Hedge FundInvestment & Trading

Hedge Fund Course

Hedge Fund Course

In this free Hedge Fund Course

 

Chapter 1—Introduction

The first chapter provides a primer on the hedge fund industry. It explains how a hedge fund differs from other investment products, the growth of the industry, and basic vocabulary and operation of hedge funds.

 

Chapter 2—Types of Hedge Funds

Most of the thousands of hedge funds resemble one of a handful of strategies. This chapter describes the most popular strategies that comprise most of the hedge fund assets under management.

 

Chapter 3—Types of Hedge Fund Investors

Although individuals began investing in hedge funds before most types of institutional investors, today nearly all types of investors invest in hedge funds. The needs and wants of individual investors differ greatly from those of pension funds and endowments. This chapter describes the most important groups of hedge fund investors.

 

Chapter 4—Hedge Fund Investment Techniques

Certain investment techniques have been developed in broker-dealers or private equity funds and fit well into hedge funds. This chapter describes investment techniques outside the domain of the traditional portfolio man- ager.

 

Chapter 5—Hedge Fund Business Models

Hedge funds and hedge fund managers are organized as corporations, partnerships, and limited liability corporations to get maximum tax advantages and limited liability for investors. Offshore funds combine several structures to comply with U.S. and offshore regulations.

 

Chapter 6—Hedge Fund Leverage

This chapter describes the many techniques used by hedge funds that allow a hedge fund to carry positions larger than the hedge fund capital. The chapter also describes how hedge funds can create short positions to implement trading strategies and control risk.

 

Chapter 7—Performance Measurement

Hedge fund investors closely monitor hedge fund performance. Investors have developed a collection of tools to measure performance and risk. Hedge funds share some of these tools with traditional asset managers, but they also have methods designed for leveraged portfolios.

 

Chapter 8—Hedge Fund Legislation and Regulation

Anyone who thinks a hedge fund is not affected by rules and regulations hasn’t read a risk disclosure document. Although most securities laws con- tain exemptions that allow hedge funds to escape some of the burdens of regulation, the exemptions create complications as well.

 

Chapter 9—Accounting

This chapter describes the accounting requirements unique to hedge funds. Hedge funds pose all the challenges typical of portfolio accounting. Hedge funds create additional challenges because they carry short positions, may finance their long positions, and may turn over their positions rapidly.

 

Chapter 10—Hedge Fund Taxation

Tax reporting is one of the most complicated topics affecting hedge fund investors. Taxes have a powerful impact on the after-tax return of investors yet tax reporting is one of the least-discussed topics affecting hedge fund investors.

 

Chapter 11—Risk Management and Hedge Funds

Risk management is more than risk measurement, but measurement is the first step. Some hedge funds take more risks than traditional portfolio managers and hedge funds almost always take different risks than traditional portfolio managers. Risk measurements provide managers, investors, and creditors with valuable insights into the nature of hedge fund positions.

 

Chapter 12—Marketing Hedge Funds

Regulations define how hedge fund managers can market their funds. A specialized industry has evolved to help managers raise money.

 

Chapter 13—Derivatives and Hedge Funds

One of the latest developments in hedge fund investing involves investing indirectly into hedge funds through derivative products. These new structures offer several potential advantages over direct hedge fund investing.

 

Chapter 14—Conclusions

This chapter provides a review of the state of the hedge fund industry and provides insight into the future of the hedge fund marketplace.

 

Preface

Business bookstores contain many different books on the general topic of hedge funds. Most of these books are written for potential investors. These books focus primarily on the investment characteristics of hedge funds, admittedly the most important topic related to this investment alter- native. Some of these texts are little more than marketing devices designed to encourage greater use of hedge funds in investor portfolios. An investor considering an investment in a hedge fund for the first time should read one or two of these books before making an investment.

