ALL ABOUT HEDGE FUNDS

By Ezra Zask

The McGraw-Hill Companies, Inc.

Copyright © 2013 The McGraw-Hill Education
All rights reserved.
ISBN: 978-0-07-176831-3

Contents

PrefaceAcknowledgmentsIntroduction: Major Themes and Organization of the BookPART ONE: INTRODUCTION TO HEDGE FUNDSChapter 1 What Is a Hedge Fund?Chapter 2 Regulation of Hedge FundsChapter 3 Hedge Fund OrganizationChapter 4 Hedge Fund Service ProvidersPART TWO: HEDGE FUND TOOLKITChapter 5 Short Selling and LeverageChapter 6 Derivatives: Financial Weapons of Mass DestructionPART THREE: HISTORY AND OVERVIEW OF THE HEDGE FUND INDUSTRYChapter 7 History of Hedge FundsChapter 8 Hedge Funds, Shadow Banking, and Systemic RiskChapter 9 Key Events in the Development of Hedge Funds: Long-Term Capital
Management and the Credit and Liquidity CrisisPART FOUR: HEDGE FUND PERFORMANCE: MOUNTING CRITICISM AND CHANGING
BENCHMARKSChapter 10 Mounting Criticism of Hedge Fund PerformanceChapter 11 Is Smaller Better in Hedge Funds?Chapter 12 Statistical Measures of PerformanceChapter 13 Aggregate Measures of Hedge Fund PerformanceChapter 14 Hedge Fund Returns from the Investors’ ViewpointPART FIVE: HEDGE FUND STRATEGIESChapter 15 Overview of Hedge Fund StrategiesChapter 16 Equity Hedge StrategiesChapter 17 Event-Driven StrategiesChapter 18 Relative Value StrategiesChapter 19 Global Macro and Commodity Trading Adviser StrategiesChapter 20 Hedge Fund of FundsPART SIX: HEDGE FUNDS AND INVESMENT PORTFOLIOSChapter 21 Modern Portfolio Theory and Efficient Market HypothesisChapter 22 Behavioral Critique of Efficient Market HypothesisChapter 23 Institutionalization of Hedge FundsChapter 24 Hedge Funds and Retail InvestorsPART SEVEN: MANAGING HEDGE FUND PORTFOLIOSChapter 25 Manager Selection and Due DiligenceChapter 26 Risk ManagementChapter 27 Recent Hedge Fund ControversiesConclusionAppendix A:Model Due Diligence Questionnaire for Hedge Fund InvestorsAppendix B:Overview of Major Hedge Fund Replication ProductsAppendix C:Internet Resources for Hedge Fund News and ResearchAppendix D:Government Agencies That Oversee Hedge FundsGlossaryBibliographyIndex

Excerpt

CHAPTER 1

What Is a Hedge Fund?

There is no universally accepted definition of a hedge fund, either legal orindustry-wide. The term is believed to have been coined by a journalist in the1950s to describe a private investment fund managed by Alfred Winslow Jones, whoused long and short equity positions to “hedge” the fund’s overall exposure tostock market movements. Today, hedge funds are no longer confined to one marketand very often do not “hedge” their portfolio against market movements. It ismuch more useful to describe hedge funds by a set of characteristics that mosthedge funds have in common. While some of these characteristics are also sharedby other investment firms and not every hedge fund has all the characteristics,taken together these features do represent a definable group of entities thatmost industry participants would recognize as hedge funds. These featuresinclude the following:

• Hedge funds pool assets from multiple investors in a limited partnershipstructure with a general partner and investment manager.

• They are offered to a restricted group of investors that meet regulatorycriteria as qualified investors.

• Hedge funds may not market themselves and can offer shares only on the basisof a private placement memorandum.

• They are largely exempt from the Securities and Exchange Commission (SEC)regulation governing investment companies, although this has changed to someextent with the implementation of the new Dodd-Frank legislation.

• Investors face restrictions on the redemption of their units or shares thatmay be as short as three months or as long as several years.

• Hedge funds have high investment minimums.

