are usually limited by high water marks and sometimes
by hurdle rates.

[edit] High water marks

A "High water mark" is often used.[1] This means that the manager does not receive incentive
fees unless the value of the fund exceeds the highest net asset value it has previously achieved.
For example, if a fund was launched at a net asset value (NAV) of 100 and rose to 130 in its first
year, a performance fee would be payable on the 30% return. If the next year it dropped to 120,
no fee is payable. If in the third year the NAV rises to 143, a performance fee will be payable
only on the 10% return from 130 to 143 rather than on the full return from 120 to 143.

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 performance fee every other year,
enriching the manager but not the investors. However, this mechanism does not provide
complete protection to investors: a manager who has lost money may simply decide to close the
fund and start again with a clean slate -- provided that he can persuade investors to trust him with
their money. A high water mark is sometimes referred to as a "Loss Carryforward Provision."

Poorly performing funds frequently close down rather than work without fees, as would be
required by their high water mark policies. [2]

[edit] Hurdle rates

Some funds also specify a 'hurdle', which signifies that the fund will not charge a performance
fee until its annualized performance exceeds a benchmark rate, such as T-bills or a fixed
percentage, over some period. This links performance fees to the ability of the manager to do
better than the investor would have done if he had put the money in a bank account.

Though logically appealing, this practice has diminished as demand for hedge funds has
outstripped supply and hurdles are now rare. [citations needed]
[edit] Strategies

Hedge funds do not constitute a homogeneous asset class. The bulk of hedge funds describe
themselves as long / short equity, perhaps because this is the least specific of the available
descriptions, but many different approaches are used taking different exposures, exploiting
different market opportunities, using different techniques and different instruments:

 Global macro – seeking assets that are mispriced relative to global alternatives.
 Arbitrage – seeking related assets that have deviated from some anticipated relationship.
o Convertible arbitrage – between a convertible bond and equity.
o Fixed income arbitrage – between related bonds.
o Risk arbitrage – between securities whose prices appear to imply different probabilities
for an event.
o Statistical arbitrage (or 'StatArb') – between securities that have deviated from some
statistically estimated relationship.
o Derivative arbitrage – between a derivative security and the underlying security.
 Long / short equity – generic term covering all hedged investment in equities.
o Short bias – emphasizing or investing solely short.
o Equity market neutral – maintaining a close balance between long and short positions.
 Event driven – specialized in the analysis of a particular kind of event
o Distressed securities – companies that are or may become bankrupt
o Regulation D – distressed companies issuing securities
o Merger arbitrage - between an acquiring public company and a target public company
 Other
o Emerging markets
o Fund of hedge funds
o Quantitative

[edit] Hedge fund risk

Investing in a hedge fund is considered to be a riskier proposition than investing in a regulated

fund, despite the traditional notion of a "hedge" being a means of reducing the risk of a bet or
investment. The following are some of the primary reasons for the increased risk:

Leverage - in addition to money put into the fund by investors, a hedge fund will typically
borrow money, with certain funds borrowing sums many times greater than the initial
investment. Where a hedge fund has borrowed $9 for every $1 invested, 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. At the beginning of 1998, shortly
before its collapse, Long Term Capital Management had borrowed over $26 for each $1
invested.

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.

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 collateralised debt obligations based on sub-prime mortgages.

Lack of transparency - hedge funds are secretive entities. 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,
and therefore some may carry undisclosed structural risks.

Investors in hedge funds 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.

[edit] Legal structure

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, and its investors being 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.

[edit] Domicile

The specific legal structure of a hedge fund – in particular its domicile and the type of 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 realises 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 2004 55% of the world’s hedge funds, accounting for nearly two-thirds of total
hedge fund assets, were established offshore. The most popular offshore location was the
Cayman Islands, followed by the British Virgin Islands, Bermuda and the Bahamas. The US was
the most popular onshore location, accounting for 34% of funds and 24% of assets. EU countries
were the next most popular location with 9% of funds and 11% of assets. Asia accounted for the
majority of the remaining assets. [citations needed]
[edit] 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.[3]

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 to 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 – most of the fund’s decisions are taken by the board of directors of the fund, which is
self-appointing and independent but invariably loyal to the investment manager.

[edit] 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 realise 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 between 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 between investors, and which distributes it
profits.

