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A hedge fund is an investment vehicle that can employ a wide range of investment and trading activities to maximize performance returns while minimizing investment risk. Most hedge funds are established as limited partnerships between the fund manager and investors. While the specific structure can vary from fund to fund, there are a few characteristics that are applicable across the industry. This presentation provides a brief overview of some of the structures of hedge funds in the marketplace today.
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Unique to the investment community, hedge funds are a partnership formed between the fund manager and the investors.
Typically hedge fund managers invest a significant amount of personal capital - in some cases in excess of 50 percent of the total assets in the fund - aligning their interests with that of their investors.
Source: Nocera, Joe (16 May 2009). "Hedge Fund Manager's Farewell". The New York Times. Retrieved 16 March 2011.
Key Players:
Portfolio Manager(s)
Determines strategy and makes investing decisions and allocations. The portfolios manager is also in the fund and is compensated via a modest management fee, as well as a performance fee based on the funds annual performance. Fund managers only get a performance fee if the fund makes money. Funds must secure their loans with collateral to gain margin and secure trades. In turn, each broker (usually a large securities firm) uses its own risk matrix to determine how much to lend to each of its clients, acting as a de facto regulator. Ensure fund compliance; verify financial statements as required by federal law.
Prime Broker
Auditors
*Note all hedge funds and managed futures firms are required by law to be registered with the SEC/CFTC or local and state regulators if they make over $100 million.
Hedge Fund
Investors Investors Executing Broker
Source: Hedge Funds and Other Private Funds: Regulation and Compliance Thomson West, 2010
Individuals with a yearly income of $200,000 or higher in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
Source: SEC, Defining the Term "Qualified Purchaser" under the Securities Act of 1933.
An executing broker is a type of financial dealer or broker that is accountable and responsible for the completion and processing of an order that is requested by a client.
As part of the process, brokers of this type will evaluate the order to make sure it is in line with all current policies and procedures and in compliance with any regulations set by the market. Below are examples of Executing Brokers:
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Hedge Fund X
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Investments Investments
Source: "Structuring Offshore Hedge Funds, Hedge Fund Fundamentals, November 30, 2012.
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General Partnership
Operational
While limited partners can make investments into the partnership and are liable only for their amounts paid-in.
Limited Partnership
Investors
The second element of the two-tiered structure is the arrangement of the general partnership. The general partner is the typical structure used for a limited liability company. The general partner's responsibility is to market and manage the fund, and perform any functions necessary in the normal course of business.
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Hedge funds fee structures differ from other types of investment vehicles. Hedge funds typically charge investors a management fee, usually 1-2% of the assets managed. Most hedge funds also charge an incentive (or performance) fee of anywhere between 10-20% of fund profits. The idea of the incentive fee is to reward the fund manager for good performance. Managers only collect an incentive fee when the fund is profitable, exceeding the fund's previous high - called a high-water mark. This means that if a fund loses 5% from its previous high, the manager will not collect an incentive fee until he or she has first made up the 5% loss.
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15%
10%
5%
Value of initial investment
- 10%
-15%
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Hedge funds offer qualified investors a unique partnership, with the ability to invest alongside the fund manager and across a variety of financial instruments. Hedge funds market-neutral, or balanced, approach to investing helps seek out positive returns and minimize risk by investing in varied instruments over long- and short-term periods. Hedge funds investor base has evolved significantly over the years, with 65% of global hedge fund assets currently held by institutional investors such as pensions, endowments and foundations.
Most hedge funds are created as limited partnerships between the fund manager and investors. While the specific structures of hedge funds can vary, there are a few organizational characteristics that are applicable across the industry.
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