Hedge Funds

A hedge fund is a private investment fund that employs investment strategies involving various types of securities in various markets. The defining characteristic of a hedge fund is that it can take both long and short positions, and use leverage and derivatives. These private investment partnerships suffered a setback in the late 1990s when they produced poor performance and several went bankrupt. In recent years, hedge funds' strong performance has found them many fans among pension plans, charities, school endowments, and rich individuals. Wall Street houses have established or bought into hedge funds to take advantage of the rising demand for such alternative investments. For example, JPMorgan Chase purchased Highbridge Capital Management in 2004 to ride such trends. There are over 8,000 hedge funds managing about $1.5 trillion by 2007.

Hedge funds now operate in currency, government securities, derivatives, and commodities transactions as well as merger and acquisition activities. Some use complex computer models to place huge bets on movements in financial markets. In the late 1990s, hedge funds received significant attention from the news media and government regulators. The Long Term Capital Management (LTCM) crisis in 1998 raised concern about whether greater regulatory oversight in the hedge fund industry was needed. As a result, the SEC has proposed rules to require registration of hedge fund managers.

Hedge Fund Structure

Hedge funds are structured as limited partnership to avoid the application of most securities laws (Figure 13.1). Offshore hedge funds are organized in locations outside of the United States and offered to non-U.S. residents. There are two types of partners in a hedge fund, a general partner (GP) and limited partners (LPs). The GP is the entity

FIGURE 13.1 Hedge Fund Structure

Note:Investors (limited partners) and the general partner invest money in the hedge fund. The general partner manages the fund ("Manager"). Other parties provide services necessary to carry out the fund's investment strategies and service investors.

who started the hedge fund. The GP handles all trading and day-to-day operations. The LPs contribute most of the capital but are not involved in trading or day-to-day operations. Note that individual investors now have access to hedge fund investing. They can buy shares of a hedge fund company that has listed shares on the exchange. For example, Fortress Investment Group LLC went public and listed its shares on the NYSE. Investors trade this hedge fund company stock just like any other listed stocks.

The typical entity of a GP is the limited liability partnership (LLP). The LLP is preferred because the GP of a limited partnership is not liable beyond the extent of his investment in a limited partnership. The GP often serves as the fund manager. Sometimes the GP relies on advice by an investment adviser to identify investment opportunities.

The GP and LPs typically sign a partnership agreement. The partnership agreement covers some of the following items:

• Investment objectives, strategies, and risk factors

• When limited partners can invest, increase investments, and withdraw from the fund

• Details of management fee and incentive fees

• Details of how full withdraws will be handled

The majority of U.S. hedge funds charge the standard 1 percent management fee and 20 percent incentive fees. The 1 percent fee is usually charged in 0.25 percent increments quarterly, in advance. However, some charge higher fees.

Most funds observe a "high-water mark." If in a given performance fee period a fund loses money, the investors will not be charged in later periods until the losses have been recovered. Another variation is the "preferred return" where a fund will not collect an incentive fee until a certain set rate of return has been achieved. Furthermore, most funds require a minimum duration of investments into the funds, known as the lockup period. The common lockup period is one year, even though a three-year lockup is not unheard of.

Prime brokerage is a suite of services providing hedge funds with custody, clearance, financing, and securities lending. These services make it possible for the hedge fund to have multiple brokers while maintaining one brokerage account. A prime broker acts as the back office for the fund by providing the operational services necessary for the money manager to effectively manage his business. This enables the GP to focus on investment strategies rather than on operational issues. The services a good prime broker provides include:

• Centralized custody

• Securities lending

• Competitive financing rates

• One debit balance/one credit balance

• Real time, daily, monthly, and annual portfolio accounting

• Position and balance validation

• Electronic trade download

• Wash sale reports

• Office facilities in selected markets

Management Style

Hedge fund managers use many different management styles and pursue various trading strategies. The risk to investors depends on the specific strategy pursued by the fund. As indicated in Table 13.5, a market-neutral strategy has low risk while emerging markets and macro styles post very high risks. Very few funds use only one strategy, and some change their investment styles over time. Even with the same investment style, the risks sometimes vary considerably. This can be largely explained by the differing liquidity of the fund's assets. For example, David Askin's funds (Granite Partners, Granite Corp, and Quartz Hedge Fund) were classified as market neutral. Nevertheless, Askin's investments proved to be extremely risky, as the market for mortgage-backed securities became very thin and eventually caused the collapse of his highly leveraged hedge funds in 1994. Another good example is Long Term Capital Management, which was also classified as market neutral. When Russia's default on its debt obligations in 1998 triggered a flight-to-quality and a flight-to-liquidity, liquidity in the global financial system dried up, and LTCM nearly collapsed. Another fund