To reach a large market, these investment books are mostly written at a very simple level. They generally do not presume any prior knowledge of investments, finance, mathematical methods, accounting, or the law. The authors develop a survey that usually leaves the reader less than an expert after reading the text. After getting a general background, the investor will likely need to hire some combination of investment professionals, tax advisers, accountants, and lawyers before making an investment.

A small number of books have been written for professionals. Usually, these books are not sold commercially. Instead, they are distributed by law firms and accountants to their customers, and most readers cannot get copies of them. Even if available, these books, while they are extremely valuable to professionals, should provide little value to most readers be- cause of the highly technical treatment of narrow topics.

The academic research on hedge funds is accumulating. The ambitious student can read a survey of the important papers concerning hedge funds and develop a good understanding of this important investment product. But few people have the time or background to learn about hedge funds from academic papers.

Some books have been written for the entrepreneur who wants to start a hedge fund. I wrote one of these for John Wiley & Sons a couple of years ago and have discovered that there is considerable demand for a book that bridges the gap between the nontechnical texts written for mass appeal and the technical books and academic papers. Although the previous book was a bit more technical than most others on the market, it also included information needed by hedge fund venture capitalists.

This book serves to bridge another gap. It provides an extensive survey of the hedge fund management business. The course book format is written at a more technical level than most books. Although no specific prior knowledge of statistics, accounting, or finance is required, the reader will find that a background in these fields will be helpful.

This book is written for students in a classroom or students in their own self-study program. It could be the basis for a class in a graduate busi- ness school or the curriculum of training programs created for new employees in banks and brokerage firms. This book is also perfect for someone who works for a hedge fund or hopes to get a job with a hedge fund and needs to learn the essential facts about this important industry. Finally, lawyers and accountants who serve the hedge fund industry can learn about the business of their hedge fund customers.

The course book format is designed to let readers quickly learn as much or as little as they require. Readers can read chapters in any order and may skip chapters or parts of chapters. Short chapters describe the essential facts on a particular topic. Questions follow each chapter, and answers are at the back of the book.

The questions are not designed to test the reader’s understanding of the reading. Instead, the questions and answers delve more deeply into the topics reviewed in the text. The question sections contain most of the quantitative material of the book, so readers comfortable with the mathematics should be careful not to skip this valu- able bonus material.

 

CHAPTER 1 Introduction

 

The first known hedge fund was created by Alfred Winslow Jones in 1949. His fund should look familiar to today’s hedge fund participants. The fund was organized as a limited partnership and used private placement rules to avoid registration. It invested primarily in common stocks and used moderate leverage to carry long and short positions modestly larger than the fund capital.

The number of hedge funds has grown significantly, and there are many different types of hedge funds. But this first hedge fund bears a close resemblance to the most common hedge fund strategy today, called long/short equity.

 

DEFINITION OF HEDGE FUND

Definitions of hedge funds run into problems because it is exceedingly difficult to describe what a hedge fund is without running into trouble with funds that don’t fit into the rules. There are investment pools that closely resemble hedge funds but are generally regarded as a different type of in- vestment. Still other types of investments may contain characteristics that are generally associated with hedge funds.

As a starting point, begin with a rather typical definition of a hedge fund:

A hedge fund is a loosely regulated investment company that charges incentive fees and usually seeks to generate returns that are not highly correlated to returns on stocks and bonds.

Many traits of hedge funds aren’t useful in defining what is and what is not a hedge fund.

 

Regulation and Hedge Funds

Chapter 8 describes the laws and regulations that control hedge funds. While hedge funds are not unregulated, as is sometimes asserted, they are more loosely regulated than mutual funds and common trusts run by bank trust departments. Other types of investments are also loosely regulated, though, including private equity partnerships, venture capital funds, and many real estate partnerships.

Investors may feel they will “know it (a hedge fund) when they see it,” but there are no firm lines separating hedge funds from these other types of investments. Hedge funds may invest part of their assets in private equity, venture capital, or real estate.

