Hedge Fund Hedge Fund Hedge Fund

or Fees “Due
Mutual Fund? Explained Diligence”
Find out on page 2 Read it on page 3 More on page 5

HEDGE FUND CHEAT SHEET Brought to you by the Hedge Fund Marketing Alliance
™

What’s Inside – What is a Hedge Fund? Who Invests in a

Sophisticated investors can benefit Hedge Fund?
The term “hedge fund” investors or institutions. “Sophisticated investors” do - those
n Avoid the high cost of
is applied to a variety of Strategies can involve who do not need the protection pro-
due diligence by investing
investment styles, but there most asset classes, and vided by the regulations that apply
in a hedge fund of funds.
are some common charac- shorting as well as lever- to mutual funds. These are entities,
An actively managed
teristics. Hedge funds are age are common. Manager or wealthy individuals that must pass
portfolio of hedge funds is
not regulated by the SEC compensation usually either an “accredited investor” test or
a solid alternative. Page 2
the same way publicly held includes a fixed manage- a “qualified purchaser” test. An ac-
funds are regulated. ment fee plus an incen- credited investor is an individual whose
n Transparency of
Their clientele are tive fee (see Hedge net worth exceeds $1 million, or whose
hedge funds has always
sophisticated, Fund Fees). income in the last 2 calendar years
been an issue and the pres-
wealthy exceeds $200,000/yr, and who expects
sure for more information
more of the same. It can also be an
is on. Move beyond the
entity with assets exceeding $5 million.
“black box.” Page 3
A qualified purchaser is someone with
over $5 million who invests in total
n Investment
assets, or one of a number of entities.
strategies are varied.
Many hedge funds rely on sections 3
There are many differ-
(c) (1) or 3 (c) (7) of the Investment
ent hedge fund strategies
Company Act of 1940 to avoid regis-
available to hedge fund
tration and regulation as investment
managers. We explain
common hedge fund Why Invest in a Hedge Fund? companies. That is why a hedge fund
partnership may often be referred to as
strategies. Page 4 Hedge funds can make layer of protection in a
sense in an overall portfo- declining market.
n Regardless of your lio context, for a number of
investment objectives, Absolute Return Focus
reasons. Here are a few:
the quality of the hedge – hedge funds concen-
fund database you use can Diversification – hedge trate on making positive
make a big difference in funds add a level of diver- returns in all kinds of
the success you achieve. sification to an investment markets–achieving an
Page 5 portfolio, since their returns absolute return.
are often not correlated with
Active Management Fo-
n Understanding hedge those of other asset classes. a “3 c 1” or a “3 c 7” fund.
cus – hedge fund manag-
fund terms is no easy task Downside Protection ers are applying strategies Hedge funds are prohibited from
for the beginner. Here we – since hedge funds can they believe will add advertising their funds to the public.
define some of the most hold both long and short alpha. They are using However, some hedge funds choose
comment phrases used in positions, they usually are their skill at interpreting to register with the SEC. This enables
the hedge fund industry. less volatile than typical information to actively them to have a lower minimum invest-
Page 6 long-only portfolios, and exploit an inefficiency in ment, and an unlimited number of
some funds can provide a the market. investors (3c1/3c7 funds have limits).

© 2010 Hedge Fund Marketing Alliance The information provided is for educational purposes only. 1
HEDGE FUND CHEAT SHEET™ HedgeFundMarketing.org

