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ALL ABOUT HEDGE FUNDS
By Ezra Zask
The McGraw-Hill Companies, Inc.Copyright © 2013 The McGraw-Hill Education
All rights reserved.
What Is a Hedge Fund?
There is no universally accepted definition of a hedge fund, either legal or industry-wide. The term is believed to have been coined by a journalist in the 1950s to describe a private investment fund managed by Alfred Winslow Jones, who used long and short equity positions to "hedge" the fund's overall exposure to stock market movements. Today, hedge funds are no longer confined to one market and very often do not "hedge" their portfolio against market movements. It is much more useful to describe hedge funds by a set of characteristics that most hedge funds have in common. While some of these characteristics are also shared by other investment firms and not every hedge fund has all the characteristics, taken together these features do represent a definable group of entities that most industry participants would recognize as hedge funds. These features include the following:
Hedge funds pool assets from multiple investors in a limited partnership structure with a general partner and investment manager.
They are offered to a restricted group of investors that meet regulatory criteria as qualified investors.
Hedge funds may not market themselves and can offer shares only on the basis of a private placement memorandum.
They are largely exempt from the Securities and Exchange Commission (SEC) regulation governing investment companies, although this has changed to some extent with the implementation of the new Dodd-Frank legislation.
Investors face restrictions on the redemption of their units or shares that may be as short as three months or as long as several years.
Hedge funds have high investment minimums.
SEC DEFINITION OF HEDGE FUNDS
The SEC, which has gained considerable supervisory authority over hedge funds as a result of the Dodd-Frank Act, defines hedge funds as follows:
What are hedge funds?
Like mutual funds, hedge funds pool investors' money and invest those funds in financial instruments in an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss. Unlike mutual funds, however, hedge funds are not required to register with the SEC. Hedge funds typically issue securities in "private offerings" that are not registered with the SEC under the Securities Act of 1933. In addition, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934. But hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary duties as other investment advisers.
What are "funds of hedge funds"?
A fund of hedge funds is an investment company that invests in hedge funds—rather than investing in individual securities. Some funds of hedge funds register their securities with the SEC. These funds of hedge funds must provide investors with a prospectus and must file certain reports quarterly with the SEC
Hedge funds make extensive use of leverage, short selling, and derivatives.
They are often active traders and speculators seeking to provide "absolute returns"— i.e., positive returns in up or down markets.
HEDGE FUNDS AND MUTUAL FUNDS
Mutual funds manage approximately $12 trillion in assets compared to around $2 trillion managed by hedge funds. Unlike hedge funds, mutual funds are open to all investors and have no minimum investment. As a result, they have a much wider investor base of both individuals and institutions. As I discuss in greater detail later in the book, mutual funds are adopting some of the strategies of hedge funds. However, even these are distinct because of the distinct features of mutual funds compared to hedge funds.
The SEC describes mutual funds as follows:
A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments and other securities or assets.
Some of the traditional, distinguishing characteristics of mutual funds include the following:
Investors purchase mutual fund shares from the fund itself (or through a broker of the fund).
The price that investors pay for mutual fund shares is the fund's per share net asset value (NAV) plus any shareholder fees.
Mutual fund shares are "redeemable," meaning investors can sell their shares back to the fund (or to a broker acting for the fund).
Mutual funds generally create and sell new shares to accommodate new investors. In other words, they sell their shares on a continuous basis.
The investment portfolios of mutual funds typically are managed by separate entities known as "investment advisers" that are registered with the SEC.
In addition to the rigorous regulation of mutual funds, a key difference with hedge funds is that mutual fund managers are constrained by their limitation on short positions and their need to adhere to benchmarks. The limitation on short positions means that mutual funds will always have a greater correlation to the markets (stocks, bonds, etc.) than hedge funds. The adherence to benchmarks place limits on the extent to which mutual fund managers are able to actively manage their portfolios.
While some mutual funds are identified as "actively managed," the meaning is completely different than hedge funds. In broad terms, mutual funds can be "index" funds, which means that they seek to exactly track a benchmark index such as the S&P 500. When a mutual fund is described as "active" the manager seeks to outperform the benchmark index by a relatively small amount.
Take an example of a mutual fund that seeks to replicate the S&P 500 index and compare it to an "actively managed" mutual fund with the same index benchmark. Both funds' returns will closely mirror the returns of the S&P 500. If the S&P 500 index declines by 20%, the index fund will decline by the same amount and the index fund will decline by almost the same amount (say between 19% and 21%).