SEC DEFINITION OF HEDGE FUNDS

The SEC, which has gained considerable supervisory authority over hedge funds asa result of the Dodd-Frank Act, defines hedge funds as follows:

What are hedge funds?

Like mutual funds, hedge funds pool investors’ money and invest those funds infinancial instruments in an effort to make a positive return. Many hedge fundsseek to profit in all kinds of markets by pursuing leveraging and otherspeculative investment practices that may increase the risk of investment loss.Unlike mutual funds, however, hedge funds are not required to register with theSEC. Hedge funds typically issue securities in “private offerings” that are notregistered with the SEC under the Securities Act of 1933. In addition, hedgefunds are not required to make periodic reports under the Securities ExchangeAct of 1934. But hedge funds are subject to the same prohibitions against fraudas are other market participants, and their managers have the same fiduciaryduties as other investment advisers.

What are “funds of hedge funds”?

A fund of hedge funds is an investment company that invests in hedgefunds—rather than investing in individual securities. Some funds of hedgefunds register their securities with the SEC. These funds of hedge funds mustprovide investors with a prospectus and must file certain reports quarterly withthe SEC

• Hedge funds make extensive use of leverage, short selling, and derivatives.

• They are often active traders and speculators seeking to provide “absolutereturns”— i.e., positive returns in up or down markets.

HEDGE FUNDS AND MUTUAL FUNDS

Mutual funds manage approximately $12 trillion in assets compared to around $2trillion managed by hedge funds. Unlike hedge funds, mutual funds are open toall investors and have no minimum investment. As a result, they have a muchwider investor base of both individuals and institutions. As I discuss ingreater detail later in the book, mutual funds are adopting some of thestrategies of hedge funds. However, even these are distinct because of thedistinct features of mutual funds compared to hedge funds.

The SEC describes mutual funds as follows:

• A mutual fund is a company that pools money from many investors and investsthe money in stocks, bonds, short-term money-market instruments and othersecurities or assets.

Some of the traditional, distinguishing characteristics of mutual funds includethe following:

• Investors purchase mutual fund shares from the fund itself (or through abroker of the fund).

• The price that investors pay for mutual fund shares is the fund’s per sharenet asset value (NAV) plus any shareholder fees.

• Mutual fund shares are “redeemable,” meaning investors can sell their sharesback to the fund (or to a broker acting for the fund).

• Mutual funds generally create and sell new shares to accommodate newinvestors. In other words, they sell their shares on a continuous basis.

• The investment portfolios of mutual funds typically are managed by separateentities known as “investment advisers” that are registered with the SEC.

In addition to the rigorous regulation of mutual funds, a key difference withhedge funds is that mutual fund managers are constrained by their limitation onshort positions and their need to adhere to benchmarks. The limitation on shortpositions means that mutual funds will always have a greater correlation to themarkets (stocks, bonds, etc.) than hedge funds. The adherence to benchmarksplace limits on the extent to which mutual fund managers are able to activelymanage their portfolios.

While some mutual funds are identified as “actively managed,” the meaning iscompletely different than hedge funds. In broad terms, mutual funds can be”index” funds, which means that they seek to exactly track a benchmark indexsuch as the S&P 500. When a mutual fund is described as “active” the managerseeks to outperform the benchmark index by a relatively small amount.

Take an example of a mutual fund that seeks to replicate the S&P 500 index andcompare it to an “actively managed” mutual fund with the same index benchmark.Both funds’ returns will closely mirror the returns of the S&P 500. If the S&P500 index declines by 20%, the index fund will decline by the same amount andthe index fund will decline by almost the same amount (say between 19% and 21%).

This is significantly different than a hedge fund which would seek to make moneyfor investors even in the fact of a stock market decline of 20%. The extent towhich they succeed is the topic of a later chapter.

HEDGE FUND ORGANIZATION

There is a widespread mistaken notion about the exact meaning of “hedge fund.” Ahedge fund is a passive investment pool—the vehicle into which thepartners place their money. Hedge funds are established as limited partnerships(typically in Delaware) or corporation (offshore), which issue units or sharesto limited partners. A hedge fund has no employees or physical presence. Alimited partnership hedge fund vehicle is structured as follows:

• The general partner (GP) (a.k.a. sponsor) is typically the creator of thefund. The GP usually manages the fund and has broad powers along with fiduciaryresponsibilities to the other (limited) partners.

