A hedge fund is a pooled
An investment fund is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group such as reducing the risks of the investment by a significant percentage. These advantages inc ...
that trades in relatively
A liquid is a nearly incompressible fluid that conforms to the shape of its container but retains a (nearly) constant volume independent of pressure. As such, it is one of the four fundamental states of matter (the others being solid, gas ...
assets and is able to make extensive use of more complex trading
-construction, and risk management
techniques in an attempt to improve performance, such as short selling
, and derivatives
generally restrict hedge fund marketing to institutional investor
s, high net worth individual
s, and accredited investors
Hedge funds are considered alternative investment
s. Their ability to use leverage and more complex investment techniques distinguishes them from regulated investment funds available to the retail market, commonly known as
A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV ...
s and ETFs
. They are also considered distinct from
private equity fund
A private equity fund (abbreviated as PE fund) is a collective investment scheme used for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated with private equity ...
s and other similar
A closed-end fund (CEF) is a fund that raises capital by issuing a fixed number of shares which are not redeemable, and then invest that capital in financial assets such as stocks and bonds. Unlike open-end funds, new shares in a closed-end fund ...
s as hedge funds generally invest in relatively liquid asset
s and are usually open-ended
. This means they typically allow investors to invest and withdraw capital periodically based on the fund's net asset value
, whereas private-equity funds generally invest in illiquid assets
and only return capital after a number of years.
However, other than a fund's regulatory status, there are no formal or fixed definitions of fund types, and so there are different views of what can constitute a "hedge fund."
Although hedge funds are not subject to the many restrictions applicable to regulated funds, regulations were passed in the United States and Europe following the
financial crisis of 2007–2008
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of ...
with the intention of increasing government oversight of hedge funds and eliminating certain regulatory gaps.
Although most modern hedge funds are able to employ a wide variety of
Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...
s and risk management techniques,
they can be very different from each other with respect to their strategies, risks, volatility and expected return profile. It is common for hedge fund investment strategies to aim to achieve a positive return on investment
regardless of whether markets are rising or falling (" absolute return
"). Although hedge funds can be considered risky investments, the expected returns of some hedge fund strategies are less volatile than those of retail funds with high exposure to stock markets because of the use of hedging techniques.
A hedge fund usually pays its investment manager a management fee (typically, 2% per annum of the net asset value of the fund) and a performance fee
(typically, 20% of the increase in the fund's net asset value during a year).
Hedge funds have existed for many decades and have become increasingly popular. They have now grown to be a substantial portion of the
Asset management is a systematic approach to the governance and realization of value from the things that a group or entity is responsible for, over their whole life cycles. It may apply both to tangible assets (physical objects such as buildings ...
industry with assets totaling around $3.8 trillion as of 2021. Hedge fund managers can have several billion dollars of assets under management
The word "hedge", meaning a line of bushes around the perimeter of a field, has long been used as a metaphor for placing limits on risk. Early hedge funds sought to hedge specific investments against general market fluctuations by shorting
the market, hence the name.
Nowadays, however, many different investment strategies are used, many of which do not "hedge" risk.
During the US bull market
of the 1920s, there were numerous private investment vehicle
s available to wealthy investors. Of that period, the best known today is the Graham-Newman Partnership, founded by
Benjamin Graham (; né Grossbaum; May 9, 1894 – September 21, 1976) was a British-born American economist, professor and investor. He is widely known as the "father of value investing", and wrote two of the founding texts in neoclassical inve ...
and his long-time business partner Jerry Newman. This was cited by
Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net w ...
in a 2006 letter to the Museum of American Finance
as an early hedge fund,
and based on other comments from Buffett,
Janet Tavakoli is the president of Tavakoli Structured Finance, Inc., a Chicago-based consulting firm. She has had three books published on credit derivatives, structured finance, and the 2008 global financial crisis.
Education and background
deems Graham's investment firm
the first hedge fund.
The sociologist Alfred W. Jones
is credited with coining the phrase "''hedged'' fund"
and is credited with creating the first hedge fund structure in 1949.
Jones referred to his fund as being "hedged", a term then commonly used on
Wall Street is an eight-block-long street in the Financial District of Lower Manhattan in New York City. It runs between Broadway in the west to South Street and the East River in the east. The term "Wall Street" has become a metonym for ...
to describe the management of investment risk
due to changes in the
A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial mark ...
In the 1970s, hedge funds specialized in a single strategy with most fund managers following the long/short equity
model. Many hedge funds closed during the recession of 1969–70
and the 1973–1974 stock market crash
due to heavy losses. They received renewed attention in the late 1980s.
During the 1990s, the number of hedge funds increased significantly with the 1990s stock market rise,] the aligned-interest compensation structure (''i.e.'', common financial interests), and the promise of above average returns as likely causes. Over the next decade, hedge fund strategies expanded to include credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy. [ US institutional investors, such as pension and endowment funds, began allocating greater portions of their portfolios to hedge funds.
During the first decade of the 21st century, hedge funds gained popularity worldwide, and, by 2008, the worldwide hedge fund industry held an estimated US$1.93 trillion in assets under management (AUM). However, the ] financial crisis of 2007–2008
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of ... caused many hedge funds to restrict investor withdrawals and their popularity and AUM totals declined. AUM totals rebounded and in April 2011 were estimated at almost $2 trillion. , 61% of worldwide investment in hedge funds came from institutional sources.
In June 2011, the hedge fund management firms with the greatest AUM were Bridgewater Associates (US$58.9 billion), Man Group (US$39.2 billion), Paulson & Co. (US$35.1 billion), Brevan Howard (US$31 billion), and Och-Ziff (US$29.4 billion). Bridgewater Associates had $70 billion in assets under management . At the end of that year, the 241 largest hedge fund firms in the United States collectively held $1.335 trillion. In April 2012, the hedge fund industry reached a record high of US$2.13 trillion total assets under management. In the middle of the 2010s, the hedge fund industry experienced a general decline in the "old guard" fund managers. Dan Loeb called it a "hedge fund killing field" due to the classic long/short falling out of favor because of unprecedented easing by central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central b ...s. The US stock market
A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks (also called shares), which represent ownership claims on businesses; these may include ''securities'' listed on a public stock exchange, ... correlation became untenable to short sellers. The hedge fund industry today has reached a state of maturity that is consolidating around the larger, more established firms such as Citadel, Elliot, Millennium, Bridgewater, and others. The rate of new fund start ups is now outpaced by fund closings.
In July 2017, hedge funds recorded their eighth consecutive monthly gain in returns with assets under management rising to a record $3.1 trillion.
Notable hedge fund managers
In 2015, ''
''Forbes'' () is an American business magazine owned by Integrated Whale Media Investments and the Forbes family. Published eight times a year, it features articles on finance, industry, investing, and marketing topics. ''Forbes'' also rep ...'' listed:
* John Meriwether of Long-Term Capital Management
Long-Term Capital Management L.P. (LTCM) was a highly-leveraged hedge fund. In 1998, it received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York.
LTCM was founded in ..., most successful returns from 27% to 59% through 1993 to 1998 until its collapse and liquidation.
* George Soros of Quantum Group of Funds
* Ray Dalio of Bridgewater Associates, the world's largest hedge fund firm with US$160 billion in assets under management as of 2017
* Steve Cohen of Point72 Asset Management, formerly known as founder of SAC Capital Advisors
* John Paulson of Paulson & Co., whose hedge funds as of December 2015 had $19 billion assets under management
* David Tepper of Appaloosa Management
Appaloosa Management is an American hedge fund founded in 1993 by David Tepper and Jack Walton specializing in distressed debt. Appaloosa Management invests in public equity and fixed income markets around the world.
In 1993, David Tep ...
* Paul Tudor Jones of Tudor Investment Corporation
* Daniel Och of Och-Ziff Capital Management Group with more than $40 billion in assets under management in 2013
* Israel Englander of Millennium Management, LLC
* Leon Cooperman of Omega Advisors [Forbes profile: Leon G. Cooperman]
* Michael Platt of BlueCrest Capital Management (UK), Europe's third-largest hedge-fund firm
* James Dinan of York Capital Management
York Capital Management is a global institutional investment management firm with approximately $18.5 billion in assets under management as of June 2019. The firm was founded in 1991 by Jamie Dinan.
York Capital is headquartered in New York Cit ... [Bloomberg: "York Capital's Dinan Finds Value in Tel Aviv Funds, Tyco Duplex" By Richard Teitelbaum](_blank)
* Stephen Mandel of Lone Pine Capital with $26.7 billion under management at end June 2015
7 September 2006
* Larry Robbins of Glenview Capital Management with $9.2 billion of assets under management as of July 2014
* Glenn Dubin of Highbridge Capital Management
* Paul Singer of Elliott Management Corporation
Elliott Investment Management is an American investment management firm. It is also one of the largest activist funds in the world.
