65. What do you know about hedge funds?

At its most basic, a hedge fund is an investment vehicle that pools capital from a number of investors and invests in securities and other instruments.

Hedge funds have made the stock market much more risky. Since they are unregulated, they can make investments without scrutiny by the SEC. Unlike mutual funds, they don’t have to report quarterly on their holdings. This means no one really knows what they are invested in.

Their use of derivatives means that, with little actual money invested, they have the capability to create large swings in the market. For example, many experts have said that the run-up in oil prices in July of 2006 was caused, in part, by hedge funds. Although no one really knows how much of the market is controlled by hedge funds, Credit Suisse estimates it could be half of the New York and London Stock Exchanges.

Key Players:

Portfolio Manager(s) Determines strategy and is invested in the fund (compensated based on fund’s annual performance)

Prime Broker Funds must secure their loans with collateral to gain margin and secure trades. In turn, each broker

(usually a large securities firm) uses its own risk matrix to determine how much to lend to each of its clients, acting as a stand-in regulator.

Auditors Ensure fund compliance; verify financial statements as required by federal law

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 stock exchanges, such as the Irish Stock Exchange, and may be purchased by non-accredited investors.

The following section highlights the main characteristics of hedge funds.

Financial instruments

Managers have a wide range of financial instruments and investment techniques to choose from, allowing them to reduce risks and take advantage of pricing inefficiencies

Performance drivers

Performance is driven by investment style and the manager’s ability to employ it within any market environment

Performance objectives

Hedge fund managers aim to achieve risk-adjusted absolute returns regardless of the market environment, rather than simply tracking or attempting to outperform a classic benchmark

Exposure

The manager is free to choose the investments and weightings with full discretion

Pricing

Fees are based both on the assets under management and the fund’s absolute performance. Most of the hedge fund manager’s remuneration is tied to performance. Generally, fees are higher than in the rest of the industry. Most hedge fund managers stop raising new money if they perceive further growth as being detrimental to the fund’s strategy

Liquidity

Some funds impose lock-up periods as well as gates. The liquidity offered to hedge fund investors often reflects the liquidity of the underlying investments in a given strategy

Alignment of interests

Managers invest part or all of their own assets in their funds and hence bear the same risks as their clients

Incorporation

Hedge funds are incorporated in offshore jurisdictions which sometimes lack specific regulations

About 61 percent of global hedge fund assets come from institutional investors such as pension funds, and university

and nonprofit endowments. The rest comes from individual investors.

Hedge funds are important tools for diversification. They provide investors with the latitude to take investment strategies based on current market conditions in order to manage risk and maximize return.

Because hedge funds are not sold to the general public or retail investors, the funds and their managers have historically been exempt from some of the regulation that governs other funds and investment managers with regard to how the fund may be structured and how strategies and techniques are employed. Regulations passed in the United States and Europe after the Financial crisis of 2007–08 were intended to increase government oversight of hedge funds and eliminate certain regulatory gaps.