U.S. Hedge Funds

Hedge fund performance data is collected and compiled by several organization, including Tremont Adviser's TASS Research unit (www.tassresearch.com), Evaluation Associates Capital Management (EACM), MAR-Zurich (Managed Account Review), CSFB/Tremont Hedge Fund Index (the only asset-weighted fund benchmark, www.hedgeindex.com), E. Lee Hennessey, and Van Hedge. Each of these organizations separate hedge funds into categories, and their category definitions and hedge fund assignments to categories are not always the same.
 

As defined by Robert A. Jaeger at EACM in his book entitled All About Hedge Funds: The Easy Way to Get Started, 2003, New York: McGraw-Hill, paperback: "A hedge fund is an actively managed investment fund that seeks attractive absolute return. In pursuit of their absolute return objective, hedge funds use a wide variety of investment strategies and tools. Hedge funds are designed for a small number of large investors, and the manager of the fund receives a percentage of the profits earned by the fund."

 

Hedge funds are also known as alternative investment strategies. Every hedge, just as every investment, has a cost. Any hedge can fail, just as any investment that is hedged can fail. Every investment and every hedge of an investment is a bet, and those bets involves some directionality in the markets: either the direction of a price (up or down) or the direction of a price difference or spread (convergence or divergence). Active management is contrasted with passive management where the goal is to track a standard market index. Absolute or positive return is contrasted with relative return where the goal is to beat a passive market index. Hedge fund tools include margin for leverage, short selling and other hedging techniques such as futures, options and other derivatives. Derivative securities also provide leverage.

 

The major hedge fund strategies and sub-strategies are classified by Robert Jaeger at EACM into 5 strategies and 13 sub-strategies as follows:

 

Relative Value

    Managers structure balanced or hedged portfolios with long and short positions that attempt to generate performance results independent of market direction.

    Four sub-strategies: long/short equity specialists (either market-neutral or dollar-neutral), convertible hedgers, bond hedgers, and multi-strategy managers that combine different relative value sub-strategies.

 

Event Driven

    Managers focus on corporate transactions and special situations, including deal or risk arbitrage and distressed debt.

    Three sub-strategies: deal or risk arbitrageurs, distressed debt specialists, and multi-strategy managers that combine different event-driven sub-strategies.

 

Equity Hedge

    Managers invest in long and short positions with varying degrees of exposure and leverage.

    Three sub-strategies: domestic long biased, domestic opportunistic, and global/international managers.

 

Global Asset Allocators

    Managers invest opportunistically, both long and short, in a variety of U.S. and non-U.S. financial and or nonfinancial assets.

    Two sub-strategies: systematic traders and discretionary managers.

  

Short Selling

    Managers short specific U.S. equities based on the fundamental characteristics of a company or current market trends, with the expectation of a decline in the share price.

    One sub-strategy: Short-only managers.

 

Tremont Hedge World http://www.hedgeworld.com/ 13 Fund Strategies	How to Create and Manage A Hedge Fund, Stuart A. McCrary, 2002, Wiley, hardback. 13 Fund Strategies
Convertible Arbitrage Dedicated Short Bias Emerging Markets (pure) Equity Market Neutral Event Driven Fixed Income Arbitrage Fund of Funds Global Macro Long Only Long/Short Equity Managed Futures Multi Strategy Other	Long/Short Equity Equity Arbitrage Equity Pairs Trading Equity Market-Neutral Funds Risk Arbitrage or Merger Arbitrage Event-Driven Strategies Convertible Bonds Fixed-Income Arbitrage Mortgage Arbitrage Emerging Markets Distressed Securities Global Macro Funds Futures Funds

 

Technically, a U.S. hedge fund is a private investment partnership which invests primarily in publicly traded securities or financial derivatives. The SEC limits a 3(c)1 hedge fund to 99 investors, 35 of whom may be "non-accredited." An accredited investor, generally speaking, must have a net worth of $1 million or more; or an annual income of $200,000 or more ($300,000 jointly, if married) in each of the most two recent years and has a reasonable expectation of reaching the same income level in the current year.

Consideration must be given to who the investors are, as in some states only "accredited investors" can become limited partners in the underlying partnership. In others, the number of unaccredited investors is limited. The typical lowest ante is $250,000 to $500,000. Most established funds take new money once a quarter, and only when they have an open slot. Funds taking new money are listed in MAR/Hedge monthly newsletter. A hedge fund might not allow investors to redeem for a year after they invest. After that you may be able to get your money back once a year, and only with a two months’ notice.

The general partner makes the investment decisions and collects management and performance based fees. The general partner of the fund usually receives 20% of the profits, in addition to an annual management fee, usually 1% of the assets under management. Should the general partner post negative results, they will have to make their investors whole before they collect any pay.

Unlike mutual funds, the hedge fund is not restricted in its investment approach and strategy, and can typically employ every financial tool known to the investment community, including selling short, engaging in arbitrage transactions, trading options and derivatives, and highly leveraged trading on margin loans. The hedge fund investment manager can invest in anything, anywhere – even place bets with a sports bookie in Las Vegas. A hedge fund is a "blind pool" in this sense.

The overarching goal for all hedge funds is to make money whether the market goes up or down, i.e., be market neutral. There is no prospectus, annual report or other standard public disclosure. What you have are financial statements from the funds, the unaudited returns published by tracking outfits like MAR/Hedge, current clients as references, and most importantly, your interview with the fund’s managers from whom you need to learn about the fund’s strategy and the source of their investment ideas.

The establishment of a hedge fund involves the creation of an offering that, if structured properly, is not subject to registration under the Investment Company Act, the Securities Act of 1933, or as a broker-dealer. However, the solicitation of investments is still subject to federal and state securities laws.

And that is the allure of the hedge fund – it does not have to register as a broker-dealer, it does not have to register with the NASD, and it is not under the jurisdiction of the SEC. There is freedom from the regulatory burden of a broker-dealer registration, or registration as a mutual fund, or even as a registered investment advisor.

Most hedge funds are private limited partnerships, prohibited from advertising. For legal and proprietary reasons, hedge fund managers have traditionally been reluctant to disclose specifics about their operation, even to investors. They have rarely spoken with the press until recent years, and now, they seldom reveal much.

A recent SEC no-action letter issued to Lamp Technologies has permitted the use of the Internet in some limited circumstances by hedge funds. This had been a boon to the hedge fund industry which has raised hundreds of millions of dollars as a result.

Many funds are operating without compliance with the applicable exemptions from the regulations, and in violation of those regulations. In fact, many investment clubs are actually hedge funds, operating in violation of the applicable security laws. Non-compliance with any element of federal or state laws may result in that the investment partnership rescind its sales to investors.

Insuring compliance is an important consideration – not only for the manager of the hedge fund who is the general partner of the limited partnership, but for the investors themselves, as a properly created and maintained limited partnership has tax implications for the individual investor. Therefore, strict compliance with the securities offering side of the hedge fund and compliance with the limited partnership laws, are required. In addition to maintaining compliance with applicable SEC regulations, the applicability of the state securities laws must also be addressed when creating a hedge fund.

In 2000, a new hedge fund can be created and established for less than $10,000 for registration in one U.S. state only. But that expense is but one small part of the total expense to organize a mew fund management company.