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“A STUDY ON HEDGE FUND MANAGEMENT”

A Project submitted to

University of Mumbai for partial completion of the degree of Bachelor of Banking and
Insurance under the faculty of Commerce

By

SHUBHAM DINESH SHINDE

Under the Guidance of

PROF.SIDDHI VARTAK

DR.BABASAHEB AMBEDKAR SCIENCE AND ADVOCATE GURUNATH


KULKARNI COMMERCE MAHAVIDYALAY VASAI (WEST)

PALGHAR 401202

ACADEMIC YEAR 2019-2020


DR.BABASAHEB AMBEDKAR SCIENCE AND ADVOCATE GURUNATH
KULKARNI COMMERCE MAHAVIDYALAY

VASAI (WEST)

CERTIFICATE

This is to certify that Mr. SHUBHAM DINESH SHINDE has worked and duly completed
her project work for the degree of bachelor in commerce (Banking and Insurance) under the
faculty of commerce in the subject of PROF. SIDDHI VARTAK project is entitled, “A
Study on Hedge Fund Management” under my supervision.

I further certify that the entire work has been done by the learner under my guidance and that
no of part of it’s has been submitted previously for any degree of diploma of any university.

It’s her own work and facts reported by her personal findings and investigations.

PROF.SIDDHI VARTAK

Date of submission:
ACKNOWLEDGMENT

To list who all helped me is difficult because they are so numerous and the depth is so
enormous.
I would like to acknowledge the following as being idealistic channels and fresh dimension
in the completion of the project.
I take this opportunity to thank the University of Mumbai for giving me chance to do this
project.
I would like to thank my Principal, Dr.Y.K.THOMBRE for providing the necessary
facilities required for completion of this project.
I take this opportunity to thank our coordinator, for his moral support and guidance.
I would also like to express my sincere gratitude towards my project guide PROF.SIDDHI
VARTAK whose guidance and care made the project successful.

I would like to thank my College Library, for having provided various reference books and
magazines related to my project.
Lastly, I would like to thank each and every person who directly or indirectly helped me in
the completion of the project especially my Parents and Peers who supported me
throughout my project.
DECLARATION BY LEARNER

I the undersigned Mr. SHUBHAM DINESH SHINDE here by, declare that the work
embodied in this project work titled “A STUDY ON HEDGE FUND MANAGEMENT”,
forms my own contribution to the research work carried out under the guidance of
PROF.SIDDHI VARTAK is a result of my own research work and has not been previously
submitted to any other University for any other Degree/ Diploma to this or any other
University.

Wherever reference has been made to previous works of others, it has been clearly indicated
as such and included in the bibliography.

I, here by further declare that all information of this document has been obtained and
presented in accordance with academic rules and ethical conduct.

Shubham Dinesh Shinde

Certified by:-

PROF.SIDDHI VARTAK
Index

SR.NO. Context Page NO.


1 Introduction 6
2 Research Methodology 26
3 Literature Review 47
4 Data Analysis 57
5 Conclusion 69
6 Reference 70
Introduction

A hedge fund is an investment fund that pools capital from accredited investors or institutional
investors and invests in a variety of assets, often with complicated portfolio-construction and risk
management techniques. It is administered by a professional investment management firm, and often
structured as a limited partnership, limited liability company, or similar vehicle. Hedge funds are generally
distinct from mutual funds and regarded as alternative investments, as their use of leverage is not capped by
regulators, and distinct from private equity funds, as the majority of hedge funds invest in relatively liquid
assets. However, funds which operate similarly to hedge funds but are regulated similarly to mutual funds
are available and known as liquid alternative investments.

The term "hedge fund" originated from the paired long and short positions that the first of these funds used
to hedge market risk. Over time, the types and nature of the hedging concepts expanded, as did the different
types of investment vehicles. Today, hedge funds engage in a diverse range of markets and strategies and
employ a wide variety of financial instruments and risk management techniques.

Hedge funds are made available only to certain sophisticated or accredited investors, and cannot be offered
or sold to the general public. As such, they generally avoid direct regulatory oversight, bypass licensing
requirements applicable to investment companies, and operate with greater flexibility than mutual funds and
other investment funds. However, following the financial crisis of 2007–2008, regulations were passed in the
United States and Europe with the intention of increasing government oversight of hedge funds and
eliminating certain regulatory gaps.

Hedge funds have existed for many decades and have become increasingly popular. They have now grown
to be a substantial fraction of asset management, with assets totalling around $3.235 trillion in 2018.
Hedge funds are almost always open-end funds, and allow additions or withdrawals by their investors
(generally on a monthly or quarterly basis). The value of an investor's holding is directly related to the
fund net asset value.

Many hedge fund investment strategies aim to achieve a positive return on investment regardless of whether
markets are rising or falling ("absolute return"). Hedge fund managers often invest money of their own in the
fund they manage. A hedge fund typically pays its investment manager an annual management fee (for
example, 2% of the assets of the fund), and a performance fee (for example, 20% of the increase in the
fund's net asset value during the year). Both co-investment and performance fees serve to align the interests
of managers with those of the investors in the fund. Some hedge funds have several billion dollars of assets
under management (AUM).
Types of Hedge Funds:

Within the investment industry, there are many different strategies that can be utilized in an attempt to get a
greater return on the capital invested. As such, there are many different types of hedge funds with a diverse
realm of investing styles. For the most part, all of the fund types fall into one of five categories or styles:
macro, event driven, arbitrage, long/short and tactical trading.

 Convertible Arbitrage- is a long/short equity strategy, but rather than buying stock in one company
while selling short the stock of another company, convertible arbitrage buys convertible securities of
the company and short-sells the common stock of the same company. Usually the convertible
security is a convertible bond that can be converted into common stock at some point in the future.
This strategy attempts to take advantage of any pricing inefficiencies. Risk expectancy- low to
moderate.

 Distressed Securities- this strategy involves purchasing the securities of companies that are in
distress, facing potential bankruptcy or restructuring. The securities are usually in the form of bonds,
but bank debt, trade claims, preferred stock or even common stock can be included in the strategy.
Because the company is in distress and investors are well aware of the issues, the securities the fund
is looking to purchase are selling at deep, deep discounts. Risk expectancy- moderate.

 Emerging Markets- funds of this variety invest in the securities of emerging market countries and
the companies within those markets. There is no clear definition of what an emerging market is, but
the general description is a country that is developing and has a low per-capita income compared to
other, more developed nations. The growth in emerging economies tends to be more volatile and is
accompanied by higher inflation rates. Risk Expectancy- High.

 Event-Driven Investing- this strategy is more open to interpretation than most of the other fund
styles. The reason for the open interpretation is due to the various events that can occur. An “event”
could include an IPO, a merger, an earnings disappointment, an acquisition or even a spinoff. The
idea is that when the news comes out, price inefficiencies tend to occur before and after such
aforementioned events. The fund managers attempt to take advantage of the inefficiencies to boost
returns. Risk Expectancy- Moderate.
 Equity-Long Only- investing only in stocks and only going long, this style of trading is more like a
traditional mutual fund than any other hedge fund strategy. The fund managers managing this type of
fund must be able to stand out considerably if they are going to attract investors and in order to be
able to justify their fees. The risk for this type of fund is a prolonged bear market that takes down
almost all sectors. Risk Expectancy- High.

 Equity Short- the opposite of equity-long only, the equity short fund looks to benefit from stocks
that are expected to fall in price by short-selling the stock. Within this category of funds there are two
separate types—short-only and short-biased funds. A short-only fund can only make bearish bets
while a short-biased fund has the majority of its assets tied up in bearish holdings. These funds can
be extremely profitable, especially during an overall bear market. Risk Expectancy- High.

 Fixed-income arbitrage- like the other arbitrage funds, fixed income funds try to take advantage of
price differences between two securities, they just happen to do it in the fixed income market only.
Securities involved in fixed income arbitrage can include corporate bonds, municipal bonds,
treasuries or even credit default swaps. These funds tend to have a high winning percentage on their
trades with smaller gains. The losses they take can be large, but tend to be less frequent. Risk
expectancy- moderate.

 Fund of Hedge Funds- as the name suggests, a fund of hedge funds is a portfolio of hedge fund
investments. The idea is to spread the assets around to different hedge fund managers and to different
styles of hedge funds. The ultimate goal being to lower risk and volatility while increasing the
returns. Funds of funds can blend strategies or they may stay within one strategy and just diversify
through managers. Risk Expectancy- low to moderate.

 Long/Short Equity- one of the most flexible types of funds, the long/short equity strategy allows the
manager to hold a long portfolio as well as a short portfolio. Fund managers buy the stock of
companies they expect to outperform and short sell the stock of the companies they expect to
underperform. Because of the balanced approach, the correlation to the overall market is low. They
can be net long, net short or market neutral. Risk Expectancy- low to moderate.
 Macro- macro funds are among the more diverse types of hedge funds. They can invest in stocks,
bonds, currencies and commodities. Regardless of the investment vehicles that are being used, at the
heart of the strategy is the search for global opportunities. These funds look to invest in situations
created by changes in government policy, economic policy and interest rates. Macro funds tend to
use derivatives and can be highly leveraged. Risk Expectancy- High.

 Market Neutral- market neutral funds are similar to equity long-short funds in that they seek returns
that are totally independent of market performance. These funds attempt to minimize or eliminate
market volatility. One strategy would be holding equal long and short positions within the same
sector. This type of strategy puts an emphasis on stock selection and analysis. Market neutral funds
may use leverage to enhance returns and they may use derivatives to hedge the overall
portfolio. Risk Expectancy- Low.

 Merger Arbitrage- merger arbitrage funds are actually a sub-section of event-driven funds. The
fund simultaneously buys and sells the stocks of two merging companies. Typically when an
announcement is made that one company intends to acquire another company, the stock of the
company being acquired jumps in price, but it usually trades below the offer price. The discount is
due to the uncertainty of whether the merger will actually go through or not. If the transaction
involves an exchange of stock, the stock of the acquiring company tends to decline in value. Risk
Expectancy- low to moderate.
Hedge Fund Structure:

Structurally, a hedge fund has some similarities to a mutual fund. For example, just like a mutual fund, a
hedge fund is a pooled investment vehicle that makes investments in equities, bonds, options and a variety of
other securities. It can also be run by a separate manager; much like a sub-advisor runs a mutual fund that is
distributed by a large mutual fund company. That, however, is basically where the similarities end. The
range of investment strategies available to hedge funds and the types of positions they can take are quite
broad and in many cases, very complex. We will focus on specific strategies later in this tutorial, so for now
we’ll focus on how hedge funds are structured.

Organizational Structure

The typical hedge fund structure is really a two-tiered organization. The general/limited partnership model is
the most common structure for the pool of investment funds that make up a hedge fund. In this structure, the
general partner assumes responsibility for the operations of the fund, while limited partners can make
investments into the partnership and are liable only for their paid-in amounts. As a rule, a general/limited
partnership must have at least one GP and one LP, but can have multiple GPs and many LPs. There is an
SEC rule, however, that generally limits investors to 99 in order to be excluded from SEC registration.

The second component of the two-tiered structure is the structure of the general partnership. The typical
structure used for the general partner is a Limited Liability Company. An LLC is very similar to a
Subchapter S corporation in that it is a flowthrough tax entity and investors are again limited in liability to
the amount of their investment. The general partner’s responsibility is to market and manage the fund, and
perform any functions necessary in the normal course of business, including hiring a fund manager
(oftentimes a related company) and managing the administration of the fund’s operations.
Fee Structure

Hedge funds also differ quite radically from mutual funds in how they charge fees. Their fee structure is one
of the main reasons why talented money managers decide to open their own hedge funds to begin with. Not
only are the fees paid by investors higher than they are for mutual funds, they include some additional fees
that mutual funds don’t even charge.