THE BASICS
Articles of Incorporation if it
The Difference Between a Legalities is an offshore fund). The Sub-
Legally, hedge funds are usually scription Agreement requires
Hedge Fund and a Mutual Fund set up as Limited Liability signatures of the investor and
Corporations (LLCs), or as the fund’s general partner, and
Hedge funds and mutual funds Self-Investment – the hedge Offshore Corporations. usually includes a questionnaire
are both “pooled” vehicles, but fund manager is expected to put Hedge funds are usually labeled to determine whether the inves-
there are more differences than some of his own capital at risk as “onshore” (domestic U.S.) tor and the fund are suited for
similarities. For instance, a in the strategy. If he does not, it or “offshore”. The onshore each other.
mutual fund is registered with can be interpreted as a bad sign. fund is for U.S. investors, who
the SEC, and can be sold to an The mutual fund does not face must face tax consequences.
unlimited number of investors. this same expectation. To avoid these consequences,
Role of the Prime
Most hedge funds are not reg- non-U.S. investors often opt Broker
istered and can only be sold to for the offshore fund, which is
carefully defined sophisticated Hedge fund managers often
domiciled outside the U.S. (e.g.,
investors. Usually a hedge fund trade with a number of brokers.
Bermuda, Cayman Islands,
will have a maximum of either The fund’s prime broker (if they
etc.). A manager will often run
100 or 500 investors. Mu- have designated one) provides
the same strategy in both an on-
tual funds may advertise freely; a consolidation service—this
shore and an offshore fund, so
hedge funds may not. Other means the executing brokers
both U.S. and non-U.S. citizens
differences include: are instructed to settle all trades
may take advantage of it.
with the prime broker. Since
Flexibility – the hedge fund A hedge fund should fully
this results in all the trade
manager has fewer constraints disclose its operations, people
information being in one place,
to deal with; he can sell short, and methods in its Private
reporting becomes much easier.
use derivatives, and use lever- Placement Memorandum
The prime broker’s role has
age. He can also make signifi- (PPM), or Offering Document.
evolved with the growth of the
cant changes to the strategy if The PPM explains the fund
hedge fund industry, and it pro-
he thinks it is appropriate. The strategy, risks, fees, restrictions,
vides a number of other useful
mutual fund manager cannot be etc. It is not the official legal
services, including custody of
as flexible. If he changes his document; that is called the
the securities, loaning of
strategy, he will be accused of Partnership Agreement (or the
Continued next page
“style drift”.
Paperwork – a mutual fund is
offered via a prospectus; a hedge
fund is offered via the private
The Hedge “Fund of Funds”
placement memorandum. The hedge fund of funds diversification. An FOF usually own portfolio of funds, or may
(FOF) has become an appeal- invests in a number of strate- be more comfortable with a
Liquidity – the mutual fund
ing avenue into hedge funds for gies, the returns of which are registered, “hedge-like” mutual
often offers daily liquidity (you
many investors. Simply put, it often historically non-correlated fund.
can withdraw at any time); the
is an actively managed portfolio (a benefit). Further, an investor The above benefits come at a
hedge fund usually has some
of hedge funds. The investor can get access to the top hedge cost. A hedge fund of funds will
sort of “lockup” provision. You
hires a third party to perform funds. Some FOF managers charge a management fee (and
can only get your money peri-
all aspects of hedge fund due have very good relationships sometimes an incentive fee) to
odically.
diligence. Investors do this with fund managers, and can perform this service, over and
Absolute vs. Relative – the for a number of reasons. First, invest in them while others find above the fees charged by the
hedge fund aims for absolute the due diligence process is themselves locked out. Smaller underlying hedge fund managers.
return (it wants to produce posi- complex and expensive. You minimum investments are an Also, since it is difficult to under-
tive returns regardless of what need knowledge, experience and additional appealing aspect. stand all of the FOF’s underly-
the market is doing); the mutual access to hedge fund databases. However, due to some fraud ing strategies, the investment
fund is usually managed relative It also involves a bit of career cases and “blow-ups,” some is usually a matter of trust. The
to an index benchmark and is risk—if you choose the wrong investors have begun to doubt relatively short track record of
judged on its variance from that funds, you might lose your job. the due diligence capabilities of many FOFs makes developing
benchmark. Another reason is to get FOFs. They may create their trust somewhat difficult.

