A hedge fund is an investment fund that is typically open to a limited range of investors who
pay a performance fee to the fund's investment manager.
Every hedge fund has its own investment strategy that determines the type of investments it
undertakes and these strategies are highly individual. As a class, hedge funds undertake a wider
range of investment and trading activities than traditional long-only investment funds, and invest
in a broader range of assets including long and short positions in shares, bonds and commodities.
As the name implies, hedge funds often seek to hedge some of the risks inherent in their
investments using a variety of methods, notably short selling and derivatives.
In most jurisdictions, hedge funds are open only to a limited range of professional or wealthy
investors who meet criteria set by regulators, and are accordingly exempted from many of the
regulations that govern ordinary investment funds. The net asset value of a hedge fund can run
into many billions of dollars, and the gross assets of the fund will usually be higher still due to
leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with
high-yield ratings and distressed debt.
Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the
first hedge fund in 1949. Jones believed that price movements of an individual asset could be
seen as having a component due to the overall market and a component due to the performance
of the asset itself. To neutralize the effect of overall market movement, he balanced his portfolio
by buying assets whose price he expected to be stronger than the market and selling short assets
he expected to be weaker than the market. He saw that price movements due to the overall
market would be cancelled out, because, if the overall market rose, the loss on shorted assets
would be cancelled by the additional gain on longed assets and vice-versa. Because the effect is
to 'hedge' that part of the risk due to overall market movements, this type of portfolio became
known as a hedge fund.
Estimates of industry size vary widely due to the absence of central statistics, the lack of an
agreed definition of hedge funds and the rapid growth of the industry. As a general indicator of
scale, the industry may have managed around $2.5 trillion at its peak in the summer of 2008.
The credit crunch has caused assets under management (AUM) to fall sharply through a
combination of trading losses and the withdrawal of assets from funds by investors. Recent
estimates suggest that hedge funds have more than $2 trillion in AUM. A recent survey of
hedge fund administrators indicates single manager hedge funds have over $2.5 trillion in assets
under administration ($AuA)
Largest hedge fund managers
The 25 largest hedge fund managers had $519.7 billion in assets under management as of
December 31, 2009. The largest manager is JP Morgan Chase ($53.5 billion) followed by
Bridgewater Associates ($43.6 billion), Paulson & Co. ($32 billion), Brevan Howard ($27
billion), and Soros Fund Management ($27 billion).
A hedge fund manager will typically receive both a management fee and a performance fee (also
known as an incentive fee) from the fund. A typical manager may charge fees of "2 and 20",
which refers to a management fee of 2% of the fund's net asset value each year and a
performance fee of 20% of the fund's profit.
As with other investment funds, the management fee is calculated as a percentage of the fund's
net asset value. Management fees typically range from 1% to 4% per annum, with 2% being the
standard figure.  Management fees are usually expressed as an annual percentage, but
calculated and paid monthly or quarterly.
The business models of most hedge fund managers provide for the management fee to cover the
operating costs of the manager, leaving the performance fee for employee bonuses. However, the
management fees for large funds may form a significant part of the manager's profits.
Management fees associated with hedge funds have been under much scrutiny, with several large
public pension funds, notably CalPERS, calling on managers to reduce fees.
Performance fees (or "incentive fees") are one of the defining characteristics of hedge funds. The
manager's performance fee is calculated as a percentage of the fund's profits, usually counting
both realized and unrealized profits. By motivating the manager to generate returns, performance
fees are intended to align the interests of manager and investor more closely than flat fees. In the
business models of most managers, the performance fee is largely available for staff bonuses and
so can be extremely lucrative for managers who perform well. Several publications provide
estimates of the annual earnings of top hedge fund managers. Typically, hedge funds
charge 20% of returns as a performance fee. However, the range is wide with highly regarded
managers charging higher fees. For example Steven Cohen's SAC Capital Partners charges a 35-
50% performance fee, while Jim Simons' Medallion Fund charged a 45% performance fee.
Average incentive fees have declined since the start of the financial crisis, with the decline being
more pronounced in funds of hedge funds (FOFs). Incentive fees for single manager funds fell to
19.2 percent (versus 19.34 percent in Q1 08) while FOFs fell to 6.9 percent (versus 8.05 percent
in Q1 08). The average incentive fee for funds launched in 2009 was 17.6 percent, 1.6 percent
below the broader industry average.