[edit] Listed funds

Corporate hedge funds often list their shares on smaller stock exchanges, such as the Irish Stock
Exchange, in the hope that the low level of quasi-regulatory oversight will give comfort to
investors and to attract certain funds, such as some pension funds, that have bars or caps on
investing in unlisted shares. Shares in the listed hedge fund are not traded on the exchange, but
the fund’s monthly net asset value and certain other events must be publicly announced there.
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"[4], the IPO of Fortress
Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it
managed.[5]

[edit] 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. With the bulk of hedge fund investment coming from the US,
this distribution is natural.

London is Europe’s leading centre for the management of hedge funds. At the end of 2006,
three-quarters of European hedge fund investments, totalling $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 2006.[6]

[edit] 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.

[edit] 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 fewer than 100
investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7
Fund"). [4] 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.) [5] A
3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited
number of investors. 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. [6]. An accredited investor is an individual with a
minimum net worth of US $5,000,000 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.

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. [7]

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. [citations needed]

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.[8] 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.[9] 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."[citation needed]
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.
[10][11][12]

[edit] 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.[citations needed]

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. [citations needed]

[edit] 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 them (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".[13]
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. [14]

[edit] 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[7].

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.

[edit] Hedge Fund Indices

This article needs additional citations for verification.
Please help improve this article by adding reliable references. Unsourced material may be challenged and
removed. (March 2007)

There are a number of indices that track the hedge fund industry. These indices come in two
types, Investable and Non-investable, both with substantial problems. There are also new types
of tracking product launched by Goldman Sachs and Merrill Lynch, "clone indices" that aim to
replicate the returns of hedge fund indices without actually holding hedge funds at all.

Investable indices are created from funds that can be bought and sold, and only Hedge Funds that
agree to accept investments on terms acceptable to the constructor of the index are included.
Investability is an attractive property for an index because it makes the index more relevant to
the choices available to investors in practice, and is taken for granted in traditional equity indices
such as the S&P500 or FTSE100. However, such indices do not represent the total universe of
hedge funds and may under-represent the more successful managers, who may not find the index
terms attractive. Fund indexes include BarclayHedge, Hedge Fund Research, Eurekahedge
Indices, CSFB Tremont and FTSE Hedge.

The index provider selects funds and develops structured products or derivative instruments that
deliver the performance of the index, making investable indices similar in some ways to fund of
hedge funds portfolios.

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

Non-investable indices inherit the databases' shortcomings in terms of scope and quality of data.
Funds’ participation in a database is voluntary, leading to “self reporting 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. As the HFR and CISDM databases began
in 1994, it is likely that they will be more accurate over the period 1994/2000 than the CSFB
database, which only began in 2000.

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 favourable,
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”.

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 liquid access to them
in most developed markets. However, among hedge funds no index combines these
characteristics. Investable indices achieve liquidity at the expense of representativeness. Non-
investable indices are representative, but their quoted returns may not be available in practice.
Neither is wholly satisfactory.

[edit] Debates and controversies

[edit] Predatory behavior

Hedge funds are often described as predatory, seeking to profit off the vulnerability of nations or
corporations. For example, some commentators, including German Vice Chancellor Franz
Muentefering have referred to the hedge funds as "locusts" (Heuschrecken,)[15][16], while
others such as Japan's financial services minister have called them "piranhas," [17] or, as in the
case of UK Prime Minister Gordon Brown, "vultures." [18][19][20] There have been allegations
that hedge funds were a significant factor in causing the 1997 Asian Financial Crisis[21],
although the National Bureau of Economic Research denies that this was the case.[22] In
September, 2007, a noted hedge fund manager told The Times that rival hedge funds had "reaped
£1 billion in profits" from the collapse of Northern Rock.[23]

[edit] Privacy issues

As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to
third parties. This is in contrast to a fully 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 personalised
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. Several hedge funds are
completely "black box"... one might question the sense in investing in these based on past
returns, as anyone who has read Hull once can easily construct a trading strategy that will return
30% 19 years out of 20, except unfortunately it has negative expectancy overall and leads to a
massive blow up in that other year.

Restrictions on marketing and the lack of regulation is that there are no official hedge fund
statistics. An industry consulting group, HFR (hfr.com), reported at the end of the second quarter
2003 that there are 5,660 hedge funds world wide managing $665 billion. To put that in
perspective, at the same time the US mutual fund sector held assets of $7.818 trillion (according
to the Investment Company Institute). [citations needed]

[edit] Market capacity

Analysis of the rather disappointing hedge fund performance in 2004 and 2005 called into
question the alternative investment industry's value proposition. Alpha may 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 and more managers, which may dilute the talent available in the industry.