It is the management affiliate of American hedge funds Elliott Associates L.P. and Elliott International Limit ..., an activist hedge fund with more than US$23 billion in assets under management in 2013, and a portfolio worth $8.1 billion as of the first quarter of 2015
* Michael Hintze of CQS with $14.4 billion of assets under management as of June 2015
* David Einhorn of Greenlight Capital [Hugo Lindgren] as the top 20 billionaire hedge fund managers.
"The Confidence Man"
, '' New York Magazine'', 2008/06/15.
* Bill Ackman of Pershing Square Capital Management LP
Hedge fund strategies are generally classified among four major categories: global macro, directional, event-driven, and relative value (
In economics and finance, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalise on the difference, the profit being the difference between th ...). Strategies within these categories each entail characteristic risk and return profiles. A fund may employ a single strategy or multiple strategies for flexibility, risk management, or diversification. The hedge fund's prospectus, also known as an offering memorandum, offers potential investors information about key aspects of the fund, including the fund's investment strategy, investment type, and leverage limit.
The elements contributing to a hedge fund strategy include the hedge fund's approach to the market, the particular instrument use, the market sector
The term market sector is used in economics and finance to describe a part of the economy. It is usually a broader term than '' industry'', which is a set of businesses that are buying and selling such similar goods and services that they are in ... the fund specializes in (''e.g.'', healthcare), the method used to select investments, and the amount of diversification within the fund. There are a variety of market approaches to different asset classes, including equity, fixed income, commodity
In economics, a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.
The price of a com ..., and currency
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general .... Instruments used include equities, fixed income, futures, options, and swaps. Strategies can be divided into those in which investments can be selected by managers, known as "discretionary/qualitative," or those in which investments are selected using a computerized system, known as "systematic/quantitative." The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager, or a combination.
Sometimes hedge fund strategies are described as " absolute return" and are classified as either " market neutral" or "directional". Market neutral funds have less correlation to overall market performance by "neutralizing" the effect of market swings whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.
Hedge funds using a global macro investing strategy take large positions in share, bond, or currency markets in anticipation of global macroeconomic events in order to generate a risk-adjusted return.
[ Global macro fund managers use macroeconomic ("big picture") analysis based on global market events and trends to identify opportunities for investment that would profit from anticipated price movements. While global macro strategies have a large amount of flexibility (due to their ability to use leverage to take large positions in diverse investments in multiple markets), the timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns.] Global macro is often categorized as a directional investment strategy. [
Global macro strategies can be divided into discretionary and systematic approaches. Discretionary trading is carried out by investment managers who identify and select investments, whereas systematic trading is based on mathematical models and executed by ] software
Software is a set of computer programs and associated documentation and data. This is in contrast to hardware, from which the system is built and which actually performs the work.
At the lowest programming level, executable code consists ... with limited human involvement beyond the programming and updating of the software. These strategies can also be divided into trend
A fad or trend is any form of collective behavior that develops within a culture, a generation or social group in which a group of people enthusiastically follow an impulse for a short period.
Fads are objects or behaviors that achieve short-l ... or counter-trend approaches depending on whether the fund attempts to profit from following market trend (long or short-term) or attempts to anticipate and profit from reversals in trends. [
Within global macro strategies, there are further sub-strategies including "systematic diversified", in which the fund trades in diversified markets, or sector specialists such as "systematic currency", in which the fund trades in ] foreign exchange market
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all as ...s or any other sector specialisition. Other sub-strategies include those employed by commodity trading advisor
A commodity trading advisor (CTA) is US financial regulatory term for an individual or organization who is retained by a fund or individual client to provide advice and services related to trading in futures contracts, commodity options and/or ...s (CTAs), where the fund trades in futures (or options) in commodity
In economics, a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.
The price of a com ... markets or in swaps. This is also known as a "managed future fund". [ CTAs trade in commodities (such as gold) and financial instruments, including stock indices. They also take both long and short positions, allowing them to make profit in both market upswings and downswings. Most global macro managers tends to be a CTA from a regulatory perspective and the main divide is between systematic and discretionary strategies. A classification framework for CTA/Macro Strategies can be found in the reference.
Directional investment strategies use market movements, trends, or inconsistencies when picking stocks across a variety of markets. Computer models can be used, or fund managers will identify and select investments. These types of strategies have a greater exposure to the fluctuations of the overall market than do market neutral strategies.
[ Directional hedge fund strategies include US and international long/short equity hedge funds, where long equity positions are hedged with short sales of equities or equity ] index
Index (or its plural form indices) may refer to:
Arts, entertainment, and media Fictional entities
* Index (''A Certain Magical Index''), a character in the light novel series ''A Certain Magical Index''
* The Index, an item on a Halo megastru ... options.
Within directional strategies, there are a number of sub-strategies. " Emerging markets
An emerging market (or an emerging country or an emerging economy) is a market that has some characteristics of a developed market, but does not fully meet its standards. This includes markets that may become developed markets in the future or were ..." funds focus on emerging markets such as China and India, whereas "sector funds" specialize in specific areas including technology, healthcare, biotechnology, pharmaceuticals, energy, and basic materials. Funds using a "fundamental growth" strategy invest in companies with more earnings Earnings are the net benefits of a corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT (earnings before intere ... growth than the overall stock market
A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks (also called shares), which represent ownership claims on businesses; these may include ''securities'' listed on a public stock exchange, ... or relevant sector, while funds using a " fundamental value" strategy invest in undervalued companies. Funds that use quantitative and financial signal processing techniques for equity trading are described as using a "quantitative directional" strategy. Funds using a " short bias" strategy take advantage of declining equity prices using short positions.
Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event. An event-driven investment strategy finds investment opportunities in corporate transactional events such as consolidations,
Mergers and acquisitions (M&A) are business transactions in which the ownership of companies, other business organizations, or their operating units are transferred to or consolidated with another company or business organization. As an aspec ..., recapitalizations, bankruptcies
Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debto ..., and liquidation
Liquidation is the process in accounting by which a company is brought to an end in Canada, United Kingdom, United States, Ireland, Australia, New Zealand, Italy, and many other countries. The assets and property of the company are redistri ...s. Managers employing such a strategy capitalize on valuation inconsistencies in the market before or after such events, and take a position based on the predicted movement of the security" \n\n\nsecurity.txt is a proposed standard for websites' security information that is meant to allow security researchers to easily report security vulnerabilities. The standard prescribes a text file called \"security.txt\" in the well known locat ... or securities in question. Large institutional investors such as hedge funds are more likely to pursue event-driven investing strategies than traditional equity investors because they have the expertise and resources to analyze corporate transactional events for investment opportunities.
Corporate transactional events generally fit into three categories: distressed securities Distressed securities are securities over companies or government entities that are experiencing financial or operational distress, default, or are under bankruptcy. As far as debt securities, this is called distressed debt. Purchasing or holding s ..., risk arbitrage, and special situations. [ ] Distressed securities Distressed securities are securities over companies or government entities that are experiencing financial or operational distress, default, or are under bankruptcy. As far as debt securities, this is called distressed debt. Purchasing or holding s ... include such events as restructurings, recapitalizations, and bankruptcies
Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debto .... [ A distressed securities investment strategy involves investing in the bonds or loans of companies facing bankruptcy or severe financial distress, when these ] bond
Bond or bonds may refer to:
* Bond (finance), a type of debt security
* Bail bond, a commercial third-party guarantor of surety bonds in the United States
* Chemical bond, the attraction of atoms, ions or molecules to form chemica ...s or loan
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that ...s are being traded at a discount to their value. Hedge fund managers pursuing the distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds purchasing distressed debt may prevent those companies from going bankrupt, as such an acquisition deters foreclosure
Foreclosure is a legal process in which a lender attempts to recover the balance of a loan from a borrower who has stopped making payments to the lender by forcing the sale of the asset used as the collateral for the loan.
Formally, a mor ... by banks. [ While event-driven investing, in general, tends to thrive during a bull market, distressed investing works best during a bear market.] [
Risk arbitrage or merger arbitrage includes such events as ] mergers
Mergers and acquisitions (M&A) are business transactions in which the ownership of companies, other business organizations, or their operating units are transferred to or consolidated with another company or business organization. As an aspec ..., acquisitions, liquidations, and hostile takeover
In business, a takeover is the purchase of one company (the ''target'') by another (the ''acquirer'' or ''bidder''). In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to t ...s. [ Risk arbitrage typically involves buying and selling the stocks of two or more merging companies to take advantage of market discrepancies between acquisition price and stock price. The risk element arises from the possibility that the merger or acquisition will not go ahead as planned; hedge fund managers will use research and analysis to determine if the event will take place.] [
Special situations are events that impact the value of a company's stock, including the restructuring of a company or corporate transactions including spin-offs, share buy backs, security issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company's equity and equity-related instruments.]
