Hedge Funds

Discussion topic: Hedge funds

I. Introduction

Hedge funds are private investment funds which charge a performance fee and typically open to only a limited number of investors. They are largely open to accredited investors only. Under Rule 506 of Regulation D of the Securities Act of 1933, accredited investor refers to an institution or high-net-worth individual that meets the following criteria: 1) Net worth higher than $1 million (for individuals or married couples) 2) Annual income greater than $200,000 for individuals or $300,000 for married couples in each of the last two years, as well as a reasonable expectation for such earnings in the current year 3) Employed as an officer or general partner of the fund 4) A bank, licensed broker-dealer, employee-benefit plan, trust or endowment with assets of $5 million or more that exists for a purpose other than investing in the fund.

Hedge funds are limited only by the terms of the contracts governing the particular fund. They may be either long or short assets and may enter into futures, swaps and other derivative contracts. Therefore, hedge funds can follow more complex investment strategies. The funds, often organized as limited partnerships, typically invest on behalf of high-net-worth individuals and institutions. Their primary objective is often to preserve investors' capital by taking positions whose returns are not closely correlated to those of the broader financial markets. Such vehicles may employ leverage, short sales, a variety of derivatives and other hedging techniques to reduce risk and increase returns Because of the substantial risks involved in unregulated, complex, and leveraged investments, hedge funds are normally open only to professional, institutional or otherwise accredited investors. This restriction is often implemented through limits on participating investors or minimum investment amounts.

II. History

The classic hedge-fund concept, a long/short investment strategy sometimes referred to as the Jones Model, was developed by Alfred Winslow Jones in 1949. Unlike traditional long-only mutual funds, the Jones model involved a limited partnership that employed a long/short investment strategy -- thus hedging the portfolio against market fluctuations. Jones, who was committed to capital preservation, targeted absolute returns rather than a return that was correlated to the broad stock market. .He charged investors a performance equal to 20% of annual gains. In 1952, he converted his general partnership fund into a limited partnership investing with several independent portfolio managers and created the first multi-manager hedge fund. In the mid 1950's other funds started using the short-selling of shares, although for the majority of these funds the hedging of market risk was not central to their investment strategy. In 1966, an article in Fortune magazine about a "hedge fund" run by a certain A. W. Jones shocked the investment community. Apparently, the fund had outperformed all the mutual funds of its time, even after accounting for a hefty 20% incentive fee. This is because the rate of return was higher on the hedge fund versus all other mutual funds.

Jones is often credited with founding the first hedge fund, but many "investment pools", "investment syndicates", "investment partnerships" or "opportunity funds" that would today be considered hedge funds were in operation long before. While most of today's hedge funds still trade stocks both long and short, some do not trade stocks at all, instead they focus on financial instruments including commodity futures, options, and emerging market debt.

III. Development

Today, the term ÐŽ§hedge fundЎЁ encompasses investment philosophies that range far from the original ÐŽ§market neutralЎЁ strategy of Jones to include the global macro styles of people like Soros and Julian Robertson. In addition, many investment firms are simply renaming their trading desks as ÐŽ§hedge fundsЎЁ and many traditional equity managers are rushing to get into what appears to be a very lucrative business. As a practical matter, hedge funds are best defined by their freedom from regulatory controls stipulated by the Investment Company Act of 1940. These controls limit fund leverage, short selling, holding shares of other investment companies, and holding more than 10% of the shares of any single company. Compensation terms typically include a minimum investment, an annual fee of 1% - 2%, and an incentive fee of 5% to 25% of annual profits. The incentive fee is usually benchmarked at 0% return each year, or against an index such as the U.S. or U.K. treasury rate. This compensation structure usually includes a ÐŽ§high water markЎЁ provision that adds past unmet thresholds to current ones.

Assets under management of the hedge fund industry totalled $1.225 trillion at the end of the second quarter of 2006 according to the recently released data by Chicago-based Hedge Fund Research Inc. (HFR). This was up 19% on the previous year and nearly twice the total three years earlier. In a separate study published by Institutional Investor News and New York City-based HedgeFund.net, total estimated assets for the industry grew by 24% in 2006 to a total of $1.9 trillion. Performance is said to have accounted for 33% of the total increase.

Because hedge funds typically use leverage/gearing or debt to invest, the positions they can take in the financial markets are larger than their assets under management. The number of hedge funds increased 10% during the past year to reach around 9,000 according to HFR. Research conducted by TowerGroup predicts that hedge fund assets will grow at an annualized rate of 15% between 2006 and 2008 while the actual number of hedge funds is likely to remain relatively flat.

IV. Strategies

The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or donÐŽ¦t use derivatives at all, and many use no leverage.

It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same -- investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be