A hedge fund is an investment fund that can undertake a wider range of investment and trading activities than other funds, but which is only open for investment from particular types of investors specified by regulators. These investors are typically institutions, such as pension funds, university endowments and foundations, or high net worth individuals. As a class, hedge funds invest in a diverse range of assets, but they most commonly trade liquid securities on public markets. They also employ a wide variety of investment strategies, and make use of techniques such as short selling and leverage.
The value of an investment in a hedge fund is calculated as a share of the fund's net asset value, meaning that increases and decreases in the value of the fund's assets (and fund expenses) are directly reflected in the amount an investor can later withdraw.
Most hedge fund investment strategies aim to achieve a positive return on investment whether markets are rising or falling. Hedge fund managers typically invest their own money in the fund they manage, which serves to align their interests with investors in the fund.[1][2] A hedge fund typically pays its investment manager a management fee, that is designed to cover the operational costs of the manager, and a performance fee if the fund's net asset value increases during the year. Some hedge funds have a net asset value of several billions dollars. As of 2009[update], hedge funds represented 1.1% of the total funds and assets held by financial institutions.[3] The estimated size of the global hedge fund industry is US$1.9 trillion.[4]
Because hedge funds are not sold to the public or retail investors, the funds and their managers have historically not been subject to the same restrictions that govern other funds and investment fund managers with regard to how the fund may be structured and how strategies and techniques are employed. Regulations passed in the United States and Europe after the 2008 credit crisis are intended to increase government oversight of hedge funds and eliminate certain regulatory gaps.[5]
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The origin of the first hedge fund is uncertain. During the US bull market of the 1920s, there were numerous such vehicles offered privately to well-heeled investors. Of that period, the best known today owing to the legacies of one of its founders was the Graham-Newman Partnership founded by Benjamin Graham and Jerry Newman.[6]
The speculative exploits of Jesse Livermore as chronicled in Reminiscences of a Stock Operator (1923) also describe speculative vehicles dubbed "pools" that are similar, if not the same, in form and function as what would later be called "hedge funds". Preceding Livermore, future statesman Bernard M. Baruch also operated such pools before jettisoning his limited partners and was later known as the "lone wolf on Wall Street" as he managed his own fortune.
Investor Warren Buffett, a former pupil and later acolyte of Benjamin Graham before founding a hedge fund in 1956, in a 2006 letter to the magazine publication of the Museum of American Finance asserts the Graham-Newman partnership of the 1920s is the first hedge fund he is aware of but suggests others may have preceded it.[6]
Sociologist, author, and financial journalist Alfred W. Jones is credited with coining the phrase "hedged fund", in contrast to prior nomenclatures, but is often erroneously credited with creating the first hedge fund structure in 1949.[7] To neutralize the effect of overall market movement, Jones balanced his portfolio by buying assets whose price he expected to increase, and selling short assets whose price he expected to decrease. Jones referred to his fund as being "hedged" to describe how the fund managed risk exposure from overall market movement.[8] This type of portfolio became known as a hedge fund.[9] Jones was the first money manager to combine a hedged investment strategy using leverage and shared risk, with fees based on performance. A 1966 Fortune magazine article reported that Jones’ fund had outperformed the best mutual funds despite his 20% performance fee.[10] By 1968 there were almost 200 hedge funds, and the first Fund of funds that utilized hedge funds was created in 1969 in Geneva.
Many of the early funds ceased trading during the Recession of 1969-70 and the 1973-1974 stock market crash due to heavy losses. In the 1970s hedge funds typically specialized in a single strategy, and most fund managers followed the long/short equity model. Hedge funds lost popularity during the downturn of the 1970s but received renewed attention in the late 1980s, following the success of several funds profiled in the media.[10]
During the 1990s the number of hedge funds increased significantly, with investments provided by the new wealth that was created during the 1990s stock market rise.[9] The increased interest from traders and investors was due to the aligned-interest compensation structure and an investment vehicle that was designed to exceed general market returns.[11] Over the next decade there was increased diversification in strategies, including: credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy, among others.[10]
During the first decade of the new century, hedge funds regained popularity worldwide and in 2008, the worldwide industry held $1.93 trillion in assets under management.[12][13] However the 2008 credit crunch was hard on hedge funds and they declined in value and hampered "liquidity in some markets" causing some hedge funds to restrict investor withdrawals.[14]
Total assets under management then rebounded and in April 2011 were estimated at almost $2 trillion.[15][16] As of January 1, 2011[update], the largest 225 hedge fund managers in the United States alone held almost $1.3 trillion.[17] with the largest hedge fund manager, Bridgewater Associates having $58.9 billion.[18] In 2011, the largest hedge funds were Bridgewater Associates ($58.9 billion), Man Group ($39.2 billion), Paulson & Co. ($35.1 billion), Brevan Howard ($31 billion), and Och-Ziff ($29.4 billion).[19] 61% of worldwide investment in hedge funds comes from institutional sources as of February 2011[update].[20]
Hedge fund managers typically charge their funds both a management fee and a performance fee.
Management fees are calculated as a percentage of the fund's net asset value and typically range from 1% to 4% per annum, with 2% being standard.[21][22][23] They are usually expressed as an annual percentage, but calculated and paid monthly or quarterly. Management fees for hedge funds are designed to cover the operating costs of the manager, whereas the performance fee provides the manager's profits. However, due to economies of scale the management fee from larger funds can generate a significant part of a manager's profits, and as a result some fees have been criticized by some public pension funds, such as CalPERS, for being too high.