To further blur the distinction between hedge funds and regulated in- vestment companies, there is increasing pressure from the Securities and Exchange Commission (SEC), bank regulators, auditors, and exchanges for hedge funds to disclose more information and to control permitted activities. Hedge funds may soon be required to disclose much of the in- formation that mutual fund companies must report. The SEC has pro- posed to require all hedge fund management companies to register as investment advisers.

 

Limited Liability

Sometimes, the definition of hedge funds mentions that hedge funds are a vehicle where investors have no liability for losses beyond their initial in- vestment. It certainly is true that most hedge funds in the United States are organized as limited partnerships or limited liability corporations (see Chapter 5) that protect the investor from liability. However, offshore funds are usually organized as corporations and, despite this difference, also create a limited liability investment.

Most other investments are also limited liability investments. Investors can lose no more than 100 percent of the value of long positions in stocks and bonds. Mutual funds also protect the investor from losses in excess of the amount of money invested. While accurate for hedge funds, the characteristic of limited liability does little to define hedge funds.

 

Flow-Through Tax Treatment

Hedge funds are not taxed like corporations. Instead, all the income, ex- penses, gains, and losses are passed through to investors. This feature does not define hedge funds because many other investment types are flow- through tax entities. Real estate investment trusts (REITs), mutual funds, venture capital funds, and other private equity funds are regularly constructed to receive flow-through tax treatment.

Hedge funds organized outside the United States are frequently organized in locations that have little or no business tax. In these locations, hedge funds are not organized to get flow-through tax treatment. Instead, these funds are organized as corporations that do not require investors to include the annual hedge fund income and expenses on investor tax returns.

 

Hedge Funds and Their Use of Leverage

Many hedge funds use leverage to carry long and short positions in excess of their capital. Not all hedge funds use leverage, and many hedge funds use leverage of two times or less (see Chapter 6).

Other types of investments also use leverage to carry assets in excess of capital. Some mutual funds use leverage. Leverage is common in real estate investments. Private equity funds may borrow money to limit the equity needed to carry investments.

 

Hedge Funds Charge Incentive Fees

Hedge funds charge a variety of fees, including a substantial management fee and an incentive fee. The management fees are similar to management fees at mutual funds, private equity funds, and real estate funds. Incentive fees are also typical in private equity funds, real estate funds, and (to a limited extent) mutual funds.

 

Hedge Funds and Lockup Commitments

Many hedge funds require investors to leave funds invested for a year or more. This lockup provision is not typical of mutual funds, but the load fees strongly encourage investors in mutual funds to hold their investments for several years. Private equity funds frequently have lockup provisions. Venture capital funds in particular may grant the investor no opportunity to exit before assets are liquidated. Real estate funds may have similar restrictions.

 

CONTRASTING MUTUAL FUNDS WITH HEDGE FUNDS

One definition of a hedge fund is that it is a mutual fund that doesn’t have to follow any rules. This overly simple distinction may help the uninitiated get a rough idea of what a hedge fund can do. Of course, there are lots of rules that a hedge fund must observe, and hedge funds are organized differently from mutual funds.

The distinction loses mean- ing as mutual funds have been given broader investment rules over time. Recently, U.S. regulators have been pressing to tighten the regulation of hedge funds. Nevertheless, there are some consistent differences between mutual funds and hedge funds.

 

Fees

Most mutual funds charge a management fee but not incentive fees. Mutual funds may charge management fees from less than 0.25 percent up to several percent of assets under management. Hedge funds also charge management fees, usually between 1 percent and 2 percent of assets. Mutual funds usually charge no incentive fee, but hedge funds charge incentive fees of 20 percent of profit or more.

While mutual funds may be sold with no sales charge (called no-load mutual funds), many are sold with commis- sions of 5 percent of assets or more. Mutual funds may also assess other sales charges called 12b-1 fees. In contrast, hedge funds generally don’t charge sales commissions.

