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Investing In Hedge Funds Strategies For The New Marketplace
By Joseph G. Nicholas
Bloomberg Press Copyright © 1999 Joseph G. Nicholas
All right reserved.
Chapter One What Is a HEDGE FUND?
A hedge fund describes an investment structure for managing a private unregistered investment pool. This structure charges an incentive-based fee that compensates the fund manager through a percentage of the profits that the fund earns. Exemption from securities registration limits the number of participants who must also be accredited investors or institutional investors. All hedge funds are not alike; managers usually specialize in one of a diverse number of alternative investment strategies operated through the hedge fund structure.
In the past, the term hedge fund described both an investment structure-a commingled investment fund-and a strategy-a leveraged long portfolio "hedged" by stock short sales. Today, it only describes the investment structure. Like the term mutual fund, which describes only the investment structure and does not indicate whether it invests in stocks or bonds or in the United States or abroad, the term hedge fund does not tell an investor anything about the underlying investment activities. A hedge fund acts as a vehicle, helping an investor get to the ultimate investment goal: to turn marketopportunities into investment returns. In this respect, a hedge fund is no different from a mutual fund. Hedge funds differ from mutual funds in the range of allowable investment approaches, the goals of the strategies that they use, and in the breadth of tools and techniques available to investment managers to achieve those goals for investors. (It should be noted that this distinction is becoming blurred. Mutual fund regulatory changes have allowed certain hedge fund strategies to operate under the mutual fund structure.)
Since the term hedge fund describes an investment structure, not an investment approach, to understand hedge funds it is necessary to separate the structure of the investment from the investment strategy.
The investment structure is the legal entity that allows investment assets to be pooled and permits the hedge fund manager to invest them. The investment approach that the manager takes is known as the hedge fund strategy or alternative investment strategy. The structure establishes such things as the method of manager compensation, the number and type of investors, and the rights and responsibilities of investors regarding profits, redemptions, taxes, and reports. The elements that make up the strategy include how the manager invests, which markets and instruments are used, and which opportunity and return source is targeted.
HEDGE FUND HISTORY
AS SURPRISING AS it may sound, some hedge fund strategies do not involve hedging. Although many strategies allow managers to use both long and short investments, some do not. A review of the strategies used by hedge fund managers today shows that, for some, the lineage stretches back to the activities of Benjamin Graham's investment activities of the 1920s. The term hedge fund, however, is said to have originated in 1949 when Alfred Winslow Jones combined a leveraged long stock position with a portfolio of short stocks in an investment fund with an incentive fee structure. Although some have argued that the Jones-style hedge fund is the only true one, the term is now universally used to describe the housing for a diverse range of underlying investment strategies.
In 1966, Fortune magazine published an article by Carol Loomis entitled "The Jones Nobody Keeps Up With" (see sidebar) that highlighted Jones's hedge fund.
Loomis's article shocked the investment community by showing that Jones's relatively unknown hedge fund outperformed all the mutual funds of its time. The best mutual fund over the prior five years had been the Fidelity Trend best mutual fund over the prior ten years had been the Dreyfuss Fund, but Jones's fund outperformed it by a whopping 87 percent. The article was widely read, and enterprising investors tried to imitate Jones's fund. The number of hedge funds quickly jumped from a handful to more than a hundred. However, the majority of the new managers were seduced by the lure of incentive-based fees and leverage in a bull market and quickly abandoned the time-consuming, risk-reducing process of hedging a portfolio with short sales. As a result, in the bust years of the early 1970s, many of the more inexperienced fund managers suffered significant losses and had to exit the hedge fund industry. Survivors of this first spate of attrition, such as George Soros and Michael Steinhardt, went on to become some of the largest hedge fund managers in the industry.
It is important to note that Jones came up with a novel and successful investment strategy. However, to pool investor assets he needed a structure, and because the public mutual fund structure did not accommodate the requirements of the strategy, he used the private limited partnership instead. When hedge fund managers decided to pool monies offshore, they also used private investment structures that incorporated many of the same features.
As the more successful hedge fund managers' assets under management grew, some of them changed their approach. In the 1970s and 1980s, managers with roots in stock picking sought opportunities in broader global markets: fixed-income securities, foreign exchange, equities, and commodities. Because they retained the private investment structure that allowed them to maintain the ability to go long or short and to use leverage, the term hedge fund stuck with them in discussions of the investment pool. The strategy that they used, however, was described as "global macro," "global opportunistic," or just "macro."
At the same time, computerization, information technology, new markets, and investment instruments such as options, futures, and swaps created new opportunities for smaller specialized money management firms. In putting together private investment pools, the hedge fund model was adopted, as was its name, by both managers and investors alike. But the underlying strategy that the manager used included any one of a number of existing or new approaches, such as fixed-income arbitrage, equity-market-neutral investing, or event-driven investing. The unifying element of hedge funds is its structure.
HEDGE FUND STRUCTURE
HEDGE FUNDS ARE usually structured as private investment pools. The actual legal entity (limited partnership, corporation, trust, mutual fund) depends on where the fund is domiciled (legally located) and the type of investors that it seeks to attract. In the United States, these usually take the form of a limited partnership, whereas outside the United States, or "offshore," they may assume corporate or other investment company forms. In contrast to mutual funds, which are structured as public investment companies, hedge funds are private. This means that the securities that they offer to investors are exempt from being publicly registered with the Securities and Exchange Commission (SEC), although they still must satisfy certain disclosure obligations in the offering of the securities and must comply with SEC antifraud provisions. The exemption that allows hedge funds to remain private also limits the number and type of investors allowed. In most cases, an investor must be either an institution or an individual classified as accredited or higher. An ACCREDITED INVESTOR is 1 an individual who has made $200,000 a year in income for the past two years and has a reasonable expectation of doing so in the future; 2 one who, together with a spouse, has an income of $300,000 per year; or 3 one who has a net worth of $1 million, excluding home and automobile. The individual exemption limits the number of investors to ninety-nine, requiring a manager to establish a high minimum investment to accumulate a reasonable amount of assets. Minimums usually range from $100,000 to $5 million.
