The Fundamentals of Hedge Fund Management

How to Successfully Launch and Operate a Hedge Fund

Daniel A. Strachman

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9781118151396
• eBook ISBN: 9781118239230
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Updated edition of the book that gives investors, advisors, and managers the tools they need to launch and maintain a hedge fund in today's economy

The hedge fund industry has gone through dramatic changes in recent years. Investors of all types continue to want to place their assets into these investment vehicles even in the wake of the credit crisis, massive frauds, and insider trading scandals. Once the forbidden fruit of Wall Street, hedge funds are now considered "must have" investments in any diversified portfolio. Now in its second edition, The Fundamentals of Hedge Fund Management is revised and updated to address how the credit crisis, legislation, fraud, technology, investor demand, global markets, and the economic landscape have affected the industry.

Providing readers with a detailed and in-depth analysis of the world of hedge funds, the people working in it, and a look at where it's headed, the book is a timely and indispensable reference and research tool for helping professional money managers, traders, and others to launch and grow successful hedge fund businesses.

• Addresses how the credit crisis and its fallout has affected the hedge fund industry and what this means for the future
• Provides the essential information needed to launch and maintain a successful hedge fund in the new global economy
• Walks the reader through running a hedge fund, helping you to gain success over years, not just months

An essential resource for anyone looking to invest in these much-discussed investment products, The Fundamentals of Hedge Fund Management, Second Edition is now fully revised and updated.

CHAPTER 1

The Hedge Fund Industry

The last pure bastion of capitalism rests in two words: hedge fund. There is no other business, enterprise, occupation, or opportunity that exists to the best of my knowledge, that allows one to make so much so fast (legally). Hedge funds are not new. These types of investment vehicles have been around since 1949 when Alfred Winslow Jones launched the first fund known to Wall Street. However, in the more than 60-odd years since Mr. Jones's invention, the industry has grown larger, more diverse, and more powerful than one could have imagined. If you ask recent business school graduates where they want to work, they no longer say IBM, General Electric (GE), Intel, or the like but rather Bridgewater, SAC, Mariner, or Maverick. People rob banks because that's where the money is. Well, people want to work at hedge funds because that's really where the money is.

The growth of the hedge fund industry over the past few years in the wake of the credit crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act, and the great recession has been amazing. Many industry observers believe that since those harrowing days in September of 2008, assets in these often-called secretive investment vehicles have continued to grow because people have realized that markets don't always rise and, as such, want some protection on the downside or better yet, a hedge. The industry continues to grow at a record pace even with the weak performance numbers in recent years.

As of the early spring of 2012, there are an estimated 12,000 hedge funds in operation globally, managing more than $1.6 trillion in assets.1 The numbers are thought-provoking and compelling, especially if you are working at a service provider. Some in the industry equate the substantial growth in hedge funds over the past five years to what happened in the mutual fund industry in the late 1980s and early 1990s. That industry contracted in light of the bursting technology bubble and bear market. Many believe that as the hedge fund industry continues to grow, it is readying itself for a burst of sorts, and, as the new manager on the block, you need to be ready for what lies ahead. It is hard to build a successful business. That said, the strong will survive, and they will prosper. Your job as a new manager about to launch a fund is to ensure that you are ready, willing, and able to deal with everything the market and investors throw at you and you are prepared for the worst.

To understand where the industry is going, you will need to understand where it has been. The evolution of the hedge fund industry is easily seen when you come out of the Wall Street subway stop. When you exit the station, head northwest toward Broadway and make a left on Broad Street. In front of you will be the New York Stock Exchange (NYSE); behind you will be the former headquarters of J.P. Morgan, and to your left will be a statue of President George Washington.

If you make this trip around 9:00 A.M., you will see what Jones saw: traders and brokers hustling to get inside the building before the market opens. It was the action and excitement of this place that led Jones to create the first known hedged fund, an investment vehicle that went long and short the market and was able to protect and grow its investors' assets regardless of market conditions. Jones, a sociologist turned journalist, came up with the concept of this long/short fund based on a thesis he had written for an article in Fortune magazine.

In the late 1940s, Jones had held a number of positions in journalism, writing about finance and industry as well as social issues. During this time, he realized that the income he earned as a freelancer was not going to be enough to sustain him or his family in the life he wanted and expected. He looked to Wall Street for the answer. What he found was an idea he believed would work. In turn, he would earn enough money to support his family and fulfill his major passion: helping people. Though Jones developed his concept and his business for the money it earned him, his idea was to take the wealth and put it to work in the community. His idea was to use his hedged fund as a tool to allow others to help themselves. His son-in-law, Robert Burch, who currently runs A.W. Jones & Company with his son, said that Jones was more interested in the intellectual challenge of the business than the rewards that it provided.