The Performance fee is typically 20% of the fund's profits during any year, though they range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits.[24][25] Performance fees have been criticized by Warren Buffett, who believes that because hedge funds share only the profits and not the losses, such fees create an incentive for high-risk investment management. Performance fee rates have fallen since the start of the credit crunch.[26]
Almost all hedge fund performance fees include a "high water mark" (or "loss carryforward provision"), which means that the performance fee only applies to net profits (i.e. profits after losses in previous years have been recovered). This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather than attempting to recover the losses over a number of years without performance fee.[27]
Some performance fees include a "hurdle", so that a fee is only paid on the fund's performance in excess of a benchmark rate (e.g. LIBOR) or a fixed percentage.[28] A "soft" hurdle means the performance fee is calculated on all the fund's returns if the hurdle rate is cleared. A "hard" hurdle is calculated only on returns above the hurdle rate. A hurdle is intended to ensure that a manager is only rewarded if it generates returns in excess of the returns that the investor would have received if it had invested its money elsewhere.
Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year) or when withdrawals exceed a predetermined percentage of the original investment.[29] The purpose of the fee is to discourage short-term investing, reduce turnover and deter withdrawals after periods of poor performance. Redemption fees usually remain in the fund and benefit the remaining investors.
Hedge funds employ a wide range of trading strategies but classifying them is difficult due to the rapidity with which they change and evolve.[30] However, hedge fund strategies are generally said to fall into four main categories: global macro, directional, event-driven, and relative value (arbitrage).[31] These four categories are distinguished by investment style and each have their own risk and return characteristics. Managed futures or multi-strategy funds may not fit into these categories, but are nonetheless popular strategies with investors.[32] It is possible for hedge funds to commit to a certain strategy[33] or employ multiple strategies to allow flexibility, for risk management purposes, or to achieve diversified returns.[30] The hedge fund’s prospectus, also known as an offering memorandum, offers potential investors information about key aspects of the fund, including the fund's investment strategy, investment type, and leverage limit.[33]
The elements contributing to a hedge fund strategy include: the hedge fund's approach to the market; the particular instrument used; the market sector the fund specializes in (e.g. healthcare); the method used to select investments; and the amount of diversification within the fund. There are a variety of market approaches to different asset classes, including equity, fixed income, commodity and currency. Instruments used include: equities, fixed income, futures, options and swaps. Strategies can be divided into those in which investments can be selected by managers, known as “discretionary/qualitative”, or those in which investments are selected using a computerized system, known as “systematic/quantitative”.[34] The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager or a combination.
Sometimes hedge fund strategies are described as absolute return and are classified as either market neutral or directional. Market neutral funds have less correlation to overall market performance by “neutralizing” the effect of market swings, whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.[30][35]
Hedge funds utilizing a global macro investing strategy take sizable positions in share, bond or currency markets in anticipation of global macroeconomic events in order to generate a risk-adjusted return.[35] Global macro fund managers use macroeconomic ("big picture") analysis based on global market events and trends to identify opportunities for investment that would profit from anticipated price movements. While global macro strategies have a large amount of flexibility due to their ability to use leverage to take large positions in diverse investments in multiple markets, the timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns.[36] Global macro is often categorized as a directional investment strategy.[35]
Global macro strategies can be divided into discretionary and systematic approaches. Discretionary trading is carried out by investment managers who identify and select investments; systematic trading is based on mathematical models and executed by software with limited human involvement beyond the programming and updating of the software. These strategies can also be divided into trend or counter-trend approaches depending on whether the fund attempts to profit from following trends (long or short-term) or attempts to anticipate and profit from reversals in trends.[34]
Within global macro strategies, there are further sub-strategies including "systematic diversified", in which the fund trades in diversified markets, or "systematic currency", in which the fund trades in currency markets.[37] Other sub-strategies include those employed by Commodity Trading Advisors (CTA), where the fund trades in futures (or options) in commodity markets or in swaps.[38] This is also known as a managed future fund.[35] CTAs trade in commodities (such as gold) and financial instruments, including stock indexes. In addition they take both long and short positions, allowing them to make profit in both market upswings and downswings.[39]
Directional investment strategies utilize market movements, trends, or inconsistencies when picking stocks across a variety of markets. Computer models can be used, or fund managers will identify and select investments. These types of strategies have a greater exposure to the fluctuations of the overall market than do market neutral strategies.[30][35] Directional hedge fund strategies include US and international long/short equity hedge funds, where long equity positions are hedged with short sales of equities or equity index options.