This is significantly different than a hedge fund which would seek to make money for investors even in the fact of a stock market decline of 20%. The extent to which they succeed is the topic of a later chapter.
HEDGE FUND ORGANIZATION
There is a widespread mistaken notion about the exact meaning of "hedge fund." A hedge fund is a passive investment pool—the vehicle into which the partners place their money. Hedge funds are established as limited partnerships (typically in Delaware) or corporation (offshore), which issue units or shares to limited partners. A hedge fund has no employees or physical presence. A limited partnership hedge fund vehicle is structured as follows:
The general partner (GP) (a.k.a. sponsor) is typically the creator of the fund. The GP usually manages the fund and has broad powers along with fiduciary responsibilities to the other (limited) partners.
The limited partners (LP) (a.k.a. investors) contribute capital and receive some form of ownership or partnership interest.
What is often mistakenly taken as the hedge fund is the investment manager (a.k.a. investment adviser) hired by the hedge fund (more specifically the GP of the hedge fund) to actively manage this pool of money on behalf of the investors. The portfolio managers and decision makers are employees of the investment manager. However, while the investment manager is hired by the hedge fund, in practice the GP is normally the investment manager and invests substantial amounts, often the great majority, of his or her total assets in the fund. The complex organization of a fund along with its service provider is diagrammed in Figure 1–1.
PRIVATELY OFFERED TO A RESTRICTED GROUP OF INVESTORS
Mutual funds are "sponsored" by an organization such as Fidelity or Vanguard. Shares in mutual funds are typically offered to the general public on the basis of a prospectus by brokers, investment advisers, financial planners, banks, or insurance companies. Mutual funds are supported by a significant amount of marketing and advertising. All this is in the context of compliance with the relevant investment laws and under the registration and supervision of the SEC.
Hedge funds can only be offered privately to investors who must meet certain legal requirements as "qualified investors" and "accredited investors" based on their wealth, income, and sophistication, and who can bear the possibility of large losses. These requirements have limited hedge fund investors to high-net- worth individuals and institutions. However, there are increasing opportunities for individuals who do not meet these criteria to invest in hedge fund products, or in investments that mimic some of the characteristics of hedge funds.
A private offering means that a hedge fund cannot advertise, although that will change to an unknown extent as a result of the JOBS Act. Investment in a hedge fund is offered via a document known as a private placement memorandum (or offering documents), which serves a similar function as the mutual funds' prospectus but which, as the name implies, is not registered with the SEC.
DODD-FRANK ACT AND HEDGE FUND REGULATION
Two overarching laws govern the investment management industry: the Securities Act of 1933 and the Investment Adviser Act of 1940, along with their many amendments. Hedge funds (along with other entities such as private equity firms) are exempt from many of the provisions of these laws. In exchange for these exemptions, the Congress limited the ability of hedge funds to market to small investors. In effect, the Congress said we will leave hedge funds largely unregulated, but they can only cater to wealthy individuals and institutions, and only reach out to them through private channels and word of mouth.
Under the provisions of the Dodd-Frank Act, hedge funds that have more than $150 million in assets under management—must register with the SEC and to file several documents and provide certain information. The Dodd-Frank Act does not change the fact that investments in hedge funds units (or shares) are not registered under the Securities Act of 1933, which governs most publicly issued investment securities.
However, it is important to point out that hedge funds have always been subject to laws that prevent fraudulent and other illegal activities, as witnessed by the recent spate of prominent arrests and conviction of hedge fund managers and employees for insider trading and for running Ponzi schemes.
RESTRICTED REDEMPTION RIGHTS
By law, mutual funds must honor investor redemption requests within seven days; although in practice, redemption is made within a day or two. Shareholders in a mutual fund return their shares to the fund and are paid their share of the funds' net asset value. Hedge fund shares or units, on the other hand, may only be redeemed on a periodic basis, typically either quarterly or annually, although they can be much longer. Most hedge funds also require notice before the redemption period. For example, hedge funds that have a three-month restriction on redemptions may require that investors notify the fund of their intent to redeem shares a month before the three-month period begins. In effect, this means that investors must wait four months to see their funds. As discussed at length below, there are investment considerations that underlay these restrictions having to do with the economic benefits of allowing hedge fund managers to invest with the knowledge that they will be able to deploy the funds for a minimum amount of time. The same considerations are behind the restrictions imposed by private equity firms, which limit customer access to their funds for five years or more.