Performance fees have been criticized by many people, including notable investor Warren
Buffett, who believe that, by allowing managers to take a share of profit but providing no
mechanism for them to share losses, performance fees give managers an incentive to take
excessive risk rather than targeting high long-term returns. In an attempt to control this problem,
fees are usually limited by a high water mark.
High water marks
A high water mark (or "loss carryforward provision") is often applied to a performance fee
calculation. This means that the manager receives performance fees only on increases in the net
asset value (NAV) of the fund in excess of the highest net asset value it has previously achieved.
For example, if a fund were launched at a NAV per share of $100, which then rose to $120 in its
first year, a performance fee would be payable on the $20 return for each share. If the next year it
dropped to $110, no fee would be payable. If in the third year the NAV per share rose to $130, a
performance fee would be payable only on the $10 profit from $120 (the high water mark) to
$130, rather than on the full return during that year from $110 to $130.
The mechanism does not provide complete protection to investors: A manager who has lost a
significant percentage of the fund's value may close the fund and start again with a clean slate,
rather than continue working for no performance fee until the loss has been made up. This
tactic is dependent on the manager's ability to persuade investors to trust him or her with their
money in the new fund.
Some managers specify a hurdle rate, signifying that they will not charge a performance fee until
the fund's annualized performance exceeds a benchmark rate, such as T-bill yield, LIBOR or a
fixed percentage. This links performance fees to the ability of the manager to provide a higher
return than an alternative, usually lower risk, investment.
With a "soft" hurdle, a performance fee is charged on the entire annualized return if the hurdle
rate is cleared. With a "hard" hurdle, a performance fee is only charged on returns above the
hurdle rate. Before the credit crisis of 2008, demand for hedge funds tended to outstrip supply,
making hurdle rates relatively rare.
Some funds charge investors a redemption fee (or "withdrawal fee" or "surrender charge") if they
withdraw money from the fund. A redemption fee is often charged only during a specified period
of time (typically a year) following the date of investment, or only to withdrawals representing a
specified portion of an investment.
The purpose of the fee is to discourage short-term investment in the fund, thereby reducing
turnover and allowing the use of more complex, illiquid or long-term strategies. The fee may
also dissuade investors from withdrawing funds after periods of poor performance.
Unlike management and performance fees, redemption fees are usually retained by the fund and
therefore benefit the remaining investors rather than the manager.
Hedge funds employ many different trading strategies, which are classified in many different
ways. No standard system is used. A hedge fund will typically commit itself to a particular
strategy, particular investment types and leverage limits via statements in its offering
documentation, thereby giving investors some indication of the nature of the particular fund.
Each strategy can be said to be built from a number of different elements:
Style: global macro, directional, event-driven, relative value (arbitrage), managed futures
Market: equity, fixed income, commodity, currency
Instrument: long/short, futures, options, swaps
Exposure: directional, market neutral
Sector: emerging market, technology, healthcare etc.
Method: discretionary/qualitative (where the individual investments are selected by
managers), systematic/quantitative (or "quant" - where the investments are selected
according to numerical methods using a computerized system)
Diversification: multi-manager, multi-strategy, multi-fund, multi-market
The four main strategy groups are based on the investment style and have their own risk and
return characteristics. The most common label for a hedge fund is "long/short equity", meaning
that the fund takes both long and short positions in shares traded on public stock exchanges.
(Macro, Trading) Global Macro funds attempt to anticipate global macroeconomic events,
generally using all markets and instruments to generate a return.
Discretionary macro - instead of being generated by software, trading is carried out by
investment managers selecting investments.
Systematic macro - trading is carried out using mathematical models and executed by
software without any human intervention other than the initial programming of the
o Commodity Trading Advisors (CTA, Managed futures, Trading) - the fund
trades in futures (or options) in commodity markets.
o Systematic diversified - the fund trades in diversified markets.
o Systematic currency - the fund trades in currency markets.
o Trend following - the fund attempts to profit from following long-term or short-
o Non-trend following (Counter trend) - the fund attempts to profit from
anticipating reversals in such trends.
Multi-strategy - the fund uses a combination of strategies.
(Equity hedge) Hedged investments with exposure to the equity market.
Long/short equity (Equity hedge) - long equity positions hedged with short sales of
stocks or stock market index options.
Emerging markets - specialized in emerging markets, such as China, India etc.
Sector funds - expertise in niche areas such as technology, healthcare, biotechnology,
pharmaceuticals, energy, basic materials.
Fundamental growth - invest in companies with more earnings growth than the broad
Fundamental value - invest in undervalued companies.