Within directional strategies, there are a number of sub-strategies. "Emerging markets" funds focus on emerging markets such as China and India,[40] whereas "sector funds" specialize in specific areas including technology, healthcare, biotechnology, pharmaceuticals, energy and basic materials. Funds using a "fundamental growth" strategy invest in companies with more earnings growth than the overall equity market or relevant sector, while funds using a "fundamental value" strategy invest in undervalued companies.[41] Funds that use quantitative techniques for equity trading are described as using a "quantitative directional" strategy.[42] Funds using a "short bias" strategy take advantage of declining equity prices using short positions.[43]
Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event.[44] An event-driven investment strategy finds investment opportunities in corporate transactional events such as consolidations, acquisitions, recapitalizations, bankruptcies, and liquidations. Managers employing such a strategy capitalize on valuation inconsistencies in the market before or after such events, and take a position based on the predicted movement of the security or securities in question. Large institutional investors such as hedge funds are more likely to pursue event-driven investing strategies than traditional equity investors because they have the expertise and resources to analyze corporate transactional events for investment opportunities.[36][45]
Corporate transactional events generally fit into three categories: distressed securities, risk arbitrage and special situations.[36] Distressed securities include such events as restructurings, recapitalizations, and bankruptcies.[36] A distressed securities investment strategy involves investing in the bonds or loans of companies facing bankruptcy or severe financial distress, when these bonds or loans are being traded at a discount to their value. Hedge fund managers pursuing the distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds purchasing distressed debt may prevent those companies from going bankrupt, as such an acquisition deters foreclosure by banks.[35] While event-driven investing in general tends to thrive during a bull market, distressed investing works best during a bear market.[45]
Risk arbitrage or merger arbitrage includes such events as mergers, acquisitions, liquidations, and hostile takeovers.[36] Risk arbitrage typically involves buying and selling the stocks of two or more merging companies to take advantage of market discrepancies between acquisition price and stock price. The risk element arises from the possibility that the merger or acquisition will not go ahead as planned; hedge fund managers will use research and analysis to determine if the event will take place.[45][46]
Special situations are events that impact the value of a company's stock, including the restructuring of a company or corporate transactions including spin-offs, share-buy-backs, security issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company's equity and equity-related instruments.[47]
Other event-driven strategies include: credit arbitrage strategies, which focus on corporate fixed income securities; an activist strategy, where the fund takes large positions in companies and uses the ownership to participate in the management; and legal catalyst strategy, which specializes in companies involved in major lawsuits.
Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, the underlying security or the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical, technical or fundamental techniques.[48] Relative value is often used as a synonym for market neutral, as strategies in this category typically have very little or no directional market exposure to the market as a whole.[49] Other relative value sub-strategies include:
In addition to those strategies within the four main categories, there are several strategies that do not fit into these categorizations or can apply across several of them.
Because investments in hedge funds can add diversification to investment portfolios, investors may use them as a tool to reduce their overall portfolio risk exposures.[50] Managers of hedge funds use particular trading strategies and instruments with the specific aim of reducing market risks to produce risk-adjusted returns, which are consistent with investors' desired level of risk.[51] Hedge funds ideally produce returns relatively uncorrelated with market indices.[52] While "hedging" can be a way of reducing the risk of an investment, hedge funds, like all other investment types, are not immune to risk. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500 between 1993 and 2010.[53]
Investors in hedge funds are, in most countries, required to be sophisticated qualified investors who are assumed to be aware of the investment risks, and accept these risks because of the potential returns relative to those risks. Fund managers may employ extensive risk management strategies in order to protect the fund and investors. According to the Financial Times, "big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management."[51] Hedge fund managers may hold a large number of investment positions for short durations and are likely to have a particularly comprehensive risk management system in place. Funds may have "risk officers" who assess and manage risks but are not otherwise involved in trading, and may employ strategies such as formal portfolio risk models.[54] A variety of measuring techniques and models may be used to calculate the risk incurred by a hedge fund's activities; fund managers may use different models depending on their fund's structure and investment strategy.[52][55] Some factors,such as normality of return, are not always accounted for by conventional risk measurement methodologies. Funds which use value at risk as a measurement of risk may compensate for this by employing additional models such as drawdown and “time under water” to ensure all risks are captured.[56]
In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence to assess the risk that error or fraud at a hedge fund might result in loss to the investor. Considerations will include the organisation and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund's ability to develop as a company.[57]
Since hedge funds are private entities and have few public disclosure requirements, this is sometimes perceived as a lack of transparency.[58] Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/or registration requirements as other financial investment managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud.[55] New regulations introduced in the US and the EU as of 2010 require hedge fund managers to report more information, leading to greater transparency.[59] In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and external regulatory requirements.[51] The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology, positions and leverage exposure.[60]
Hedge funds share many of the same types of risk as other investment classes, including liquidity risk and manager risk.[55] Liquidity refers to the degree to which an asset can be bought and sold or converted to cash; similar to private equity funds, hedge funds employ a lock-up period during which an investor cannot remove money.[35][61] Manager risk refers to those risks which arise from the management of funds. As well as specific risks such as style drift, which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors include valuation risk, capacity risk, concentration risk and leverage risk.[58] Valuation risk refers to the concern that the net asset value of investments may be inaccurate;[62] capacity risk can arise from placing too much money into one particular strategy, which may lead to fund performance deterioration;[63] and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group of correlated funds.[64] These risks may be managed through defined controls over conflict of interest,[62] restrictions on allocation of funds,[63] and set exposure limits for strategies.[64]
Many investment funds use leverage, the practice of borrowing money or trading on margin in addition to capital from investors. Although leverage can increase potential returns, the opportunity for larger gains is weighed against the possibility of greater losses.[61] Hedge funds employing leverage are likely to engage in extensive risk management practices.[54][58] In comparison with investment banks, hedge fund leverage is relatively low; according to a National Bureau of Economic Research working paper, the average leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.[65]
Some types of funds, including hedge funds, are perceived as having a greater appetite for risk, with the intention of maximizing returns,[61] subject to the risk tolerance of investors and the fund manager. Managers will have an additional incentive to increase risk oversight when their own capital is invested in the fund.[54]
A hedge fund itself has no employees and no assets other than its investments. The portfolio is managed by the investment manager, a separate entity which is the actual business and has employees.