2 The information provided is for educational purposes only. © 2010 Hedge Fund Marketing Alliance
HEDGE FUND CHEAT SHEET™ HedgeFundMarketing.org

THE BASICS
securities for short sales, pro-
viding margin financing, and Hedge Fund Fees
providing back office technol- only be paid a percentage of the the rate of return on US treasury
Hedge fund fees are often higher
ogy and reporting. As competi- profits if the net value of the fund bills, or other rates of return in the
than those of mutual funds and
tion among prime brokers heats exceeds the previous highest value financial industry. Guaranteeing
they frequently involve both a
up, the role of technology is achieved by the fund. A fund must that performance fees will not be
management fee and a perfor-
growing. The prime broker can actually make up losses before it levied helps to reassure investors
mance fee. A commonly-quoted
actually help a hedge fund man- can charge an incentive. In other that they will be compensated
hedge fund fee is “two and
ager to gather assets by making words, if a $1,000,000 investment somewhat if the return fails to
twenty”—an annual two percent
introductions to potential inves- loses 50% in the first year (leaving exceed that of other investment
of assets fee plus 20 percent of
tors. This is known as capital $500,000), then earns 100% the options.
the gains over some base return or
introduction. following year, it cannot charge an In addition to management fees
“hurdle rate.”
The management fee was a incentive fee the second year be- and incentive or performance
Hedge Fund basic part of the early hedge fund cause the investment is only back fees, some hedge funds also
“Transparency” compensation schemes. These
fees are generally determined
Transparency of a hedge fund
“Times have changed and managers are setting fee
annually (but don’t often change)
has always been an issue, but as as a percentage of the net value structures lower than the traditional structure in order
larger institutions move toward of the fund, ranging from one to earn back the attention of institutional investors.”
investing in hedge strategies, percent to four percent, and are
it takes on more importance. typically paid to the fund man-
Most institutions do not want to ager in quarterly installments.
invest in a “black box”—they Smaller funds may determine this
want to know what is in the percentage by seeking to cover the
fund and what the fund’s risk operating costs of management
characteristics are. This desire of the fund, while larger funds
to know what is in the fund is may offer higher management fee
in direct conflict with the fund percentages in order to attract and
manager’s desire to keep that in- retain greater fund management
formation private. If a manager expertise.
runs a proprietary methodology In addition to management fees,
that adds value, why should the hedge fund managers are typically
portfolio holdings be known to paid a performance fee, calcu- to where it began. Some investors charge withdrawal fees when
anyone? If they were, someone lated as a percentage of the profits feel the high-water mark can lead money is removed by an inves-
might figure out the strategy and gained by the fund under their to the manager taking on more tor from a hedge fund account.
eat up some of the alpha. management. The performance risk, if he is in a position where These fees usually are applied
Some progress is being made fee is generally around twenty per- he has to play catch-up. Others to a certain time period, such as
on this front. To raise assets, cent of the increase in value over a would not invest without it. withdrawals within a set number
some funds have agreed to specified period of time, although Hurdle rates, also referred to of years of the initial investment,
the institution’s transparency some larger management firms as minimum acceptable rates of or to withdrawals above a certain
demands. Others are opting have charged as much as forty return, are also used as a determin- amount, usually defined as a
for a partial solution, but never percent of the profits. Because ing factor for hedge fund perfor- given percentage of the invest-
showing the detailed holdings fund managers are rewarded with mance fees, by measuring fund ment. Withdrawal fees are meant
of a portfolio. Some prime performance incentive fees based performance against an external to discourage casual withdrawals
brokers can provide summary on net value gains, but are not benchmark. Where hurdle rates are from the fund assets, in order to
data on a portfolio (overall risk penalized on losses, some limiting applied, performance fee per- allow fund managers to employ
characteristics, etc.). To many measures are employed by hedge centages are not paid to the fund longer-term strategies. Other
investors, this is satisfactory. A funds as a means of competing manager unless the rate of return funds address this problem with
number of firms that specialize for investors, such as high water on the fund meets or exceeds that lock-up periods, which refer to
in risk analytics are working to marks and hurdle rates. benchmark rate. The rates used for a minimum amount of time that
develop standardized summary High water marks refer to comparison may be a pre-deter- must pass after the initial invest-
hedge fund risk measures to sat- performance fee policies that mined percentage, or some other ment before the investor may
isfy most hedge fund investors. specify that the fund manager will financial industry measure such as withdraw money from the fund.