 Management Fee: The management fee for a hedge fund is for the same service that the
management fee covers in mutual funds. The difference is that hedge funds typically charge a
management fee of 2% of assets managed – and in some cases even higher, if the manager is in high
demand and has had a very good track record. This fee alone makes managing a hedge fund
attractive, but it is the next fee that really makes it a profitable endeavour for good fund managers.

 Incentive Fee: Most if not all hedge funds charge an incentive fee of anywhere between 10% to 20%
of fund profits, and some hedge funds have even gone as high as 50%. The idea of the incentive fee
is to reward the hedge fund manager for good performance, and if the fund’s performance is
attractive enough, investors are willing to pay this fee. For example, if a hedge fund manager
generates a 20% return per year, after management fee, the hedge fund manager will collect 4% of
those profits, leaving the investor with a 16% net return. In many cases, this is an attractive return
despite the high incentive fee, but with more mediocre managers entering the industry in search of
fortune, investors have more often than not been disappointed with net returns on many funds. There
is one caveat to the incentive fee, however. A manager only collects an incentive fee for profits
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. In addition, some managers must clear a hurdle rate, such as the return on U.S.
Treasuries, before they collect any incentive fees.
Term Structure

The terms offered by a hedge fund are so unique that each fund can be completely different from another,
but they usually are based on the following factors:

 Subscriptions and redemptions: Hedge funds do not have daily liquidity like mutual funds do.
Some hedge funds can have subscriptions and redemptions monthly, while others accept them only
quarterly. The terms of each hedge fund should be consistent with the underlying strategy being used
by the manager. The more liquid the underlying investments, the more frequent the
subscription/redemption terms should be. Each fund also specifies the number of days required for
redemption, ranging from 15 days to 180 days, and this too should be consistent with the underlying
strategy. Requiring redemption notices allows the hedge fund manager to efficiently raise capital to
cover cash needs.

 Lock-Ups: Some funds require up to a two-year “lock-up” commitment, but the most common lock-
up is limited to one year. In some cases, it could be a hard lock, preventing the investor from
withdrawing funds for the full time period, while in other cases, an investor can withdraw funds
before the expiration of the lock-up period provided they pay a penalty. This second form of lock-up
is called a soft lock and the penalty can range from 2% to 10% in some extreme cases.

Conclusion

There are a variety of different combinations that can be used to structure a hedge fund and its related
companies and investors. The above summary briefly describes one very common method used to structure
the hedge fund and its management company. There are many others and just as hedge funds are creative
with their investment strategies, they can also be very creative with their organizational structure. The
takeaway of this section is to stress that each corporate structure is unique and should be evaluated along
with all other factors covered in the rest of this tutorial.
History of Hedge Fund:

Over the years, hedge funds have tended to capture the public imagination at times of economic extremes. In
boom times, they have been held up to be miracle money-making machines, but in times of economic crisis,
they have come in harsh scrutiny from the press, from government regulators, and from the public. The truth
is somewhere in between, and at the time of writing, that’s about where we are at with regard to their
widespread perception and the wider economic situation, which is neither as desperate as it seemed in 2008
or as buoyant as it was in the years preceding the credit crisis.

Hedge funds can have a positive impact in terms of generating wealth, providing liquidity for the markets,
and greasing the wheels of capitalism, but they can also have a negative impact when the culture of greed
that drives the whole process goes into overdrive and neglects wider societal responsibilities in favour of
profits. Here, we shall tell the story of hedge funds, from their conceptual birth in the boom years of the
1920s through their emergence in the post-war years into their current status as the pre-eminent high-end
investment vehicle. It’s a chequered history, to be sure, but it’s nonetheless one that sheds light on the
evolution of the cult of wealth throughout the 20th and early 21st centuries.

Birth of the Hedge Fund

The boom years of the 1920s brought about, and were to a large extent driven by, the emergence of the
pooled fund as a mainstream method of preserving wealth and providing capital growth for investors.
Although pooled funds had been around for over a century beforehand, the spectacular wealth-generating
properties of the markets after the Great War created an unprecedented demand for more accessible routes
into this money machine. During this decade, a whole host of new investment vehicles came into play, and
among them was the Graham-Newman Partnership, which has since been cited by uber-investor Warren
Buffet as being the earliest example of a hedge fund.
The investment craze of the 1920s saw millions of dollars poured into the markets, creating what we now
refer to as a bubble, and when the overheated capital markets went into a tailspin in 1929, the results were
catastrophic. What followed was the Great Depression, and for a time, faith in the markets all but dissipated
among a disillusioned and heavily-impoverished public. The vast majority of funds and investment banks
shut down under the weight of heavy losses, but a few remained, and many of those that did grew to be
powerhouses in the years following the Second World War.

Alfred Jones (Hedge Fund Pioneer)

Although the strategy of hedging had been explored by investors during the 1920s, it wasn’t until the late
1940s that it became systematized into an investment product. Alfred Jones, considered by many to be the
father of the modern hedge fund, was born in 1901 in Melbourne, Australia to American parents. His family
moved back to the U.S. while Jones was still a young child, and he later went on to graduate from Harvard in
1923 before going on to serve as a diplomat in Berlin, Germany. He then earned himself a sociology PhD at
Columbia University before joining the editorial staff at Fortune magazine in the early 1940s.

The big turning point in Alfred Jones’ life occurred in 1948 when he was asked by his employers at Fortune
magazine to write an article about current investment trends. This inspired him to try his hand at being a
money manager in his own right, and with $40,000 of his own money and a further $60,000 solicited from
investors, he launched a fund based on the concept of the long/short equities model, which he dubbed the
‘hedged fund”. In addition to this investment principle, he used leverage – the idea of borrowing money at a
lower interest rate than the anticipated rate of return from his investment strategy – to enhance the returns
from the fund.

In 1952, he changed the structure of his investment vehicle from a general partnership to a limited
partnership, and gave the managing partner a 20% cut of the profits from the fund as an added incentive.
This made Jones the first money manager to combine the use of leverage, short selling, and shared risk
through a partnership with other investors, as well as a means of compensation based on investment
performance. To a large extent, this investment model remains the template for hedge funds, and this is why
Jones is so often credited as being the true hedge fund pioneer.
The Rise of the Hedge Fund

As is so often the case, it took time for the world to catch up with a truly innovative concept, and it was more
than a decade before Alfred Jones’ hedge (d) fund idea took off as a major investment vehicle. Again,
Fortune magazine holds a place in the story.

In 1966, it published an article that shone a spotlight on an obscure investment that has somehow managed
to outperform every mutual fund on the market by double-digit figures over the past year. The investment
had also outperformed the mutual’s by high double-digits over the last five years. Money managers and
investors sat up and took notice, and for the first time hedge funds became a real industry. Just two years
later, there were 140 hedge funds in operation.

During the boom years of the 1960s, the hedge fund industry underwent a period of frantic expansion, but
the recession of 1969–70 and the 1973–1974 stock market crash put the kibosh on this growing trend, in the
same way that previous and subsequent recessions had done to the investment industry in general. It didn’t
help that by this time many funds had turned their back on Jones’ original strategy by engaging in much
riskier strategies based on long-term leverage. As a result, many fund suffered heavy losses during the bear
markets of 1969-70 and 1973-74.

Having had their fingers burned badly by the market downturns of the late ’60s/early ’70s, hedge funds
found themselves very much out of fashion among investors. However, in an echo of the original hedge fund
boom, the tide turned in 1986 when an article in Institutional Investor shone the spotlight on the phenomenal
double-digit success of Julian Robertson’s Tiger Fund.

In 1980, Julian Robertson started the Tiger fund with $8 million in start-up capital. By the late ’90s – the
peak of this fund’s performance – the fund was worth over $22 billion, and in 1993 Robertson was estimated
to have made $300 million personally from the fund. Although his actual methods were a lot more subtle
than his public pronouncements might have indicated.
The performance of this high-flying hedge fund inspired a flood of interest among investors in the world of
hedge funds, and by this point the industry had evolved substantially. In their new incarnation, hedge funds
employed a much bigger variety of strategies including derivatives and currency trading.

The Bubble Bursts Once Again

The bull market days of the early 1990s saw a huge outflow of top market talent from the mutual fund
industry into the hedge fund industry, where they enjoyed far greater flexibility and remuneration. The high-
profile success of George Soros and Jim Rogers’ Quantum Fund – particularly the trade that forced the exit
of the UK from the European Exchange Rate Mechanism – only fanned the flames.

But just as hedge funds suffered hugely during the 70s market crash, a similar fate would befall many hedge
funds when the dot-com bubble burst in the late 1990s and early 2000s.

Several high-profile funds failed in spectacular fashion, including Long Term Capital Management in 1998,
the collapse of Robertson’s own Tiger Fund in March 2000, and the enforced reorganisation of George
Soros’ and Jim Rogers’ Quantum Fund into the Quantum Group of Funds just one month later.
The Modern Hedge Fund

Following the dot-com crash of 2000 and the global economic crisis of 2008, regulators have clamped down
on the previously regulation-light world of hedge funds.

For instance, the U.S. Securities and Exchange Commission (SEC) implemented changes that require hedge
fund managers and sponsors to register as investment advisors in 2004. As a result, the number of
requirements placed on hedge funds has increased greatly, such as hiring compliance officers, creating a
code of ethics, and being sure to keep up-to-date performance records. Essentially this was all done with the
intention of protecting investors.

Today, despite recent troubles, the hedge fund industry continues to flourish once more. Crucial to its
success was the development of the ‘fund of funds’, essentially a hedge fund with a diversified portfolio of
numerous underlying single-manager hedge funds.

The introduction of the fund of funds allowed for greater diversification, thereby taking some of the risk out
of hedge funding, but also allowed minimum investment requirements of as low as $25,000. This greatly
opened up the hedge fund investment option to a far greater number of average investors than ever before.

Hedge Funds Today

Today’s hedge funds look significantly different to their forerunners of the 1940s, and even the 1980s. A far
greater variety of strategies is used by today’s hedge funds, including many that do not involve traditional
hedging techniques at all.

The size of the industry is now absolutely vast. While Albert Jones started the first hedge fund with just
$100, 000,in 2013 the global hedge fund industry recorded a record high of US$2.4 trillion in assets under
management.
Hedge Fund in India:

With the notification of SEBI (Mutual Fund) Regulations 1993, the asset management business under private
sector took its root in India. In the same year SEBI, also notified Regulations and Rules governing Portfolio
Managers who pursuant to a contract or arrangement with clients, advise clients or undertake the
management of portfolio of securities or funds of the client. We have however, no information about any
hedge funds domiciled in India. Further, on account of limited convertibility, offshore hedge funds have yet
to offer their products to Indian investors within India. Recently, RBI through liberalized remittance scheme,
allowed resident individuals to remit up to US $ 25,000 per year for any current or capital account
transaction. The liberalized scheme will allow Indian individual investors to explore the possibility of
investing in offshore financial products. Considering the existing limit being only US $ 25,000 per year,
Indian market may not be attractive to hedge fund product marketing. As long as there will be restriction on
capital account Convertibility, foreign hedge funds, by virtue of their minimum investment limit being $
100,000 or higher, do not seem to be excited to access investment from Indian investors in India.