As well as the investment manager, the functions of a hedge fund are delegated to a number of other service providers. The most common service providers are:
The legal structure of a specific hedge fund – in particular its domicile and the type of legal entity used – is usually determined by the tax environment of the fund’s expected investors. Regulatory considerations will also play a role. Many hedge funds are established in offshore financial centres so that the investor, rather than the fund, pays tax on the increase in the value of the portfolio. The investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund.
It is estimated that around 60% of the number of hedge funds in 2010 were registered offshore, with the Cayman Islands accounting for 37%, the British Virgin Islands 7% and Bermuda 5%. Among onshore funds, Delaware (US) accounts for 27% and the EU (primarily Ireland and Luxembourg) accounts for 5%.[66]
In contrast to the funds themselves, investment managers are primarily located onshore in order to draw on the major pools of financial talent and to be close to investors. With the bulk of hedge fund investment coming from the US East coast – principally New York City and the Gold Coast area of Connecticut – this has become the leading location for hedge fund managers. It was estimated there were 7,000 investment managers in the United States in 2004.[67]
London is Europe’s leading centre for hedge fund managers, with 70% of European hedge fund investments, about $420 billion, at the end of 2010. Asia, and more particularly China, is taking on a more important role as a source of funds for the global hedge fund industry. The UK and the US are leading locations for management of Asian hedge funds' assets with around a quarter of the total each.[66]
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, which would otherwise be subject to more complex tax issues by investing in a tax-transparent entity such as a partnership, and US entities that do not pay tax such as state, corporate, private and union pension funds, which would otherwise be subject to unrelated business income tax in the United States. Unit trusts are sometimes used to market to Japanese investors. Other than taxation, the type of entity used does not have a significant bearing on the nature of the fund.
The investment manager, which will have organized the establishment of the hedge fund, may retain an interest in the hedge fund, either as the general partner of a limited partnership or as the holder of “founder shares” in a corporate fund. Founder shares typically have no economic rights, and voting rights over only a limited range of issues, such as selection of the investment manager. The fund’s strategic decisions are taken by the board of directors of the fund, which is independent but generally loyal to the investment manager.
Hedge funds are typically open-ended, meaning that the fund will periodically accept further investment and allow investors to withdraw their money from the fund. For a fund structured as a company, shares will be both issued and redeemed at the net asset value (“NAV”) per share, so that if the value of the underlying investments has increased (and the NAV per share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Similarly, where a fund is structured as a limited partnership the investor's account will be allocated its proportion of any increase or decrease in the NAV of the fund, allowing an investor to withdraw more (or less) when it withdraws its capital.
Investors do not typically trade shares or limited partnership interests among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund, which either has a limited number of shares which are traded among investors, and which distributes its profits, or which has a limited lifespan at the end of which capital is returned to investors. Most hedge funds allow money to be withdrawn monthly or quarterly, while others allow it biannually or annually.[68][69]
Where a hedge fund holds assets that are hard to value reliably or are relatively illiquid (in comparison to the redemption terms of the fund itself), the fund may employ a "side pocket". A side pocket is a mechanism whereby the fund segregates the illiquid assets from the main portfolio of the fund and issues investors with a new class of interests or shares which participate only in the assets in the side pocket. Those interests/shares cannot be redeemed by the investor. Once the fund is able to sell the side pocket assets, the fund will generally redeem the side pocket interests/shares and pay investors the proceeds.
Side pockets are designed to address issues relating to the need to value investors' holdings in the fund if they choose to redeem. If an investor redeems when certain assets cannot be valued or sold, the fund cannot be confident that the calculation of his redemption proceeds would be accurate. Moreover, his redemption proceeds could only be obtained by selling the liquid assets of the fund. If the illiquid assets subsequently turned out to be worth less than expected, the remaining investors would bear the full loss while the redeemed investor would have borne none. Side pockets therefore allow a fund to ensure that all investors in the fund at the time the relevant assets became illiquid will bear any loss on them equally and allow the fund to continue subscriptions and redemptions in the meantime in respect of the main portfolio. A similar problem, inverted, applies to subscriptions during the same period.
Side pockets are most commonly used by funds as an emergency measure. They were used extensively following the collapse of Lehman Brothers in September 2008, when the market for certain types of assets held by hedge funds collapsed, preventing the funds from selling or obtaining a market value for the assets.
Specific types of fund may also use side pockets in the ordinary course of their business. A fund investing in insurance products, for example, may routinely side pocket securities linked to natural disasters following the occurrence of such a disaster. Once the damage has been assessed, the security can again be valued with some accuracy.
Corporate hedge funds sometimes list their shares on smaller stock exchanges, such as the Irish Stock Exchange, as this provides a low level of regulatory oversight that is required by some investors. Shares in the listed hedge fund are not generally traded on the exchange.