© 2010 Hedge Fund Marketing Alliance The information provided is for educational purposes only. 3
HEDGE FUND CHEAT SHEET™ HedgeFundMarketing.org

INVESTMENT STRATEGIES
Hedge Fund Investment Strategies
There are many different hedge bankruptcy, a distressed sale or models are often employed to modities, currencies, derivatives,
fund investment strategies. Here some other form of corporate automate these strategies. etc.). Some bets can be huge
are some of the most common: event for exploitation. and this strategy allows great
Event-Driven – focuses on op-
flexibility.
Convertible Arbitrage – the Emerging Markets – involves portunities in corporate events
fund manager typically holds a equity or debt investing in like a merger, acquisition, Long/Short Equity – picks both
convertible bond long, and sells emerging markets around the bankruptcy, reorganization, or long and short stock candidates,
short the underlying common world. Each market is unique simply some bad news about a but does not attempt to be
stock. Returns come from bond and has its own rules. For company. An example would be market-neutral. The manager
coupon payments and the short example, some countries lack those who sold Enron short at may switch from net long to net
rebate. There is a cash outflow derivative markets or simply the right time. short, but most long/short equity
as well, to cover dividend pay- prohibit short selling. Hedging strategies have a long bias. In-
Fixed Income Arbitrage
ments on the short positions. is more difficult (or impossible) vestors see this strategy as a way
– seeks to profit from price
in markets like these, so most to generate returns in a rising
Dedicated Short Bias – the goal discrepancies in related fixed
investing here is long-only. market while reducing volatility.
is to earn returns by maintaining income instruments. A manager
net short exposure (more dollars Equity Market Neutral – the might buy long a bond he thinks Managed Futures Strategy –
short than long) in securities. equity market neutral manager is undervalued and sell short a invests in financial and com-
The number of dedicated short takes both long and short posi- similar bond he thinks is over- modities futures markets.
sellers varies based on market tions in stocks while minimizing valued. One goal is to neutralize Directional bets are made with
condition. It is common to see exposure to the systematic risk interest rate risk. long and/or short positions. The
a “short bias,” and still hold of the market (i.e., a beta of zero managers are called Commodity
Fund of Funds – involves ac-
some securities long—a hedged is desired). The long and short Trading Advisors (CTAs).
tive management of a portfolio
position. sides are equal in dollar amount
of hedge funds. For more infor- Statistical Arbitrage – known
(“dollar neutral”). Returns are
Distressed Securities – an mation on hedge funds of funds as “stat arb,” this strategy uses
generated by the spread between
event-driven strategy, focus- see page 2. quantitative models to predict
the longs and the shorts + the
ing on companies in financial price discrepancies in securities.
short rebate + the difference be- Global Macro –Leveraged
trouble. Positions in debt or Market neutrality is often used.
tween dividends earned on long directional bets are made using
in equity can be both long and The models often employ some
positions and dividends paid many of the world’s financial
short. The event might be a mean reversion assumptions.
on short positions. Quantitative instruments (stocks, bonds, com-

Hedge Fund Indices

Market indices have long been accepted in the conventional dex is broken down into a number of sub-categories (event-
investment world, but continue to develop in the hedge fund driven, etc.) for comparisons. Various criteria are applied to
world. Hedge fund strategies are the database to select funds for
so diverse that the development inclusion. Other indices compet-
of a generally-accepted hedge ing for investors’ attention include
fund index is difficult. New funds the MSCI Hedge Fund Indices,
are constantly being launched and indices from Hedge Fund Re-
and others are closing or shutting search, Hennessee Group and Dow
down. Some funds use leverage, Jones. Each has its own method
and some use shorting strategies. for index construction, and may
A moving target is hard to hit ac- have different sub-categories. As
curately, but a number of organiza- organizations collect more data,
tions are trying. rest assured that we will see more
The CSFB/Tremont Hedge Fund Index (based on the TASS indices and some of these will be “investable”. There are also
hedge fund database) is frequently cited in the media. The in- new indices with a geographic focus, such as Asia or Europe.

