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As on February 7, 2012 Taken from: Wikipedia - Hedge fund Introduction 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. Hedge funds are typically open-ended, meaning that investors can invest and withdraw money at regular, specified intervals. 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. A hedge fund typically pays its investment manager a management fee, which is a percentage of the assets of the fund, 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 billion dollars. As of 2009, hedge funds represented 1.1% of the total funds and assets held by financial institutions. The estimated size of the global hedge fund industry is US$1.9 trillion. 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. History 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 wealthy 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. The fictional 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 removing his investors and was later known as the "lone wolf on Wall Street", as he managed his own fortune. Warren Buffett, in a 2006 letter to the magazine publication of the Museum of American Finance asserted that the Graham-Newman partnership of the 1920s was the first hedge fund he was aware of, but suggested others may have preceded it. Sociologist, author, and financial journalist Alfred W. Jones is credited with coining the phrase "hedged fund", in contrast to prior nomenclatures, and is often erroneously credited with creating the first hedge fund structure in 1949. 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. This type of portfolio became known as a hedge fund. 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. 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. 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. 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. Over the next decade there was increased diversification in strategies, including: credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy, among others. 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. 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. Total assets under management then rebounded and in April 2011 were estimated at almost $2 trillion. As of January 1, 2011 (2011 -01-01), the largest 225 hedge fund managers in the United States alone held almost $1.3 trillion. with the largest hedge fund manager, Bridgewater Associates having $58.9 billion. 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). As of February 2011, 61% of worldwide investment in hedge funds comes from institutional sources. Fees 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. 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. 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. 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. 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. 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. The purpose of the fee is to discourage short-term investing, reduce turnover and deter withdrawals after periods of poor performance. Strategies Hedge funds employ a wide range of trading strategies but classifying them is difficult due to the rapidity with which they change and evolve. However, hedge fund strategies are generally said to fall into four main categories: global macro, directional, event-driven, and relative value (arbitrage). 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. It is possible for hedge funds to commit to a certain strategy or employ multiple strategies to allow flexibility, for risk management purposes, or to achieve diversified returns. 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. 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”. 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. Global macro 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. 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. Global macro is often categorized as a directional investment strategy. 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. 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. 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. This is also known as a managed future fund. 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. Directional 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. 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, 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. Funds that use quantitative techniques for equity trading are described as using a "quantitative directional" strategy. Funds using a "short bias" strategy take advantage of declining equity prices using short positions. Event-driven Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event. 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. Corporate transactional events generally fit into three categories: distressed securities, risk arbitrage and special situations. Distressed securities include such events as restructurings, recapitalizations, and bankruptcies. 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. While event-driven investing in general tends to thrive during a bull market, distressed investing works best during a bear market. Risk arbitrage or merger arbitrage includes such events as mergers, acquisitions, liquidations, and hostile takeovers. 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. 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. 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 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. 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. Other relative value sub-strategies include: - Fixed income arbitrage: exploit pricing inefficiencies between related fixed income securities. - Equity market neutral: exploits differences in stock prices by being long and short in stocks within the same sector, industry, market capitalization, country, which also creates a hedge against broader market factors. - Convertible arbitrage: exploit pricing inefficiencies between convertible securities and the corresponding stocks. - Asset-backed securities (Fixed-Income asset-backed): fixed income arbitrage strategy using asset-backed securities. - Credit long / short: the same as long / short equity but in credit markets instead of equity markets. - Statistical arbitrage: identifying pricing inefficiencies between securities through mathematical modeling techniques. - Volatility arbitrage: exploit the change in implied volatility instead of the change in price. - Yield alternatives: non-fixed income arbitrage strategies based on the yield instead of the price. - Regulatory arbitrage: the practice of taking advantage of regulatory differences between two or more markets. - Risk arbitrage: exploiting market discrepancies between acquisition price and stock price. Miscellaneous 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. - Fund of hedge funds (Multi-manager): a hedge fund with a diversified portfolio of numerous underlying single-manager hedge funds. - Multi-strategy: a hedge fund using a combination of different strategies to reduce market risk. - Multi-manager: a hedge fund wherein the investment is spread along separate sub-managers investing in their own strategy. - 130-30 funds: equity funds with 130% long and 30% short positions, leaving a net long position of 100%. - Risk parity: equalizing risk by allocating funds to a wide range of categories while maximizing gains through financial leveraging. |