The difference between mutual funds and most hedge funds can be seen in their different approaches to fee structures, liquidity, asset valuation, and disclosure of information. Whereas mutual funds charge an ongoing percentage fee based on the amount of assets invested, hedge funds charge both an asset-based fee and an incentive fee. The asset-based fee, called the management fee, is usually 1 percent per annum, charged monthly or quarterly. The incentive fee, also called a carried interest, gives the hedge fund manager a percentage of the profits earned by the fund. Incentive fees range from 10 to 30 percent but are normally 20 percent of annual profit. Hedge funds are also less liquid than mutual funds. Although mutual funds offer daily liquidity, U.S. hedge funds often require a lockup period of up to one year or more, although offshore funds may allow monthly or quarterly exits. Lockup periods are necessary because many of the alternative investment strategies that hedge fund managers use are long term in nature and do not provide ongoing liquidity. In addition, certain securities laws that prohibit the collection of incentive fees for less than a twelve-month period affect hedge funds. Hedge funds and mutual funds also differ in the way that their portfolios are valued. Mutual funds are valued daily with a published net asset value (NAV). In most cases, U.S. hedge funds provide investors only a monthly estimate of percentage gain or loss. Offshore funds may offer NAV form reporting, although it is usually on a monthly basis. In any case, information about mutual funds is more readily available than that about hedge funds. Because of their public status, mutual funds are required to disclose certain financial information. Hedge funds, however, have no obligation to disclose their information publicly. Even investors themselves often have only limited access to information, although this is changing as hedge fund managers increasingly move to attract and accommodate institutional investors.
HEDGE FUND STRATEGIES
THERE IS NOTHING mystical about the strategies that hedge fund managers use. These strategies can be described in the same terms as those for a traditional portfolio: return source, investment method, buy/sell process, market and instrument concentrations, and risk control. The alternative investment strategies that hedge fund managers tend to use produce returns by leveraging some kind of informational or strategic advantage. Essentially, although some hedge fund strategies are complex, hedge fund investing can be understood by anyone familiar with financial markets and instruments who also has a basic working knowledge of corporate structure and finance.
Although it is important to acknowledge that most money managers who operate private investment pools using the hedge fund structure have their own styles, most of these specialized investment approaches can be categorized within the list of general strategies described in this book. The hedge fund universe is composed of managers who use a broad range of variations of these strategies. These strategies may have little or nothing in common except that they operate under the hedge fund structure and are considered to be alternatives to traditional investment approaches.
Alternative investments differ from the traditional investment approaches used in mutual funds in many significant ways. Traditional investment strategies are exclusively long. Their practitioners seek stocks or bonds that they think will outperform the market. However, alternative investment strategies invest long, short, or both, combining two or more instruments to create one investment position. Traditional strategies do not take advantage of leverage. Some alternative strategies do.
Many alternative strategies make use of hedging techniques. Unlike traditional strategies that lose money in a market decline, hedged strategies will generate profit on their hedges to offset all or a portion of the market losses. Hedging may take a number of forms, depending on the strategy. Some hedges seek to generate profit on an ongoing basis; others may be purely defensive or insurance against market crashes. In general, they are positions that will profit in a market decline by providing an offset, or hedge, to losses incurred on investments in the portfolio that are exposed to the market.
The returns generated by traditional long-only strategies are relative, or benchmarked, to market indices. For example, if a traditional mutual fund invests in large-capitalization U.S. equities, its return is benchmarked to the performance of a large-capitalization stock index, and performance is judged relative to that index. Most alternative strategies, however, target absolute returns. Because the source of return for most of these strategies is not based on market direction and does not relate to a particular market or index, it is not useful to compare returns with a traditional market index. Rather, returns are expected to fall within a certain range, regardless of what the markets do.
The hedge fund strategies covered in this book are differentiated by the tools used and the profit opportunities targeted. The different strategies have very different risk/reward characteristics, so it is important that potential investors distinguish between them instead of lumping them together under the heading of "hedge funds." Hedge funds are heterogeneous. To render them comparable, they must be categorized by the core strategy that the fund manager uses. Some hedge fund strategies, such as macro funds, use aggressive approaches, whereas others, such as nonleveraged market-neutral funds, are conservative. Many have significantly lower risk than a traditional portfolio of long stocks and bonds for the same levels of return.
HEDGE FUND MANAGERS
HEDGE FUND MANAGERS are more difficult to categorize than the various strategies of the funds they manage. Their diverse backgrounds often provide them with the specialized knowledge, expertise, and skills they use to implement unique variations of general strategies.
The typical hedge fund manager is an entrepreneur who organizes a money management company and investment fund to pool the manager's assets (often a substantial portion of his or her net worth) with those of family, friends, and other investors. The manager's primary efforts are directed toward the implementation of a hedge fund strategy and the management of a profitable investment portfolio. Often, the "business culture" of the manager and the money management company will reflect these primary efforts, with less emphasis on selling and investor relations when compared with traditional investment operations.
Excerpted from Investing In Hedge Funds by Joseph G. Nicholas Copyright © 1999 by Joseph G. Nicholas . Excerpted by permission.
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