TABLE 13.5

Hedge Fund Investment Styles

Holding

Expected

Style

Definition

Period

Volatility

Emerging

Invest in emerging markets; shorting is not

Short/

Very high

markets

permitted in some markets, so managers must resort to other alternatives to hedge

medium term

Short only

Go only short on securities

Medium

Very high

Macro

Strategies designed to profit from major currency or interest rate shifts

Medium

Very high

Sector play

Invest in a specific sector of the market

Medium

High

Distressed

Invest primarily in securities of companies in bankruptcy or reorganization

Medium/ long

Moderate

Growth

Dominant theme involves high-growth firms

Medium/ long

Moderate

Risk arbitrage

Simultaneously long the target and short the acquirer

Medium

Moderate

Convertible

Long convertible securities and short the

Medium

Low

arbitrage

underlying equities

High yield

Invest mainly in noninvestment-grade securities

Medium

Moderate

Event driven

Play on anticipated event

Medium

Moderate

Value

Dominant theme is intrinsic value: asset, cash flow, book value, and out-of-favor stock

Long

Low/ moderate

Opportunistic

Momentum trading with short-term horizon

moderate

Market

Combine positions to create a zero-beta

Short/

Low

neutral

portfolio

medium

Convergence

Exploit temporary out-of-line relationships; take profits when relationships among various securities return to historical norm

Short/ medium

Low

Sources: Hennessee Hedge Fund Advisory Group and Van Hedge Fund Advisors, 2004.

Sources: Hennessee Hedge Fund Advisory Group and Van Hedge Fund Advisors, 2004.

betting on convergence plays went bust in 2006. Amaranth Advisors, based in Greenwich, Connecticut, made a convergence bet on the spread between two futures contracts. On September 18, 2006, the fund told its investors that it had lost more than $3 billion in the downturn of natural gas. By April of2007, it had stopped operations.

Hedge Fund Performance

Hedge funds are extremely flexible in their investment options because they use financial instruments that are generally beyond the reach of mutual funds. This flexibility, which includes the use of hedging strategies to protect downside risk, gives hedge funds the ability to better manage investment risks. Studies have shown that hedge funds usually provide excellent returns to investors. Sources of such information include Hennessee Hedge Fund Advisory Group, Van Hedge Fund Advisors, and the Hedge Fund Association.

The strong performance results of hedge funds can be linked to their performance incentives, in addition to their investment flexibility. The hedge fund GP is usually heavily invested in a significant portion of the fund and shares the rewards as well as the risks. The incentive fee remunerates the hedge fund managers in accordance with their performance. In contrast, mutual funds generally pay managers a fixed percentage of the amount of money attracted, regardless of performance. This incentive fee structure tends to attract many of Wall Street's best practitioners to the hedge fund industry.

Nevertheless, the collapse of LTCM and the failures of several other hedge funds in 1998 suggested that the hedge fund industry was becoming the victim of its own success. First of all, the star managers were attracting too much money so it was difficult to find similar investment opportunities to get top returns. At the same time, talent was being diluted, meaning that some managers lacked the necessary skills to succeed. And with more and more funds pursuing similar trading strategies, the markets were becoming more efficient and less profitable. Under pressure to produce, some funds were using more leverage and/or changing management styles. Furthermore, many star traders could not do as well on their own as they did when with a Wall Street house. Once independent, they lost the support a big firm provides in risk monitoring, advanced technology, and multiple levels of management and governance.

In recent years, hedge funds have made a comeback. Many produced above average market returns to investors. As a result, these private investment partnerships have raised management fees and upped the incentive fees as well.

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Lessons From The Intelligent Investor

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