“Jones was not a man who was interested in Wall Street,” said Burch. “Although he made a lot of money over the years, he gave a lot of it away to create programs and organizations to help people here in the United States.”

Jones was not interested in talking about the fund, how it worked, or what it did. He wanted to talk about how to make the country and the world a better place.

“When you had dinner with Jones, you always had four or five guys from various parts of the world,” recalled Burch. “You didn't know if that night you were going to discuss some pending revolt in Albania or what language they speak in Iran. But what you did know was that you would definitely not be talking about money, Wall Street, or the firm. His mind was beyond that.”

The foundation of the hedge fund industry lay not in the pursuit of money for conspicuous consumption but in the pursuit of money to help people.

It all began in a magazine. The article was not some how-to or get-rich-quick piece about making a fast buck but rather a thought-provoking look at how money is managed and the idea that going long some stocks and short others can earn great and stable rewards. In short, the Jones piece examined how you could go long a basket of stocks and short a basket of stocks yet protect and grow your assets.

The article that put his plan in motion was titled “Fashion in Forecasting,” which ran in the March 1949 issue of Fortune magazine. It gave him the foundation for what today some people view as one of the most important tools used by money managers to make money. Following is an excerpt from the article:

The standard, old-fashioned method of predicting the course of the stock market is first to look at facts and figures external to the market itself, and then examine stock prices to see whether they are too high or too low. Freight-car loadings, commodity prices, bank clearings, the outlook for tax legislation, political prospects, the danger of war, and countless other factors determine corporations' earnings and dividends, and these, combined with money rates, are supposed to (and in the long run do) determine the prices to common stocks. But in the meantime awkward things get in the way (and in the long run, as Keynes said, we shall be dead).

In the late summer of 1946, for instance, the Dow Jones industrial stock average dropped in five weeks from 205 to 163, part of the move to a minor panic. In spite of the stock market, business was good before the break, remained good through it, and has been good ever since.

Nevertheless there are market analysts, whose concern is the internal character of the market, who could see the decline coming. To get these predictive powers they study the statistics that the stock market itself grinds out day after day. Refined, manipulated in various ways, and interpreted, these data are sold by probably as many as twenty stock market services and are used independently by hundreds, perhaps thousands, of individuals. They are increasingly used by brokerage firms, by some because the users believe in them and by others because their use brings in business.2

The idea was simple: Some stocks go up and others go down and rarely do all stocks move in the same direction at the same time. If this makes sense to you, then the next thing you need to understand is that as some stocks move up and others move down, there is a way to make money when they go up, by being long a basket of stocks, and when they go down, by being short a basket of stocks. The key is to forecast which stocks go up and which go down and to position a portfolio accordingly.

The issue has remained the same over the years: How do you determine which stocks are going to go up and which are going to go down? Jones had a unique problem. He was not a stock picker. Fortunately, he learned this early on and was able to compensate for his inability to pick stocks by hiring those who could.

“My father was a good salesman. He knew people to raise money from and was a good organizer and administrator. But when it came to picking stocks, he had no particular talent,” Tony Jones told me. “This meant that his job was to find people who did have the talent.”

Jones was an executive, not a stock picker. He understood how to get things done and how to find people to execute his ideas. In the end, he created the first hedge fund and with it an entire industry.

Some 50-odd years later, in the fall of 2003, a report by the Securities and Exchange Commission (SEC) estimated that 6,000 to 7,000 hedge funds were managing between $600 billion and $650 billion in assets. The report noted that hedge fund assets were expected to grow to more than $1 trillion between 2008 and 2010.3 In mid-October 2011, according to BarclayHedge, at quarter end of 2011, total assets under management in the hedge fund industry stood at $1,806.4 billion. Barclay tracks more than 21,000 funds in its database.4

Jones never saw this coming. He believed that his business did not have legs even though it was successful and even though his concept worked. In one of the few profiles of the founder of the hedge fund industry, Jones was quoted saying, “I don't believe that it [the hedge fund] is ever going to become as big a part of the investment scene as it was in the 1960s. The hedge fund does not have a terrific future.”5

Jones seemed to have misunderstood the value of his invention because, as many people have realized, having a portfolio that is long and short is the only way to ensure, over a long period of time, that assets are protected and will grow—regardless of whether the market rises or falls.