Quantitative Directional - equity trading using quantitative techniques.
Short bias - take advantage of declining equity markets using short positions.
Multi-strategy - diversification through different styles to reduce risk.
(Special situations) Exploit pricing inefficiencies caused by anticipated specific corporate events.
Distressed securities (Distressed debt) - specialized in companies trading at discounts to
their value because of (potential) bankruptcy.
Merger arbitrage (Risk arbitrage) - exploit pricing inefficiencies between merging
Special situations - specialized in restructuring companies or companies engaged in a
Multi-strategy - diversification through different styles to reduce risk.
Credit arbitrage - specialized in corporate fixed income securities.
Regulation D - specialized in private equities.
Activist - take large positions in companies and use the ownership to be active in the
Legal Catalysts - specialized in companies involved in major lawsuits.
(Arbitrage, Market neutral) Exploit pricing inefficiencies between related assets that are
Fixed income arbitrage - exploit pricing inefficiencies between related fixed income
Equity market neutral (Equity arbitrage) - being market neutral by maintaining a close
balance between long and short positions.
Convertible arbitrage - exploit pricing inefficiencies between convertible securities and
the corresponding stocks.
Fixed income corporate - fixed income arbitrage strategy using corporate fixed income
Asset-backed securities (Fixed-Income asset-backed) - fixed income arbitrage strategy
using asset-backed securities.
Credit long / short - as long / short equity but in credit markets instead of equity
Statistical arbitrage - equity market neutral strategy using statistical models.
Volatility arbitrage - exploit the change in implied volatility instead of the change in
Yield alternatives - non-fixed income arbitrage strategies based on the yield instead of
Multi-strategy - diversification through different styles to reduce risk.
Regulatory arbitrage - the practice of taking advantage of regulatory differences
between two or more markets.
Fund of hedge funds (Multi-manager) - a hedge fund with a diversified portfolio of
numerous underlying hedge funds.
Fund of fund of hedge funds (F3, F cube) - a fund invested in other funds of hedge
Multi-strategy - a hedge fund exploiting a combination of different hedge fund strategies
to reduce market risk.
Multi-manager - a hedge fund wherein the investment is spread along separate sub-
managers investing in their own strategy.
130-30 funds - unhedged equity fund with 130% long and 30% short positions, the
market exposure is 100%.
Long-only absolute return funds - partly hedged fund excluding short selling but allow
Hedge fund risk
Despite a "hedge" being a means of reducing the risk of a bet or investment, investing in certain
types of hedge fund can be a riskier proposition than investing in a regulated fund. Many hedge
funds have some of these characteristics:
Leverage - in addition to money invested into the fund by investors, a hedge fund will
typically borrow money or trade on margin, with certain funds borrowing sums many
times greater than the initial investment. If a hedge fund has borrowed $9 for every $1
received from investors, a loss of only 10% of the value of the investments of the hedge
fund will wipe out 100% of the value of the investor's stake in the fund, once the
creditors have called in their loans. In September 1998, shortly before its collapse, Long-
Term Capital Management had $125 billion of assets on a base of $4 billion of investors'
money, a leverage of over 30 times. It also had off-balance sheet positions with a notional
value of approximately $1 trillion.
Short selling - due to the nature of short selling, the losses that can be incurred on a
losing bet are in theory limitless, unless the short position directly hedges a
corresponding long position. Ordinary funds very rarely use short selling in this way.
Appetite for risk - hedge funds are more likely than other types of funds to take on
underlying investments that carry high degrees of risk, such as high yield bonds,
distressed securities, and collateralized debt obligations based on sub-prime mortgages.
Lack of transparency - hedge funds are private entities with few public disclosure
requirements. It can therefore be difficult for an investor to assess trading strategies,
diversification of the portfolio, and other factors relevant to an investment decision.
Lack of regulation - hedge fund managers are, in some jurisdictions, not subject to as
much oversight from financial regulators as regulated funds, and therefore some may
carry undisclosed structural risks.
Short volatility - certain hedge fund strategies involve writing out of the money call or
put options. If these expire in the money the fund may take large losses.
Conflict of Interest - Inherent within the concept of paying a performance fee is the
notion that an investment advisor may construct a portfolio of higher risk than would
otherwise be taken, in hopes of increasing return and therefore performance fees.