However, the market capacity effect has been questioned by the EDHEC Risk and Asset
Management Research Centre through a decomposition of hedge fund returns between pure
alpha, dynamic betas, and static betas.[8]

While pure alpha is generated by exploiting market opportunities, the dynamic betas depend on
the manager’s skill in adapting the exposures to different factors, and these authors claim that
these two sources of return do not exhibit any erosion. This suggests that the market environment
(static betas) explains a large part of the poor performance of hedge funds in 2004 and 2005.

[edit] Systematic 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 by the U.S. Federal
Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM
disaster.

The ECB (European Central Bank) has issued a warning 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."[9]

The Times wrote about this review: "In one of the starkest warnings yet from an official
institution over the role of the burgeoning but secretive industry, the ECB sounded a note of
alarm over the possible repercussions from any collapse of a hedge fund, or group of funds."[10]

However, the ECB statement itself has been criticized by a part of the financial research
community. These arguments are developed by the EDHEC Risk and Asset Management
Research Centre:[24]. The main conclusions of the study are that “the ECB article’s conclusion
of a risk of “disorderly exits from crowded trades” is based on mere speculation. While the
question of systemic risk is of importance, we do not dispose of enough data to reliably address
this question at this stage”, “ it would be worthwhile for financial regulators to work towards
obtaining data on hedge fund leverage and counterparty credit risk. Such data would allow a
reliable assessment of the question of systemic risk”, and “besides evaluating potential systemic
risk, it should be recognised that hedge funds play an important role as “providers of liquidity
and diversification”.

The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge
funds in June 2007.[25] 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.[11]

[edit] Performance measurement

The issue of performance measurement in the hedge fund industry 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.

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). An overview of these performance measures is available
in Géhin, W., 2006, The Challenge of Hedge Fund Performance Measurement: a Toolbox rather
than a Pandora’s Box, EDHEC Risk and Asset Management Research Center, Position Paper,
December. However, there is no consensus on the most appropriate absolute performance
measure, and traditional performance measures are still widely used in the industry.

[edit] Relationships with analysts

In June 2006. the U.S. Senate Judiciary Committee began an investigation into the links between
hedge funds and independent analysts, and other issues related to the funds. Connecticut
Attorney General Richard Blumenthal testified that an appeals court ruling striking down
oversight of the funds by federal regulators left investors "in a regulatory void, without any
disclosure or accountability."[26] The hearings heard testimony from, among others, Gary
Aguirre, a staff attorney who was recently fired by the SEC. [27] [28]

[edit] Transparency

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 [29] which allegedly defrauded clients of close to $180 million.[30]

[edit] Hedge fund data

[edit] Top performing funds

The top 50 performing hedge funds, based on average annual return over the previous three
years, were ranked by Barron's Online[12] in October 2007 (Hedge Fund 50). The top 10 are as
follows:

 1. RAB Special Situations Fund (RAB Capital, London) - 47.69%

 2. The Children's Investment Fund (The Children's Investment Fund Management, London) -
44.27%
 3. Highland CDO Opportunity Fund (Highland Capital Management, Dallas) - 43.98%
 4. BTR Global Opportunity Fund, Class D (Salida Capital, Toronto) - 43.42%
 5. SR Phoenicia Fund (Sloane Robinson, London) - 43.10%
 6. Atticus Euopean Fund (Atticus Management, New York) - 40.76%
 7. Gradient European Fund A (Gradient Capital Partners, London) - 39.18%
 8. Polar Capital Paragon Absolute Return Fund (Polar Capital Partners, London) - 38.00%
 9. Paulson Enhanced Partners Fund (Paulson & Co., New York) - 37.97%
 10. Firebird Global Fund (Firebird Management, New York) - 37.18%

Because of the unavailability of reliable figures, the top 50 list excludes funds such as
Renaissance Technologies' Renaissance Medallion Fund and ESL Investments' ESL Partners
(each thought to have returned an average of over 35% in the previous 3 years) and funds by
SAC Capital and Appaloosa Management, which might otherwise have made the list.

The list also excludes funds with a net asset value of less than $250 million. The returns are net
of fees.

[edit] Top earners

Institutional Investor magazine annually ranks top-earning hedge fund managers. Earnings from
a hedge fund are simply 100% of the capital gains on the manager's own equity stake in the fund
plus the manager's share of the performance fee (usually 20% to 50% (depending on policy) of
the gains on the other investors' capital).

The 2004 top earner was Edward Lampert of ESL Investments Inc. who earned $1.02 billion
during the year (PR Newswire link).