A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an investment manager. Although widely reported as a "hedge-fund IPO",[70] the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.[71]
A range of regulatory methods are used to provide oversight of hedge funds worldwide. According to a report by the International Organization of Securities Commissions, the most common tactic is the direct regulation of financial advisers—including hedge fund managers, which is primarily intended to protect investors against fraud. Specific regulations differ by national, federal and state jurisdiction. Historically, hedge funds have been exempted from certain registration and reporting requirements that apply to other investment companies, because in most jurisdictions regulation permits investments in hedge funds by only "qualified" investors who are able to make an informed decision about investment decisions without relying on regulatory oversight.[35] In 2010, new regulations were passed in the US and European Union, which (among other changes) introduced new hedge fund reporting requirements. The Dodd-Frank Wall Street Reform Act was passed in the US in July 2010, and contains provisions which require hedge fund advisers with $150 million or more in assets to register with the SEC.[5] In November 2010, the EU Parliament passed the Alternative Investment Fund Managers Directive, which seeks to provide greater monitoring and control of alternative investment fund managers operating in the EU.[72]
Hedge funds within the US are subject to various regulatory trading reporting and record keeping requirements that also apply to other investors in publicly traded securities.[73] Before the Dodd-Frank Act made registration mandatory for hedge fund advisers with more than US$150 million in assets under management, hedge funds were primarily regulated through their managers or advisers, under the anti-fraud provisions of the Investment Advisers Act of 1940. Hedge funds are privately-owned pools of investment capital with regulatory limits on the number and type of investor that each fund may have. Because of these regulatory restrictions on ownership, hedge funds have been exempted from mandatory registration with the US Securities and Exchange Commission (SEC) under the Investment Company Act of 1940, which is generally intended to regulate investment funds sold to retail investors.[35] The two primary exemptions in the Investment Company Act of 1940 that hedge funds relied on were (a) Section 3(c)1 which restricts funds to 100 or fewer investors and (b) Section 3(c)7, which requires all investors to meet a "qualified purchaser" criterion. These sections also both prohibit hedge funds from selling their securities through public offerings.[74][75] Under 3(c)7, a qualified purchaser is defined to include an individual with at least $5,000,000 in investment assets. Companies, including institutional investors, generally qualify as qualified purchasers if they have at least $25,000,000 in investment assets.[76] Although under Section 3(c)7 a fund can have an unlimited number of investors, if a fund has any class of equity securities owned by more than 499 investors, it must register its securities with the SEC under the Securities Exchange Act of 1934.[77][78]
Because Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940 prohibit hedge funds from making public offerings, funds must sell their securities in accordance with the private offering rules under the Securities Act of 1933. The 1933 Act generally requires companies to file a registration statement with the SEC if they want to sell their securities publicly, or comply with private placement rules under the Act.[79] Though the securities of hedge funds are not registered under the 1933 Act, they remain subject to the anti-fraud provisions of the Act.
Hedge funds raise capital via private placement under Regulation D of the Securities Act of 1933, which means the shares are not registered. To comply with the private placement rules in Regulation D, hedge funds generally offer their securities solely to accredited investors. An accredited investor is an individual person with a minimum net worth of $1,000,000 or, alternatively, a minimum income of $200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. For banks and corporate entities, the minimum net worth is $5,000,000 in invested assets.[80]
For SEC registered hedge fund advisers to charge an incentive or performance fee, the investors in the funds must be "qualified clients" as defined in the Investment Advisers Act of 1940 Rule 205–3. To be a qualified client an individual must have $750,000 in assets invested with the adviser or a net worth in excess of $1.5 million, or be one of certain high-level employees of the investment adviser.[81] Under the Dodd-Frank Act, the SEC is required to periodically adjust the qualified client standard for inflation.[82]
Because hedge funds do not have publicly traded securities, they are not subject to all of the reporting requirements of the Securities Exchange Act of 1934. Hedge funds that have a class of equity securities owned by more than 499 investors do, however, have to register under Section 12(g) of the 1934 Act and are subject the quarterly reporting requirements of the Act.[83] Similar to other institutional investors, hedge fund managers with at least $100,000,000 in assets under management are required to file publicly quarterly reports disclosing ownership of registered equity securities. Also similar to other investors, hedge fund managers are subject to public disclosure if they own more than 5% of the class of any registered equity security.[77] Hedge fund managers are also subject to anti-fraud provisions.
Prior to the requirements of the Dodd-Frank Act, many hedge fund advisers voluntarily registered with the SEC. Advisers who do so are subject to the same requirements as all other registered investment advisers. Registered advisers must provide information about their business practices and disciplinary history to the SEC and investors. They are required to have written compliance policies and have a chief compliance officer to enforce those policies. In addition, they are required to maintain certain books and records and have their practices examined by SEC staff.[73] As a result of the Dodd-Frank Wall Street Reform Act, hedge fund advisers with at least $150,000,000 in assets under management will be required to register with the SEC as of July 21, 2011, while smaller advisers will be subject to state registration.[84]
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.[85] The requirement, with minor exceptions, applied to firms managing in excess of $25,000,000 with over 14 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.[86] The new rule was controversial, with two commissioners dissenting,[87] and was later challenged in court by a hedge fund manager. In June 2006, the U.S. Court of Appeals for the District of Columbia overturned the rule and sent it back to the agency to be reviewed.[88] In response to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the earlier challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity.[89]
Many hedge funds also fall under the jurisdiction of the Commodity Futures Trading Commission. Hedge fund advisers registered as Commodity Pool Operators (CPO) or Commodity Trading Advisors (CTA) would fall within this category, as would any manager of a hedge fund investing in markets under the CFTC’s jurisdiction, even if they qualify for an exemption from CPO or CTA registration. Hedge fund managers who meet these criteria are subject to rules and provisions of the Commodity Exchange Act prohibiting fraud and manipulation.[90]
The regulations and restrictions that apply to hedge funds and mutual funds differ in three major ways.[91] First, mutual funds are required to be registered with and regulated by the SEC, while hedge funds historically have not. Investors in hedge funds must be accredited investors, with certain exceptions (employees, etc.), and cannot be marketed to retail investors; mutual funds, however, do not have this restriction. Finally, mutual funds must be liquid on a daily basis. If a mutual fund investor wishes to redeem his or her investment the fund must be able to meet that request immediately. Hedge funds 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.