Investors in hedge funds are, in most countries, required to be sophisticated investors who are
assumed to be aware of these risks, and willing to take these risks because of the corresponding
leverage amplifies profits as well as losses;
short selling opens up new investment opportunities;
riskier investments typically provide higher returns;
secrecy helps to prevent imitation by competitors; and
being unregulated reduces costs and allows the investment manager more freedom to
make decisions on a purely commercial basis.
One approach to diagnosing hedge fund risk is operational due diligence.
Hedge fund structure
A hedge fund is a vehicle for holding and investing the money of its investors. The fund itself
has no employees and no assets other than its investment portfolio and cash. The portfolio is
managed by the investment manager, a separate entity which is the actual business and has
As well as the investment manager, the functions of a hedge fund are delegated to a number of
other service providers. The most common service providers are:
Prime broker – prime brokerage services include lending money, acting as counterparty
to derivative contracts, lending securities for the purpose of short selling, trade execution,
clearing and settlement. Many prime brokers also provide custody services. Prime
brokers are typically parts of large investment banks.
Administrator – the administrator typically deals with the issue and redemption of
interests and shares, calculates the net asset value of the fund, and performs related back
office functions. In some funds, particularly in the U.S., some of these functions are
performed by the investment manager, a practice that gives rise to a potential conflict of
interest inherent in having the investment manager both determine the NAV and benefit
from its increase through performance fees. Outside of the U.S., regulations often require
this role to be taken by a third party.
Distributor - the distributor is responsible for marketing the fund to potential investors.
Frequently, this role is taken by the investment manager.
The legal structure of a specific hedge fund – in particular its domicile and the type of legal
entity used – is usually determined by the tax environment of the fund’s expected investors.
Regulatory considerations will also play a role. Many hedge funds are established in offshore
financial centres so that the fund can avoid paying tax on the increase in the value of its
portfolio. An investor will still pay tax on any profit it makes when it realizes its investment, and
the investment manager, usually based in a major financial centre, will pay tax on the fees that it
receives for managing the fund.
An IFSL Research report states: "Around 60% of the number of hedge funds in 2009 were
registered in offshore locations. The Cayman Islands was the most popular registration location
and accounted for 39% of the number of global hedge funds. It was followed by Delaware (US)
27%, British Virgin Islands 7% and Bermuda 5%. Around 5% of global hedge funds are
registered in the EU, primarily in Ireland and Luxembourg."
Investment manager locations
In contrast to the funds themselves, investment managers are primarily located onshore in order
to draw on the major pools of financial talent and to be close to investors. With the bulk of hedge
fund investment coming from the U.S. East coast – principally New York City and the Gold
Coast area of Connecticut – this has become the leading location for hedge fund managers. It
was estimated there were 7,000 investment managers in the United States in 2004.
London is Europe’s leading centre for hedge fund managers, with three-quarters of European
hedge fund investments, about $400 billion, at the end of 2009. Asia, and more particularly
China, is taking on a more important role as a source of funds for the global hedge fund industry.
The UK and the U.S. are leading locations for management of Asian hedge funds' assets with
around a quarter of the total each.
The legal entity
Limited partnerships are principally used for hedge funds aimed at US-based investors who pay
tax, as the investors will receive relatively favorable tax treatment in the US. The general partner
of the limited partnership is typically the investment manager (though is sometimes an offshore
corporation) and the investors are the limited partners. Offshore corporate funds are used for
non-U.S. investors, which would otherwise be subject to more complex tax issues by investing in
a tax-transparent entity such as a partnership, and U.S. entities that do not pay tax such as
pension funds, which would otherwise be subject to unrelated business income tax in the United
States. Unit trusts are sometimes used to market to Japanese investors. Other than taxation, the
type of entity used does not have a significant bearing on the nature of the fund.
Many hedge funds are structured as master-feeder funds. In such a structure, the investors will
invest into a feeder fund, which will, in turn, invest all of its assets into the master fund. The
assets of the master fund will then be managed by the investment manager in the usual way. This
allows several feeder funds (e.g. an offshore corporate fund, a U.S. limited partnership and an
entity established for a particular investor) to invest into the same master fund, allowing an
investment manager the benefit of managing the assets of a single entity while giving all
investors the best possible tax treatment. The master fund will be tax-transparent for US tax
The investment manager, which will have organized the establishment of the hedge fund, may
retain an interest in the hedge fund, either as the general partner of a limited partnership or as the
holder of “founder shares” in a corporate fund. Founder shares typically have no economic
rights, and voting rights over only a limited range of issues, such as selection of the investment
manager. The fund’s strategic decisions are taken by the board of directors of the fund, which is
independent but generally loyal to the investment manager.