The 2005 top earner was James Harris Simons with an earning of $1.6 billion according to Alpha
magazine.[13] However, Trader Monthly reported that Simons only earned about $1 billion and
that the top earner was instead T. Boone Pickens with an estimated earning of over $1.5 billion
during the year.[14]

The full top 10 list of hedge fund earners according to Trader Monthly includes:

 1. T. Boone Pickens - estimated 2005 earnings $1.5bn +

 2. Steven A. Cohen, SAC Capital Advisers - $1bn +
 3. James H. Simons, Renaissance Technologies Corp. - $900m - $1bn
 4. Paul Tudor Jones, Tudor Investment Corp. - $800m - $900m
 5. Stephen Feinberg, Cerberus Capital Management - $500 - $600m
 6. Bruce Kovner, Caxton Associates - $500m - $600m
 7. Eddie Lampert, ESL Investments - $500m - $600m
 8. David E. Shaw, D. E. Shaw & Co. - $400m - $500m
 9. Jeffrey Gendell, Tontine Partners - $300m - $400m
 10. Louis Bacon, Moore Capital Management - $300m - $350m

The 2006 top earner was John Arnold according to Trader Monthly Magazine. The list includes:

 1. John D. Arnold, Houston, Texas- of Centauras Energy- $1.5-2B

 2. James Simons, East Setauket, New York- of Renaissance Technologies Corp.- $1.5-2B
 3. Eddie Lampert, Greenwich, Connecticut- of ESL Investments- $1-1.5B

[edit] Notable hedge fund management companies

Sometimes also known as alternative investment management companies.

  Amaranth Advisors
 Bridgewater Associates
 Caxton Associates
 Centaurus Energy
 Citadel Investment Group
 D. E. Shaw & Co.
 Fortress Investment Group
 Goldman Sachs Asset Management
 Long Term Capital Management
 Man Group
 Pirate Capital LLC
 Renaissance Technologies
 SAC Capital Advisors
 Soros Fund Management
 Marshall Wace

[edit] Top 25 funds of hedge funds by assets

Funds of hedge funds invest in a portfolio of underlying hedge funds rather than investing in
securities directly. They hire the hedge fund managers on behalf of their clients following due
diligence on the managers in addition to building diversified portfolios of these managers. They
are ranked by Dec 2005 Assets Under Management (though this cannot be taken as the final
word on the matter given the intense privacy that surrounds much of the industry).

 Union Bancaire Privée (UBP) (Geneva, Switzerland) $20.8 billion ([31])

 Grosvenor Capital Management (Chicago, IL) $20.2 billion ([32])
 HSBC Private Bank (Suisse) / HSBS Republic Investments (London, UK) $20.2 billion ([33])
 Permal Asset Management (New York, NY) $18.8 billion ([34])
 Crédit Agricole Alternative Investment Products Group (Paris, France) $18.5 billion [citation needed]
([35])
 Société Générale (Paris, France) $15.9 billion ([36])
 Quellos Capital Management (Seattle, WA) $15.0 billion ([37])
 Ivy Asset Management (Jericho, NY) $14.9 billion ([38])
 Financial Risk Management (FRM) (London, UK) $ 13.3 billion ([39])
 Pictet & Cie. (Geneva, Switzerland) $13.0 billion ([40])
 Sewell & Marbury. (British Columbia, Canada)
 Man Investments (London, UK and Pfaffikon, Switzerland) $12.7 billion ([41])
 Notz Stucki & Cie. (Geneva, Switzerland) $10.7 billion ([42])
 Blackstone Alternative Asset Management (New York, NY) $9.3 billion ([43])
 Arden Asset Management (New York, NY) $9.2 billion ([44])
 Black River Asset Management (Minnetonka, MN) $9 billion ([45])
 Pacific Alternative Asset Management Co. (PAAMCO) (Irvine, CA) $8.9 billion ([46])
 J.P. Morgan Alternative Asset Management (New York, NY) $8.8 billion ([47])
 Mesirow Advanced Strategies (Chicago, IL) $8.2 billion ([48])
 Tremont Capital Management (Rye, NY) $8.2 billion ([49])
 CSFB Alternative Capital (New York, NY) $7.9 billion ([50])
 AIG Global Investment Group (New York, NY) $6.7 billion ([51])
Hedge fund
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 v • d • e 

A hedge fund is a private investment fund that charges a performance fee and is typically open
to only a limited range of qualified investors. Hedge fund activity in the public securities markets
has grown substantially as it constitutes approximately 30% of all U.S. fixed-income security
transactions, 55% of U.S. activity in derivatives with investment-grade ratings, 55% of the
trading volume for emerging-market bonds, as well as 30% of equity trades. Hedge Funds
dominate certain specialty markets such as trading in derivatives with high-yield ratings, and
distressed debt.[1]