Some hedge funds have invested in offshore derivative instruments (PNs) issued by FIIs against underlying
Indian securities. Through this route hedge funs can derive economic benefit of investing in Indian securities
without directly entering the Indian market as FIIs or their sub-accounts. Through recent amendments to the
FII Regulations (Regulation 15A and 20 A), the regulatory regime has been further strengthened and
periodic disclosures regime has been introduced. As at the end of March, 2004, total investment by hedge
funds. In the offshore derivative instruments (PNs) against Indian equity, are Rs. 8050 crores which
represent about 8% total net equity investments of all FIIs. On the basis of market value, the hedge funds
account for about 5% of the market value of the total assets held by the FIIs in India.

The fiscal year (2003-2004) has seen a spectacular increase in FII activities in Indian market. Till this report
is filed FIIs have already invested US $ 10 bn. during this year alone which is a record. Robust economic
fundamentals, strong corporate earnings and improvement in market micro structure are driving the FII
interest in India. Investors all over the world are keen to come to Indian market. From informal discussions
with institutional investors including some reputed and well established hedge funds, one could gauge the
extent of interest they have about Indian markets. During the discussions they have requested whether India,
like other Asian emerging markets, can provide regulatory framework that will allow them to directly invest
in Indian market in transparent manner.
How to Invest in a Hedge Fund:

Hedge Fund is more loosely regulated than traditional mutual funds and tend to invest in different types of
securities. This can mean higher returns, but it can also mean higher fees and greater risk of loss. If you’re
thinking of investing in a hedge fund, here’s what you need to know

Hedge funds are like mutual funds, except that they’re designed to increase potential returns and hedge
against market losses by investing in a wider array of assets.

Hedge funds don’t experience the same regulatory scrutiny as mutual funds. This gives their managers more
room to operate and take risk. That might mean shorting stocks, making leveraged investments and betting
on foreign currencies and commodities.

This is one reason why hedge funds are restricted to accredited investors. These are investors who have the
resources to withstand high fees and (potentially) heavy asset declines. To qualify as a hedge fund accredited
investor, you must clear two primary hurdles established by the SEC:

 An individual must demonstrate earned annual income of $200,000 (or $300,000 for married
spouses) in each of the past two calendar years. That income must be equal or greater in the year he
or she applies to be an accredited investor.

 A person or married couple can qualify by showing they have a net worth of $1 million or more.
Note that this does not include any assets linked to their primary residence.
If you meet these criteria, here’s what you should look for in potential funds:

Vet the fund

Start by thoroughly reviewing the hedge fund you’re considering. Focus first on the fund’s prospectus and its
marketing and performance-related collateral. It’s always a good idea to get a financial advisor on board at
this stage of the process, so you can get a realistic view of the fund’s risk potential and how it fits into your
own unique investment needs, goals and timetable.

Don’t focus solely on any history of high returns, and always make a thorough risk evaluation before writing
any checks.

Focus on fund assets, too

You’ll need to properly evaluate the value of a fund’s holdings. Hedge funds often hold investment vehicles
that can be hard to sell and difficult to price. A financial professional with hedge fund evaluation experience
can help you understand a fund’s holdings.

Understand your fee obligations

Hedge funds charge higher fees than regular mutual funds. Expect to pay between on 1%-to-2% of total
assets, along with a 20% performance fee based on the hedge fund’s profit levels. Note going into your
hedge fund investing experience that it’s common for hedge fund managers to take greater investment risks
to earn that profit and collect that 20% fee.

Know your redeemable timelines

Hedge funds don’t let investors redeem shares any time they want. Instead, you can only redeem your shares
four times (or fewer) annually. There are also lockdown periods when you can’t get your money. Know
before you invest what your hedge fund’s share redemption timetable is, and if it meets your unique personal
financial needs.
Know your hedge fund manager

One of the most important “homework” tasks as a potential hedge fund investor is to research your fund
manager before you invest any money. Specifically, be sure to check the advisor/manager’s Form ADV,
which spells out all information related to a fund, including its investment strategies and any conflicts of
interest or past disciplinary actions.

Final Hedge Fund Considerations:

Above all, keep your check book closed until you get all of your questions about the fund answered to your
satisfaction. You’ll want to know who is managing your money and how they intend to invest it. You should
also know if there are any potential road blocks in getting your cash back. If any of those questions aren’t
answered to your satisfaction, keep looking for another hedge fund. You may also need to entertain the
possibility that hedge funds aren’t the right investment for you.

Still convinced that a particular hedge fund is right for you? Investing in a hedge fund is not a simple matter
of creating an account on a website and transferring in some funds, as is the case on a typical brokerage
account. You’ll likely have to contact that hedge fund or have your financial advisor do it for you. At that
point, you might find that the fund is no longer accepting new investors, or that the minimum investment
amount is out of your reach.

But if the fund is accepting new investors, and you meet the criteria, you can become a hedge fund investor
– with all the risk and reward that this entails.
Who Invest in Hedge Fund?

Hedge funds are limited to wealthier investors, who can afford the higher fees and risks associated with
hedge fund investing, and institutional investors. Hedge fund investors generally need to be accredited
investors under the federal securities laws, and must meet certain net income or earned income thresholds.

Investors invest in hedge funds for varying reasons. Some believe that they can achieve higher-than-average
returns, while others seek diversification beyond stocks and bonds. According to a 2019 institutional investor
survey conducted by J.P. Morgan, 73% of all respondents considered portfolio diversification among the top
three reasons they invest in hedge funds; 58% indicated access to select or niche opportunities; and 1% noted
access to leverage.

That said, while institutional investors have invested heavily in hedge funds that have begun to change. As
of 2016, 65% of the hedge fund industry's capital came from institutional investors. But most recently, these
investors have shifted their focus to other investment options, such as exchange-traded funds (ETFs), private
equity, and real estate.
How Hedge Funds Offer Rewards:

Hedge funds offer more financial rewards because of the way managers are paid, the types of financial
vehicles they can invest in, and the dearth of financial regulation that govern them.

First, since hedge fund managers are compensated based on the returns they earn, they are driven to achieve
above-market returns. This can attract investors who are frustrated by the fact that funds like mutual
funds are paid fees regardless of fund performance.

Second, hedge fund managers are able to make outsized returns when they correctly predict the market's rise
or fall. Hedge fund managers specialize in using sophisticated derivatives, which enable them to
create leverage and profit even when the stock goes down.

Third, since hedge funds are not as well regulated as the stock market, managers have more flexibility with
investing in financial vehicles that are speculative but offer higher returns

That said, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"),
which was enacted in 2010, does regulate some aspects of the hedge fund industry. Among other things, the
Dodd-Frank Act:

 required all hedge fund managers above $150 million to register with the U.S. Securities and
Exchange Commission;

 limited the amount of hedge fund investments banks can make, and prevented banks from using
hedge funds to boost their own corporate profits;

 called for greater regulation of derivatives; and


 created the Financial Stability Oversight Council, which would look for hedge funds and other
financial companies that were growing too large and would need to be recommended to be regulated
by the Federal Reserve.

According to certain empirical studies, the hedge fund industry appears to have adjusted well to the
heightened requirements under the Dodd-Frank Act.
Research Methodology

Research:

Research is the systematic process of collecting and analyzing information to increase our understanding of
the phenomenon under study. It is the function of the researcher to contribute to the understanding of the
phenomenon and to communicate that understanding to others.

Definition:

The term "hedge fund" originated from the paired long and short positions that the first of these funds used
to hedge market risk. Over time, the types and nature of the hedging concepts expanded, as did the different
types of investment vehicles.

Types of Research:

There are two types of researches:

 Primary Research.
 Secondary Research.

Primary Research:

Primary data is collected for a particular purpose and is new information. This is conducted using some

Means of questioning usually via a survey or interviews, or the information can be gathered through

Observation.

Secondary Research:

Secondary research gathers information which has already been collected from Journals, books, internet,

Etc. were used.


Advantage and Disadvantage of Hedge Fund:

The advocates of hedge funds paint a colourful picture of this type of investment. What you will hear less
about the funds are its negative aspects.

Looking at the hedge funds, investors have to be concerned with some key aspects. These include:

 Alignment of interest

 Higher fees

 Less liquidity

 Less transparency

 Effective implementation

All these are issues that investors have to address before stepping into hedge fund investments. If one is able
to manage these issues effectively, then we are able to take advantage of the benefits hedge funds bring
along.
Advantage:

Flexibility

Unlike mutual funds, the hedge funds are much more flexible. SEC (Securities and Exchange Commissions)
do not put much focus on hedge funds. Basically, people do not trade hedge funds publicly. Therefore, for
this reason, they are more flexible as there is no particular body regulating their performance. A hedge fund
could use strategies such as short selling, derivatives, and leverage to invest across an array of investments.
Short selling is a key element you need to look at. Short selling (shorting) in finance is a way to profit from
declining price of the security, bond or stock. This is an aspect contract to what most investors would want.
Benefiting from the rising price of their investment option.

Aggressive Investment Strategy

When hedge funds are in question, one thing is particularly clear: aggressiveness in investment. This is
important in order to realize the higher return. These investment strategies include short selling as well,
using borrowed money to buy more assets (leverage buying) and finally derivatives.

Increases the Chance of Diversification

There are a variety of reasons to include hedge funds in a portfolio of investments. One of the most
important and basic reason is the fund’s ability to add diversification and also reduce risk. Hedge funds have
the ability to diversify the investment in that it offers an array of investments. These include, the long/short,
tactical trading, event-driven and also the emerging markets are some of the opportunities managers take. By
taking advantage of this diversification opportunity, the managers are able to reduce the risks. However, in a
certain specific style. Hedge funds enable investors to obtain instant diversification in a portfolio of
investment. This is particularly beneficial for the investors with a larger basket of hedge fund portfolios but
too small to achieve proper diversification.
The allocation of a class of assets to a hedge fund from a traditional investment portfolio diversifies the risks
that may be associated with the conventional equity and bonds market. By focusing on certain specific risks,
the funds reduce the risk exposure by 50% to the general market movements. This is made possible by
specific risk targeting. The fund could produce a stream with a lower correlation level and lower downside
volatility than general risk assets like the equities. From 0% to 10% and so on, the portfolio creation would
continue to grow in magnitude leading to a more diversified portfolio. Also, funds of funds (alternatives to
investing directly into individual funds) are a good case to mention. They are well-diversified investment
vehicles that are made up of a variety of other funds. For example, with the hedge funds minimums often
starting at $1 million, it would be difficult for an investor with $2 million accounts to diversify their
portfolio hedge funds.

Lose Reduction

In many cases, a hedge fund that provides consistent results in returns increases portfolio stability. This is in
case all the traditional investments are falling or underperforming. There are some hedge funds strategies
nice returns with the fixed-income-volatility. For example, if there is a sell-off in the market, somewhat an
unpredictable trend, the chance of loss may be reduced by quite significantly and even by close to 80%.
Unlike in traditional investments, where chances of loss are 100%. With the loss reduction strategy by the
hedge funds, the investor would be able to improve their portfolio by over 50%. This is rare compared to
other investment platforms.

Expert Advice and Transparency

Hedge funds are one of the funds that offer handsome payments to their workers. The hedge funds managers,
aside from being advanced in matters to do with investment; they are also well versed in financial
management matters. Therefore, when you go to the market, as an investor, you are sure to get the best
information. Advice on which hedge funds to use. Also future predictions in the performance of the
individual funds. One thing that attracts investors to hedge funds is their disclosure. They do not require any
public trading. Basically, the investors and the regulators are unable to regulate the activities of the fund’s
managers
Huge Gains

One other advantage to hedge funds is the large amount of money that can be made by utilizing them within
your portfolio. The aim of hedge funds is to acquire a high-return despite what market fluctuations are
occurring at any given period. For example, one type of hedge fund strategy is called a “global macro”
approach. This strategy attempts to take a large position in commodities, stocks, bonds, etc., by forecasting
what investment opportunities one can take in relation to what may happen in future global economic events.
This is done in order to create the largest return with the least amount of risk.
Disadvantage:

Hedge Fund Fees

Most of the operating hedge funds have a fee structure known widely as “2 and 20”.