Though a portfolio of longs and a portfolio of shorts make sense, the key to long-term success is to hit the ball out of the park with your stock picks and to put up singles and doubles every day. Move the runners around the bases and back to home plate while protecting your assets at all costs to ensure they go on to win another day. That, my friends, is the secret of successful hedge fund businesses, and it allows these organizations to maintain and create wealth in a safe and secure environment.

UNDERSTANDING HEDGE FUNDS

The concept of this book is not complex. It provides you with the tools you need to understand the functions that go into creating, launching, and running an investment vehicle that is a hedge fund. It provides you with information to make better decisions when choosing a lawyer, prime broker, accountant, administrator, and other service providers. These are the people who will help you grow and maintain your business. This book provides you with insight into the perceptions versus the realities of the hedge fund business, and most of all, it gives you a clear understanding of where the hedge fund industry came from, where it is now, and where it is going. In this way, you and your partners can create and run a successful business that allows you and your investors to build and preserve wealth.

This book is not about managing money or implementing trading strategies. That is covered in other, more thought-provoking books about money and markets. This book is a tool—a reference guide, if you will—that will be used by your front-, middle-, and back-office personnel. It will be used as a reference guide when you decide what sort of funds to launch, how the vehicles should be structured, and whom you should choose as a lawyer and prime broker, helping you create and implement a strategy for marketing your fund to raise money. If you want to learn about trading, stop reading right now and buy one of the countless get-rich-quick trading books.

With that said, we need to look at hedge fund basics to get started on developing and running a successful investment management business. The basics are, quite honestly, basic. One thing that needs to be said is that hedge funds, like most things on Wall Street, are thought to be intricate, confusing, and sophisticated. This is not the case. Hedge funds, like almost everything else on the Street, are simple when you break them down. These often-called secretive investment vehicles are easy to understand once you look at them closely and dissect them in an orderly and efficient manner.

Some aspects of the hedge fund industry are sophisticated, including structuring for tax efficiency and registration issues based on new legislation. For the most part, however, it is like riding a bike: After you have done it once (i.e., set up a hedge fund), you never forget how it works and what needs to be done. In addition, you'll be able to rely on a critical resource in the lawyers, accountants, and other service providers who will help you make the right decisions.

Although investors may initially assume that hedge funds and mutual funds operate in a similar fashion, the only similarity between the funds is that both operate as pooled investment vehicles. This means that a number of investors entrust their money to a manager for a specific fund that goes out and buys and sells securities to make a profit.

Hedge funds differ from mutual funds in that investors provide hedge fund managers with the ability to pursue absolute return strategies. Mutual funds generally offer only relative return strategies.

An absolute return strategy is the new name for the strategy that Jones invented in the late 1940s. It means that regardless of market conditions, a hedge fund manager should make money. This differs from what is called a relative return strategy, which is how one fund does against a benchmark. In recent years, a number of indices have been created to track and benchmark hedge funds. Even though these products are good, they are flawed. Therefore, it is best to think of hedge funds as vehicles that are measured on their specific performance, and not on how their performance is relative to the Standard & Poor's 500 Index (S&P 500), the Russell 2000 Index, or any other benchmark used to measure performance of traditional investments.

Mutual funds, due to their structure and the laws that govern how they operate, invest in a predefined style and strategies such as large-cap growth and mid-cap value or in a particular sector such as the utilities or biotechnology. The mutual fund defines its strategy and style in its prospectus, which is given to existing and prospective investors. Manager performance is measured on how a fund's return compares to that of a specific index or benchmark. For example, if you buy into a l...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Dedication
• Epigraph
• Preface
• Acknowledgments
• Chapter 1: The Hedge Fund Industry
• Chapter 2: The Service Providers
• Chapter 3: Hedge Fund Structures
• Chapter 4: Hedge Fund Accounting
• Chapter 5: ERISA, UBTI, and Offshore Funds
• Chapter 6: Marketing and Capital Raising
• Chapter 7: Why the Back Office Matters
• Chapter 8: The Launch
• Chapter 9: Perception versus Reality
• Appendix A: The Hedge Fund Industry
• Appendix B: Examples of Hedge Fund Structures
• Resource Guide
• Glossary
• Bibliography
• About the Author
• Index