Alfred Winslow Jones is credited with inventing hedge funds in 1949. [2]

In the United States, in order for an investment fund to be exempt from direct regulation, it must
be open to accredited investors only and only a limited number of investors can belong to it.
While there is no legal definition of "hedge fund" under U.S. securities laws and regulations,
typically they include any investment fund that, because of an exemption from the types of
regulation that otherwise apply to mutual funds, brokerage firms or investment advisers can
invest in more complex and more risky investments than a public fund might. As a hedge fund's
investment activities are limited only by the contracts governing the particular fund, it can make
greater use of complex investment strategies such as short selling, entering into futures, swaps
and other derivative contracts and leverage.

As their name implies, hedge funds often seek to offset potential losses in the principal markets
they invest in by hedging via any number of methods. However, the term "hedge fund" has come
in modern parlance to be overused and inappropriately applied to any absolute-return fund –
many of these so-called "hedge funds" do not actually hedge their investments.

Hedge funds have acquired a reputation for secrecy. Unlike open-to-the-public "retail" funds
(e.g., U.S. mutual funds) which market freely to the public, in most countries, hedge funds are
specifically prohibited from marketing to investors who are not professional investors or
individuals with sufficient private wealth. This limits the information a hedge fund is legally
required to release. Additionally, divulging a hedge fund's methods could unreasonably
compromise their business interests; this limits the information a hedge fund would want to
release.[4][5]

Since hedge fund assets can run into many billions of dollars and will usually be multiplied by
leverage, their sway over markets, whether they succeed or fail, is potentially substantial and
there is a continuing debate over whether they should be more thoroughly regulated.

Contents
[hide]

 1 Industry
 2 Fees
o 2.1 Management fees
o 2.2 Performance fees
 2.2.1 High water marks
 2.2.2 Hurdle rates
 3 Strategies
 4 Hedge fund risk
  5 Legal structure
o 5.1 Domicile
o 5.2 The legal entity
o 5.3 Open-ended nature
o 5.4 Listed funds
 6 Hedge fund management worldwide
 7 Regulatory Issues
o 7.1 US regulation
o 7.2 Comparison to private equity funds
o 7.3 Comparison to U.S. mutual funds
o 7.4 Offshore regulation
 8 Hedge Fund Indices
 9 Debates and controversies
o 9.1 Systemic risk
o 9.2 Transparency
o 9.3 Market capacity
o 9.4 Investigations of illegal conduct
o 9.5 Performance measurement
o 9.6 Relationships with analysts
 10 Hedge fund data
o 10.1 Top performing funds
o 10.2 Top earners
o 10.3 Notable hedge fund management companies
o 10.4 Terminology
 11 See also
 12 References
 13 Further reading
o 13.1 Research Articles
o 13.2 Research Papers
o 13.3 Books
 14 External links
o 14.1 Academic research
o 14.2 Indices
o 14.3 Trade associations
o 14.4 Other links

[edit] Industry
In 2005, Absolute Return magazine found there were 196 hedge funds with $1 billion or more in
assets, with a combined $743 billion under management - the vast majority of the industry's
estimated $1 trillion in assets.[3] However, according to hedge fund advisory group Hennessee,
total hedge fund industry assets increased by $215 billion in 2006 to $1.442 trillion, up 17.5% on
a year earlier, an estimate for 2005 seemingly at odds with Absolute Return.[4]

As large institutional investors have entered the hedge fund industry the total asset levels
continue to rise. The 2008 Hedge Fund Asset Flows & Trends Report [5] published by
HedgeFund.net and Institutional Investor News estimates total industry assets reached $2.68
trillion in Q3 2007. According to the BarclayHedge Monthly Asset Flow Report, hedge funds
received only $16 billion in October, the second-lowest inflow in 2007. Year-to-date hedge
funds attracted $278.5 billion, three times year-to-date inflow into equity mutual funds.

[edit] Fees
Usually the hedge fund manager will 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 incentivize the investment manager to produce the largest returns they can.

[edit] Management fees

As with other investment funds, the management fee is calculated as a percentage of the net asset
value of the fund at the time when the fee becomes payable. Management fees typically range
from 1% to 4% per annum, with 2% being the standard figure. Therefore, if a fund has $1 billion
of assets at the year end and charges a 2% management fee, the management fee will be $20
million in total. Management fees are usually calculated annually and paid monthly.

