Hedge Funds

The idea of using dynamic and complex trading strategies to minimize risk is said to have been started in 1949 by Alfred Winslow Jones, who began selling short some stocks while buying others, enabling him to hedge some of the market risk. Following the market crash of 2000, hedge funds proved to be a superior asset management vehicle. As many investors went through years of negative returns, hedge funds continued to produce, which led to massive amounts of money being invested from institutions. As the industry grew, many of the financial world's most talented and gifted individuals traveled over to hedge funds due to their flexibility and eye-catching compensation structure (5, preface). Almost 60 years after Mr. Jones began minimizing his risk by offsetting his investments; the hedge fund industry has around 9,000 firms and about $1.225 trillion in assets under management with an annualized growth rate of about 15 percent claims the research firm TowerGroup (1).

In 2004, D.E. Shaw & Co., Tudor Investment Corp. and Citadel Investment Group LLC managed less than $10 billion. Today these firms manage between $13 billion and $31 billion each, respectfully. Big firms are trying to transform themselves into organizations that can compete with Wall Street's investment banks by hiring employees from smaller firms. In 2003, the top 100 funds managed 49%of the assets in the market, leaving 51% to smaller firms. In 2006, the top 100 controlled 67% of the assets under management (8).

It's becoming harder for smaller funds to attract investors because bigger funds create advantages such as lower trading fees and financing costs and better risk management, and have essentially become one-stop shops . Robert Discolo of AIG says, "Today it is institutions that are going into hedge funds, and they're looking for the biggest funds. Larger, longer-established funds are increasingly capturing capital--squeezing smaller funds and making it difficult for new start-ups to raise capital" (8). Barton Biggs on young fund managers: "If you can't raise the capital, then you can't control the 'carry' (allocation of profits). An individual or firm that will fund a young guy with $20 - $50 million will be entitled to 30% - %40 of the carry" (4, p195). But there is some optimism for smaller firms because many hedge fund managers believe that institutions investing in the bigger hedge funds will move to smaller funds after they have developed sufficient knowledge of the business.

Many hedge funds, big and small, have their legal residence offshore in countries isolated from the main players involved in their operations. This makes taxes payable only by the investors, not the fund. By the end of 2004, 55% of hedge funds managing 66% of the total assets under management were registered offshore mainly in, London, Dublin, Luxembourg, and the Cayman Islands (British Virgin Islands and Bermuda) (1).

In the United States, New York, Stamford, and Greenwich, are the most popular onshore hedge fund sites. When based in the U.S., the hedge fund is structured as a limited partnership to receive favorable tax treatment. The manager of the fund acts as the corporate entity and makes all the investment decisions while the investors act as the limited partners (1).

Managers of these funds charge a 1.5% - 2% fee for running the fund. On top of their management fees they receive performance fees that can range between 20% and 50% of the gross return of the fund (1). Performance fees are computed as a percentage of the funds profits and exist because investors are usually willing to pay managers more generously when they make money. This helps align the interests of the managers with the investors. But there needs to be an instrument implemented into the manager/investor relationship to ensure investors that managers will continuously work in maximizing the funds net asset value.

High water marks are values placed on the fund that have to be met in order for managers to receive incentive fees. If the managers fail to exceed the fund's highest net asset value it has previously achieved, then the managers make no money. Let's say a fund with an NAV of 100 in the first year rose to 140 to yield a 40% return performance fee. The next year the fund NAV fell to 110, which pays no fee. The third year the NAV soars to 155 which would give you a performance fee of 15% from 140-155, not 110-155 (1). No high water mark set, then managers make money and the investors do not.

The majority of managers who are under constant pressure to perform are men. "Truth is that in the investment management business, there is an unspoken, inherent bias against women in the portfolio manager role", claims Barton Biggs (4, p206). And many of them believe that woman aren't capable of "playing the money game" for two reasons. The first reason is that they are too emotional. The second is that they have no time. Biggs says, "Managing time is essential. Limit the reading material and research. If information is obtained from conversing, then make talks short and to the point" (4, p199). If a mother, women are more than likely not to have the time to do the reading homework and put in the office and travel time due to the distractions at home (4, p207).

For the managers who are successful, male or female, the funds they manage act as individual retirement accounts. A large number of hedge fund managers today set up offshore accounts in order to avoid paying taxes on much of their income for 10 or more years(2). Their money grows tax-free in these accounts and prevents extra taxes for their investors. It also serves as a marketing tool because it draws tax-exempt investors such as pension funds as well as foreign investors, two groups investing in hedge funds today. The problem that managers face when they pump their earnings back into the fund is that the money is inaccessible at first and that if the fund fails; the deferred compensation is subject to claims from creditors (2).

A unique character trait that hedge funds obtain is that they do not have to disclose their activities to third parties. Typically located offshore, regulation of investment funds permits wider power of investment which leads to higher levels of disclosure. Recently, several portfolio managers have expressed outrage when they heard that their detailed trading histories were available to anyone willing to pay $75 thousand to overview the material (6). Many managers don't disclose this information to their own clients. The information at hand, which is comprised only of the previous year, could inevitably give competitors a chance to duplicate trading systems (6). Keeping investment strategies private is the backbone of the hedge fund