Hedge funds are typically open-ended, meaning that the fund will periodically accept further
investment and allow investors to withdraw their money from the fund. For a fund structured as a
company, shares will be both issued and redeemed at the net asset value (“NAV”) per share, so
that if the value of the underlying investments has increased (and the NAV per share has
therefore also increased) then the investor will receive a larger sum on redemption than it paid on
investment. Similarly, where a fund is structured as a limited partnership the investor's account
will be allocated its proportion of any increase or decrease in the NAV of the fund, allowing an
investor to withdraw more (or less) when it withdraws its capital.
Investors do not typically trade shares or limited partnership interests among themselves and
hedge funds do not typically distribute profits to investors before redemption. This contrasts with
a closed-ended fund, which either has a limited number of shares which are traded among
investors, and which distributes its profits, or which has a limited lifespan at the end of which
capital is returned to investors.
Where a hedge fund holds assets that are hard to value reliably or are relatively illiquid (in
comparison to the redemption terms of the fund itself), the fund may employ a "side pocket". A
side pocket is a mechanism whereby the fund segregates the illiquid assets from the main
portfolio of the fund and issues investors with a new class of interests or shares which participate
only in the assets in the side pocket. Those interests/shares cannot be redeemed by the investor.
Once the fund is able to sell the side pocket assets, the fund will generally redeem the side
pocket interests/shares and pay investors the proceeds.
Side pockets are designed to address issues relating to the need to value investors' holdings in the
fund if they choose to redeem. If an investor redeems when certain assets cannot be valued or
sold, the fund cannot be confident that the calculation of his redemption proceeds would be
accurate. Moreover, his redemption proceeds could only be obtained by selling the liquid assets
of the fund. If the illiquid assets subsequently turned out to be worth less than expected, the
remaining investors would bear the full loss while the redeemed investor would have borne none.
Side pockets therefore allow a fund to ensure that all investors in the fund at the time the relevant
assets became illiquid will bear any loss on them equally and allow the fund to continue
subscriptions and redemptions in the meantime in respect of the main portfolio. A similar
problem, inverted, applies to subscriptions during the same period.
Side pockets are most commonly used by funds as an emergency measure. They were used
extensively following the collapse of Lehman Brothers in September 2008, when the market for
certain types of assets held by hedge funds collapsed, preventing the funds from selling or
obtaining a market value for the assets.
Specific types of fund may also use side pockets in the ordinary course of their business. A fund
investing in insurance products, for example, may routinely side pocket securities linked to
natural disasters following the occurrence of such a disaster. Once the damage has been assessed,
the security can again be valued with some accuracy.
Corporate hedge funds sometimes list their shares on smaller stock exchanges, such as the Irish
Stock Exchange, as this provides a low level of regulatory oversight that is required by some
investors. Shares in the listed hedge fund are not generally traded on the exchange.
A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an
investment manager. Although widely reported as a "hedge-fund IPO", the IPO of Fortress
Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it
Part of what gives hedge funds their competitive edge, and their cachet in the public imagination,
is that they straddle multiple definitions and categories; some aspects of their dealings are well-
regulated, while others are unregulated or at best quasi-regulated.
The typical public investment company in the United States is required to be registered with the
U.S. Securities and Exchange Commission (SEC). Mutual funds are the most common type of
registered investment companies. Aside from registration and reporting requirements, investment
companies are subject to strict limitations on short-selling and the use of leverage. There are
other limitations and restrictions placed on public investment company managers, including the
prohibition on charging incentive or performance fees.
Although hedge funds are investment companies, they have avoided the typical regulations for
investment companies because of exceptions in the laws. The two major exemptions are set forth
in Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940. Those exemptions are for
funds with 100 or fewer investors (a "3(c) 1 Fund") and funds where the investors are "qualified
purchasers" (a "3(c) 7 Fund"). A qualified purchaser is an individual with over US$5,000,000
in investment assets. (Some institutional investors also qualify as accredited investors or
qualified purchasers.) A 3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund
can have an unlimited number of investors. The Securities Act of 1933 disclosure requirements
apply only if the company seeks funds from the general public, and the quarterly reporting
requirements of the Securities Exchange Act of 1934 are only required if the fund has more than
499 investors. A 3(c)7 fund with more than 499 investors must register its securities with the
In order to comply with 3(c)(1) or 3(c)(7), hedge funds raise capital via private placement under
the Securities Act of 1933, and normally the shares sold do not have to be registered under
Regulation D. Although it is possible to have non-accredited investors in a hedge fund,[citation
the exemptions under the Investment Company Act, combined with the restrictions
contained in Regulation D, effectively require hedge funds to be offered solely to accredited
investors. An accredited investor is an individual person with a minimum net worth of
$1,000,000 or, alternatively, a minimum income of US$200,000 in each of the last two years and
a reasonable expectation of reaching the same income level in the current year. For banks and
corporate entities, the minimum net worth is $5,000,000 in invested assets.