In addition, the GP is normally allowed to suspend redemptions for a variety of reasons or to place some or even the entire fund in a segregated account called a "side pocket," where the portfolio is essentially locked up until the GP decides to allow redemptions.
MAY USE LEVERAGE, SHORT SELLING, DERIVATIVES
A number of financial techniques and instruments are widely associated with hedge funds. In fact, hedge funds (along with investment banks) are the primary users of some of these instruments, especially for speculative purposes. The industry has had close links to the derivatives world from its earliest days, when many hedge funds were closely associated with the futures and options exchanges. The expertise of hedge funds with derivatives and complex financial structures (futures, forwards, options, swaps, structured products) is now widespread within the industry. They are a regular feature of hedge funds involved in the fixed-income markets, which are extensive users of both futures and swaps, and the equity markets through stock index options and options on individual securities. In more recent times, this expertise has placed hedge funds front and center in the mortgage crisis as major users of mortgage-backed securities and credit default swaps.
A trademark of hedge funds is their ability to "short" markets either as short sellers of stocks or through the use of derivatives in fixed income, currency, and commodity markets. Hedge funds' active use of shorting has repeatedly brought them into conflict with governments who blame hedge funds shorting for declines in the value of stocks and currencies. Finally, many hedge fund strategies and fund of funds vehicles rely on credit from banks and investment banks to leverage or enhance their returns (and risks) using vehicles such as repurchase agreements, credit lines, total return swaps, and the leverage inherent in many derivatives.
ACTIVE MANAGERS SEEKING TO PRODUCE ABSOLUTE RETURNS
Hedge fund managers are often described as "active managers seeking absolute return." In the mutual fund industry, there are broadly two types of funds. Index funds attempt to replicate the returns of an index (e.g., the S&P 500). Active managers seek to provide returns higher than a relevant index. However, active managers typically seek small enhancements to the index and are tightly constrained in terms of how much they can deviate and the tools (i.e., leverage, short selling, and derivatives) they can use.
In the hedge fund arena, all managers are active in the sense that their objective is to deliver a positive return to investors under all economic and market conditions utilizing all the tools at their disposal. Hedge funds are not constrained to beat the S&P 500, which has had declines of 40% or more. As absolute return managers, with the tools to short a market, their objective is to make money whether the S&P 500 declines or rises. In reality, hedge funds are judged by some benchmarks and do not always achieve this absolute return.
SPECULATION, TRADING, INVESTMENT, AND GAMBLING
Hedge funds are often said to speculate, with the inference that they take greater risk with their clients' money than other investment managers. It would be useful to deal with this early in the text and clear up some misconceptions about the related concepts of speculation, trading, and investment and gambling.
First, trading is merely the selling or buying of any security, and is therefore a part of any form of any investment strategy, including those of mutual funds.
Next, there are differences between speculation and gambling: speculation is taking a calculated risk, where the outcome can be rationally (if imperfectly and incorrectly) analyzed. On the other hand, the outcome of gambling is entirely dependent on pure chance and totally random outcome for results. While hedge funds certainly gamble, they at least attempt to speculate and put much time and effort into analyzing the potential outcome of their trading decisions.
It is more difficult to differentiate between investment and speculation. It would be tempting to neatly distinguish between hedge funds (speculators) on the one hand and "responsible" investors on the other. However, even Ben Graham, the noted financial adviser and author of the classic investment book The Intelligent Investor, finds it difficult to separate the two. He describes the prototypical investor as "one interested chiefly in safety plus freedom from bother." He admits, however, that "some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone."
Finally, economic theory ascribes a significant economic and social benefit to what is commonly thought of as speculation. By buying and selling instruments, it often provides liquidity in markets that in turn helps establish realistic prices, narrow spreads between purchase and sales, and assume risks that enable hedgers to gain certainty in their businesses. The classic example here is of a farmer who is able to plant a field with greater certainty because a "speculator" has taken the other side of a futures contract on the price of wheat.
Excerpted from ALL ABOUT HEDGE FUNDS by Ezra Zask. Copyright © 2013 by The McGraw-Hill Education. Excerpted by permission of The McGraw-Hill Companies, Inc..
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