Mutual funds must also determine the net asset value (NAV) of the fund. While some hedge funds that are based offshore report their NAV to the Financial Times, for the most part there is no method of ascertaining pricing on a regular basis. In addition, mutual funds must have a prospectus available to anyone who requests one (either electronically or via US postal mail), and must disclose their asset allocation quarterly, whereas hedge funds do not have to abide by these terms.
All investment funds are subject to regulations that prohibit charging fees to investors, unless the investment performance of the fund is equivalent to that of an index or other measure of performance. This regulation is set out under Section 205(b) of the Investment Advisers Act of 1940, which limits performance fees to so-called "fulcrum fees". Due to this regulation, hedge funds charging a performance fee are unique compared with other funds.[92]
The Dodd-Frank Wall Street Reform Act was passed in the US in July 2010, aiming to increase regulation of financial companies, including hedge funds.[5][59] The act requires advisers with private pools of capital exceeding $150 million or more in assets to register with the SEC as investment advisers and become subject to all rules which apply to registered advisers by July 21, 2011. Previous exemptions from registration provided under the Investment Advisers Act of 1940 will no longer apply to most hedge fund advisers.[84] Under Dodd-Frank, hedge fund managers who have less than $100 million in assets under management will be overseen by the state where the manager is domiciled and become subject to state regulation.[84] This will significantly increase the number of hedge funds under state supervision, as the threshold for SEC regulation was previously $30 million.[93] In addition to US hedge funds, many overseas funds with more than 15 US clients and investors, and managing more than $25 million for these clients, will also have to register with the SEC by July 21, 2011.[5] Mandatory registration of hedge fund advisers was supported by the largest hedge fund trade group, the Managed Funds Association (MFA), which announced its support for registration in testimony to a US congressional committee on May 7, 2009.[94]
Additionally, Dodd-Frank requires hedge funds to provide information about their trades and portfolios to help regulators fulfill their obligation to monitor and regulate systemic risk. The aim is for this data to be analyzed and shared among regulators – including the newly created Financial Stability Oversight Council – and for the SEC to report to Congress on how the data is being used to protect both investors and market integrity.[93] Under the so-called "Volcker Rule", regulators are also required to implement regulations for banks, their affiliates and holding companies to limit their relationships with hedge funds and also to prohibit these organizations from proprietary trading, and limit their investment in, and sponsorship of hedge funds.[93]
Within the European Union (EU), as with the US, hedge funds are primarily regulated through advisers who manage the funds.[35] In the United Kingdom, which is the hedge fund centre of the EU, hedge fund managers are required to be authorised and regulated by the Financial Services Authority (FSA), the national regulator.[72] Historically, there have been different regulatory approaches within each country in the EU. In some countries there are specific restrictions on hedge fund activities, including controls on use of derivatives in Portugal, and limits on leverage in France.[35]
In 2010, the EU approved a law that will require all EU hedge fund managers to register with national regulatory authorities. The EU's Directive on Alternative Investment Fund Managers (AIFMD) was passed by the EU Parliament on November 11, 2010 and is the first EU directive focused on "alternative investment fund managers", including hedge fund managers.[72] According to the EU, the aim of the directive is to provide greater monitoring and control of alternative investment funds.[95] The directive requires managers to disclose more information, on a more frequent basis, to regulators about their investment strategies. The directive also introduces a rule that hedge fund managers should hold larger amounts of capital. All hedge fund managers within the EU will also be subject to potential limitations on the amount of leverage they can use.[59] Since AIFMD covers the entire EU, and individual countries have different rules for hedge fund marketing, the directive introduced a "passport" for hedge funds authorized in one EU country to operate throughout the EU.[59][72] The scope of AIFMD is broad and encompasses managers located within the EU as well as non-EU managers that market their funds to European investors. Countries within the EU are required to adopt the directive in national legislation by early 2013.[59]
Offshore centers offer business-friendly regulation, which has encouraged the establishment of hedge funds. Major centers include the Cayman Islands, Dublin, Luxembourg, the British Virgin Islands, and Bermuda.[96] Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centers. 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.
In Asia, Singapore offers fewer licensing requirements and regulations for hedge funds than Hong Kong and other financial capitals in the region.[5] Singapore’s oversight of hedge funds will increase following the introduction of new rules and regulations in 2011,[72] but small funds will be able to continue operating without a license. Hedge funds based in Hong Kong are subject to the same licensing requirements as mutual funds.[5]
In South Africa, investment fund managers require approval and registration from the Financial Services Board (FSB) for them to operate as hedge fund investment managers. Some restrictions preclude the South African market from following international trends, the local is restricted to local investment opportunities in terms of exchange control, the lack of regulated structures restricts the amount of exposure which the South African retirement fund industry has to hedge fund strategies and foreign investors are put off investing directly into South African hedge funds by adverse taxes and other obstacles.[97]
Many international hedge fund markets are affected by regulation passed in 2010 within the United States and European Union. Under the EU’s Alternative Investment Fund Managers directive, offshore hedge funds using prime brokers as depositaries will be required to use EU-registered credit institutions before they can be sold in the EU.[98] The AIFMD’s regulatory requirements will essentially mandate equivalent regulations for non-EU investment funds, if they wish to operate in EU markets.[72]
The Dodd-Frank Act, passed in the US in 2010, will have several key implications for overseas hedge funds. Funds with more than 15 US clients and investors managing $25 million or more will have to register with the SEC by July 21, 2011. Registered managers must file and maintain information including the assets under management and trading positions. Prior to the Dodd-Frank act, some Asian hedge funds had registered with the SEC.[5]
There are many indices that track the hedge fund industry, and these fall into three main categories. In their historical order of development they are Non-investable, Investable and Clone.