There have been attempts to register hedge fund investment managers. There are numerous
issues surrounding these proposed requirements. A client who is charged an incentive fee must
be a "qualified client" under Advisers Act Rule 205-3. To be a qualified client, an individual
must have US$750,000 in assets invested with the adviser or a net worth in excess of US$1.5
million, or be one of certain high-level employees of the investment adviser.
In December 2004, the SEC issued a rule change that required most hedge fund advisers to
register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers
Act. The requirement, with minor exceptions, applied to firms managing in excess of
US$25,000,000 with over 14 investors. The SEC stated that it was adopting a "risk-based
approach" to monitoring hedge funds as part of its evolving regulatory regimen for the
burgeoning industry. The new rule was controversial, with two commissioners dissenting.
The rule change was challenged in court by a hedge fund manager, and, in June 2006, the U.S.
Court of Appeals for the District of Columbia overturned it and sent it back to the agency to be
reviewed. See Goldstein v. SEC. In response to the court decision, in 2007 the SEC adopted Rule
206(4)-8. Rule 206(4)-8, 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.
In February 2007, the President's Working Group on Financial Markets rejected further
regulation of hedge funds and said that the industry should instead follow voluntary guideline.In
November 2009 the House Financial Services Committee passed a bill that would allow states to
oversee hedge funds and other investment advisors with $100m or less in assets under
management, leaving larger investment managers up to the Securities and Exchange
Commission. Because the SEC currently regulates advisers with $25m or more under
management, the bill would shift 43% of these companies, or roughly 710, back over to state
Comparison to U.S. private equity funds
Hedge funds are similar to private equity funds in many respects. Both are lightly regulated,
private pools of capital that invest in securities and compensate their managers with a share of
the fund's profits. Most hedge funds invest in relatively liquid assets, and permit investors to
enter or leave the fund, perhaps requiring some months notice. Private equity funds invest
primarily in very illiquid assets such as early-stage companies and so investors are "locked in"
for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition
Between 2004 and February 2006, some hedge funds adopted 25-month lock-up rules expressly
to exempt themselves from the SEC's new registration requirements and cause them to fall under
the registration exemption that had been intended to exempt private equity funds.
Comparison to U.S. mutual funds
Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to
invest). However, there are many differences between the two, including:
Mutual funds are regulated by the SEC, while hedge funds are not
A hedge fund investor must be an accredited investor with certain exceptions (employees,
Mutual funds must price and be liquid on a daily basis
Some hedge funds that are based offshore report their prices to the Financial Times, but for most
there is no method of ascertaining pricing on a regular basis. In addition, mutual funds must have
a prospectus available to anyone that requests one (either electronically or via U.S. postal mail),
and must disclose their asset allocation quarterly, whereas hedge funds do not have to abide by
Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time
where the total returns are generated (net of fees) for their investors and then returned when the
term ends, through a passthrough requiring CPAs and U.S. Tax W-forms. Hedge fund investors
tolerate these policies because hedge funds are expected to generate higher total returns for their
investors versus mutual funds.
Recently, however, the mutual fund industry has created products with features that have
traditionally been found only in hedge funds.
Mutual funds that utilize some of the trading strategies noted above have appeared. Grizzly Short
Fund (GRZZX), for example, is always net short, while Arbitrage Fund (ARBFX) specializes in
merger arbitrage. Such funds are SEC regulated, but they offer hedge fund strategies and
protection for mutual fund investors.
Also, a few mutual funds have introduced performance-based fees, where the compensation to
the manager is based on the performance of the fund. However, under Section 205(b) of the
Investment Advisers Act of 1940, such compensation is limited to so-called "fulcrum fees".
Under these arrangements, fees can be performance-based so long as they increase and decrease
For example, the TFS Capital Small Cap Fund (TFSSX) used to have a management fee that
behaved, within limits and symmetrically, similarly to a hedge fund "0 and 50" fee: A 0%
management fee coupled with a 50% performance fee if the fund outperformed its benchmark
index. However, the 125 bp base fee was reduced (but not below zero) by 50% of
underperformance and increased (but not to more than 250 bp) by 50% of outperformance.