In the structure, what normally happens is that investors pay a 2% in management fee. This fee is usually for
the operations of the fund. Additionally, they have to also pay 20% to the fund manager. This is usually a
performance fee to fund the manager for any profits made through the year. Consider an investment vehicle
such as mutual funds. In mutual funds, they often have their management fees below 2%. In addition to that,
there is no performance fee. The high fees mean that the growth of an investment of a hedge fund needs to
be big enough. This is to outweigh the performance status quo.

In hedge fund investment, it means more risk for better performance. The management and the performance
fee are based on this. This results in the manager taking up more risks in order to increase the performance
and thus a nicer return. This could amount to huge loses making the investors pull away from the fund. For
more info, see fees and other expenses associated with mutual funds.

The Downside Capture

This is a risk management measure used to assess what level of correlation a hedge has to a specific market.
This happens to the hedge funds that demand/claim the absolute returns objectives. The lower the downside
capture, the better the fund preserves wealth during any market downturn. The perfect correlation with the
market comes about when there is an equation of 100%. The disadvantage of this is that all the funds there is
being compared to a unified benchmark for the market.
The Risks and Returns

Hedge funds are regarded as an investment vehicle taking up so many risks. In their investment strategies,
they usually drag so many risks with them in pursuit of a larger return (report from SEC). The higher risk
could lead to fallout in the returns. However, in this case, this issue is double-edged. It may be a boom and it
may also be a bust. In 2011, the hedge funds were falling below the market with 4.8% fallout. This was quite
disappointing as the other counterpart (mutual funds) were performing relatively well.

Standard Deviation

Hedge funds use this statistical tool to anticipate the risk of investing in a particular fund. If a certain fund
has an average annual return of say 8% and the standard deviation is about 3%. Then an investor would
expect a return that is between 5% and 11%. 68% of the time (one standard deviation from the mean 8% -3%
and also 8% + 3%).

In the same case, the investor would be expected between 2% and 14%. 95% of the time (two standard
deviations from the mean 8%-6% and also 8%+6%).The disadvantage of this statistical tool is that it
measures the volatility of possible gains. This is normally expressed as a certain percentage per year. Thus, it
doesn’t indicate the overall picture of the risk of return.

Drawdown

The drawdown is basically a statistic that provides an estimation in the overall rate of return on an
investment compared to that investment’s most recent highest return, a peak-to-valley ratio. The
disadvantage to this measure is related to the disadvantage that the standard deviation has with a hedge fund,
mainly that hedge funds do not operate very consistently and predictably in order for the standard deviation,
and thus the drawdown, to be very useful.
Leverage

Leverage is an investment measure that’s often overlooked as being the main factor in hedge funds acquiring
large losses. Basically, when leverage rises, any downsides in investment returns are magnified, often
causing the hedge fund to sell off its assets at a cheap price. Leverage is typically a main reason why so
many hedge funds go bankrupt.
Hedge Fund or Mutual Fund?

The hedge funds vs. mutual funds debate can be made simple with a clear understanding of the key
similarities and differences between the two types of funds. Once you understand the basics, you can decide
if hedge funds or mutual funds are best for your personal investment objectives.

Hedge Funds vs. Mutual Funds: The Similarities

There are only a few similarities between hedge funds and mutual funds. These similarities may also be
considered as advantages for most investors.

Here are the key similarities of hedge funds and mutual funds:

 Pooled Investments: Hedge funds and mutual funds are pooled investment types, which mean that
the assets are comprised of money from multiple investors pooled together into one portfolio.

 Diversification: Hedge funds and mutual funds both provide diversification by investing multiple
securities. It’s important to note, however, that some funds are highly concentrated in one particular
security type or sector of the economy. Typically, hedge funds are highly diversified into different
security types, such as stocks, bonds, and commodities, whereas most mutual funds have stated
objectives and invest in just one type of security or category.

 Professional Management: When investing in hedge funds or mutual funds, investors do not choose
the securities in the portfolio; a manager or management team selects the securities. Hedge funds are
usually actively-managed, which means that the manager or management team can use discretion is
the security selection and the timing of trades. Mutual funds can be actively managed or passively
managed. If it is the latter, the mutual fund manager does not use discretion in security selection or
the timing of trades; they simply match the holdings with that of a benchmark index, such as the S&P
500.
Hedge Funds vs. Mutual Funds: The Differences

The differences between hedge funds and mutual funds are the key deciding factors for choosing which is
best for the individual investor.

Here are the key differences between hedge funds and mutual funds:

 Accessibility: Although hedge funds and mutual funds have certain limitations on investing, such as
minimum initial investment, hedge funds are not as accessible to the mainstream investor as mutual
funds. For example, some hedge funds require that the investor have a minimum net worth of $1
million or they may have minimum initial investments that are much higher than mutual funds. Some
mutual funds have minimum initial investments as low as $100 and none of them have net worth
requirements.

 Expenses: Hedge funds typically have much higher expenses than mutual funds. For example, hedge
funds often have expenses that exceed 2.00%, whereas most mutual funds have expenses that are
1.00% or below. Also, hedge funds may also take a cut of the profits before passing them along to
the investors.

 Objective/Performance: Hedge funds are generally designed to produce positive returns in any
economic or market environment, even in recession and bear markets. However, because of this
defensive nature, returns may not be as high as some mutual funds during bull markets. For example,
a hedge fund might produce a 4-5% rate of return during a bear market, while the average stock fund
declines in value by 20%. During a bull market, the hedge fund might still produce low single-digit
returns while the stock mutual fund could produce high single-digit to double-digit return. Over the
long run, a low-cost stock mutual fund would typically produce a higher average annual return than a
typical hedge fund.
Bottom Line on Hedge Funds vs. Mutual Funds

The greatest advantage of hedge funds may be their potential for producing steady returns that outpace
inflation while minimizing market risk. However, the average investor will not have a high net worth or
minimum initial investment often required to invest in them in the first place.

For most investors, a diverse portfolio of mutual funds and/or exchange-traded funds (ETFs) is a smarter
investment choice than hedge funds. This is because mutual funds are more accessible and cheaper than
hedge funds and the long-term returns can be equal to or higher than that of hedge funds.
Hedge Fund Performance:

Hedge funds have come into public view in recent years as a result of their growth in numbers and the
publicity about their successes and failures. Largely unregulated and for the most part restricted to individual
investors, hedge funds have features absent in mutual funds that influence their performance. Using
historical data, the authors find that hedge funds net of fees consistently outperform mutual funds but are
more volatile than mutual funds. Furthermore, they are unable to consistently beat the market on a risk-
adjusted basis, indicating average gross outperformance equal to the fees paid. Incentive fees explain some
of the higher performance but not the increased volatility.

In 1997, assets of hedge funds totalled more than $200 billion. Although fewer in number and smaller in size
than mutual funds, hedge funds have grown in recent years as an alternative investment vehicle for wealthy
individual investors and institutional investors. A number of features characterize hedge funds and
distinguish them from mutual funds, including a largely unregulated organizational structure, flexible
investment strategies, relatively sophisticated investors, and strong managerial incentives and investment
participation.

Hedge funds are also characterized by strong performance incentives. Their successes and, in cases such as
Long-Term Capital Management, their failures have led to increased scrutiny by the general investing
public. The authors examine the performance of hedge funds with the objective of linking performance to a
number of characteristics, with a particular focus on the hedge fund incentive fee structure. Besides the focus
on incentive fees, a number of other factors distinguish this research from prior research on hedge funds.
These factors include the use of a large sample consisting of offshore as well as U.S. funds and the use of
monthly instead of annual return data. A broad set of performance metrics are used and several data-
conditioning bias analyses are completed.
The authors construct the sample from two publicly available hedge fund databases that contain voluntarily
reported return data and include both existing and defunct hedge funds. Gross monthly return data are
adjusted for incentive and management fees. Funds in the sample had at least 24 months of returns in order
to have a sufficient number of observations to measure risk and risk-adjusted returns. More than 500 funds
had monthly returns for calendar years 1994 and 1995. Besides the two-year sample, the authors also find
results for funds with four, six, and eight years of monthly returns ending December 31, 1995.

The organizational features of hedge funds should help align the interests of fund managers and investors.
These fund manager features include large-percentage ownership in the funds, incentive pay as a substantial
portion of total compensation, and liability exposure incurred for being general partners of the funds. These
managers also have substantial latitude and flexibility with regards to investment strategy and investment
alternatives, such as leverage, options, and short selling. The authors suggest that these features, which are
not generally available to mutual fund managers, produce a clear performance advantage over mutual funds.

For the overall sample and time period examined, the average hedge fund Sharpe ratio was 21 percent higher
than comparable mutual fund Sharpe ratios. This advantage over mutual funds was achieved despite higher
total risk. Hedge funds, however, are unable to consistently beat the market. When compared with eight
standard market indexes, the results are mixed because the time period, index choice, and hedge fund
category are all strong influences. On average, the ability to earn superior gross returns is about equal to the
incentive and administrative fees charged. Although hedge funds appear to offer little advantage over
indexing, the authors suggest that the generally low correlations of hedge funds with most other asset classes
make them a potentially valuable addition to many investors' portfolios.

The authors also investigate six related data-conditioning biases. Termination and self-selection bias are the
most powerful and, working in opposite directions, remove any significant effect of survivorship bias on the
data. Specifically, funds that terminated had significantly lower median performance measures than extant
funds. The group of funds that voluntarily ceased to report their returns on average outperformed.
The authors state that several caveats about the results are warranted. The time period is short, and the
diverse investment options make it difficult to classify funds and identify correct benchmarks. Systematic
risk was not estimated with a high degree of confidence. Also, the approaches used to measure incentive fees
did not control for such complications as varying policies on fee-allocation mechanisms and the treatment of
new and existing investors.
Role of Hedge Fund in the Capital Market:

The role that hedge funds are playing in capital markets cannot be quantified with any precision. A
fundamental problem is that the definition of a hedge fund is imprecise, and distinctions between hedge
funds and other types of funds are increasingly arbitrary. Hedge funds often are characterized as unregulated
private funds that can take on significant leverage and employ complex trading strategies using derivatives
or other new financial instruments. Private equity funds are usually not considered hedge funds, yet they are
typically unregulated and often leverage significantly the companies in which they invest. Likewise,
traditional asset managers more and more are using derivatives or are investing in structured securities that
allow them to take on leverage or establish short positions.

Although several databases on hedge funds are compiled by private vendors, they cover only the hedge
funds that voluntarily provide data. Consequently, the data are not comprehensive. Furthermore, because the
funds that choose to report may not be representative of the total population of hedge funds, generalizations
based on these databases may be misleading. Data collected by the Securities and Exchange Commission
(SEC) from registered advisers to hedge funds are not comprehensive either. The primary purpose of
registration is to protect investors by discouraging hedge fund fraud. The SEC does not require an adviser to
a hedge fund, regardless of how large it is, to register if the fund does not permit investors to redeem their
interests within two years of purchasing them. While registration of advisers of such funds may well be
unnecessary to discourage fraud, the exclusion from the database of funds with long lock-up periods makes
the data less useful for quantifying the role that hedge funds are playing in the capital markets.

