The Complete Guide to Hedge Funds and Hedge Fund Strategies

D. Capocci

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137264442
• Topic: Business
• Subtopic: Financial Services
• Index: Business

One-stop-guide to the hedge fund industry, investment and trading strategies adopted by hedge funds and the industry's regulation. For anyone with an interest in investing or managing funds, it presents everything practitioners need to know to understand these investment vehicles from their theoretical underpinnings, to how they work in practice.

1

What Is a Hedge Fund?

This chapter aims to define hedge funds in a broad sense, listing and defining elements common to all such funds that explain why these investment products are grouped within what is called the hedge fund industry. The first section of this chapter gives a general definition of hedge funds. The second section describes the birth of the industry and its development over the years. The third focuses on the geographical development of hedge funds, and the fourth presents the big names of the industry. We end this chapter with a description of the future perspective of the industry, and we present a theory on its state of maturity.

1 General definition of hedge funds

In the financial semantic field, the verb “to hedge” means to cover or spread risks. In contrast to what we might think, not all hedge funds have the objective of neutralizing one or several sources of risk; today this term includes a variety of funds that use non-traditional management strategies. There is no legal definition of these funds, but practically every author or specialist has a definition that ranges from the general to the very precise. So, many definitions of hedge funds exist; we report on a few of these below.

According to the Alternative Investment Management Association (AIMA), hedge funds are difficult to define. The association does nevertheless include a definition in its glossary:

There is no standard international/legal definition though they may have all or some of the following characteristics: May use some form of short asset exposure; may use derivatives and/or more diverse risks or complex underlying products are involved; may use some form of leverage, measured by gross exposure of underlying assets exceeding the amount of capital in the fund; Funds charge a fee based on the performance of the fund relative to an absolute return benchmark as well as a management fee; investors are typically permitted to redeem their interest only periodically, e.g. quarterly or semi-annually; often, the manager is a significant investor alongside other fund investors.

The Hedge Fund Association (HFA), an international not-for-profit industry trade and non-partisan lobbying organization devoted to advancing transparency, development and trust in alternative investments, gives the following definition on its website:¹

Hedge funds refer to funds that can use one or more alternative investment strategies, including hedging against market downturns, investing in asset classes such as currencies or distressed securities, and utilizing return-enhancing tools such as leverage, derivatives, and arbitrage. At a time when world stock markets appear to have reached excessive valuations and may be due for further correction, hedge funds provide a viable alternative to investors seeking capital appreciation as well as capital preservation in bear markets. The vast majority of hedge funds make consistency of return, rather than magnitude, their primary goal.

Hedge Fund Research, Inc. (HFR), a hedge fund database provider specializing in alternative investments, states:²

[A] structure that usually takes a limited partnership or an offshore legal form. This structure is paid by a performance fee that is based on the fund profits. Exemptions exist and include a limit in the number of participants that should all be accredited or institutional. All hedge funds are not the same; managers are usually specialized in one of the investment strategies that are applied using a hedge fund structure.

Investopedia.com provides the following definition:³

An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.

The Securities and Exchange Commission recently defined hedge funds as:⁴

Any private fund (other than a securitized asset fund):

(a) with respect to which one or more investment advisers (or related persons of investment advisers) may be paid a performance fee or allocation calculated by taking into account unrealized gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses);

(b) that may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or

(c) that may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration).

On the basis of the definitions given above and many others, and arising from my own experience, please see below a general definition of hedge funds that is in accordance with the industry:

A Hedge Fund is an investment limited partnership (private) that uses a broad range of instruments like short selling, derivatives, leverage or arbitrage on different markets. Generally, the managers of the fund invest some of their own money in the fund and are paid by performance-related commissions. These funds require high minimum investments and their access is limited. These funds apply particularly to individual investors or to institutions with high financial resources.

This definition specifies many characteristics from the hedge fund industry, although not all of these will always be present at the level of individual funds. This definition does not give any information on the investment strategy applied by the investment team. This is in line with what we can find for mutual funds. The term “investment fund” does not give the investor information about what the fund is doing and/or if it is invested in shares, bonds or in derivatives. It does not confirm whether or not the fund has a geographical focus. But as we will see in the section relative to the origin of the industry, the situation was very different at the dawn of the industry. Every term in this definition has its importance; we will briefly cover these one by one, then explore each of them individually in detail later.

Hedge funds generally take the legal form of a private investment vehicle. Historically, the private structure arose from the fact that in the United States hedge fund managers had to comply with certain specific rules in order to limit the number of constraints on their management. Such constraints include, for example, restrictions regarding advertising or access being limited to high net worth individuals or professional investors. Such limitations tend to be standard even if some hedge fund strategies have been made available in a regulated onshore UCITS format in Europe. This means that the private structure is no longer an exclusive rule by which to define hedge funds, at least in Europe; however, in the US hedge funds are still proposed as private investments.

Hedge funds tend to invest in classic financial instruments such as equities and bonds, but their investment range is not always restricted to such securities. The use of more sophisticated instruments, including derivatives such as options (including exotic ones), futures, swaps, credit default swaps (CDS), warrants or convertible bonds, are common. Typically, they also use original and more complex investment techniques such as short selling⁵ or arbitrage. Depending on the investment strategy and their investment styles, managers may also tend to take the opportunity of using leverage.⁶ This part of the definition illustrates the level of freedom that managers tend to retain; the scope here is very broad, as some managers may only invest in equities by combining long and short positions in a market-neutral portfolio, while others will consider a wide range of different asset classes, including stocks, bonds and derivatives, and short-sell equities, take short positions in credit through CDS and combine naked, long, short, and some arbitrage or relative value positions.

Another characteristic of the definition is that hedge fund managers are paid mainly through performance-related fees, and that they invest a – usually significant – part of their personal cash holdings in their fund. This has been the case historically, and has become standard. Investors see that as an alignment of interest; when managers have their own money invested alongside that of investors, they are more involved and incentivized to deliver. The risk is that managers that have not co-invested with their clients could focus more on the management fee and on raising the asset rather than on delivering. While originally hedge funds involved only a 20 per cent performance-related commission, today management fees are also imposed, ranging between one and two per cent.

The last part of the definition stresses that hedge funds have been created for high net worth individuals and institutional investors. This arises from the fact that in most countries investments in individual hedge funds are limited to high net worth individuals, complying with strict rules. This constraint comes from the rules governing public funds that can be sold to any customer, but are restricted regarding the investment securities used, and cannot have sophisticated investment techniques applied to them. This rule protects the smaller investors; richer investors are likely to be more sophisticated, or they can pay for advice if needed; they can also afford a greater level of risk in their investments. Investment in hedge funds via funds of hedge funds...