Proposed U.S. regulation
Hedge funds are exempt from regulation in the United States. Several bills have been introduced
in the 110th Congress (2007–08), however, relating to such funds. Among them are:
S. 681, a bill to restrict the use of offshore tax havens and abusive tax shelters to
inappropriately avoid Federal taxation;
H.R. 3417, which would establish a Commission on the Tax Treatment of Hedge Funds
and Private Equity to investigate imposing regulations;
S. 1402, a bill to amend the Investment Advisors Act of 1940, with respect to the
exemption to registration requirements for hedge funds; and
S. 1624, a bill to amend the Internal Revenue Code of 1986 to provide that the exception
from the treatment of publicly traded partnerships as corporations for partnerships with
passive-type income shall not apply to partnerships directly or indirectly deriving income
from providing investment adviser and related asset management services.
S. 3268, a bill to amend the Commodity Exchange Act to prevent excessive price
speculation with respect to energy commodities. The bill would give the federal regulator
of futures markets the resources to detect, prevent, and punish price manipulation and
None of the bills has received serious consideration yet.
Hedge funds managed by UK hedge fund managers are always incorporated outside the UK,
usually in an offshore location such as the Cayman Islands, and are not directly regulated by the
UK authorities. However, a hedge fund manager based in the UK is required to be authorised and
regulated by the UK's Financial Services Authority, and accordingly the UK hedge fund industry
As the UK is part of the European Union, the UK hedge fund industry will also be affected by
the EU's Directive on Alternative Investment Fund Managers.
Many offshore centers are keen to encourage the establishment of hedge funds. To do this they
offer some combination of professional services, a favorable tax environment, and business-
friendly regulation. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin
Islands, and Bermuda. The Cayman Islands have been estimated to be home to about 75% of
world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM.
Hedge funds have to file accounts and conduct their business in compliance with the
requirements of these offshore centres. Typical rules concern restrictions on the availability of
funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the
requirement for the fund to be independent of the fund manager.
Hedge fund indices
There are many indices that track the hedge fund industry, and these fall into three main
categories. In their historical order of development they are Non-investable, Investable and
In traditional equity investment, indices play a central and unambiguous role. They are widely
accepted as representative, and products such as futures and ETFs provide investable access to
them in most developed markets. However hedge funds are illiquid, heterogeneous and
ephemeral, which makes it hard to construct a satisfactory index. Non-investable indices are
representative, but, due to various biases, their quoted returns may not be available in practice.
Investable indices achieve liquidity at the expense of limited representativeness. Clone indices
seek to replicate some statistical properties of hedge funds but are not directly based on them.
None of these approaches is wholly satisfactory.
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 biases.
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 means that there are many new entrants and many
departures each year, which raises the problem of survivorship bias. 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
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, and most seriously they
may under-represent more successful managers.
Hedge fund replication
The most recent addition to the field approach 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
However, they rely on a statistical modelling process. As replication indices have a relatively
short history it is not yet possible to know how reliable this process will be in practice, although
initially indications are that much of hedge fund returns can be replicated in this manner without
the problems of illiquidity, transparency and fraud that exist in direct hedge fund investments.
Debates and controversies
Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital
Management (LTCM) in 1998, which necessitated a bailout coordinated (but not financed) by
the U.S. Federal Reserve. Critics have charged that hedge funds pose systemic risks highlighted
by the LTCM disaster. The excessive leverage (through derivatives) that can be used by hedge
funds to achieve their return is outlined as one of the main factors of the hedge funds'
contribution to systemic risk.
The ECB (European Central Bank) issued a warning in June 2006 on hedge fund risk for
financial stability and systemic risk: "... the increasingly similar positioning of individual hedge
funds within broad hedge fund investment strategies is another major risk for financial stability,
which warrants close monitoring despite the essential lack of any possible remedies. Some
believe that broad hedge fund investment strategies have also become increasingly correlated,
thereby further increasing the potential adverse effects of disorderly exits from crowded
trades." However the ECB statement has been disputed by parts of the financial industry.
The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge
funds in June 2007. The funds invested in mortgage-backed securities. The funds' financial
problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside
assistance. It was the largest fund bailout since Long Term Capital Management's collapse in
1998. The U.S. Securities and Exchange commission is investigating.
As private, lightly regulated entities, hedge funds are not obliged to disclose their activities to
third parties. This is in contrast to a regulated mutual fund (or unit trust), which will typically
have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has
direct access to the investment advisor 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 $50,000.