Even if a fund is included in a private database or its adviser is registered with the SEC, the information
available is quite limited. The only quantitative information that the SEC currently collects is total assets
under management. Private databases typically provide assets under management as well as some limited
information on how the assets are allocated among investment strategies, but they do not provide detailed
balance sheets. Some databases provide information on funds’ use of leverage, but their definition of
leverage is often unclear. As hedge funds and other market participants increasingly use financial products
such as derivatives and securitized assets that embed leverage, conventional measures of leverage have
become much less useful. More meaningful economic measures of leverage are complex and highly
sensitive to assumptions about the liquidity of the markets in which financial instruments can be sold or
hedged.
Although the role of hedge funds in the capital markets cannot be precisely quantified, the growing
importance of that role is clear. Total assets under management are usually reported to exceed $1
trillion. Furthermore, hedge funds can leverage those assets through borrowing money and through their use
of derivatives, short positions, and structured securities. Their market impact is further magnified by the
extremely active trading of some hedge funds. The trading volumes of these funds reportedly account for
significant shares of total trading volumes in some segments of fixed income, equity, and derivatives
markets.

In various capital markets, hedge funds clearly are increasingly consequential as providers of liquidity and
absorbers of risk. For example, a study of the markets in U.S. dollar interest rate options indicated that
participants viewed hedge funds as a significant stabilizing force. In particular, when the options and other
fixed income markets were under stress in the summer of 2003, the willingness of hedge funds to sell
options following a spike in options prices helped restore market liquidity and limit losses to derivatives
dealers and investors in fixed-rate mortgages and mortgage-backed securities. Hedge funds reportedly are
significant buyers of the riskier equity and subordinated tranches of collateralized debt obligations (CDOs)
and of asset-backed securities, including securities backed by nonconforming residential mortgages.

At the same time, however, the growing role of hedge funds has given rise to public policy concerns. These
include concerns about whether hedge fund investors can protect themselves adequately from the risks
associated with such investments, whether hedge fund leverage is being constrained effectively, and what
potential risks the funds pose to the financial system if their leverage becomes excessive.
Investor Protection:

Hedge funds and their investment advisers historically were exempt from most provisions of the federal
securities laws. Those laws effectively allow only institutions and relatively wealthy individuals to invest in
hedge funds. Such investors arguably are in a position to protect themselves from the risks associated with
hedge funds. However, in recent years hedge funds reportedly have been marketed increasingly to a less
wealthy clientele. Furthermore, pension funds, many of whose beneficiaries are not wealthy, have increased
investments in hedge funds.

Concerns about the potential direct and indirect exposures of less wealthy investors from hedge fund
investments and hedge fund fraud contributed to the SEC’s decision in December 2004 to require many
advisers to hedge funds that are offered to U.S. investors to register with the commission.

The SEC believes that the examination of registered hedge fund advisers will deter fraud. But fraud is very
difficult to uncover, even through on-site examinations. Therefore, it is critical that investors do not view the
SEC registration of advisers as an effective substitute for their own due diligence in selecting funds and their
own monitoring of hedge fund performance. Most institutional investors probably understand this well. In a
survey several years ago of U.S. endowments and foundations, 70 percent of the respondents said that a
hedge fund adviser’s registration or lack of registration with the SEC had no effect on their decision about
whether or not to invest because the institutions conducted their own due diligence.

In the case of pension funds, sponsors and pension fund regulators should ensure that pension funds conduct
appropriate due diligence with respect to all their investments, not just their investments in hedge funds.
Pension funds and other institutional investors seem to have a growing appetite for a variety of alternatives
to holding stocks and bonds, including real estate, private equity and commodities, and investments in hedge
funds are only one means of gaining exposures to those alternative assets. The registration of hedge fund
advisers simply cannot protect pension fund beneficiaries from the failures of plan sponsors to carry out their
fiduciary responsibilities.
As for individual investors, the income and wealth criteria that define eligible investors in hedge funds
unavoidably are a crude test for sophistication. If individuals with relatively little wealth increasingly
become the victims of hedge fund fraud, it may become appropriate to tighten the criteria for an individual to
be considered an eligible investor.

Excessive Leverage and Systemic Risk:

The near failure of the hedge fund Long-Term Capital Management (LTCM) in September 1998 illustrated
the potential for a large hedge fund to become excessively leveraged and raised concerns that a forced
liquidation of large positions held by a highly leveraged institution would create systemic risk by
exacerbating market volatility and illiquidity. In our market-based economy, the primary mechanism that
regulates firms’ leverage is the market discipline imposed by creditors and counterparties. Even when the
government has oversight of leverage, as in the case of banks and broker-dealers, such oversight is intended
to supplement market discipline rather than to replace it. In the case of LTCM, however, market discipline
broke down.

In the wake of the LTCM episode, the President’s Working Group on Financial Markets considered how
best to constrain excessive leverage by hedge funds. The Working Group concluded that hedge funds’
leverage could be constrained most effectively by promoting measures that enhance market discipline by
improving credit risk management by hedge funds’ counterparties and creditors, nearly all of which are
regulated banks and securities firms. The Working Group termed this approach “indirect regulation” of
hedge funds. The Working Group considered the alternative of direct government regulation of hedge funds,
but it concluded that developing a regulatory regime for hedge funds would present formidable challenges in
terms of cost and effectiveness. It believed that indirect regulation would address concerns about systemic
risks from hedge funds most effectively and would avoid the potential attendant costs of direct regulation.
The Federal Reserve and Hedge Funds

The President’s Working Group made a series of recommendations for improving market discipline on
hedge funds. These included recommendations for improvements in credit risk management practices by the
banks and securities firms that are hedge funds’ counterparties and creditors and improvements in
supervisory oversight of those banks and securities firms. As a regulator of banks and bank holding
companies, the Federal Reserve has worked with other domestic and international regulators to implement
the necessary improvements in supervisory oversight. Regulatory cooperation is essential in this area
because hedge funds’ principal creditors and counterparties include foreign banks as well as U.S. banks and
securities firms.

In January 1999, the Basel Committee on Banking Supervision (BCBS) published a set of recommendations
for sound practices for managing counterparty credit risks to hedge funds and other highly leveraged
institutions. Around the same time, the Federal Reserve, the SEC, and the Treasury Department encouraged
a group of twelve major banks and securities firms to form a Counterparty Risk Management Policy Group
(CRMPG), which in July 1999 issued its own complementary recommendations for improving counterparty
risk management practices.

The BCBS sound practices have been incorporated into Federal Reserve supervisory guidance and
examination procedures applicable to banks’ capital market activities. In general terms, routine supervisory
reviews of counterparty risk management practices with respect to hedge funds and other counterparties seek
to ensure that banks

(1) Perform appropriate due diligence in assessing the business, risk exposures, and credit standing of their
counterparties;

(2) Establish, monitor, and enforce appropriate quantitative risk exposure limits for each of their
counterparties;

(3) Use appropriate systems to measure and manage counterparty credit risk; and

(4) Deploy appropriate internal controls to ensure the integrity of their processes for managing counterparty
credit risk.
Besides conducting routine reviews and continually monitoring counterparty credit exposures, the Federal
Reserve periodically performs targeted reviews of the credit risk management practices of banks that are
major hedge fund counterparties. These targeted reviews examine in depth the banks’ practices against the
BCBS and Federal Reserve sound practices guidance and the CRMPG recommendations.

According to supervisors and most market participants, counterparty risk management has improved
significantly since the LTCM episode in 1998. However, since that time, hedge funds have greatly expanded
their activities and strategies in an environment of intense competition for hedge fund business among banks
and securities firms. Furthermore, some hedge funds are among the most active investors in new, more-
complex structured financial products, for which valuation and risk measurement are challenging both to the
funds themselves and to their counterparties. Counterparties and supervisors need to ensure that competitive
pressures do not result in any significant weakening of counterparty risk management and that risk
management practices are evolving as necessary to address the increasing complexity of the financial
instruments used by hedge funds.

The Federal Reserve has also sought to limit hedge funds’ potential to be a source of systemic risk by
ensuring that the clearing and settlement infrastructure that supports the markets in which the funds trade is
robust. Very active trading by hedge funds has contributed significantly to the extraordinary growth in the
past several years of the markets for credit derivatives. A July 2005 report by a new Counterparty Risk
Management Policy Group (CRMPG II) called attention to the fact that the clearing and settlement
infrastructure for credit derivatives (and over-the-counter derivatives generally) had not kept pace with the
volume of trading. In particular, a backlog of unsigned trade confirmations was growing, and the acceptance
by dealers of assignments of trades by one counter party without the prior consent of the other, despite trade
documentation requirements for such consent, was becoming widespread.

To address these and other concerns about the clearing and settlement of credit derivatives, in September
2005 the Federal Reserve Bank of New York brought together fourteen major U.S. and foreign derivatives
dealers and their supervisors. The supervisors collectively made clear their concerns about the risks created
by the infrastructure weaknesses and asked the dealers to develop plans to address those concerns.
With supervisors providing common incentives for the collective actions that were necessary, the dealers
have made remarkable progress since last September. The practice of unauthorized assignments has almost
ceased, and dealers are now expeditiously responding to requests for the authorization of assignments. For
the fourteen dealers as a group, total credit derivative confirmations outstanding for more than thirty days
fell 70 percent between September 2005 and March 2006. The reduction in outstanding confirmations was
made possible in part by more widespread and intensive use of an electronic confirmation-processing system
operated by the Depository Trust and Clearing Corporation (DTCC). The dealers have worked with their
largest and most active clients, most of which are hedge funds, to ensure that they can electronically confirm
trades in credit derivatives. By March 2006, 69 percent of the fourteen dealers’ credit derivatives trades were
being confirmed electronically, up from 47 percent last September.

Supervisors and market participants agree that further progress is needed, and in March the fourteen dealers
committed themselves to achieving by October 31, 2006, a “steady state” position for the industry.

The steady state will involve

(1) The creation of a largely electronic marketplace in which all trades that can be processed electronically
will be;

(2) The creation by DTCC of an industry trade information warehouse and support infrastructure to
standardize and automate processing of events throughout each contracts’ life;

(3) New processing standards for those trades that cannot be confirmed electronically; and

(4) The creation of an automated platform to support notifications and consents with respect to trade
assignments. The principal trade association for the hedge fund industry has stated its support for plans
embodied in the dealers’ commitments.
Literature review

Ackermann et al. (1999), Liang (1999), and Edwards and Caglayan (2001) study the association
between IF and risk-adjusted performance and report a statistically significant positive association
between them. Their results suggest that IF is an effective tool to align the interest of both managers and
investors.

Anson (2001) uses the Black-Scholes option pricing model to determine a suitable value for the option-like
IFC and concludes that this option has a significant value and the performance-based incentive fee
along with the requirement for HFM having their own money invested in the fund are the best ways to
alignment the interests of both managers and investors.

Agarwal et al. (2009) work is based on the assumption that the IF percentage rate does not explain
performance. They use instead the delta6 of the call option underlying the IFC along with the HR and the
HWM provision and conclude that the HFs with better performances have higher option deltas and include
an HWM.

Liang and Schwarz (2011) investigate whether the managerial pay-performance compensation structure is
able to reduce agency costs. They examine the effects of the HFM’s decisions to close funds to new
investors to prevent diseconomies of scale and report evidence that managers do not close funds unless there
is a significant diseconomy of scale.
Agarwal and Ray (2011) study the determinants and consequences of fee changes and whether the
structure of fee changes (i.e. management fee percentage rate, IF, and HWM provision) are related to each
other and to the fund’s past performance and expectations for the future performance, using a dataset
comprising information on the HF fee structure, for the period between April 2008 and November 2010.
Their results suggest that the IF tend to increase over time and that this tendency is more frequent in younger
and smaller HF than in older and larger HF. It appears that investors view the increase in the fee as a signal
of managerial ability and reward those funds with a higher investment.