 

Leverage

A small number of mutual funds borrow to carry long positions in excess of capital or to carry short positions. One mutual fund, Northeast Investors Trust, bought corporate bonds as long as 30 years ago using borrowed funds to increase the return on the fund. Most mutual funds use debt only to provide short-term liquidity to accommodate withdrawals. Mutual funds also use derivative instruments in lieu of investing in cash securities, not to create leverage.

In contrast, a survey conducted by Van Hedge Fund Advisors International, LLC in 1997 reported that 70 percent of hedge funds used leverage. During the time of the study, some fixed income hedge funds ran positions 70 times their capital or higher.

 

Transparency

Mutual funds publish quarterly income statements and balance sheets at least quarterly. The balance sheets aggregate assets so that investors cannot see details of individual positions. Nevertheless, mutual funds publish detailed portfolios annually, albeit with substantial delays.

Hedge funds have typically refused to disclose positions or trade de-tails to the public. Some funds would disclose this information to a small number of important investors. More recently, funds of funds investors have often demanded to know position details. A survey by Deutsche Bank found that one-third of investors demanded transparency and information about risk. Only 3 percent of investors would invest in funds that refused to provide any position information to investors.

 

Liquidity

Mutual fund investors generally may redeem shares at any time, not subject to restrictions on exit under normal market conditions. In some cases, fees encourage investors to remain invested for several years, but investors may otherwise exit without restrictions. Mutual funds generally accept or redeem investments on the same day or next day. In contrast, hedge funds allow entry or exit only at certain times of the year, monthly, quarterly, or annually. In addition, hedge funds may restrict redemptions for a year or more.

CONTRASTING PRIVATE EQUITY FUNDS WITH HEDGE FUNDS

Private equity funds include leveraged buyout funds, venture capital funds, mezzanine financing funds, and other portfolios of direct investment in private corporations.

 

Legal Structures

Private equity funds entities are organized as limited partnerships or limited liability corporations if located in the United States or as corporations in tax-favored offshore locations. Private equity funds use the same exemptions that hedge funds use to escape many of the regulations that affect regulated investment companies.

 

Fee Structures

Private equity funds generally charge both an incentive and a management fee much like the fees charged by hedge funds. Unlike hedge funds, though, many private equity funds charge no incentive fees until individual investments are liquidated because there is no verifiable way to mark the assets to market prior to sale. Upon sale, the investment and gain are returned to investors less an incentive fee on profits. Occasionally, hedge funds will carve out portions of their assets and treat them similarly to private equity investments. These assets are called side-pocket allocations.

 

Leverage and Private Equity Investments

Like hedge funds, private equity funds can borrow money to buy assets in excess of their capital. Leveraged buyout funds and venture capital funds may carry the debt on the balance sheet of the companies they own. Leverage in private equity is lower than the leverage in the most leveraged hedge funds.

 

Private Equity and Absolute Returns

Many hedge funds seek returns that are relatively uncorrelated to stock and bond returns. They don’t try to keep up with the stock market when returns are very high on stocks. Likewise, they seek to avoid losing money in periods when stock returns are negative. These hedge funds are seeking absolute returns, to contrast the traditional portfolio manager that bench- marks return relative to a market index.

Most private equity strategies are not absolute return strategies. Venture capital returns, for example, are highly correlated with Nasdaq returns because the venture capital funds and the Nasdaq share a con- centration of investment in technology companies.

 

Private Equity and Liquidity

Private equity funds generally offer little or no liquidity to investors. As mentioned earlier, venture capital funds generally don’t charge incentive fees un- til assets are liquidated because it is difficult to defend mark-to-market valuations of their assets.

For the same reason, venture capital funds generally don’t redeem their investments until assets are liquidated to avoid having to defend a mark-to-market net asset value. As a practical matter, the venture capital fund may not have cash available to redeem investments and no means to readily generate cash because it carries assets with limited marketability.

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