Other event-driven strategies include credit arbitrage strategies, which focus on corporate fixed income securities; an activist strategy, where the fund takes large positions in companies and uses the ownership to participate in the management; a strategy based on predicting the final approval of new pharmaceutical drug
A medication (also called medicament, medicine, pharmaceutical drug, medicinal drug or simply drug) is a drug used to diagnose, cure, treat, or prevent disease. Drug therapy (pharmacotherapy) is an important part of the medical field an ...s; and legal catalyst strategy, which specializes in companies involved in major lawsuits.
Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, the underlying security or the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical, technical, or fundamental techniques. Relative value is often used as a synonym for market neutral, as strategies in this category typically have very little or no directional market exposure to the market as a whole. Other relative value sub-strategies include:
* Fixed income arbitrage: exploit pricing inefficiencies between related fixed income securities.
* Equity market neutral: exploit differences in stock prices by being
Long may refer to:
* Long, characteristic of something of great duration
* Long, characteristic of something of great length
* Longitude (abbreviation: long.), a geographic coordinate
* Longa (music), note value in early music mens ... and short in stocks within the same sector, industry, market capitalization, country, which also creates a hedge against broader market factors.
* Convertible arbitrage: exploit pricing inefficiencies between convertible securities and the corresponding stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...s.
*Asset-backed securities (fixed-income asset-backed): fixed income arbitrage strategy using asset-backed securities.
*Credit long/short: the same as long/short equity, but in credit markets instead of equity markets.
* Statistical arbitrage: identifying pricing inefficiencies between securities through mathematical modelling techniques
* Volatility arbitrage: exploit the change in volatility, instead of the change in price.
*Yield alternatives: non- fixed income arbitrage strategies based on the yield, instead of the price.
*Regulatory arbitrage: exploit regulatory differences between two or more markets.
* Risk arbitrage: exploit market discrepancies between acquisition price and stock price.
* Value investing
Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham ...: buying securities that appear underpriced by some form of fundamental analysis.
In addition to those strategies within the four main categories, there are several strategies that do not entirely fit into these categories.
* Fund of hedge funds (multi-manager): a hedge fund with a diversified portfolio of numerous underlying single-manager hedge funds.
*Multi-manager: a hedge fund wherein the investment is spread along separate sub-managers investing in their own strategy.
*Multi-strategy: a hedge fund using a combination of different strategies.
* 130-30 funds: equity funds with 130% long and 30% short positions, leaving a net long position of 100%.
* Risk parity: equalizing risk by allocating funds to a wide range of categories while maximizing gains through financial leveraging.
*AI-driven: using sophisticated
Machine learning (ML) is a field of inquiry devoted to understanding and building methods that 'learn', that is, methods that leverage data to improve performance on some set of tasks. It is seen as a part of artificial intelligence.
Machine ... models and sometimes big data
Though used sometimes loosely partly because of a lack of formal definition, the interpretation that seems to best describe Big data is the one associated with large body of information that we could not comprehend when used only in smaller am ....
For an investor who already holds large quantities of equities and bonds, investment in hedge funds may provide diversification and reduce the overall portfolio risk.
Managers of hedge funds often aim to produce returns that are relatively uncorrelated with market indices and are consistent with investors' desired level of risk. While hedging can reduce some risks of an investment it usually increases others, such as operational risk and model risk, so overall risk is reduced but cannot be eliminated. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500
The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of D ... between 1993 and 2010.
Investors in hedge funds are, in most countries, required to be qualified investors who are assumed to be aware of the investment risks, and accept these risks because of the potential returns relative to those risks. Fund managers may employ extensive risk management strategies in order to protect the fund and investors. According to the ''
The ''Financial Times'' (''FT'') is a British daily newspaper printed in broadsheet and published digitally that focuses on business and economic current affairs. Based in London, England, the paper is owned by a Japanese holding company, Nikk ...'', "big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management." Hedge fund managers that hold a large number of investment positions for short periods are likely to have a particularly comprehensive risk management system in place, and it has become usual for funds to have independent risk officers who assess and manage risks but are not otherwise involved in trading. [ A variety of different measurement techniques and models are used to estimate risk according to the fund's leverage, liquidity, and investment strategy.] [ Non-normality of returns, volatility clustering and trends are not always accounted for by conventional risk measurement methodologies and so in addition to value at risk and similar measurements, funds may use integrated measures such as drawdowns.]
In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence to assess the risk that error or fraud
In law, fraud is intentional deception to secure unfair or unlawful gain, or to deprive a victim of a legal right. Fraud can violate civil law (e.g., a fraud victim may sue the fraud perpetrator to avoid the fraud or recover monetary compens ... at a hedge fund might result in a loss to the investor. Considerations will include the organization and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund's ability to develop as a company.
Transparency, and regulatory considerations
Since hedge funds are private entities and have few public disclosure requirements, this is sometimes perceived as a lack of transparency.
Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/or registration requirements as other financial investment managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud. [ New regulations introduced in the US and the EU as of 2010 required hedge fund managers to report more information, leading to greater transparency.] In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and external regulatory requirements. [ The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology, positions, and leverage exposure.
Risks shared with other investment types
Hedge funds share many of the same types of risk as other investment classes, including liquidity risk and manager risk.
Liquidity refers to the degree to which an asset can be bought and sold or converted to cash; similar to private-equity funds, hedge funds employ a lock-up period during which an investor cannot remove money. Manager risk refers to those risks which arise from the management of funds. As well as specific risks such as style drift, which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors include valuation risk, capacity risk, concentration risk, and leverage risk. [ Valuation risk refers to the concern that the net asset value (NAV) of investments may be inaccurate;] capacity risk can arise from placing too much money into one particular strategy, which may lead to fund performance deterioration; and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group of correlated funds. These risks may be managed through defined controls over conflict of interest
A conflict of interest (COI) is a situation in which a person or organization is involved in multiple interests, financial or otherwise, and serving one interest could involve working against another. Typically, this relates to situations in ..., [ restrictions on allocation of funds,] [ and set exposure limits for strategies.]
Many investment funds use leverage, the practice of borrowing money, trading on margin, or using derivatives to obtain market exposure in excess of that provided by investors' capital. Although leverage can increase potential returns, the opportunity for larger gains is weighed against the possibility of greater losses. Hedge funds employing leverage are likely to engage in extensive risk management practices. [ In comparison with ] investment bank
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing is ...s, hedge fund leverage is relatively low; according to a National Bureau of Economic Research working paper, the average leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.
Some types of funds, including hedge funds, are perceived as having a greater appetite for risk, with the intention of maximizing returns, subject to the risk tolerance of investors and the fund manager. Managers will have an additional incentive to increase risk oversight when their own capital is invested in the fund. [
Fees and remuneration
Fees paid to hedge funds
Hedge fund management firms typically charge their funds both a management fee and a performance fee.
Management fees are calculated as a percentage of the fund's net asset value and typically range from 1% to 4% per annum, with 2% being standard. They are usually expressed as an annual percentage, but calculated and paid monthly or quarterly. Management fees for hedge funds are designed to cover the operating costs of the manager, whereas the performance fee provides the manager's profits. However, due to
economies of scale
In microeconomics, economies of scale are the cost advantages that enterprises obtain due to their scale of operation, and are typically measured by the amount of output produced per unit of time. A decrease in cost per unit of output enables a ... the management fee from larger funds can generate a significant part of a manager's profits, and as a result some fees have been criticized by some public pension funds, such as CalPERS
The California Public Employees' Retirement System (CalPERS) is an agency in the California executive branch that "manages pension and health benefits for more than 1.5 million California public employees, retirees, and their families".CalPERSFa ..., for being too high.
The performance fee is typically 20% of the fund's profits during any year, though performance fees range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits. Performance fees have been criticized by Warren Buffett
Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net w ..., who believes that because hedge funds share only the profits and not the losses, such fees create an incentive for high-risk investment management. Performance fee rates have fallen since the start of the credit crunch
A credit crunch (also known as a credit squeeze, credit tightening or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit cr ....
Almost all hedge fund performance fees include a " high water mark
A high water mark is a point that represents the maximum rise of a body of water over land. Such a mark is often the result of a flood, but high water marks may reflect an all-time high, an annual high (highest level to which water rose that ..." (or "loss carryforward provision"), which means that the performance fee only applies to net profits (''i.e.'', profits after losses in previous years have been recovered). This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather than attempt to recover the losses over a number of years without a performance fee.