Schwarz (2007) provides, however, a detailed cross-sectional analysis of fee variation and studies the
effect on HFP and cash flow showing that management fees and IF are positively correlated with the lock up
period which means that managers charging higher fees tend to have longer lock-up periods in their funds.
However, investors do not view these fee levels as a signal of better future performance.

Fung and Hsieh (1997) find that when the IFC is out of the money, i.e. the current HF value is below the
strike price of the underlying call options, contractual constraints, and reputational concerns may prevent
managers from increasing risk. It appears that, once a good reputation is built, HFM tend to preserve it by
following less risky management strategies.

Brown et al. (2001) examine the association between the risk taken by HFM and reputational or career-
management related concerns and conclude that poor relative performance and low-risk premium increases
the probability of HF termination and that the subsequent related reputation cost offsets the effect of IFC
on risk taking. This pattern is more evident, however, for out-of-the-money (call options) IFC.

Kouwenberg and Ziemba (2007) examine the effect of the characteristics of the IFC on the RM behaviour
of the HFM and show that HFs with IFC have higher downside risk than HFs without IFC, and that risk-
taking behaviour is significantly reduced when HFM invest their own money in a proportion higher than
30% of the total value of the fund.
Aragon (2007) finds that HF with lockup period constraints have higher excess returns than HF without
lockup periods, and show that there is a negative relationship between share restrictions8 and the
liquidity of the fund's portfolio.

Liang (1999), Koh et al. (2003) and Agarwal et al. (2009) report a positive relationship between HF
returns and the length of the lockup period. The higher the investors’ cash outflow restrictions, defined
as the sum of the lockup period, redemption notice period and redemption period in months, the lower is
the likelihood of the fund closure and the higher is the loss in performance over time.

Liang (1999) and Koh et al. (2003) study the effect of HF size, proxied by the HF assets value under
management, on HFP and both arrive at the conclusion that the larger the size of the HF the better is the
performance. It appears that HFs of larger size benefit from economies of scale and are more likely to
attract new investors.

Getmansky (2004) find, however, that there is a concave negative relationship between HFP and the size of
the assets under management. This finding suggests that there is an optimal asset value size to
maximize return. The optimal asset size depends, however, on several variables, whose effect on
performance can offset each other, such as past returns, fund flows, market impact and competition in the
industry (i.e. for instance, HFs in illiquid categories are subject to high market impact and have limited
investment opportunities and are therefore more likely to exhibit a different optimal size compared with
those in more liquid HF categories).

Agarwal et al. (2009) examine the effect of HF size and fund flows on returns and show that there is a
negative association between the size of the HFs and the evolution of the cash flows over time, which
suggests that there is a decreasing return to HF size.
Moerth (2007) uses multi-factor regression models to examine the relationship between HF size, evolution
of HF flows over time and HFP, considering the following regression variables: return, standard deviation,
Sharpe ratio and alpha per asset class, and a data sample that comprises 4,699 HFs collected from the period
between January 1994 and April 2005. His results show that on average larger HFs do not take advantage of
the economies of scale but, on the contrary, there is a significant negative relationship between HF size
and performance. He also studies whether HF allocates new capital efficiently as the inflows increase and
shows that periods with high asset inflows are typically followed by periods where returns are below
average.

Howell (2001) investigates the relationship between the age of hedge funds and their performance, from
1994 to 2000. Young hedge funds are usually defined as those with a track record of less than three years.
The first step was to adjust the returns by applying the probabilities of failure to report to the surviving
funds. This gives ex-post returns, which correspond to the true costs and benefits of investing in funds with
different maturities. The second step was to adjust the returns by applying the probability of future survival
to the survivors' returns by age decile. This gives ex-ante returns, which are the expected returns from
investing in hedge funds with different maturities. Ex-ante returns infer that young funds' returns are
superior to those of seasoned funds: the youngest decile exhibits a return of 21.5%, while the whole sample
median exhibits a return of 13.9% (a spread of 760 basis points in favour of young funds). Moreover, the
spread between the decile of youngest funds and the decile of oldest funds is 970 points, and the spread
between the second youngest fund decile and the whole sample median is 290 points. The conclusion of this
study is that hedge fund performance deteriorates over time, even when the risk of failure is taken into
account. Consequently, the youngest funds seem particularly attractive.

Kat (2004) discusses the differences in analyzing hedge fund index data and the returns to individual hedge
funds. Individual hedge funds typically have a higher standard deviation than their style index because a less
than perfect correlation exists between funds in the same style. When aggregating hedge funds into a style
index, the standard deviation of the index is lower than the standard deviation of the average fund, but the
index tends to have more negative skewness and a higher correlation with equity markets. Although each
fund has its own specific risks and market timing, those exposures are averaged when funds are bundled into
an index. Although it diversifies the specific risk of each fund, the indexing process reduces standard
deviation but increases the exposures to common factor risks.
Beckers et al. (2007) discuss the performance persistence of hedge funds and find that the persistence of
alpha is higher than the persistence of total returns. The persistence of funds with high information ratios
(i.e., alpha divided by the standard deviation of alpha) is greater than that of funds with high Sharpe ratios.
Specifically, funds with top quartile rankings of information ratios during the trailing three years have a 51
percent chance of remaining in the top quartile of that same measure during the subsequent year. Persistence
is also strong for lower quartile funds because a large percentage of funds repeat as below average
performers. Funds of funds show much greater persistence than single strategy hedge funds. The common
factor risks tend to dominate the performance of single strategy funds, which are often clustered around the
average return for the strategy. Funds of funds diversify among hedge fund styles, which diversifies the risks
of relying on returns from a specific market factor

Naik and Agarwal (2000) analyzed the performance persistence of hedge funds by calculating the alpha of
each fund relative to its style index using quarterly returns. Past performance was calculated by using a
variety of methodologies, including regressions, contingency tables, and appraisal ratios, which explicitly
consider volatility and leverage. The results indicated that persistence varies by hedge fund style because 6
to 8 of 13 strategies showed reasonable persistence using different methodologies. Losers tend to exhibit
greater persistence than winners, which shows the importance of manager selection when building a
portfolio of hedge funds.

Hsieh (2006) explains that many funds of funds take substantial risk in traditional market factors. Investors
in these beta funds may be paying high fees for risk exposures that can be sourced more cheaply outside of
the hedge fund universe. The limited number of funds of funds that provide true alpha with low beta risks
will rapidly grow as a share of the industry’s AUM, whereas funds of funds that provide beta exposures with
minimal value added will struggle to retain market share.
Anson (2001) has described hedge fund incentive fees as a free call option because the manager earns high
fees for large investment gains but does not share in any investor losses. This lack of sharing in losses could
provide an incentive for the manager to take risks larger than the investor would choose. An offsetting factor
to this asymmetrical fee structure is when the investment manager has invested a substantial portion of his or
her net worth in the fund, which would cause the manager and the investor to simultaneously experience
trading losses.

Asness (2006) suggests several modifications to hedge fund fee structures. Higher hedge fund fees should be
paid to managers that have demonstrated skill by earning alpha, which is a high return after adjusting for all
applicable risks. Leveraged hedge funds may also justify higher fees because these strategies earn a greater
benefit from the manager’s insight for each dollar of invested capital. Hedge fund investors are starting to
separate alpha from beta in their performance calculation, leading them to ask hedge funds to charge lower
fees for beta exposures to traditional market factors. By replacing high beta hedge funds with index funds or
hedge fund beta replications (see the section “Hedge Fund Replication”), investors can substantially reduce
the fees they pay. As the hedge fund industry comes to rely more on institutional investors, such as pension
plans, and less on high net-worth individuals, hedge fund fees for larger investments are likely to decline.

Malkiel and Saha (2005) report that less than 25 percent of funds operating in 1996 were still reporting to
databases in 2004. Because liquidated funds tend to have lower returns and higher risks than funds with
continuing operations, a database in which the track records of no surviving funds are excluded will produce
an analysis that suffers from survivor, or survivorship, bias. In the literature, authors report a wide range of
estimates of survivor bias; the returns to live funds exceed the returns to the combination of live and defunct
funds by between 0.6 percent and 3.6 percent per year. By not including failed funds in return calculations,
hedge fund returns will be overstated by this amount.
Kat (2003) and Cremers, Kritzman, and Page (2005) show that applying many of the classical techniques
and ratios to hedge fund returns without accounting for nonlinearities can cause investors to reach
inappropriate conclusions about the attractiveness of hedge funds. As a result, some investors allocate too
much of their portfolio to hedge funds and are disappointed when their assumptions are violated.

Till (2004) discusses the costs of illiquidity in hedge funds. As mentioned earlier, investors should be
compensated for longer lockup periods, and many hedge funds are now offering lower fees in exchange for
investors agreeing to longer lockup periods. Investors should also be compensated for short volatility risk
and event risk. Illiquid assets, such as emerging markets, over-the-counter derivatives, microcap stocks, and
distressed fixedincome securities, are difficult to value and difficult to trade. Investors in these assets are
taking the risk that the assets will be valued at a price far different from what would be realized when asking
the market for liquidity. Should the hedge fund choose or be forced to sell during a liquidity crisis, prices
will be even lower.

Getmansky, Lo, and Makarov (2004) show that stale pricing risks are most prominent in fixed-income and
convertible bond strategies, as well as event driven and relative value strategies and emerging markets.
These markets are known for their illiquidity and the need for mark-to-market valuation. Strategies that rely
on trading in more liquid markets, such as large-cap stocks, currencies, and commodity futures, do not show
evidence of stale pricing because fund managers can easily calculate NAV from each day’s market
settlement prices. Beyond the effect of underestimated risks, stale pricing can have clear financial
implications for investors. If the monthly NAV for a hedge fund is struck using stale prices, investors who
sell hedge fund interests during a bull market may receive proceeds of less than the fair value for those
assets. Conversely, investors who redeem hedge fund interests during a bear market will receive a higher
than realistic price for their assets because future prices are likely to be lower when full markdowns of assets
are taken.
Géhin and Vaissié (2006) and Amenc and Martinelli (2002) discuss the proper calculation of the alpha
earned by hedge funds. Alpha is the return to the hedge fund after accounting for the risks incurred by both
traditional and alternative beta exposures. Estimate the alpha of hedge funds to be 5.8 percent per year in
excess of the exposure to traditional beta risks. After adding the exposure to alternative beta risks, the alpha
declines to –1.0 percent. The implication of this analysis is that hedge funds, as a group, do not earn positive
alpha but simply provide investors with the ability to access alternative beta exposures.

Hsieh (2006) estimates that by exploiting market inefficiencies a static $30 billion in alpha is available to be
earned by all hedge fund managers combined. This amount is based on 3 percent alpha from a hedge fund
industry size of $1 trillion, but as hedge fund assets grow to $2 trillion, the percentage return to each fund in
alpha terms would decline to 1.5 percent. This argument assumes that a finite capacity for AUM for hedge
funds exists, both as an industry and in each strategy. As greater assets enter each strategy, the market
inefficiencies disappear more quickly, making the future prognosis for hedge fund growth dim.

