What is a Hedge Fund?

A hedge fund is an investment product like a mutual fund or a pension fund and not necessarily maintaining a hedge position. A hedge fund is an actively managed fund of a tailored investment pool which is organised by an investment advisor who sets up a company under a limited liability partnership to invest money that is privately placed by a group of not more than 499 accredited investors as the partners. Accredited investors mean individuals with net worth more than US$1 million or income more than US$200 thousand. The hedge fund manager or the investment advisor will be compensated by a large incentive normally 15%-25% of the fund’s net profit. Because of its nature, hedge funds exempt from 1940 Company Act in order to minimise public disclosures and 1933 Securities Act in order to charge asymmetric performance fees.

Seemingly, it is quite simple to set up a hedge fund on the grounds that one has excellent skills and knowledge in portfolio analysis, network relationship building and marketing. As an investment advisor or financial planner she may offer some of her wealthy clients to go to the next step in business relationship as her limited partners under a limited liability partnership. By having an excellent concept of what to hold, buy and sell in the portfolio, she may start to explore some better offers available in the market with counterparties, in the exchanges or over-the-counter, with ordinary securities or derivatives. She may build relationship with some exchanges, investment banks or other financial institutions for some chances in repurchase agreement, fund borrowing and margin facility. The most common trading strategy is by going long and/or short in the stock and/or derivatives exchanges, whether domestic and/or offshore. To avoid higher tax, she may choose some tax havens for the domicile of the funds. She may also need to test first that her managed portfolio is supreme before offering to her clients as they need some kind of proof of a sought-after investment. In practice, many hedge funds nowadays operate under the umbrella of investment banks which are investing in portfolio of hedge funds. All of the above shows some level of freedom in hedge fund transactions compared to ordinary mutual funds.

Unlike mutual funds that usually take long positions, hedge funds have more degree of freedom to take any speculative position for increasing investors’ profit and managers’ incentives from investment returns above average benchmark returns. Now is popular with the term of seeking alpha. They can go mainly long, mainly short or combination of both. A short position can be done by entering a repurchase agreement or borrowing with high leverage.

To pursue a high leverage level, hedge funds are likely to go short and bet on a decreasing price or alternatively borrow directly from major banks to upsize the volume for a bigger chance return. For private equity funds, they can borrow funds for far more percent of the equity they are willing to invest through a leveraged buyout (LBO). Creditworthiness of hedge funds could be viewed from the managers’ skill to implement a good strategy for a big return. Hedge funds are somehow able to take other financial players as counterparts.

The nature of short position, high leverage and high incentives are similar to those in the first hedge fund set up by Alfred Winslow Jones in 1949. His strategy was a market neutral or hedge strategy by buying undervalued shares with an offset position of short selling overvalued shares. Since his long and short positions were applied to different shares, it was a leverage strategy as he possibly expected a profitable divergent movement of such shares.

A hedge fund is structured as a heterogeneous asset class by employing different approaches, strategies and instruments to explore opportunities to generate abnormal returns. Some hedge funds trade in shares and some do not trade at all but more focus on emerging market debt, fixed income and derivatives. Latter development shows that some hedge funds play in credit derivatives market offsetting positions with fixed income trading and through interest rate swaps.

Classification of hedge funds according to TASS, as follows: convertible arbitrage (between a convertible bond and equity), dedicated short, emerging market funds, equity market neutral (maintaining close balance), event driven (responding corporate event, e.g. merger, LBO), fixed income arbitrage (long/short related bonds), macro (directional movement in financial market and macro economic indicators), long/short equity (with a long bias), managed futures and others (risk arbitrage, statistical arbitrage, derivative arbitrage, distressed securities, fund of hedge funds). In 2004, the largest percentage of asset under management is long/short equity 32% followed by event drive 19%. There is a slight decline from the previous year in macro strategy from 11% to 10% and an increase in others from 8.5% to 10.1%.

Hedge fund industry has been growing rapidly along with investors’ desire to enjoy excess returns or alpha. The spirit of seeking alpha becomes the main goal of hedge fund strategy. Assets under management of the hedge fund industry grew from US$456 with number of funds from 3,102 in 1999 to US$973 with 5,782 number of funds in 2004 according HFR database and it is estimated to be more than US$2 trillion at the end of 2006, 30 percent more than a year earlier . The average annual return from 1994 to 2004 for live hedge funds is 14.4% for TASS, 14.3% for HFR and 15.5% for CISDM. TASS, HFR (Hedge Fund Research) and CISDM (Centre for International Securities and Derivatives Markets) are three commercial databases for hedge fund research.

However, despite the prospect in generating excess returns hedge funds also experience some failures. This is due to the speculative risk in taking such positions that can offer big returns therefore also big risks. The survivorship bias return in the table-1 shows the average lost return deduction after some collapsed hedge funds. Some failures in the hedge fund businesses gathered from different news sources in the internet are as follows:

• Long-Term Capital Management in 1999 lost US$2.3 billion in equity value after its bet on narrowing credit spread after the Asian crisis being hit by Russian default.
• Tiger Management in 2000 failed to return US$6 billion in investors’ assets after its strategy to go short of overpriced technology stock being hit by the bull market in technology.
• Aman Capital in June 2005 lost more than US$100 million from its leveraged credit derivatives strategy.
• Marin Capital in June 2005 closed its funds valued at US$1.7 billion after its bet on the outlook for General Motors by buying its bonds, shorting its stock, and with $500m long equity position and $1bn short mezzanine position, being hit by GM junk bonds rate.
• Bailey Coates Cromwell Fund in June 2005 dissolved and lost 20% of US$1.3 billion asset due to wrong bets on the movement of US stocks.
• Amaranth Advisors in September 2006 lost the total of US$6 billion in two weeks after its bet on an appreciation natural-gas futures post Katrina Hurricane 2005 being hit by the depreciation of the futures.