[edit] Performance fees

Performance fees, which give a share of positive returns to the manager, are one of the defining
characteristics of hedge funds. In contrast to retail investment firms, performance fees are
prohibited in the U.S. for stock brokers.[citation needed] A hedge fund's performance fee is calculated
as a percentage of the fund's profits, counting both unrealized profits and actual realized trading
profits. Performance fees exist because investors are usually willing to pay managers more
generously when the investors have themselves made money. For managers who perform well
the performance fee is extremely lucrative.

Typically, hedge funds charge 20% of gross returns as a performance fee, but again the range is
wide, with highly regarded managers demanding higher fees. In particular, Steven Cohen's SAC
Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons'
Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its
flagship Medallion Fund before returning all investors' capital and running solely on its
employees' money.[citations needed]

Managers argue that performance fees help 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 and sometimes by a hurdle
rate. Alternatively, the investment manager might be required to return performance fees when
the value of the fund drops. This provision is sometimes called a ‘claw-back.’

[edit] High water marks

A "High water mark" is often applied to a performance fee calculation.[6] This means that the
manager does not receive performance fees unless the value of the fund exceeds the highest net
asset value it has previously achieved. For example, if a fund was launched at a net asset value
(NAV) per share of $100, which then rose to $130 in its first year, a performance fee would be
payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If
in the third year the NAV per share rises to $143, a performance fee will be payable only on the
extra $13 return from $130 to $143 rather than on the full return from $120 to $143.

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 performance fee every other year,
enriching the manager but not the investors. However, this mechanism does not provide
complete protection to investors: a manager who has lost money may simply decide to close the
fund and start again with a clean slate -- provided that he can persuade investors to trust him with
their money. A high water mark is sometimes referred to as a "Loss Carryforward Provision."

Poorly performing funds frequently close down rather than work without fees, as would be
required by their high water mark policies. [7]

[edit] Hurdle rates

Some funds also specify a hurdle rate, which signifies that the fund will not charge a
performance fee until its annualized performance exceeds a benchmark rate, such as T-bills or a
fixed percentage, over some period. This links performance fees to the ability of the manager to
do better than the investor would have done if he had put the money elsewhere.

Funds which specify a soft hurdle rate charge a performance fee based on the entire annualized
return. Funds which use a hard hurdle rate only charge a performance fee on returns above the
hurdle rate.

Though logically appealing, this practice has diminished as demand for hedge funds has
outstripped supply and hurdles are now rare.[citations needed]

[edit] Strategies
Hedge funds are no longer a homogeneous class. Under certain circumstances, an investor or
hedge fund can completely hedge the risks of an investment, leaving pure profit.[citation needed] 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.[citation needed]
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. Some styles of hedge fund investing, such as global macro investing, may involve
no hedging at all. Strictly speaking, it is not accurate to call such funds hedge funds, but that is
current usage.

The bulk of hedge funds describe themselves as long / short equity, but many different
approaches are used taking different exposures, exploiting different market opportunities, using
different techniques and different instruments:

 Global macro – seeking related assets that have deviated from some anticipated
relationship.
 Arbitrage – seeking assets that are mispriced relative to related assets.
o Convertible arbitrage – between a convertible bond and the same company's
equity.
o Fixed income arbitrage – between related bonds.
o Risk arbitrage – between securities whose prices appear to imply different
probabilities for one event.
o Statistical arbitrage (or StatArb) – between securities that have deviated from
some statistically estimated relationship.
o Derivative arbitrage – between a derivative and its security.
 Long / short equity – generic term covering all hedged investment in equities.
o Short bias – emphasizing or solely using short positions.
o Equity market neutral – maintaining a close balance between long and short
positions.
 Event driven – specialized in the analysis of a particular kind of event.
o Distressed securities – companies that are or may become bankrupt.
o Regulation D – distressed companies issuing securities.
o Merger arbitrage - arbitrage between an acquiring public company and a target
public company.
 Other – the strategies below are sometimes considered hedge strategies, although in
several cases usage of the term is debatable.
o Emerging markets- this usually means unhedged, long positions in small overseas
markets.
o Fund of hedge funds - unhedged, long only positions in hedge funds (though the
underlying funds, of course, may be hedged). Additional leverage is sometimes
used.[citation needed]
o Quantitative
o 130-30 funds - Through leveraging, 130% of the money invested in the fund is
used to buy stocks. 30% of the money invested in the fund is used to short stock.