Jaeger and Wagner (2005) develop replicating factor strategies, which can replicate many hedge fund
styles with just three or four traditional market exposures. Of 11 styles tested, 8 could be replicated with an
R2 above 49 percent. Long–short equity, emerging market, short selling, and distressed strategies can be
most closely replicated, with an R2 of between 68 percent and 88 percent. Less efficient replications can be
developed for equity market neutral, risk arbitrage, fixed-income arbitrage, convertible bond arbitrage,
global macro, and managed futures strategies. For example, a simple replication of a fixed-income arbitrage
fund would take a long position in a credit fund, such as corporate bonds, high yield bonds, or mortgage-
backed securities, and a short position in a Treasury securities fund of a similar duration. The weights for
each fund would be determined through a linear regression of long-term hedge fund returns on the traditional
bond market sector funds. A slightly more complex form of replication uses dynamic weights with the same
traditional market factors. Rather than having static weights, the beta exposure to each market sector is
determined through the use of rolling regressions, with common look back periods of one to three years.
Kabiller (2008) seek to separate hedge fund beta from hedge fund replication. Hedge fund replication using
factor models and liquid index products avoids many of the issues of liquidity and complex valuation faced
by hedge funds that invest in specific securities. To capture the returns to event risk, illiquidity, and complex
securities, the hedge fund beta strategy seeks to mechanically reproduce hedge fund strategies by investing
in specific securities. A fund designed to provide merger arbitrage beta, for example, would purchase the
target company and sell short the acquiring company in all announced merger transactions. Beta exposure to
managed futures could be developed through a mechanical trend following system that seeks to buy futures
in any market with a trend of rising prices and sell short futures in any market in which prices are expected
to decline. A distressed or convertible arbitrage beta could be devised through the purchase of those specific
fixed-income securities, perhaps by selling short the related equity security.

Allison and Lin (2004) show that a number of caveats exist when attempting to model the addition of hedge
funds to traditional portfolios. Specifically, it is difficult to develop expected return assumptions for hedge
funds given the survivor, selection, stale pricing, and backfill biases inherent in hedge fund databases.
Correlation and volatility of historical hedge fund returns, however, can be appropriately used to develop
estimates of future risks. After determining the beta of each hedge fund strategy in relation to the underlying
traditional market factors, an expected return assumption for the hedge fund style can be derived by adding
estimated alpha to the beta adjusted expected returns of the underlying asset classes.

Dopfel (2005) also uses the alpha and beta estimates of factor analysis to derive expected returns for hedge
fund strategies. Investors need to be aware, however, that hedge fund performance can be quite dynamic,
with correlation, volatility, and beta exposures that can change significantly over time. In addition,
derivatives and short volatility trading strategies can add nonlinearities to the hedge fund return generation
process. These properties can lead hedge funds to have asymmetrical beta exposures, in which the beta of the
hedge fund differs according to the volatility and the direction of the underlying market. For example,
managed futures and dedicated short bias funds have attractive asymmetrical exposures to equity index
prices, with higher betas in rising markets and lower betas in falling markets. Multi strategy and market
neutral equity funds have little exposure to asymmetrical beta. Unfortunately, all other hedge fund styles
have negative asymmetrical beta exposures, and betas tend to rise in falling markets. Also discusses using
factor analysis to target overall asset allocation. When the hedge fund portfolio has a persistent beta relative
to equity markets, it is wise to reduce the portfolio’s exposure to equity markets by a similar amount to
ensure that equity market risk is consistent with the strategic asset allocation.
Kat (2004) warns about the use of mean–variance optimization and Sharpe ratios in building hedge fund
portfolios because standard deviation is not a complete measure of risk for hedge funds. Some hedge fund
styles are known to smooth returns, as well as experience negative skewness and excess kurtosis. In fact, the
hedge fund styles with the lowest standard deviations and highest Sharpe ratios are often the ones with the
most unattractive higher moment exposures. A high Sharpe ratio and high alpha are simply invitations to
further research the hedge fund manager’s trading strategy. Investors need to determine whether the trading
strategy is a short volatility, convergence related, or event-risk-laden strategy in which future risks could
potentially be larger than historical risk. The typical result of adding hedge funds to a portfolio of traditional
investments is that standard deviation will decline and the Sharpe ratio will increase but at the cost of
worsening higher moment exposures. This result is attributed to the variable correlation and asymmetrical
beta exposures of hedge funds, in which losses to hedge fund portfolios tend to increase during times of
extreme losses in stock and bond markets. Mean–variance optimization also assumes that assets have the
same liquidity characteristics and return distributions. If mean–variance optimization is to be used to add
hedge funds to traditional investment portfolios, constraints on the deterioration of skewness and kurtosis
risks should be added to the optimization equation. Placing constraints on the nonlinearities of hedge funds
will cause investors to choose lower allocations to hedge funds than when mean–variance optimization is
used without considering higher moment risks.

Sharma (2004) states that higher moment risks are more prevalent in lower volatility strategies because 75
percent of no directional strategies have returns that are not normally distributed, whereas only 39 percent of
directional strategies reject normality.

Fothergill and Coke (2001) describe the advantages and disadvantages of investing in funds of funds.
Funds of funds use investment managers that perform due diligence on single strategy hedge fund
investments, with the goal of building a lower risk, well-diversified hedge fund portfolio. By investing in 15
to 20 single manager hedge funds across a variety of trading styles, funds of funds can reduce the standard
deviation of a hedge fund portfolio. Smaller investors may be able to access a fund of funds portfolio with a
minimum investment as low as $100,000, far lower than the $7 million to $20 million required to meet the
minimum investment requirements of each of the underlying hedge fund managers. Funds of funds may
offer preferential liquidity terms to investors, perhaps allowing monthly redemptions, which are preferable to
the quarterly or annual redemptions of the underlying managers.
Data Analysis

Growth of Hedge Fund:

In the entire financial services arena, the sector showing the most growth is clearly the area of hedge funds.
While brokerage commissions continue to decline, investment banking fees start to come under pressure and
the entire financial services industry worries about intensified regulatory scrutiny, the hedge fund industry
with its rapid growth stands out from the crowd.

New funds are starting up every week and many are beginning with an excess of a billion dollars under
management from day one.

The amount of money under management with hedge funds has gone up four times between 1996 and 2004
and is expected to further triple between now and 2010 to over $2.7 trillion.

Public funds, endowments, and corporate sponsors have all increased their allocations to hedge funds within
the context of an increased allocation towards alternative investments more generally.

This move towards increased investments in real estate/private equity/hedge funds (alternative investments)
is driven by the need for a higher return to compensate for the expected lower returns from more
conventional investment strategies focused on US bonds and equities.

There is also a clear desire among this investor base to be more focused on absolute-return strategies rather
than relative return. Given the current level of allocations most of these large long-term investors have
towards alternative investments, and their professed long-term target allocation, the flow of funds to these
asset classes will remain strong.
One of the intriguing developments in the hedge fund world is the clear desire and ability of the newer funds
to charge higher fees and impose more stringent terms on investors.

No longer are funds charging a 1 per cent management fee and 20 per cent of profits -- the norm for the first
generation of funds set up in the early to mid 1990s.

As per an interesting study done by Morgan Stanley's prime brokerage unit, about a third of the funds
opening in the past six months are charging a 2 per cent management fee and 20 per cent of profits or higher,
while the majority are charging a 1.5 per cent management fee and 20 per cent of profits.

Many of the new funds have more stringent lock-ups and stiff penalties if you redeem early, as well as
modified high-water marks.

The hedge fund business thus seems to have the unique characteristic of being possibly the only business
that I know of wherein new players (most of whom are unproven) have the ability to charge more and get
better terms than the established operators.

This implies a negative franchise value for the established large fund complexes which have survived and
prospered through the years. Given that most of the best hedge fund complexes are closed to new investors,
the new guys seem to be taking advantage of the huge demand-supply mismatch for quality money
managers.

There is a feeding frenzy currently under way in the world of alternative investments and clients are paying
up the higher fees for fear of being locked out from these funds at a later date, if they actually survive and
grow.
One reason why the new boys are focusing more on fees and lock-ups could be the difficulty all hedge funds
are having in generating adequate alpha (excess return) to ensure an adequate payout for themselves.

In a study done by Morgan Stanley on the excess returns generated by hedge funds over the last decade, this
trend of declining returns was very apparent. In the study they defined excess returns as the return of the
Hedge Fund research composite over one month LIBOR (a proxy for cash returns).

In the 1995-97 period, excess returns were 14 per cent; these returns have consistently declined dropping to
as low as 5 per cent in 2001-03 and have dropped further since.

The current huge inflows into funds focused on emerging markets make sense if you look at performance
numbers over the past three years.

Hedge funds focused on the emerging markets had the best returns with an 18 per cent annual return during
2001-04, closely followed by distressed debt focused funds at 17 per cent. More conventional hedge fund
strategies of tech at 0 per cent and risk arbitrage at 3 per cent annual return lagged far behind.

Given the constant inflows into new hedge funds, clients do not yet seem to be bothered about paying higher
and higher fees for lower returns, but this is a discussion that I am sure will come up at some stage in most
investment committees.

At some stage if the hedge fund community continues to show declining alpha (excess returns), clients will
need to question whether the proliferation of hedges has reduced returns because the field has become too
competitive.
The beauty of the hedge fund business and the reason why the upward drift in fee structure is even more
surprising is the ease of entry of new players into the game. The average long short hedge fund needs only
about six back office staff per billion dollars, while a global macro fund needs about 11 people for a fund of
similar size (Morgan Stanley survey).

The typical long short US equity manager has only nine investment professionals and three in the back
office. These funds are also not really regulated and have very limited disclosure requirements, if any.

The start-up costs of these vehicles are also minimal and most funds will be able to break even at sub $100
million in assets under management. There is no other industry that I am aware of where exit and entry are
as simple.

Hedge funds till date in 2005 have had a tough year; there have been few strong trends to capitalise on and
most funds are struggling to show a positive return. If the hedge fund industry ends the year flat or even (god
forbid) negative after disappointing relative performance in 2003 and just about average numbers in 2004,
some of the more sophisticated clients may migrate back to more conventional forms of investing with lower
fee structures.

Hedge funds are clearly here to stay, and continue to attract the best talent because of their payout structures;
however, their ability to continue to command a premium fee structure will eventually be limited by their
ability to differentiate themselves from their long-only brethren on the performance front.
Growth of Hedge Fund in India:

Hedge fund industry is drawing media attention in India. Recently Avendus Capital has reported as the first
domestic hedge fund to have $1 billion asset under management. A hedge fund is an alternative investment
fund (AIF), which employs diverse or complex trading strategies and invests and trades in securities having
diverse risks or complex products including listed and unlisted derivatives. AIFs are classified into three
broad categories. While category I AIF includes Angel, venture capital, social and infrastructure funds,
category II includes private equity, real estate, distressed and PIPE funds. Hedge funds are classified as
category III AIFs as per SEBI regulations.

There are currently 346 AIFs registered with SEBI. The Indian income tax law is not very supportive of
AIFs; particularly for hedge funds. Income accruing to category I and category II AIFs, registered with
SEBI, is taxed at the investor and not at the fund level. However, category III AIFs are not accorded pass
through status. In other words, any income or gain of category III AIFs is taxed at the fund level. This is
contrary to the taxation on mutual funds, where tax is charged at investors’ level. This provision leads to
increase in the operating costs of hedge funds.

In fact, hedge funds are not clearly defined in the income tax laws in India. If any AIF, irrespective of
category, suffers a loss, such loss has to be absorbed at the fund level and cannot be passed on to the
investors. This is quite a punitive provision and calls for review. Like income or gains, losses should be
given pass through status.