Some performance fees include a " hurdle", so that a fee is only paid on the fund's performance in excess of a benchmark rate (''e.g.'', LIBOR
The London Inter-Bank Offered Rate is an interest-rate average calculated from estimates submitted by the leading banks in London. Each bank estimates what it would be charged were it to borrow from other banks. The resulting average rate is u ...) or a fixed percentage. The hurdle is usually tied to a benchmark rate such as Libor or the one-year Treasury bill rate plus a spread. A "soft" hurdle means the performance fee is calculated on all the fund's returns if the hurdle rate is cleared. A "hard" hurdle is calculated only on returns above the hurdle rate. By example the manager sets a hurdle rate equal to 5%, and the fund return 15%, incentive fees would only apply to the 10% above the hurdle rate. A hurdle is intended to ensure that a manager is only rewarded if the fund generates returns in excess of the returns that the investor would have received if they had invested their money elsewhere.
Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year), or when withdrawals exceed a predetermined percentage of the original investment. The purpose of the fee is to discourage short-term investing, reduce turnover, and deter withdrawals after periods of poor performance. Unlike management fees and performance fees, redemption fees are usually kept by the fund and redistributed to all investors.
Remuneration of portfolio managers
Hedge fund management firms are often owned by their
portfolio manager A portfolio manager (PM) is a professional responsible for making investment decisions and carrying out investment activities on behalf of vested individuals or institutions. Clients invest their money into the PM's investment policy for future gro ...s, who are therefore entitled to any profits that the business makes. As management fees are intended to cover the firm's operating costs, performance fees (and any excess management fees) are generally distributed to the firm's owners as profits. Funds do not tend to report compensation, and so published lists of the amounts earned by top managers tend to be estimates based on factors such as the fees charged by their funds and the capital they are thought to have invested in them. Many managers have accumulated large stakes in their own funds and so top hedge fund managers can earn extraordinary amounts of money, perhaps up to $4 billion in a good year.
Earnings at the very top are higher than in any other sector of the financial industry, and collectively the top 25 hedge fund managers regularly earn more than all 500 of the chief executives in the S&P 500
The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of D .... Most hedge fund managers are remunerated much less, however, and if performance fees are not earned then small managers at least are unlikely to be paid significant amounts. [
In 2011, the top manager earned $3 billion, the tenth earned $210 million, and the 30th earned $80 million. In 2011, the average earnings for the 25 highest-compensated hedge fund managers in the United States was $576 million] while the mean total compensation for all hedge fund investment professionals was $690,786 and the median was $312,329. The same figures for hedge fund CEOs were $1,037,151 and $600,000, and for chief investment officers were $1,039,974 and $300,000, respectively.
Of the 1,226 people on the ''Forbes'' World's Billionaires List for 2012, 36 of the financiers listed "derived significant chunks" of their wealth from hedge fund management. Among the richest 1,000 people in the United Kingdom, 54 were hedge fund managers, according to the ''Sunday Times'' Rich List for 2012.
A porfolio manager risks losing his past compensation if he engages in insider trading. In '' Morgan Stanley v. Skowron'', 989 F. Supp. 2d 356 (S.D.N.Y. 2013), applying New York's faithless servant doctrine, the court held that a hedge fund's portfolio manager engaging in insider trading in violation of his company's code of conduct, which also required him to report his misconduct, must repay his employer the full $31 million his employer paid him as compensation during his period of faithlessness. The court called the insider trading the "ultimate abuse of a portfolio manager's position." The judge also wrote: "In addition to exposing Morgan Stanley to government investigations and direct financial losses, Skowron's behavior damaged the firm's reputation, a valuable corporate asset."
A hedge fund is an investment vehicle that is most often structured as an offshore corporation,
A limited partnership (LP) is a form of partnership similar to a general partnership except that while a general partnership must have at least two general partners (GPs), a limited partnership must have at least one GP and at least one limited ..., or limited liability company
A limited liability company (LLC for short) is the US-specific form of a private limited company. It is a business structure that can combine the pass-through taxation of a partnership or sole proprietorship with the limited liability o .... The fund is managed by an investment manager in the form of an organization or company that is legally and financially distinct from the hedge fund and its portfolio of asset
In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that c ...s. Many investment managers utilize service providers for operational support. Service providers include prime brokers, banks, administrators, distributors, and accounting firms.
Prime brokers clear
Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market.
An early form of trade, barter, saw the direct excha ...s and provide leverage and short-term financing. They are usually divisions of large investment banks. The prime broker acts as a counterparty
A counterparty (sometimes contraparty) is a legal entity, unincorporated entity, or collection of entities to which an exposure of financial risk may exist. The word became widely used in the 1980s, particularly at the time of the Basel I deliber ... to derivative contracts, and lends securities for particular investment strategies, such as long/short equities and convertible bond arbitrage. It can provide custodial services for the fund's assets, and trade execution and clearing services for the hedge fund manager.
Hedge fund administrators are typically responsible for valuation services, and often operations, and
Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "languag ....
Calculation of the net asset value ("NAV") by the administrator, including the pricing of securities at current market value and calculation of the fund's income and expense accruals, is a core administrator task, because it is the price at which investors buy and sell shares in the fund. The accurate and timely calculation of NAV by the administrator is vital. [ The case of ''Anwar v. Fairfield Greenwich'' (SDNY 2015) is the major case relating to fund administrator liability for failure to handle its NAV-related obligations properly.] ["The Citco Settlement And What Lies Ahead For PwC,"] There, the hedge fund administrator and other defendants settled in 2016 by paying the ''Anwar'' investor plaintiffs $235 million.
Administrator ] back office
A back office in most corporations is where work that supports ''front office'' work is done. The front office is the "face" of the company and is all the resources of the company that are used to make sales and interact with customers and client ... support allows fund managers to concentrate on trades. Administrators also process subscriptions and redemptions and perform various shareholder services. Hedge funds in the United States are not required to appoint an administrator and all of these functions can be performed by an investment manager. A number of conflict of interest
A conflict of interest (COI) is a situation in which a person or organization is involved in multiple interests, financial or otherwise, and serving one interest could involve working against another. Typically, this relates to situations in ... situations may arise in this arrangement, particularly in the calculation of a fund's net asset value. Most funds employ external auditor
An auditor is a person or a firm appointed by a company to execute an audit.Practical Auditing, Kul Narsingh Shrestha, 2012, Nabin Prakashan, Nepal To act as an auditor, a person should be certified by the regulatory authority of accounting and ...s, thereby arguably offering a greater degree of transparency. [
An auditor is an independent
Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "languag ... firm used to perform a complete audit the fund's financial statements. The year-end audit is performed in accordance with the standard accounting practices enforced within the country in which the fund it established, typically US GAAP or the International Financial Reporting Standards
International Financial Reporting Standards, commonly called IFRS, are accounting standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB). They constitute a standardised way of describing the company's fina ... (IFRS). The auditor may verify the fund's NAV and assets under management (AUM). Some auditors only provide "NAV lite" services, meaning that the valuation is based on prices received from the manager rather than an independent assessment.
A distributor is an
Underwriting (UW) services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liabilit ..., broker
A broker is a person or firm who arranges transactions between a buyer and a seller for a commission when the deal is executed. A broker who also acts as a seller or as a buyer becomes a principal party to the deal. Neither role should be conf ..., dealer
Dealer may refer to:
Film and TV
* ''Dealers'' (film), a 1989 British film
* ''Dealers'' (TV series), a reality television series where five art and antique dealers bid on items
* ''The Dealer'' (film), filmed in 2008 and released in 2010
* ..., or other person who participates in the distribution of securities. The distributor is also responsible for marketing the fund to potential investors. Many hedge funds do not have distributors, and in such cases the investment manager will be responsible for distribution of securities and marketing, though many funds also use placement agents and broker-dealers for distribution.
Domicile and taxation
The legal structure of a specific hedge fund, in particular its domicile and the type of
In law, a legal person is any person or 'thing' (less ambiguously, any legal entity) that can do the things a human person is usually able to do in law – such as enter into contracts, sue and be sued, own property, and so on. The reason for ... in use, is usually determined by the tax expectations of the fund's investors. Regulatory considerations will also play a role. Many hedge funds are established in offshore financial centers to avoid adverse tax consequences for its foreign and tax-exempt investors. Offshore funds that invest in the US typically pay withholding tax
Tax withholding, also known as tax retention, Pay-as-You-Go, Pay-as-You-Earn, Tax deduction at source or a ''Prélèvement à la source'', is income tax paid to the government by the payer of the income rather than by the recipient of the income ...es on certain types of investment income, but not US capital gains tax
A capital gains tax (CGT) is the tax on profits realized on the sale of a non-inventory asset. The most common capital gains are realized from the sale of stocks, bonds, precious metals, real estate, and property.