Some hedge funds, mainly American, do not use third parties either as the custodian of their
assets or as their administrator (who will calculate the NAV of the fund). This can lead to
conflicts of interest, and in extreme cases can assist fraud. In a recent example, Kirk Wright of
International Management Associates has been accused of mail fraud and other securities
violations which allegedly defrauded clients of close to $180 million. In December 2008,
Bernard Madoff was arrested for running a $50 billion Ponzi scheme. While Madoff did not
run a hedge fund, several hedge funds (so called feeder funds), of which the largest was Fairfield
Sentry, were overseen by Madoff and practically all their funds were funnelled to Madoff.
Alpha appears to have been becoming rarer for two related reasons. 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, though these causes are disputed.
In June 2006, prompted by a letter from Gary J. Aguirre, the 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 at Morgan Stanley. The Judiciary Committee and the U.S. 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 $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 SEC is focusing resources on investigating insider trading by hedge funds, though a
statement by SEC Enforcement Director Robert Khuzami put some of its impact in question
and Senator Chuck Grassley has asked for an explanation of Khuzami's remarks.
Performance statistics are hard to obtain because of restrictions on advertising and the lack of
centralized collection. However summaries are occasionally available in various journals.
The question of how performance should be adjusted for the amount of risk that is being taken
has led to literature that is both abundant and controversial. Traditional indicators (Sharpe,
Treynor, Jensen) work best when returns follow a symmetrical distribution. In that case, risk is
represented by the standard deviation. Unfortunately, hedge fund returns are not normally
distributed, and hedge fund return series are autocorrelated. Consequently, traditional
performance measures suffer from theoretical problems when they are applied to hedge funds,
making them even less reliable than is suggested by the shortness of the available return series.
Several innovative performance measures have been introduced in an attempt to deal with this
problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003), Omega by Keating and
Shadwick (2002), Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma
(2004), and Kappa by Kaplan and Knowles (2004). However, there is no consensus on the most
appropriate absolute performance measure, and traditional performance measures are still widely
used in the industry.
Value in mean/variance efficient portfolios
According to Modern Portfolio Theory, rational investors will seek to hold portfolios that are
mean/variance efficient (that is, portfolios offer the highest level of return per unit of risk, and
the lowest level of risk per unit of return). 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 three reasons why one might not wish to allocate a high proportion of assets
into hedge funds. These reasons are:
1. Hedge funds are highly individual and it is hard to estimate the likely returns or risks;
2. Hedge funds’ low correlation with other assets tends to dissipate during stressful market
events, making them much less useful for diversification than they may appear; and
3. Hedge fund returns are reduced considerably by the high fee structures that are typically
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 incurred no performance fees. The result from this second
optimization was an allocation of 74% to hedge funds.
The other factor reducing the attractiveness of hedge funds in a diversified portfolio is that they
tend to under-perform 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 was down 9.87%. According to the same index series, even "dedicated
short bias" funds had a return of -6.08% during September 2008. In other words, even though
low average correlations may appear to make hedge funds attractive this may not work in
turbulent period, for example around the collapse of Lehman Brothers in September 2008.
Hedge funds posted disappointing returns in 2008, but the average hedge fund return of -18.65%
(the HFRI Fund Weighted Composite Index return) was far better than the returns generated by
most assets other than cash. The S&P 500 total return was -37.00% in 2008, and that was one of
the best performing equity indices in the world. Several equity markets lost more than half their
value. Most foreign and domestic corporate debt indices also suffered in 2008, posting losses
significantly worse than the average hedge fund. Mutual funds also performed much worse than
hedge funds in 2008. According to Lipper, the average U.S. domestic equity mutual fund
decreased 37.6% in 2008. The average international equity mutual fund declined 45.8%. The
average sector mutual fund dropped 39.7%. The average China mutual fund declined 52.7% and
the average Latin America mutual fund plummeted 57.3%. Real estate, both residential and
commercial, also suffered significant drops in 2008. In summary, hedge funds outperformed
many similarly-risky investment options in 2008.
Notable hedge fund firms
Citadel Investment Group
Fortress Investment Group
Highbridge Capital Management
Long-Term Capital Management
SAC Capital Advisors
Soros Fund Management
The Children's Investment Fund Management (TCI)