High net worth individuals and institutional investors are allowed to invest in risky AIFs. Each scheme of
AIF should have a minimum corpus of Rs. 200 million and the minimum investment amount by any investor
is pegged at Rs.10 million. Private equity (PE) and venture capital (VC) are the most popular AIF followed
by real estate funds; hedge funds come as distant fourth. Alternative Assets under management in India is
very small compared to USA ($2.8 trillion), UK ($495 billion and China ($265 billion). However, the Indian
market has huge growth potential- it grew by 55% in 2017.
There are several important differences between hedge funds and PE (and similarly VC) funds. Managers of
hedge funds have flexibility to buy or sell a wide range of assets. PEs can hold long only portfolios. Hedge
funds can take leverage positions, which PE cannot. Hedge funds normally seek to make profits from market
inefficiencies (mispricing), rather than purely relying on economic growth to drive returns. While hedge
funds have low holding period (sometimes even intraday), PEs have much longer holding period (5-7 years).

Managers of hedge funds are pure financial investors, whereas PE investment comes with some degree of
operational control on the investee company. Since investment horizon for hedge funds is relatively short,
performance of such funds is estimated on monthly/quarterly basis. PE funds see returns only after 5-7
years. Private equity investors simply cannot withdraw capital before the end of a fund’s life.
Ways Hedge Funds Avoid Taxes

Many hedge funds are structured to take advantage of carried interest. Under this structure, a fund is treated
as a partnership. The founders and fund managers are the general partners, while the investors are the limited
partners. The founders also own the management company that runs the hedge fund. The managers earn the
20% performance fee of the carried interest as the general partner of the fund.

Hedge fund managers are compensated with this carried interest; their income from the fund is taxed as a
return on investments as opposed to a salary or compensation for services rendered. The incentive fee is
taxed at the long-term capital gains rate of 20% as opposed to ordinary income tax rates, where the top rate
is 39.6%. This represents significant tax savings for hedge fund managers.

This business arrangement has its critics, who say that the structure is a loophole that allows hedge funds to
avoid paying taxes. The carried interest rule has not yet been overturned despite multiple attempts in
Congress. It became a topical issue during the 2016 primary election.

Many prominent hedge funds use reinsurance businesses in Bermuda as another way to reduce their tax
liabilities. Bermuda does not charge a corporate income tax, so hedge funds set up their own reinsurance
companies in Bermuda. The hedge funds then send money to the reinsurance companies in Bermuda.
These reinsurers, in turn, invest those funds back into the hedge funds. Any profits from the hedge funds go
to the reinsurers in Bermuda, where they owe no corporate income tax. The profits from the hedge fund
investments grow without any tax liability. Taxes are only owed once the investors sell their stakes in the
reinsurers.

The business in Bermuda must be an insurance business. Any other type of business would likely incur
penalties from the U.S. Internal Revenue Service (IRS) for passive foreign investment companies. The IRS
defines insurance as an active business. To qualify as an active business, the reinsurance company cannot
have a pool of capital that is much larger than what it needs to back the insurance that it sells. It is unclear
what this standard is, as it has not yet been defined by the IRS.
Hedge Fund Strategies:

Hedge funds use a variety of different strategies, and each fund manager will argue that he or she is unique
and should not be compared to other managers. However, we can group many of these strategies into certain
categories that assist an analyst/investor in determining a manager’s skill and evaluating how a particular
strategy might perform under certain macroeconomic conditions. The following is loosely defined and does
not encompass all hedge fund strategies, but it should give the reader an idea of the breadth and complexity
of current strategies.

Equity Hedge:

The equity hedge strategy is commonly referred to as long/short equity and although it is perhaps one of the
simplest strategies to understand, there are a variety of sub strategies within the category.

 Long/Short – In this strategy, hedge fund managers can either purchase stocks that they feel are
undervalued or sell short stocks they deem to be overvalued. In most cases, the fund will have
positive exposure to the equity markets – for example, having 70% of the funds invested long in
stocks and 30% invested in the shorting of stocks. In this example, the net exposure to the equity
markets is 40% (70%-30%) and the fund would not be using any leverage (Their gross exposure
would be 100%). If the manager, however, increases the long positions in the fund to, say, 80% while
still maintaining a 30% short position, the fund would have gross exposure of 110% (80%+30% =
110%), which indicates leverage of 10%.
 Market Neutral – In this strategy, a hedge fund manager applies the same basic concepts mentioned
in the previous paragraph, but the manager seeks to minimize the exposure to the broad market.
He/she can do this in two ways. If there are an equal amount of investments in both long and short
positions, the net exposure of the fund would be zero. For example, if 50% of funds were invested
long and 50% were invested short, the net exposure would be 0% and the gross exposure would be
100%. (Find out how this strategy works with mutual funds.
There is a second way to achieve market neutrality, and that is to have zero beta exposure. In this case, the
fund manager would seek to make investments in both long and short positions so that the beta measure of
the overall fund is as low as possible. In either of the market-neutral strategies, the fund manager’s intention
is to remove any impact of market movements and rely solely on his/her ability to pick stocks.

Either of these long/short strategies can be used within a region, sector or industry, or can be applied to
market-cap-specific stocks, etc. In the world of hedge funds, where everyone is trying to differentiate
themselves, you will find that individual strategies have their unique nuances, but all of them use the same
basic principles described here.

Global Macro:

Generally speaking, these are the strategies that have the highest risk/return profiles of any hedge fund
strategy. Global macro funds invest in stocks, bonds, currencies, commodities, options, futures, forwards and
other forms of derivative securities. They tend to place directional bets on the prices of underlying assets and
they are usually highly leveraged. Most of these funds have a global perspective and, because of the
diversity of investments and the size of the markets in which they invest, they can grow to be quite large
before being challenged by capacity issues. Many of the largest hedge fund “blow-ups” were global macros,
including Long-Term Capital Management and Amaranth Advisors. Both were fairly large funds and both
were highly leveraged.
Relative Value Arbitrage:

This strategy is a catchall for a variety of different strategies used with a broad array of securities. The
underlying concept is that a hedge fund manager is purchasing a security that is expected to appreciate,
while simultaneously selling short a related security that is expected to depreciate. Related securities can be
the stock and bond of a specific company; the stocks of two different companies in the same sector; or two
bonds issued by the same company with different maturity dates and/or coupons. In each case, there is an
equilibrium value that is easy to calculate since the securities are related but differ in some of their
components.

Let’s look at a simple example:

Price Coupon Term Current Interest


Rate
$1,000.00 6% 30 years 6%
$1,276.76 8% 30 years 6%

Assume a company has two outstanding bonds, one of which pays 8% and the other that pays 6%. They are
both first-lien claims on the company’s assets and they both expire on the same day. Since the 8% bond pays
a higher coupon, it should sell at a premium to the 6% bond. When the 6% bond is trading at par ($1,000),
the 8% bond should be trading at $1,276.76, all else equal. However, the amount of this premium is often
out of equilibrium, creating an opportunity for a hedge fund to enter into a transaction to take advantage of
the temporary price differences. Assume that the 8% bond is trading at $1,100 while the 6% bond is trading
at $1,000. To take advantage of this price discrepancy, a hedge fund manager would buy the 8% bond and
short sell the 6% bond in order to take advantage of the temporary price differences. I have used a fairly
large spread in the premium to reflect a point. In reality, the spread from equilibrium is much narrower,
driving the hedge fund to apply leverage to generate meaningful levels of returns.
Convertible Arbitrage:

This is one form of relative value arbitrage. While some hedge funds simply invest in convertible bonds, a
hedge fund using convertible arbitrage is actually taking positions in both the convertible bonds and the
stocks of a particular company. A convertible bond can be converted into a certain number of shares.
Assume a convertible bond is selling for $1,000 and is convertible into 20 shares of company stock. This
would imply a market price for the stock of $50. In a convertible arbitrage transaction, however, a hedge
fund manager will purchase the convertible bond and sell the stock short in anticipation of either the bond’s
price increasing, the stock price decreasing, or both.

Keep in mind that there are two additional variables that contribute to the price of a convertible bond other
than the price of the underlying stock. For one, the convertible bond will be impacted by movements in
interest rates, just like any other bond. Secondly, its price will also be impacted by the embedded option to
convert the bond to stock, and the embedded option is influenced by volatility. So, even if the bond was
selling for $1,000 and the stock was selling for $50 – which in this case is equilibrium, – the hedge fund
manager will enter into a convertible arbitrage transaction if he/she feels that 1) the implied volatility in the
option portion of the bond is too low, or 2) that a reduction in interest rates will increase the price of the
bond more than it will increase the price of the stock.

Even if they are incorrect, and the relative prices move in the opposite direction, because the position is
immune from any company-specific news, the impact of the movements will be small. A convertible
arbitrage manager, then, has to enter into a large number of positions in order to squeeze out many small
returns that add up to an attractive risk-adjusted return for an investor. Once again, as in other strategies, this
drives the manager to use some form of leverage to magnify returns.
Distressed:

Hedge funds that invest in distressed securities are truly unique. In many cases, these hedge funds can be
heavily involved in loan workouts or restructurings, and may even take positions on the board of directors of
companies in order to help turn them around. (You can see a little more about these activities at Activist
Hedge Funds.) That’s not to say that all hedge funds do this. Many of them purchase the securities in the
expectation that the security will increase in value based on fundamentals or current management’s strategic
plans. In either case, this strategy involves purchasing bonds of a company that have lost a considerable
amount of their value because of the company’s financial instability or investor expectations that the
company is in dire straits. In other cases, a company may be coming out of bankruptcy and a hedge fund
would be buying the low-priced bonds if their evaluation deems that the company’s situation will improve
enough to make their bonds more valuable. The strategy can be very risky as many companies do not
improve their situation, but at the same time, the securities are trading at such discounted values that the
risk-adjusted returns can be very attractive.
Conclusion

Hedge funds can be complicated investment vehicles that are difficult to understand. This is due partly to the
complex strategies they use, and partly to the high level of secrecy inherent in trying to prevent others from
copying your investment methodology. It doesn’t help the industry that the media usually only showcases
hedge funds when there is a huge blow-up or, in a few cases, when a hedge fund has incredibly high returns.

The truth of the matter is that there are hedge funds that generate attractive (relative to expectations) returns,
and sometimes the return pattern can be volatile while other times the pattern is very stable. There is a hedge
fund to fit the risk/return guidelines of any investor and with proper education, evaluation, and familiarity
with them, they become much less intimidating.

While I say this, I don’t mean for anyone to take a hedge fund investment lightly. As I mentioned earlier,
there are more risks to a hedge fund than the probability of losing money. For example, there is the risk that
an investor may not have access to their cash for extended periods due to lock-ups. And there is a much
more subtle risk of a hedge fund having style drift and causing the investor’s portfolio allocation to become
suboptimal.

As the industry continues to evolve, we may see additional regulation that may help to assess the merits of
hedge fund investing. Or we may see third-party research companies increase their hedge fund coverage to
provide opinions to investors. Morningstar has already begun to perform analysis on certain hedge funds and
has their own hedge fund database. For now, most of the due diligence needs to be performed by the investor
or their investment advisor.
Reference

http://i.investopedia.com/inv/pdf/tutorials/hedgefund.pdf

https://www.investopedia.com/terms/h/hedgefund.asp

https://infoforinvestors.com/investing/etf-funds/hedge-funds-pros-cons/

http://www.investogram.net/hedge-funds/advantages-and-disadvantages-of-hedge-funds/

https://www.newyorkfed.org/newsevents/speeches/2004/gei041117

https://www.federalreserve.gov/newsevents/testimony/parkinson20060516a.htm

https://www.managementstudyguide.com/types-of-hedge-funds.htm
Questionnaires

1. What do you understand by a Hedge Fund?

2. State a few differences between Hedge Funds and Mutual Funds?

3. What are the benefits of investing in hedge funds?

4. Who Invest in Hedge Fund?

5. What kind of strategies can hedge funds use?

6. What is convertible arbitrage?

7. How to Invest in Hedge Fund?

8. What are the types of Hedge Fund?