Not all countries impose a c .... However, the fund's investors are subject to tax in their own jurisdictions on any increase in the value of their investments. This tax treatment promotes cross-border investments by limiting the potential for multiple jurisdictions to layer taxes on investors.
US tax-exempt investors (such as pension plans and endowments) invest primarily in offshore hedge funds to preserve their tax exempt status and avoid unrelated business taxable income Taxable income refers to the base upon which an income tax system imposes tax. In other words, the income over which the government imposed tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. T .... [ The investment manager, usually based in a major financial center, pays tax on its management fees per the tax laws of the state and country where it is located.] In 2011, half of the existing hedge funds were registered offshore and half onshore. The Cayman Islands
The Cayman Islands () is a self-governing British Overseas Territory—the largest by population in the western Caribbean Sea. The territory comprises the three islands of Grand Cayman, Cayman Brac and Little Cayman, which are located to the ... was the leading location for offshore funds, accounting for 34% of the total number of global hedge funds. The US had 24%, Luxembourg
Luxembourg ( ; lb, Lëtzebuerg ; french: link=no, Luxembourg; german: link=no, Luxemburg), officially the Grand Duchy of Luxembourg, ; french: link=no, Grand-Duché de Luxembourg ; german: link=no, Großherzogtum Luxemburg is a small land ... 10%, Ireland
Ireland ( ; ga, Éire ; Ulster-Scots: ) is an island in the North Atlantic Ocean, in north-western Europe. It is separated from Great Britain to its east by the North Channel, the Irish Sea, and St George's Channel. Ireland is the s ... 7%, the British Virgin Islands
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Hedge funds take advantage of a tax loopole called carried interest to get around paying too much in taxes by fancy legalistic maneouvres on their part.
The US Senate Permanent Subcommittee on Investigations chaired by Carl Levin issued a 2014 report that found that from 1998 and 2013, hedge funds avoided billions of dollars in taxes by using basket options. The
Internal Revenue Service
The Internal Revenue Service (IRS) is the revenue service for the United States federal government, which is responsible for collecting U.S. federal taxes and administering the Internal Revenue Code, the main body of the federal statutory ... began investigating Renaissance Technologies
Renaissance Technologies LLC, also known as RenTech or RenTec, is an American hedge fund based in East Setauket, New York, on Long Island, which specializes in systematic trading using quantitative models derived from mathematical and stati ... in 2009, and Levin criticized the IRS for taking six years to investigate the company. Using basket options Renaissance avoided "more than $6 billion in taxes over more than a decade".
A dozen other hedge funds along with Renaissance Technologies used Deutsche Bank
Deutsche Bank AG (), sometimes referred to simply as Deutsche, is a German multinational investment bank and financial services company headquartered in Frankfurt, Germany, and dual-listed on the Frankfurt Stock Exchange and the New York St ...'s and Barclays
Barclays () is a British multinational universal bank, headquartered in London, England. Barclays operates as two divisions, Barclays UK and Barclays International, supported by a service company, Barclays Execution Services.
Barclays traces ...' basket options. Renaissance argued that basket options were "extremely important because they gave the hedge fund the ability to increase its returns by borrowing more and to protect against model and programming failures". In July 2015, the United States Internal Revenue claimed hedge funds used basket options "to bypass taxes on short-term trades". These basket options will now be labeled as listed transactions that must be declared on tax returns, and a failure to do would result in a penalty.
Investment manager locations
In contrast to the funds themselves, investment managers are primarily located onshore. The United States remains the largest center of investment with US-based funds managing around 70% of global assets at the end of 2011.
As of April 2012, there were approximately 3,990 investment advisers managing one or more private hedge funds registered with the Securities and Exchange Commission. New York City and the Gold Coast area of Connecticut
Connecticut () is the southernmost state in the New England region of the Northeastern United States. It is bordered by Rhode Island to the east, Massachusetts to the north, New York to the west, and Long Island Sound to the south. Its capit ... are the leading locations for US hedge fund managers.
London was Europe's leading center for hedge fund managers, but since the Brexit
Brexit (; a portmanteau of "British exit") was the withdrawal of the United Kingdom (UK) from the European Union (EU) at 23:00 GMT on 31 January 2020 (00:00 1 February 2020 CET).The UK also left the European Atomic Energy Community (EAEC ... referendum some formerly London-based hedge funds have relocated to other European financial centers such as Frankfurt
Frankfurt, officially Frankfurt am Main (; Hessian dialects, Hessian: , "Franks, Frank ford (crossing), ford on the Main (river), Main"), is the most populous city in the States of Germany, German state of Hesse. Its 791,000 inhabitants as o ..., Luxembourg
Luxembourg ( ; lb, Lëtzebuerg ; french: link=no, Luxembourg; german: link=no, Luxemburg), officially the Grand Duchy of Luxembourg, ; french: link=no, Grand-Duché de Luxembourg ; german: link=no, Großherzogtum Luxemburg is a small land ..., Paris
Paris () is the capital and most populous city of France, with an estimated population of 2,165,423 residents in 2019 in an area of more than 105 km² (41 sq mi), making it the 30th most densely populated city in the world in 2020. ..., and Dublin
Dublin (; , or ) is the capital and largest city of Ireland. On a bay at the mouth of the River Liffey, it is in the province of Leinster, bordered on the south by the Dublin Mountains, a part of the Wicklow Mountains range. At the 2016 cen ..., while some other hedge funds have moved their European head offices back to New York City. Before Brexit, according to EuroHedge data, around 800 funds located in the UK had managed 85% of European-based hedge fund assets in 2011. [ Interest in hedge funds in Asia has increased significantly since 2003, especially in Japan, Hong Kong, and Singapore.] After Brexit, Europe and the US remain the leading locations for the management of Asian hedge fund assets. [
Hedge fund legal structures vary depending on location and the investor(s). US hedge funds aimed at US-based, taxable investors are generally structured as
A limited partnership (LP) is a form of partnership similar to a general partnership except that while a general partnership must have at least two general partners (GPs), a limited partnership must have at least one GP and at least one limited ...s or limited liability companies. Limited partnerships and other flow-through taxation structures assure that investors in hedge funds are not subject to both entity-level and personal-level taxation. [ A hedge fund structured as a limited partnership must have a general partner. The general partner may be an individual or a corporation. The general partner serves as the manager of the limited partnership, and has unlimited liability.] The limited partners serve as the fund's investors, and have no responsibility for management or investment decisions. Their liability is limited to the amount of money they invest for partnership interests. As an alternative to a limited partnership arrangement, U.S. domestic hedge funds may be structured as limited liability companies, with members acting as corporate shareholders and enjoying protection from individual liability.
By contrast, offshore corporate funds are usually used for non-US investors, and when they are domiciled in an applicable offshore tax haven
A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or ..., no entity-level tax is imposed. [ Many managers of offshore funds permit the participation of tax-exempt US investors, such as pensions funds, institutional endowments, and charitable trusts.] [ As an alternative legal structure, offshore funds may be formed as an open-ended ] unit trust
A unit trust is a form of collective investment constituted under a trust deed.
A unit trust pools investors' money into a single fund, which is managed by a fund manager. Unit trusts offer access to a wide range of investments, and depending ... using an unincorporated mutual fund
A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV ... structure. Japanese investors prefer to invest in unit trust
A unit trust is a form of collective investment constituted under a trust deed.
A unit trust pools investors' money into a single fund, which is managed by a fund manager. Unit trusts offer access to a wide range of investments, and depending ...s, such as those available in the Cayman Islands.
The investment manager who organizes the hedge fund may retain an interest in the fund, either as the general partner of a limited partnership or as the holder of "founder shares" in a corporate fund. For offshore funds structured as corporate entities, the fund may appoint a board of directors
A board of directors (commonly referred simply as the board) is an executive committee that jointly supervises the activities of an organization, which can be either a for-profit or a nonprofit organization such as a business, nonprofit orga .... The board's primary role is to provide a layer of oversight while representing the interests of the shareholders. However, in practice board members may lack sufficient expertise to be effective in performing those duties. The board may include both affiliated directors who are employees of the fund and independent directors whose relationship to the fund is limited. [
Types of funds
* Open-ended hedge funds continue to issue shares to new investors and allow periodic withdrawals at the net asset value ("NAV") for each share.
* Closed-ended hedge funds issue a limited number of tradeable shares at inception.
*Shares of Listed hedges funds are traded on
A stock exchange, securities exchange, or bourse is an exchange where stockbrokers and traders can buy and sell securities, such as shares of stock, bonds and other financial instruments. Stock exchanges may also provide facilities for the ...s, such as the Irish Stock Exchange, and may be purchased by non- accredited investors.
A side pocket is a mechanism whereby a fund compartmentalizes assets that are relatively illiquid or difficult to value reliably.