4 The information provided is for educational purposes only. © 2010 Hedge Fund Marketing Alliance
HEDGE FUND CHEAT SHEET™ HedgeFundMarketing.org

RESEARCH
The importance of Hedge Fund “Due Diligence” Hedge Fund
Due diligence is the term as- to examine hedge fund risks portfolio the way he has pro- Databases
signed to investigating a hedge without asking for too much posed, and that the infrastructure
The hedge fund due dili-
fund (or any investment) in transparency (see section on and resources are in place to do
detail. It delves into more than transparency). so. This leads to a significant gence process often begins
just historic returns and their Qualitative Due Diligence question and answer session, by screening a hedge fund
volatilities. Investors want to focuses more on the Fund itself, such as: database. A growing number
understand the fund Strategy and on the Manager of the fund. • Where did the fund principals of organizations collect data
and its risks, the Fund itself, and The Fund characteristics that are come from, and what are their on hedge funds. The idea
the fund Manager, and do so reviewed are somewhat “legal- backgrounds?
is similar to a collection of
with quantitative and qualita- istic,” and involve the terms of • Has the manager invested
tive research. Quantitative Due participating in the fund or part- some of his own money in the mutual fund data, but there
Diligence concentrates mainly nership. Diligent investors want fund? are a few unique characteris-
on the strategy itself, while • Who is the prime broker? tics. The first characteristic is
Qualitative Due Diligence • Who is the custodian of incomplete coverage. Many
concerns itself with charac- the assets? hedge funds are not registered
teristics of the Fund and of • Who is the compliance
with the SEC, so they do not
the Manager. person, and what is his
Quantitative Due Dili- background? have to report data to anyone.
gence digs into the numbers • What data sources and Those that seek additional
generated and implied by analytic software is used to assets most likely will do so,
the hedging strategy, and run the product? especially if returns have been
why. It also wants to know • Who is the fund adminis- good. Those with mediocre
how the strategy works (is trator?
returns or that have reached
it model-driven?), whether • Can the Manager ade-
it makes intuitive sense, and quately explain the strategy capacity may choose not to
if it is repeatable. Is there and its risks taken? Do you report. This may bias the
good information in the feel that the Manager is be- average return. Survivorship
strategy, or is the man- ing evasive when answering bias can be another trait of the
ager just a lucky or skilled questions? hedge fund database. A num-
trader without a discipline? • How are the key people
ber of hedge funds fail each
Speaking of trading, there compensated? Is there sig-
should be a well-defined nificant incentive for them year, and some databases may
trading process. Some of the to stay with the firm? remove the history of these
measures used in Quanti- • Have many people re- “dead” funds. This can bias
tative Due Diligence are cently left the firm? Why? the overall returns upward if
listed here, but these do not fully to know things like the mini- • Do the key people in the we assume the dead funds had
address the risk assessment that mum investment, the fee struc- investment process have other
poor returns. Another issue
is necessary. A strategy has risk ture, the “lockup” period and duties at the firm?
exposures that are not obvious. liquidity rules, whether leverage In the end, investors are involves selection; databases
The way a hedge fund is run will is employed (does the manager investing in people, not just don’t necessarily apply the
result in certain risks such as borrow money to invest?), what a strategy. Lots of detailed same selection criteria when
market risk, currency risk, sector the latest audited fund financials questions may be asked, but choosing funds for inclusion.
risk, interest rate risk, country look like, transparency issues due diligence is not fail safe. These databases have not been
risk and factor risk (style, size, and even information on the By being diligent, however,
collecting data as long as the
etc.). It is not easy to get a Fund’s current investors. one can increase the odds of
handle on these and other risks, Perhaps the most expensive making money and of avoiding mutual fund databases have,
so an entire cottage industry and time-consuming part of due fund “blowups.” Due diligence so some funds have not been
has sprung up that offers risk diligence involves investigating will not guarantee that one around long enough for one
analytics for hedge funds. A the fund Manager. Ultimately, selects the best manager, but it to tell whether returns are at-
number of analytic software/ you want to be reasonably sure may help avoiding some of the tributed to luck or skill.
data providers are devising ways that the Manager will run the worst.