In traditional equity investment, indices play a central and unambiguous role. They are widely accepted as representative, and products such as futures and ETFs provide investable access to them in most developed markets. However hedge funds are illiquid, heterogeneous and ephemeral, which makes it hard to construct a satisfactory index. Non-investable indices are representative, but, due to various biases, their quoted returns may not be available in practice. Investable indices achieve liquidity at the expense of limited representativeness. Clone indices seek to replicate some statistical properties of hedge funds but are not directly based on them. None of these approaches is wholly satisfactory.
Non-investable indices are indicative in nature, and aim to represent the performance of some database of hedge funds using some measure such as mean, median or weighted mean from a hedge fund database. The databases have diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different indices.
Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list of biases.
Funds’ participation in a database is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money.
The short lifetimes of many hedge funds means that there are many new entrants and many departures each year, which raises the problem of survivorship bias. If we examine only funds that have survived to the present, we will overestimate past returns because many of the worst-performing funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial.
When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favorable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias” or “backfill bias”.
Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. To create an investable index, the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. When investors buy these products the index provider makes the investments in the underlying funds, making an investable index similar in some ways to a fund of hedge funds portfolio.
To make the index investable, hedge funds must agree to accept investments on the terms given by the constructor. To make the index liquid, these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. This means that investable indices do not represent the total universe of hedge funds, and most seriously they may under-represent more successful managers.
The most recent addition to the field approach the problem in a different manner. Instead of reflecting the performance of actual hedge funds they take a statistical approach to the analysis of historic hedge fund returns, and use this to construct a model of how hedge fund returns respond to the movements of various investable financial assets. This model is then used to construct an investable portfolio of those assets. This makes the index investable, and in principle they can be as representative as the hedge fund database from which they were constructed.
However, they rely on a statistical modelling process. As replication indices have a relatively short history it is not yet possible to know how reliable this process will be in practice, although initially indications are that much of hedge fund returns can be replicated in this manner without the problems of illiquidity, transparency and fraud that exist in direct hedge fund investments.
Systemic risk refers to the risk of instability across the entire financial system, as opposed to within a single company. Such risk may arise following a destabilizing event or events affecting a group of financial institutions linked through investment activity.[99] Organizations such as the National Bureau of Economic Research[99] and the European Central Bank have charged that hedge funds pose systemic risks to the financial sector,[100][101] and following the failure of hedge fund Long-Term Capital Management (LTCM) in 1998 there was widespread concern about the potential for systemic risk if a hedge fund failure led to the failure of its counterparties. (As it happens, no financial assistance was provided to LTCM by the US Federal Reserve, so there was no direct cost to US taxpayers,[102] but a large bailout had to be mounted by a number of financial institutions.)
However these claims are widely disputed by the financial industry.[103] Financial writer Sebastian Mallaby has described hedge funds as "small enough to fail".[104][105] Hedge funds fail regularly, and numerous hedge funds failed during the financial crisis.[106] In testimony to the House Financial Services Committee in 2009, Ben Bernanke, the Federal Reserve Board Chairman said he “would not think that any hedge fund or private equity fund would become a systemically-critical firm individually”.[107]
Nevertheless, although hedge funds go to great lengths to reduce the ratio of risk to reward, inevitably a number of risks remain.[108] Systemic risk is increased if in a crisis there is "herd" behaviour, causing a number of similar hedge funds to make losses in similar trades. The extensive use of leverage (loans to amplify gains) can lead to forced liquidations in a crisis. This can be exacerbated by the illiquid nature of some investments. The close interconnectedness of the hedge funds with their prime brokers, typically investment banks, can lead to domino effects in a crisis, and indeed failing counterparty banks can freeze hedge funds, as with Lehmans in 2008. The large sums of money involved – globally, well over a trillion US dollars, and amplified by leverage – add to all these risks.
Starting in October 2009, the UK Financial Services Authority (FSA) commenced six-monthly surveys of the risks posed by hedge funds and their counterparties. The July 2011 survey[109] looked at market dislocation risks and counterparty risks caused by losses for a broad spread of more than 100 funds managed by about 50 managers, with total assets of about US$390bn, amounting to about 20% of global hedge fund assets under management. It concluded that risks were limited and had reduced as a result inter alia of larger margins being required by counterparty banks, but might change rapidly according to market conditions. In stressed market conditions, investors might suddenly withdrawal large sums, resulting in forced asset sales. This might cause liquidity and pricing problems if it occurred across a number of funds or in one large highly-leveraged fund.