[edit] Hedge fund risk

Investing in a hedge fund is considered to be a riskier proposition than investing in a regulated
fund, despite the traditional notion of a "hedge" being a means of reducing the risk of a bet or
investment. The following are some of the primary reasons for the increased risk:

Leverage - in addition to putting money into the fund by investors, a hedge fund will
typically borrow money, with certain funds borrowing sums many times greater than the
initial investment. Where a hedge fund has borrowed $9 for every $1 invested, 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. At
the beginning of 1998, shortly before its collapse, Long Term Capital Management had
borrowed over $26 for each $1 invested.
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.
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 collateralised debt obligations based on sub-prime mortgages.
Lack of transparency - hedge funds are secretive entities. 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, and therefore some may carry undisclosed structural risks.

Investors in hedge funds 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.

[edit] Legal structure

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, and its investors being 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.

[edit] Domicile

The specific legal structure of a hedge fund – in particular its domicile and the type of 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 realises 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 2004 55% of the world’s hedge funds, accounting for nearly two-thirds of total
hedge fund assets, were established offshore. The most popular offshore location was the
Cayman Islands, followed by the British Virgin Islands, Bermuda and the Bahamas. The US was
the most popular onshore location, accounting for 34% of funds and 24% of assets. EU countries
were the next most popular location with 9% of funds and 11% of assets. Asia accounted for the
majority of the remaining assets.[citations needed]

[edit] 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.[8]

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 – most of the fund’s decisions are taken by the board of directors of the fund, which is
self-appointing and independent but invariably loyal to the investment manager.

[edit] 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 realise 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 between 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 between investors, and which distributes its
profits.

[edit] Listed funds

Corporate hedge funds often list their shares on smaller stock exchanges, such as the Irish Stock
Exchange, in the hope that the low level of quasi-regulatory oversight will give comfort to
investors and to attract certain funds, such as some pension funds, that have bars or caps on
investing in unlisted shares. Shares in the listed hedge fund are not traded on the exchange, but
the fund’s monthly net asset value and certain other events must be publicly announced there.

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"[9], the IPO of Fortress
Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it
managed.[10]

[edit] 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. With the bulk of hedge fund investment coming from the US,
this distribution is natural.

London is Europe’s leading centre for the management of hedge funds. At the end of 2006,
three-quarters of European hedge fund investments, totalling $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 2006.[11]

[edit] Regulatory Issues

This article or section deals primarily with the United States and does not represent a
worldwide view of the subject.
Please improve this article or discuss the issue on the talk page.

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.

[edit] 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"). [6] 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.) [7] A
3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited
number of investors. 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. [8]. An accredited investor is an individual with a
minimum net worth of US $5,000,000 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.

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. [9]

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.[citations needed]

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.[10] 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.[11] 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."[citation needed]

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.
[12][13][14]

[edit] 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.[citations needed]

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.[citations needed]

[edit] 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 them (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".[15]
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. [16]

[edit] 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[12].

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.

[edit] Hedge Fund Indices

 This article needs additional citations for verification.
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There are a number of indices that track the hedge fund industry. These indices come in two
types, Investable and Non-investable, both with substantial problems. There are also new types
of tracking product launched by Goldman Sachs and Merrill Lynch, "clone indices" that aim to
replicate the returns of hedge fund indices without actually holding hedge funds at all.

Investable indices are created from funds that can be bought and sold, and only Hedge Funds that
agree to accept investments on terms acceptable to the constructor of the index are included.
Investability is an attractive property for an index because it makes the index more relevant to
the choices available to investors in practice, and is taken for granted in traditional equity indices
such as the S&P500 or FTSE100. However, such indices do not represent the total universe of
hedge funds and may under-represent the more successful managers, who may not find the index
terms attractive. Fund indexes include BarclayHedge, Hedge Fund Research, Eurekahedge
Indices, Credit Suisse Tremont and FTSE Hedge.

The index provider selects funds and develops structured products or derivative instruments that
deliver the performance of the index, making investable indices similar in some ways to fund of
hedge funds portfolios.

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

Non-investable indices inherit the databases' shortcomings, or strengths, in terms of scope and
quality of data. Funds’ participation in a database is voluntary, leading to “self reporting 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. This tends to lead to a clustering of returns around the
mean rather than representing the full diversity existing in the hedge fund universe. Examples of
non-investable indices include an equal weighted benchmark series known as the HFN Averages,
and a revolutionary rules based set known as the Lehman Brothers/HFN Global Index Series
which leverages an Enhanced Strategy Classification System.