• The limited partners (LP) (a.k.a. investors) contribute capital and receivesome form of ownership or partnership interest.

What is often mistakenly taken as the hedge fund is the investment manager(a.k.a. investment adviser) hired by the hedge fund (more specifically the GP ofthe hedge fund) to actively manage this pool of money on behalf of theinvestors. The portfolio managers and decision makers are employees of theinvestment manager. However, while the investment manager is hired by the hedgefund, in practice the GP is normally the investment manager and investssubstantial amounts, often the great majority, of his or her total assets in thefund. The complex organization of a fund along with its service provider isdiagrammed in Figure 1–1.

PRIVATELY OFFERED TO A RESTRICTED GROUP OF INVESTORS

Mutual funds are “sponsored” by an organization such as Fidelity or Vanguard.Shares in mutual funds are typically offered to the general public on the basisof a prospectus by brokers, investment advisers, financial planners, banks, orinsurance companies. Mutual funds are supported by a significant amount ofmarketing and advertising. All this is in the context of compliance with therelevant investment laws and under the registration and supervision of the SEC.

Hedge funds can only be offered privately to investors who must meet certainlegal requirements as “qualified investors” and “accredited investors” based ontheir wealth, income, and sophistication, and who can bear the possibility oflarge losses. These requirements have limited hedge fund investors to high-net-worth individuals and institutions. However, there are increasing opportunitiesfor individuals who do not meet these criteria to invest in hedge fund products,or in investments that mimic some of the characteristics of hedge funds.

A private offering means that a hedge fund cannot advertise, although that willchange to an unknown extent as a result of the JOBS Act. Investment in a hedgefund is offered via a document known as a private placement memorandum (oroffering documents), which serves a similar function as the mutual funds’prospectus but which, as the name implies, is not registered with the SEC.

DODD-FRANK ACT AND HEDGE FUND REGULATION

Two overarching laws govern the investment management industry: the SecuritiesAct of 1933 and the Investment Adviser Act of 1940, along with their manyamendments. Hedge funds (along with other entities such as private equity firms)are exempt from many of the provisions of these laws. In exchange for theseexemptions, the Congress limited the ability of hedge funds to market to smallinvestors. In effect, the Congress said we will leave hedge funds largelyunregulated, but they can only cater to wealthy individuals and institutions,and only reach out to them through private channels and word of mouth.

Under the provisions of the Dodd-Frank Act, hedge funds that have more than $150million in assets under management—must register with the SEC and to fileseveral documents and provide certain information. The Dodd-Frank Act does notchange the fact that investments in hedge funds units (or shares) are notregistered under the Securities Act of 1933, which governs most publicly issuedinvestment securities.

However, it is important to point out that hedge funds have always been subjectto laws that prevent fraudulent and other illegal activities, as witnessed bythe recent spate of prominent arrests and conviction of hedge fund managers andemployees for insider trading and for running Ponzi schemes.

RESTRICTED REDEMPTION RIGHTS

By law, mutual funds must honor investor redemption requests within seven days;although in practice, redemption is made within a day or two. Shareholders in amutual fund return their shares to the fund and are paid their share of thefunds’ net asset value. Hedge fund shares or units, on the other hand, may onlybe redeemed on a periodic basis, typically either quarterly or annually,although they can be much longer. Most hedge funds also require notice beforethe redemption period. For example, hedge funds that have a three-monthrestriction on redemptions may require that investors notify the fund of theirintent to redeem shares a month before the three-month period begins. In effect,this means that investors must wait four months to see their funds. As discussedat length below, there are investment considerations that underlay theserestrictions having to do with the economic benefits of allowing hedge fundmanagers to invest with the knowledge that they will be able to deploy the fundsfor a minimum amount of time. The same considerations are behind therestrictions imposed by private equity firms, which limit customer access totheir funds for five years or more.

In addition, the GP is normally allowed to suspend redemptions for a variety ofreasons or to place some or even the entire fund in a segregated account calleda “side pocket,” where the portfolio is essentially locked up until the GPdecides to allow redemptions.