As private, lightly regulated entities, hedge funds are not obliged to disclose their activities to third parties. This is in contrast to a regulated mutual fund (or unit trust), which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment advisor of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, while some hedge funds have very limited transparency even to investors.[110]
Funds may choose to report some information in the interest of recruiting additional investors. Much of the data available in consolidated databases is self-reported and unverified.[111] A study was done on two major databases containing hedge fund data. The study noted that 465 common funds had significant differences in reported information (e.g. returns, inception date, net assets value, incentive fee, management fee, investment styles, etc.) and that 5% of return numbers and 5% of NAV numbers were dramatically different.[112] With these limitations, investors have to do their own research, which may cost on the scale of $50,000.[113]
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[114] which allegedly defrauded clients of close to $180 million.[115] In December 2008, Bernard Madoff was arrested for running a $50 billion Ponzi scheme.[116] While Madoff did not run a hedge fund, several feeder funds, of which the largest was Fairfield Sentry, channelled money to Madoff.
Alpha appears to have been becoming rarer for two related reasons. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more managers, which may dilute the talent available in the industry, though these causes are disputed.[117]
In June 2006, prompted by a letter from Gary J. Aguirre, the Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. Aguirre was fired from his job with the SEC when, as lead investigator of insider trading allegations against Pequot Capital Management, he tried to interview John Mack, then being considered for chief executive officer at Morgan Stanley.[118] The Judiciary Committee and the US Senate Finance Committee issued a scathing report in 2007, which found that Aguirre had been illegally fired in reprisal[119] for his pursuit of Mack and in 2009, the SEC was forced to re-open its case against Pequot. Pequot settled with the SEC for $28 million and Arthur J. Samberg, chief investment officer of Pequot, was barred from working as an investment advisor.[120] Pequot closed its doors under the pressure of investigations.[121]
The SEC is focusing resources on investigating insider trading by hedge funds,[122][123] though a statement by SEC Enforcement Director Robert Khuzami put some of its impact in question[124] and Senator Chuck Grassley has asked for an explanation of Khuzami's remarks.[125]
Performance statistics for individual hedge funds are difficult to obtain, as the funds have historically not been required to report their performance to a central repository and restrictions against public offerings and advertisement have led many managers to refuse to provide performance information publicly. However, summaries of individual hedge fund performance are occasionally available in industry journals[126][127] and databases.[128] and investment consultancy Hennessee Group.[129]
One estimate is that the average hedge fund returned 11.4% per year,[104] representing a 6.7% return above overall market performance before fees, based on performance data from 8,400 hedge funds.[35] Another is that between January 2000 and December 2009 the hedge funds outperformed other investments were significantly less volatile, with stocks falling −2.62% per year over the decade and hedge funds rising +6.54%.[129]
Hedge funds performance is measured by comparing their returns to an estimate of their risk.[130] Common measures are the Sharpe ratio.,[131] Treynor measure and Jensen's alpha.[132] These measures work best when returns follow normal distributions without autocorrelation, and these assumptions are often not met in practice.[133]
New performance measures have been introduced that attempt to address some of theoretical concerns with traditional indicators, including: modified Sharpe ratios;[133][134] the Omega ratio introduced by Keating and Shadwick in 2002;[135] Alternative Investments Risk Adjusted Performance (AIRAP) published by Sharma in 2004;[136] and Kappa developed by Kaplan and Knowles in 2004.[137]
According to modern portfolio theory, rational investors will seek to hold portfolios that are mean/variance efficient (that is, portfolios offer the highest level of return per unit of risk, and the lowest level of risk per unit of return). One of the attractive features of hedge funds (in particular market neutral and similar funds) is that they sometimes have a modest correlation with traditional assets such as equities. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers, reducing overall portfolio risk.[28]
However, there are three reasons why one might not wish to allocate a high proportion of assets into hedge funds. These reasons are:
Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in investor portfolios, but this is disputed for example by Mark Kritzman[138][139] who performed a mean-variance optimization calculation on an opportunity set that consisted of a stock index fund, a bond index fund, and ten hypothetical hedge funds. The optimizer found that a mean-variance efficient portfolio did not contain any allocation to hedge funds, largely because of the impact of performance fees. To demonstrate this, Kritzman repeated the optimization using an assumption that the hedge funds incurred no performance fees. The result from this second optimization was an allocation of 74% to hedge funds.
The other factor reducing the attractiveness of hedge funds in a diversified portfolio is that they tend to under-perform during equity bear markets, just when an investor needs part of their portfolio to add value.[28] For example, in January–September 2008, the Credit Suisse/Tremont Hedge Fund Index[140] was down 9.87%. According to the same index series, even "dedicated short bias" funds had a return of −6.08% during September 2008. In other words, even though low average correlations may appear to make hedge funds attractive this may not work in turbulent period, for example around the collapse of Lehman Brothers in September 2008.
Hedge funds posted disappointing returns in 2008, but the average hedge fund return of −18.65% (the HFRI Fund Weighted Composite Index return) was far better than the returns generated by most assets other than cash or cash equivalents. The S&P 500 total return was −37.00% in 2008, and that was one of the best performing equity indices in the world. Several equity markets lost more than half their value. Most foreign and domestic corporate debt indices also suffered in 2008, posting losses significantly worse than the average hedge fund. Mutual funds also performed much worse than hedge funds in 2008. According to Lipper, the average US domestic equity mutual fund decreased 37.6% in 2008. The average international equity mutual fund declined 45.8%. The average sector mutual fund dropped 39.7%. The average China mutual fund declined 52.7% and the average Latin America mutual fund plummeted 57.3%. Real estate, both residential and commercial, also suffered significant drops in 2008. In summary, hedge funds outperformed many similarly-risky investment options in 2008.
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