When an investment is side-pocketed, its value is calculated separately from the value of the fund's main portfolio. Because side pockets are used to hold illiquid investments, investors do not have the standard redemption rights with respect to the side pocket investment that they do with respect to the fund's main portfolio. [ Profits or losses from the investment are allocated on a '' pro rata'' basis only to those who are investors at the time the investment is placed into the side pocket and are not shared with new investors.] Funds typically carry side pocket assets "at cost" for purposes of calculating management fees and reporting net asset values. This allows fund managers to avoid attempting a valuation of the underlying investments, which may not always have a readily available market value
Market value or OMV (Open Market Valuation) is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with ''open market value'', ''fair value'' or ''fair market value'', although the .... [
Side pockets were widely used by hedge funds during the ] financial crisis of 2007–2008
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of ... amidst a flood of withdrawal requests. Side pockets allowed fund managers to lay away illiquid securities until market liquidity improved, a move that could reduce losses. However, as the practice restricts investors' ability to redeem their investments it is often unpopular and many have alleged that it has been abused or applied unfairly. The SEC also has expressed concern about aggressive use of side pockets and has sanctioned certain fund managers for inappropriate use of them. [Gerald T. Lins, Thomas P. Lemke, Kathryn L. Hoenig & Patricia Schoor Rube, ''Hedge Funds and Other Private Funds: Regulation and Compliance'' § 5:23 (2013–2014 ed.).]
Hedge funds must abide by the national, federal, and state regulatory laws in their respective locations. The U.S. regulations and restrictions that apply to hedge funds differ from those that apply to its mutual funds. Mutual funds, unlike hedge funds and other private funds, are subject to the Investment Company Act of 1940, which is a highly detailed and extensive regulatory regime. According to a report by the
International Organization of Securities Commissions
The International Organization of Securities Commissions (IOSCO) is an association of organizations that regulate the world's securities and futures markets. Members are typically primary securities and/or futures regulators in a national jurisdi ..., the most common form of regulation pertains to restrictions on financial adviser
A financial adviser or financial advisor is a professional who provides financial services to clients based on their financial situation. In many countries, financial advisors must complete specific training and be registered with a regulatory ...s and hedge fund managers in an effort to minimize client fraud. On the other hand, U.S. hedge funds are exempt from many of the standard registration and reporting requirements because they only accept accredited investors. In 2010, regulations were enacted in the US and European Union which introduced additional hedge fund reporting requirements. These included the U.S.'s Dodd-Frank Wall Street Reform Act [ and European Alternative Investment Fund Managers Directive.] [
In 2007, in an effort to engage in self-regulation, 14 leading hedge fund managers developed a voluntary set of international standards in best practice and known as the ''Hedge Fund Standards'' they were designed to create a "framework of transparency, integrity and good governance" in the hedge fund industry.] The Hedge Fund Standards Board was set up to prompt and maintain these standards going forward, and by 2016 it had approximately 200 hedge fund managers and institutional investors with a value of US$3tn investment endorsing the standards. The Managed Funds Association is a US-based trade association
A trade association, also known as an industry trade group, business association, sector association or industry body, is an organization founded and funded by businesses that operate in a specific industry. An industry trade association partici ..., while the Alternative Investment Management Association is the primarily European counterpart.
Hedge funds within the US are subject to regulatory, reporting, and record-keeping requirements.
Many hedge funds also fall under the jurisdiction of the Commodity Futures Trading Commission, and are subject to rules and provisions of the 1922 Commodity Exchange Act, which prohibits fraud and manipulation. The Securities Act of 1933
The Securities Act of 1933, also known as the 1933 Act, the Securities Act, the Truth in Securities Act, the Federal Securities Act, and the '33 Act, was enacted by the United States Congress on May 27, 1933, during the Great Depression and after ... required companies to file a registration statement with the SEC to comply with its private placement rules before offering their securities to the public, and most traditional hedge funds in the United States are offered effectively as private placement offerings. The Securities Exchange Act of 1934 required a fund with more than 499 investors to register with the SEC. [Skeel D. (2005)] The
Behind the Hedge
. '' Legal Affairs''.
Investment Advisers Act of 1940 The Investment Advisers Act of 1940, codified at through , is a United States federal law that was created to monitor and regulate the activities of investment advisers (also spelled "advisors") as defined by the law. It is the primary source of r ... contained anti-fraud provisions that regulated hedge fund managers and advisers, created limits for the number and types of investors, and prohibited public offering
A public offering is the offering of securities of a company or a similar corporation to the public. Generally, the securities are to be listed on a stock exchange. In most jurisdictions, a public offering requires the issuing company to publish a ...s. The Act also exempted hedge funds from mandatory registration with the SEC [ when selling to accredited investors with a minimum of US$5 million in investment assets. Companies and institutional investors with at least US$25 million in investment assets also qualified.
In December 2004, the SEC began requiring hedge fund advisers, managing more than US$25 million and with more than 14 investors, to register with the SEC under the Investment Advisers Act. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regime for the burgeoning industry. The new rule was controversial, with two Commissioners dissenting, and was later challenged in court by a hedge fund manager. In June 2006, the U.S. Court of Appeals for the District of Columbia overturned the rule and sent it back to the agency to be reviewed. In response to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the earlier-challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity. Hedge fund managers with at least US$100 million in assets under management are required to file publicly quarterly reports disclosing ownership of registered equity securities and are subject to public disclosure if they own more than 5% of the class of any registered equity security.] [ Registered advisers must report their business practices and disciplinary history to the SEC and to their investors. They are required to have written compliance policies, a chief compliance officer, and their records and practices may be examined by the SEC.]
The U.S.'s Dodd-Frank Wall Street Reform Act was passed in July 2010 and requires SEC registration of advisers who manage private funds with more than US$150 million in assets. Registered managers must file Form ADV with the SEC, as well as information regarding their assets under management and trading positions. Previously, advisers with fewer than 15 clients were exempt, although many hedge fund advisers voluntarily registered with the SEC to satisfy institutional investors. Under Dodd-Frank, investment advisers with less than US$100 million in assets under management became subject to state regulation. [ This increased the number of hedge funds under state supervision.] [ Overseas advisers who managed more than US$25 million were also required to register with the SEC. The Act requires hedge funds to provide information about their trades and portfolios to regulators including the newly created Financial Stability Oversight Council.] In this regard, most hedge funds and other private funds, including private-equity funds, must file Form PF with the SEC, which is an extensive reporting form with substantial data on the funds' activities and positions. [ Under the "] Volcker Rule
The Volcker Rule iof the Dodd–Frank Wall Street Reform and Consumer Protection Act (). The rule was originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker to restrict United States banks from m ...," regulators are also required to implement regulations for banks, their affiliates, and holding companies to limit their relationships with hedge funds and to prohibit these organizations from proprietary trading, and to limit their investment in, and sponsorship of, hedge funds.
Within the European Union (EU), hedge funds are primarily regulated through their managers.
[ In the United Kingdom, where 80% of Europe's hedge funds are based, hedge fund managers are required to be authorised and regulated by the ] Financial Conduct Authority
The Financial Conduct Authority (FCA) is a financial regulatory body in the United Kingdom, but operates independently of the UK Government, and is financed by charging fees to members of the financial services industry. The FCA regulates financ ... (FCA). Each country has its own specific restrictions on hedge fund activities, including controls on use of derivatives in Portugal, and limits on leverage in France. [
In the EU, managers are subject to the EU's Directive on Alternative Investment Fund Managers (AIFMD). According to the EU, the aim of the directive is to provide greater monitoring and control of alternative investment funds. AIFMD requires all EU hedge fund managers to register with national regulatory authorities and to disclose more information, on a more frequent basis. It also directs hedge fund managers to hold larger amounts of capital. AIFMD also introduced a "passport" for hedge funds authorised in one EU country to operate throughout the EU.] [ The scope of AIFMD is broad and encompasses managers located within the EU as well as non-EU managers that market their funds to European investors.] [ An aspect of AIFMD which challenges established practices in the hedge funds sector is the potential restriction of remuneration through bonus deferrals and ] clawback
The term clawback or claw back refers to any money or benefits that have been given out, but are required to be returned (clawed back) due to special circumstances or events, such as the monies having been received as the result of a financial crim ... provisions.
Some hedge funds are established in offshore centres, such as the
The Cayman Islands () is a self-governing British Overseas Territory—the largest by population in the western Caribbean Sea. The territory comprises the three islands of Grand Cayman, Cayman Brac and Little Cayman, which are located to the ..., Dublin
Dublin (; , or ) is the capital and largest city of Ireland. On a bay at the mouth of the River Liffey, it is in the province of Leinster, bordered on the south by the Dublin Mountains, a part of the Wicklow Mountains range. At the 2016 cen ..., Luxembourg
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, es ..., which have different regulations concerning non-accredited investors, client confidentiality, and fund manager independence. [
In South Africa, investment fund managers must be approved by, and register with, the Financial Services Board (FSB).