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. As the HFR and CISDM databases began
in 1994, it is likely that they will be more accurate over the period 1994/2000 than the Credit
Suisse database, which only began in 2000.
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 favourable,
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”.

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 liquid access to them
in most developed markets. However, among hedge funds no index combines these
characteristics. Investable indices achieve liquidity at the expense of representativeness. Non-
investable indices are representative, but their quoted returns may not be available in practice.
Neither is wholly satisfactory.

[edit] Debates and controversies

[edit] 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 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 [13] is outlined as one of the main factors of the hedge funds contribution to systematic
risk.

The ECB (European Central Bank) has issued a warning 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."[14]

The Times wrote about this review: "In one of the starkest warnings yet from an official
institution over the role of the burgeoning but secretive industry, the ECB sounded a note of
alarm over the possible repercussions from any collapse of a hedge fund, or group of funds."[15]

However, the ECB statement itself has been criticized by a part of the financial research
community. These arguments are developed by the EDHEC Risk and Asset Management
Research Centre:[17]. The main conclusions of the study are that “the ECB article’s conclusion
of a risk of “disorderly exits from crowded trades” is based on mere speculation. While the
question of systemic risk is of importance, we do not dispose of enough data to reliably address
this question at this stage”, “ it would be worthwhile for financial regulators to work towards
obtaining data on hedge fund leverage and counterparty credit risk. Such data would allow a
reliable assessment of the question of systemic risk”, and “besides evaluating potential systemic
risk, it should be recognised that hedge funds play an important role as “providers of liquidity
and diversification”.
The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge
funds in June 2007.[18] 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.[16]

[edit] Transparency

As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to
third parties. This is in contrast to a fully 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 personalised
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. Several hedge funds are
completely "black box", meaning that their returns are uncertain to the investor.[citation needed]

Restrictions on marketing and the lack of regulation is that there are no official hedge fund
statistics. An industry consulting group, HFR (hfr.com), reported at the end of the second quarter
2003 that there are 5,660 hedge funds world wide managing $665 billion. For comparison, at the
same time the US mutual fund sector held assets of $7.818 trillion (according to the Investment
Company Institute).[citations needed]

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 [19] which allegedly defrauded clients of close to $180 million.[20]

[edit] Market capacity

Analysis of the rather disappointing hedge fund performance in 2004 and 2005 called into
question the alternative investment industry's value proposition. Alpha may 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 and more managers, which may dilute the talent available in the industry.[citation
needed]

However, the market capacity effect has been questioned by the EDHEC Risk and Asset
Management Research Centre through a decomposition of hedge fund returns between pure
alpha, dynamic betas, and static betas.[17]

While pure alpha is generated by exploiting market opportunities, the dynamic betas depend on
the manager’s skill in adapting the exposures to different factors, and these authors claim that
these two sources of return do not exhibit any erosion. This suggests that the market environment
(static betas) explains a large part of the poor performance of hedge funds in 2004 and 2005.
[citation needed]

[edit] Investigations of illegal conduct

In the U.S., the SEC is focusing more resources on investigating violations and illegal conduct
on the part of hedge funds in the public securities markets.[18], [19]Linda C. Thomsen, enforcement
director of the SEC, said in November 2007 that federal regulators were concerned about illegal
trading and the potential for harm to hedge fund investors. She said, “These days, the money is in
hedge funds, so the potential for abuse, the potential for securities law violations is there because
there is so much money there.” Outside firms offering services to the hedge funds such as Prime
Brokerage may be held accountable for failing to report illegal conduct on account of their client
hedge funds.[20]

[edit] Performance measurement

The issue of performance measurement in the hedge fund industry 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.[citation needed]

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). An overview of these performance measures is available
in Géhin, W., 2006, The Challenge of Hedge Fund Performance Measurement: a Toolbox rather
than a Pandora’s Box, EDHEC Risk and Asset Management Research Center, Position Paper,
December. However, there is no consensus on the most appropriate absolute performance
measure, and traditional performance measures are still widely used in the industry.[citation needed]

[edit] Relationships with analysts

In June 2006. the U.S. Senate Judiciary Committee began an investigation into the links between
hedge funds and independent analysts, and other issues related to the funds. Connecticut
Attorney General Richard Blumenthal testified that an appeals court ruling striking down
oversight of the funds by federal regulators left investors "in a regulatory void, without any
disclosure or accountability."[21] The hearings heard testimony from, among others, Gary
Aguirre, a staff attorney who was recently fired by the SEC. [22] [23]