Hedge Funds Defined
What Happened to the Original Concept of Playing Against the Market?
Considering the role that hedge funds have played in the current subprime mess in the U.S., it would seem prudent to first learn what they are.
Hedge funds arrived on the markets with a bang in the early 1990s. Regardless of the enormous losses that this asset class had suffered in 1994, the industry managed to keep its allure. To illustrate, in 1988 there were 1,373 hedge funds. By the end of 2001, the industry grew to approximately 7,000 hedge funds.
In terms of assets under management, the dollar size of the industry grew from $42.0 billion in 1988, to $311.0 billion in 1998, to over $600.0 billion in 2001. Today, the global hedge fund industry is estimated at $2.0 trillion and with approximately 10,000 active hedge funds. (Source: The Hedge Fund Association).
Objectives and Characteristics
Originally, hedge funds offered investors opportunities to play against the markets. Strategies used varied from short selling, to trading futures, to trading other types of forward commitments and contingent claims. Today, however, hedge funds are anything but a homogeneous class pursuing some goal common to all.
As the subprime lending crisis unraveled, it became apparent that a number of hedge funds were highly leveraged. Of course, not all of them were or are, and the ability to use leverage is not the only characteristic unique to hedge funds. There are also funds that bet on commodity prices, on currencies, interest rates and other financial derivatives. And there are hedge funds that focus on exploiting violations of the law of one price. But the common denominator to all appears to be searching for absolute returns.
Most money managers today labor under intense public scrutiny and pressure to beat some benchmark, usually a broader market index. In contrast, hedge funds are not “tied down” by a specific mandate, but rather they are “free” to search for absolute returns every which way. That being the case, the only “deities” hedge fund managers bow to are alphas and betas.
Investors should be aware that since hedge funds’ profit extracting strategies are also extremely high risk activities, it is hardly surprising that hedge fund managers demand serious compensation for their efforts and why hedge funds have very high fee structures.
Structure
Hedge funds in the U.S. can be set up in one of two ways:
- limited partnerships; and,
- offshore corporations.
In essence, both legal structures permit hedge fund managers to go long or short on a security, to employ any type of a derivative they like, and to borrow more or less without adhering to the usual regulatory minimum capital restrictions.
Most hedge funds in the U.S. are structured as limited partnerships. Such structure allows them to be exempt from certain Securities and Exchange Commission (SEC) regulations under the Investment Company Act, especially if incorporated in the state of Delaware, the so-called “fund-friendly” state.
Note that some rules still apply, such as, generally, having no more than a hundred accredited investors (individuals with a net worth of more than $1.0 million or annual income of more than $200,000). Hedge funds are also not allowed to advertise themselves to the general investing public.
Offshore hedge funds have also been popular among North American investors. Incorporated in places such as the Cayman Islands or Bermuda, due to a number of legal and fiscal exemptions, offshore hedge funds appeal to a wide spectrum of investors worldwide, from ordinary people, to tax-free pension funds, to Japanese investors hedging their profits in yen, etc. In most cases, offshore hedge funds are merely a stopover on the paper trail that goes to a “parent fund,” usually a limited partnership incorporated in the Cayman Islands.
Types of Hedge Funds
Hedge funds are not as easy to classify as one might think. As their popularity grew, numerous types and sub-types of hedge funds emerged, catering to a truly diversified global client base.
- Long/short funds—a traditional type that balances long and short positions depending on market forecasts;
- Market-neutral funds—a form of long/short funds whereby long and short positions are both dollar and market-neutral; note that other market-neutral strategies include fixed income hedging, pairs trading, various types of arbitrage, etc.
- Global macro funds—these funds bet against some macroeconomic variable, such as a currency, interest rates, direction of a market, etc.; in addition, global macro funds are often highly leveraged and their performance depends on extensive use of derivative instruments;
- Event-driven funds—these funds bet on certain developments to take place, usually with a company or a security; the idea is to earn profits as prices move from imbalance to new equilibrium.
With some basic definitions out of the way, the next discussion concerns the issue of leverage and exposure to various risks that are unique to hedge funds.
Source: International Investments, Fifth Edition, by Bruno Solnik and Dennis McLeavey, Copyright 2004.