Performance statistics for individual hedge funds are difficult to obtain, as the funds have historically not been required to report their performance to a central repository, and restrictions against public offerings and advertisement have led many managers to refuse to provide performance information publicly. However, summaries of individual hedge fund performance are occasionally available in industry journals and databases.
One estimate is that the average hedge fund returned 11.4% per year, [ representing a 6.7% return above overall market performance before fees, based on performance data from 8,400 hedge funds.] Another estimate is that between January 2000 and December 2009 hedge funds outperformed other investments and were substantially less volatile, with stocks falling an average of 2.62% per year over the decade and hedge funds rising an average of 6.54% per year; this was an unusually volatile period with both the 2001-2002 dot-com bubble
The dot-com bubble (dot-com boom, tech bubble, or the Internet bubble) was a stock market bubble in the late 1990s, a period of massive growth in the use and adoption of the Internet.
Between 1995 and its peak in March 2000, the Nasdaq Comp ... and a recession beginning mid 2007. However, more recent data show that hedge fund performance declined and underperformed the market from about 2009 to 2016.
Hedge funds performance is measured by comparing their returns to an estimate of their risk. Common measures are the Sharpe ratio, Treynor measure and Jensen's alpha. These measures work best when returns follow normal distributions without autocorrelation
Autocorrelation, sometimes known as serial correlation in the discrete time case, is the correlation of a signal with a delayed copy of itself as a function of delay. Informally, it is the similarity between observations of a random variable a ..., and these assumptions are often not met in practice.
New performance measures have been introduced that attempt to address some of theoretical concerns with traditional indicators, including: modified Sharpe ratios; [ the ] Omega ratio The Omega ratio is a risk-return performance measure of an investment asset, portfolio, or strategy. It was devised by Con Keating and William F. Shadwick in 2002 and is defined as the probability weighted ratio of gains versus losses for some thres ... introduced by Keating and Shadwick in 2002; Alternative Investments Risk Adjusted Performance (AIRAP) published by Sharma in 2004; and Kappa developed by Kaplan and Knowles in 2004.
There is a debate over whether
Alpha (uppercase , lowercase ; grc, ἄλφα, ''álpha'', or ell, άλφα, álfa) is the first letter of the Greek alphabet. In the system of Greek numerals, it has a value of one. Alpha is derived from the Phoenician letter aleph , whi ... (the manager's skill element in performance) has been diluted by the expansion of the hedge fund industry. Two reasons are given. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more managers, which may dilute the talent available in the industry.
Hedge fund indices
Indices play a central and unambiguous role in traditional asset markets, where they are widely accepted as representative of their underlying portfolios. Equity and debt index fund products provide investable access to most developed markets in these asset classes.
Hedge fund indices are more problematic. The typical hedge fund is not traded on exchange, will accept investments only at the discretion of the manager, and does not have an obligation to publish returns. Despite these challenges, Non-investable, Investable, and Clone indices have been developed.
Non-investable indices are indicative in nature and aim to represent the performance of some database of hedge funds using some measure such as mean, median, or weighted mean from a hedge fund database. The databases have diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different indices.
Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list of
Bias is a disproportionate weight ''in favor of'' or ''against'' an idea or thing, usually in a way that is closed-minded, prejudicial, or unfair. Biases can be innate or learned. People may develop biases for or against an individual, a group, .... Funds' participation in a database is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money.
The short lifetimes of many hedge funds mean that there are many new entrants and many departures each year, which raises the problem of survivorship bias
Survivorship bias or survival bias is the logical error of concentrating on entities that passed a selection process while overlooking those that did not. This can lead to incorrect conclusions because of incomplete data.
Survivorship bias is .... If we examine only funds that have survived to the present, we will overestimate past returns because many of the worst-performing funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial.
When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favorable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias" or "backfill bias".
Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. To create an investable index, the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. When investors buy these products the index provider makes the investments in the underlying funds, making an investable index similar in some ways to a fund of hedge funds portfolio.
To make the index investable, hedge funds must agree to accept investments on the terms given by the constructor. To make the index liquid, these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. This means that investable indices do not represent the total universe of hedge funds. Most seriously, they under-represent more successful managers, who typically refuse to accept such investment protocols.
Hedge fund replication
The most recent addition to the field approaches the problem in a different manner. Instead of reflecting the performance of actual hedge funds, they take a statistical approach to the analysis of historic hedge fund returns and use this to construct a model of how hedge fund returns respond to the movements of various investable financial assets. This model is then used to construct an investable portfolio of those assets. This makes the index investable, and in principle, they can be as representative as the hedge fund database from which they were constructed. However, these clone indices rely on a statistical modelling process. Such indices have too short a history to state whether this approach will be considered successful.
In March 2017, HFR – a hedge fund research data and service provider – reported that there were more hedge-fund closures in 2016 than during the 2009 recession. According to the report, several large public pension funds pulled their investments in hedge funds, because the funds’ subpar performance as a group did not merit the high fees they charged.
Despite the hedge fund industry topping $3 trillion for the first time ever in 2016, the number of new hedge funds launched fell short of levels before the
financial crisis of 2007–2008
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of .... There were 729 hedge fund launches in 2016, fewer than the 784 opened in 2009, and dramatically fewer than the 968 launches in 2015.
Debates and controversies
Systemic risk refers to the risk of instability across the entire financial system, as opposed to within a single company. Such risk may arise following a destabilizing event or events affecting a group of
Financial institutions, sometimes called banking institutions, are business entities that provide services as intermediaries for different types of financial monetary transactions. Broadly speaking, there are three major types of financial inst ...s linked through investment activity. Organizations such as the European Central Bank
The European Central Bank (ECB) is the prime component of the monetary Eurosystem and the European System of Central Banks (ESCB) as well as one of seven institutions of the European Union. It is one of the world's most important central ... have charged that hedge funds pose systemic risks to the financial sector, and following the failure of hedge fund Long-Term Capital Management
Long-Term Capital Management L.P. (LTCM) was a highly-leveraged hedge fund. In 1998, it received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York.
LTCM was founded in ... (LTCM) in 1998 there was widespread concern about the potential for systemic risk if a hedge fund failure led to the failure of its counterparties. (As it happens, no financial assistance was provided to LTCM by the US Federal Reserve, so there was no direct cost to US taxpayers, but a large bailout
A bailout is the provision of financial help to a corporation or country which otherwise would be on the brink of bankruptcy.
A bailout differs from the term ''bail-in'' (coined in 2010) under which the bondholders or depositors of global syst ... had to be mounted by a number of financial institutions.)
However, these claims are widely disputed by the financial industry, who typically regard hedge funds as " small enough to fail", since most are relatively small in terms of the assets they manage and operate with low leverage, thereby limiting the potential harm to the economic system should one of them fail. Formal analysis of hedge fund leverage before and during the financial crisis of 2007–2008
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of ... suggests that hedge fund leverage is both fairly modest and counter-cyclical
Procyclical and countercyclical variables are variables that fluctuate in a way that is positively or negatively correlated with business cycle fluctuations in gross domestic product (GDP). The scope of the concept may differ between the contex ... to the market leverage of investment banks and the larger financial sector. Hedge fund leverage decreased prior to the financial crisis, even while the leverage of other financial intermediaries continued to increase. [ Hedge funds fail regularly, and numerous hedge funds failed during the financial crisis. In testimony to the US House Financial Services Committee in 2009, ] Ben Bernanke
Ben Shalom Bernanke ( ; born December 13, 1953) is an American economist who served as the 14th chairman of the Federal Reserve from 2006 to 2014. After leaving the Fed, he was appointed a distinguished fellow at the Brookings Institution. Duri ..., the Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ... Board Chairman said he "would not think that any hedge fund or private-equity fund would become a systemically critical firm individually".
This does leave the possibility that hedge funds collectively might contribute to systemic risk if they exhibit herd or self-coordinating behavior, perhaps because many hedge funds make losses in similar trades. This coupled with the extensive use of leverage could lead to forced liquidations in a crisis.
Hedge funds are also closely connected to their prime brokers, typically investment banks, can could contribute to their instability in a crisis, though this works both ways and failing counterparty
A counterparty (sometimes contraparty) is a legal entity, unincorporated entity, or collection of entities to which an exposure of financial risk may exist. The word became widely used in the 1980s, particularly at the time of the Basel I deliber ... banks can freeze hedge funds assets, as Lehman brothers
Lehman Brothers Holdings Inc. ( ) was an American global financial services firm founded in 1847. Before filing for bankruptcy in 2008, Lehman was the fourth-largest investment bank in the United States (behind Goldman Sachs, Morgan Stanley, an ... did in 2008.