© 2010 Hedge Fund Marketing Alliance The information provided is for educational purposes only. 5
HEDGE FUND CHEAT SHEET™ HedgeFundMarketing.org

DEFINITIONS
Common Hedge Fund Terms
Absolute Return – the goal is to Hurdle Rate – the return where to a long/short strategy where short rebate is the interest earned
have a positive return, regardless the manager begins to earn one stock is bought long, and a on that cash.
of market direction. An absolute incentive fees. If the hurdle rate similar stock is sold short, often
Transportable Alpha – the
return strategy is not managed is 5% and the fund earns 15% for within the same industry. Buy-
alpha of one active strategy can
relative to a market index. the year, then incentive fees are ing the stock of Home Depot
be combined with another asset
applied to the 10% difference. and shorting Lowe’s in an equal
Arbitrage – any strategy that class. For example, an equity
amount would be an example.
invests long in an asset, and Leverage – one uses leverage if market-neutral strategy’s value-
short in a related asset, hoping he borrows money to increase Portfolio Simulation – involves added can be “transported” to
the prices will converge. his position in a security. If one testing an investment strategy by a fixed income asset class by
uses leverage and makes good “simulating” it with a database simply buying a fixed income
Attribution – the process of
investment decisions, leverage and analytic software. Often futures contract. The total return
“attributing” returns to their
can magnify the gain. However, referred to as “backtesting” a comes from both sources.
sources. For example, did the
it can also magnify a loss. strategy. The simulated returns
returns to a portfolio (over and
of the strategy are compared to
above some benchmark) come Opportunistic – a general term
those of a benchmark over a spe-
from stock selection, industry/ that describes an aggressive
cific time frame to see if it can
sector over- or under-weighting strategy with a goal of making
beat that benchmark.
or factor weighting. Software money (as opposed to holding on
programs are helpful in report- to the money one already has). Short Rebate – if you borrow
ing an attribution. stock and then sell it short, you
Pairs Trading – usually refers
have cash in your account. The

Quantitative Hedge Fund Definitions If you are seriously interested

in pursuing a career in hedge
Alpha – the return to a portfolio Drawdown – the percentage Value at Risk - a technique funds, we invite you to visit
over and above that of an appro- loss from a fund’s highest value which uses the statistical analy- JobSearchDigest.com to see
priate benchmark portfolio (the to its lowest, over a particular sis of historical market trends the types of positions available
manager’s “value added”). time frame. A fund’s “maximum and volatilities to estimate the and to begin your search.

Beta – a measure of systematic drawdown” is often looked at as likelihood that a specific portfo- Since 2002, Job Search Digest
(i.e., non-diversifiable) risk. The a measure of potential risk. lio’s losses will exceed a certain has helped finance and invest-
goal is to quantify how much amount. ment professionals to be much
R-Squared - a measure of how
systematic risk is being taken closely a portfolio’s performance Absolute vs. Relative – the more effective in their job
by the fund manager vis-à-vis varies with the performance of a hedge fund aims for absolute search. Every day their team
different risk factors, so that one benchmark, and thus a measure of return (it wants to produce posi- researches all the online job
can estimate the alpha or value- what portion of its performance tive returns regardless of what sources (including the spe-
added on a risk-adjusted basis. can be explained by the perfor- the market is doing); the mutual cialty niche sites) and captures
mance of the overall market or fund is usually managed relative every Hedge Fund, Private
Correlation – a measure of how Equity, Venture Capital and
strategy returns move with index. Hedge fund investors want to an index benchmark and is
to know how much performance judged on its variance from that Investment Banking job —
one another, in a range of –1 to giving you a competitive
+1. A correlation of –1 implies can be explained by market expo- benchmark.
sure versus manager skill. advantage in your job search.
that the strategies move in op- Self-Investment – the hedge
posite directions. In construct- Sharpe Ratio – a measure of fund manager is expected to put To get started and obtain
ing a portfolio of hedge funds, risk-adjusted return, computed some of his own capital at risk instant access to their jobs da-
one usually wants to combine by dividing a fund’s return over in the strategy. If he does not, it tabase, niche recruiter profiles,
a number of non-correlated the risk-free rate by the standard can be interpreted as a bad sign. and career resources, simply
strategies (with decent expected deviation of returns. The idea is The mutual fund does not face visit JobSearchDigest.com and
returns) to be well diversified. to understand how much risk was this same expectation. select your particular area of
undertaken to generate the alpha. interest.

6 The information provided is for educational purposes only. © 2010 Hedge Fund Marketing Alliance