MAY USE LEVERAGE, SHORT SELLING, DERIVATIVES

A number of financial techniques and instruments are widely associated withhedge funds. In fact, hedge funds (along with investment banks) are the primaryusers of some of these instruments, especially for speculative purposes. Theindustry has had close links to the derivatives world from its earliest days,when many hedge funds were closely associated with the futures and optionsexchanges. The expertise of hedge funds with derivatives and complex financialstructures (futures, forwards, options, swaps, structured products) is nowwidespread within the industry. They are a regular feature of hedge fundsinvolved in the fixed-income markets, which are extensive users of both futuresand swaps, and the equity markets through stock index options and options onindividual securities. In more recent times, this expertise has placed hedgefunds front and center in the mortgage crisis as major users of mortgage-backedsecurities and credit default swaps.

A trademark of hedge funds is their ability to “short” markets either as shortsellers of stocks or through the use of derivatives in fixed income, currency,and commodity markets. Hedge funds’ active use of shorting has repeatedlybrought them into conflict with governments who blame hedge funds shorting fordeclines in the value of stocks and currencies. Finally, many hedge fundstrategies and fund of funds vehicles rely on credit from banks and investmentbanks to leverage or enhance their returns (and risks) using vehicles such asrepurchase agreements, credit lines, total return swaps, and the leverageinherent in many derivatives.

ACTIVE MANAGERS SEEKING TO PRODUCE ABSOLUTE RETURNS

Hedge fund managers are often described as “active managers seeking absolutereturn.” In the mutual fund industry, there are broadly two types of funds.Index funds attempt to replicate the returns of an index (e.g., the S&P 500).Active managers seek to provide returns higher than a relevant index. However,active managers typically seek small enhancements to the index and are tightlyconstrained in terms of how much they can deviate and the tools (i.e., leverage,short selling, and derivatives) they can use.

In the hedge fund arena, all managers are active in the sense that theirobjective is to deliver a positive return to investors under all economic andmarket conditions utilizing all the tools at their disposal. Hedge funds are notconstrained to beat the S&P 500, which has had declines of 40% or more. Asabsolute return managers, with the tools to short a market, their objective isto make money whether the S&P 500 declines or rises. In reality, hedge funds arejudged by some benchmarks and do not always achieve this absolute return.

SPECULATION, TRADING, INVESTMENT, AND GAMBLING

Hedge funds are often said to speculate, with the inference that they takegreater risk with their clients’ money than other investment managers. It wouldbe useful to deal with this early in the text and clear up some misconceptionsabout the related concepts of speculation, trading, and investment and gambling.

First, trading is merely the selling or buying of any security, and is thereforea part of any form of any investment strategy, including those of mutual funds.

Next, there are differences between speculation and gambling: speculation istaking a calculated risk, where the outcome can be rationally (if imperfectlyand incorrectly) analyzed. On the other hand, the outcome of gambling isentirely dependent on pure chance and totally random outcome for results. Whilehedge funds certainly gamble, they at least attempt to speculate and put muchtime and effort into analyzing the potential outcome of their trading decisions.

It is more difficult to differentiate between investment and speculation. Itwould be tempting to neatly distinguish between hedge funds (speculators) on theone hand and “responsible” investors on the other. However, even Ben Graham, thenoted financial adviser and author of the classic investment book TheIntelligent Investor, finds it difficult to separate the two. He describes theprototypical investor as “one interested chiefly in safety plus freedom frombother.” He admits, however, that “some speculation is necessary andunavoidable, for in many common-stock situations, there are substantialpossibilities of both profit and loss, and the risks therein must be assumed bysomeone.”

Finally, economic theory ascribes a significant economic and social benefit towhat is commonly thought of as speculation. By buying and selling instruments,it often provides liquidity in markets that in turn helps establish realisticprices, narrow spreads between purchase and sales, and assume risks that enablehedgers to gain certainty in their businesses. The classic example here is of afarmer who is able to plant a field with greater certainty because a”speculator” has taken the other side of a futures contract on the price ofwheat.
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