An August 2012 survey by the Financial Services Authority concluded that risks were limited and had reduced as a result, ''inter alia'', of larger margins being required by counterparty banks, but might change rapidly according to market conditions. In stressed market conditions, investors might suddenly withdraw large sums, resulting in forced asset sales. This might cause liquidity and pricing problems if it occurred across a number of funds or in one large highly leveraged fund.
Hedge funds are structured to avoid most direct
Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. For ... (although their managers may be regulated), and are not required to publicly disclose their investment activities, except to the extent that investors generally are subject to disclosure requirements. This is in contrast to a regulated mutual fund or exchange-traded fund
An exchange-traded fund (ETF) is a type of investment fund and exchange-traded product, i.e. they are traded on stock exchanges. ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold from other owners throughout the ..., which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment adviser of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, while some hedge funds have very limited transparency even to investors.
Funds may choose to report some information in the interest of recruiting additional investors. Much of the data available in consolidated databases is self-reported and unverified. A study was done on two major databases containing hedge fund data. The study noted that 465 common funds had significant differences in reported information (''e.g.'', returns, inception date, net assets value, incentive fee, management fee, investment styles, etc.) and that 5% of return numbers and 5% of NAV numbers were dramatically different. With these limitations, investors have to do their own research, which may cost on the scale of US$50,000 for a fund that is not well-established.
A lack of verification of financial documents by investors or by independent auditors has, in some cases, assisted in fraud
In law, fraud is intentional deception to secure unfair or unlawful gain, or to deprive a victim of a legal right. Fraud can violate civil law (e.g., a fraud victim may sue the fraud perpetrator to avoid the fraud or recover monetary compens .... In the mid-2000s, Kirk Wright of International Management Associates was accused of mail fraud
Mail fraud and wire fraud are terms used in the United States to describe the use of a physical or electronic mail system to defraud another, and are federal crimes there. Jurisdiction is claimed by the federal government if the illegal activit ... and other securities violations which allegedly defrauded clients of close to US$180 million. In December 2008, Bernard Madoff was arrested for running a US$50 billion Ponzi scheme
A Ponzi scheme (, ) is a form of fraud that lures investors and pays profits to earlier investors with funds from more recent investors. Named after Italian businessman Charles Ponzi, the scheme leads victims to believe that profits are comin ... that closely resembled a hedge fund and was incorrectly described as one. Several feeder hedge funds, of which the largest was Fairfield Sentry, channeled money to it. Following the Madoff case, the SEC adopted reforms in December 2009 that subjected hedge funds to an audit requirement.
The process of matching hedge funds to investors has traditionally been fairly opaque, with investments often driven by personal connections or recommendations of portfolio managers. Many funds disclose their holdings, strategy, and historic performance relative to market indices, giving investors some idea of how their money is being allocated, although individual holdings are often not disclosed. Investors are often drawn to hedge funds by the possibility of realizing significant returns, or hedging against volatility in the market. The complexity and fees associated with hedge funds are causing some to exit the market – CalPERS
The California Public Employees' Retirement System (CalPERS) is an agency in the California executive branch that "manages pension and health benefits for more than 1.5 million California public employees, retirees, and their families".CalPERSFa ..., the largest pension fund in the US, announced plans to completely divest from hedge funds in 2014. Some services are attempting to improve matching between hedge funds and investors: HedgeZ is designed to allow investors to easily search and sort through funds; iMatchative aims to match investors to funds through algorithms that factor in an investor's goals and behavioral profile, in hopes of helping funds and investors understand the how their perceptions and motivations drive investment decisions.
Links with analysts
In June 2006, prompted by a letter from Gary J. Aguirre, the U.S. Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. Aguirre was fired from his job with the SEC when, as lead investigator of insider trading allegations against Pequot Capital Management, he tried to interview John Mack, then being considered for
chief executive officer
A chief executive officer (CEO), also known as a central executive officer (CEO), chief administrator officer (CAO) or just chief executive (CE), is one of a number of corporate executives charged with the management of an organization especial ... at Morgan Stanley
Morgan Stanley is an American multinational investment management and financial services company headquartered at 1585 Broadway in Midtown Manhattan, New York City. With offices in more than 41 countries and more than 75,000 employees, the .... The Judiciary Committee and the US Senate Finance Committee issued a scathing report in 2007, which found that Aguirre had been illegally fired in reprisal for his pursuit of Mack, and in 2009 the SEC was forced to re-open its case against Pequot. Pequot settled with the SEC for US$28 million, and Arthur J. Samberg, chief investment officer of Pequot, was barred from working as an investment advisor. Pequot closed its doors under the pressure of investigations.
The systemic practice of hedge funds submitting periodic electronic questionnaires to stock analysts as a part of market research was reported by '' The New York Times'' in July 2012. According to the report, one motivation for the questionnaires was to obtain subjective information not available to the public and possible early notice of trading recommendations that could produce short-term market movements.
Value in a mean/variance efficient portfolio
According to modern portfolio theory, rational investors will seek to hold portfolios that are mean/variance efficient (that is, portfolios that offer the highest level of return per unit of risk). One of the attractive features of hedge funds (in particular market neutral and similar funds) is that they sometimes have a modest correlation with traditional assets such as equities. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers, reducing overall portfolio risk.
However, there are at least three reasons why one might not wish to allocate a high proportion of assets into hedge funds. These reasons are:
* Hedge funds are highly individual, making it hard to estimate the likely returns or risks.
* Hedge funds' correlation with other assets tends to rise during stressful market events, making them much less useful for diversification in bad times than they may appear in good times.
* Hedge fund returns are reduced considerably by the high fees that are typically charged.
Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in investor portfolios, but this is disputed for example by Mark Kritzman who performed a mean-variance optimization calculation on an opportunity set that consisted of a stock index fund, a bond index fund, and ten hypothetical hedge funds. The optimizer found that a mean-variance efficient portfolio did not contain any allocation to hedge funds, largely because of the impact of performance fees. To demonstrate this, Kritzman repeated the optimization using an assumption that the hedge funds took no performance fees. The result from this second optimization was an allocation of 74% to hedge funds.
Hedge funds tend to perform poorly during equity bear markets, just when an investor needs part of their portfolio to add value. For example, in January–September 2008, the Credit Suisse/Tremont Hedge Fund Index returned -9.87%. According to the same index series, even "dedicated short bias" funds returned −6.08% in September 2008, when Lehman Brothers
Lehman Brothers Holdings Inc. ( ) was an American global financial services firm founded in 1847. Before filing for bankruptcy in 2008, Lehman was the fourth-largest investment bank in the United States (behind Goldman Sachs, Morgan Stanley, an ... collapsed.
* Activist shareholder
* Alternative investment
Board of directors
A board of directors (commonly referred simply as the board) is an executive committee that jointly supervises the activities of an organization, which can be either a for-profit or a nonprofit organization such as a business, nonprofit orga ...
* Corporate governance
Corporate governance is defined, described or delineated in diverse ways, depending on the writer's purpose. Writers focused on a disciplinary interest or context (such as accounting, finance, law, or management) often adopt narrow definitions t ...
* Fund governance
* Investment banking
Investment banking pertains to certain activities of a financial services company or a corporate division that consist in advisory-based financial transactions on behalf of individuals, corporations, and governments. Traditionally associated with ...
* List of hedge funds
* Vulture fund
A vulture fund is a hedge fund, private-equity fund or distressed debt fund, that invests in debt considered to be very weak or in default, known as distressed securities. Investors in the fund profit by buying debt at a discounted price on ...
*Thomas P. Lemke, Gerald T. Lins, Kathryn L. Hoenig & Patricia S. Rube, ''Hedge Funds and Other Private Funds: Regulation and Compliance'' (Thomson West 2014 ed.).
*Thomas P. Lemke & Gerald T. Lins, ''Regulation of Investment Advisers'' (Thomson West 2014 ed.).
*Thomas P. Lemke, Gerald T. Lins & A. Thomas Smith III, ''Regulation of Investment Companies'' (Matthew Bender 2014 ed.).
*Marcel Kahan & Edward B. Rock, 'Hedge Funds in Corporate Governance and Corporate Control' (2007) 155 University of Pennsylvania Law Review 1021
*Makrem Boumlouka, 'Regulation and Transparency in US OTC Derivative Markets', ''Original Thoughts Series #1'', August 2010, Hedge Fund Societ
Hedge Fund Society
Archive of articles on hedge funds controversies in the 21st century
'' Naked Capitalism''
Products introduced in 1949
Alternative investment management companies