Hedge funds: Articles

Hedge funds are specialised investment funds that are rarely made available to ordinary private investors, although in reality much of the growth in this industry has come from wealthy private investors.

Hedge funds regulation

Hedge funds are very lightly regulated, whether they are domiciled in an onshore location, like the US, or offshore, like the Cayman Islands, a popular home for hedge funds. Historically, this has been because they have maintained very high minimum investment levels - you would need a million dollars to invest in one. This has changed now, with minimum investment levels creeping ever downwards. Some funds can be accessed directly for US$100,000 or less.

Because they felt such funds could only be used by wealthy or sophisticated investors, regulators of the investment industry have been content to allow hedge funds more freedom to invest.

There are very few limits on what a hedge fund manager is allowed to do with his portfolio: many achieve much higher levels of risk in the assets they invest in than would be acceptable in many funds sold via retail banks or financial advisers. Obviously, the upside of this is that they are capable of superior returns, even in a bear market.

Investing in hedge funds

An easier means to access a portfolio of multiple hedge funds is either via your private bank, which should be able to buy funds 'in bulk' for many of its clients, or via a fund of hedge funds.

Funds of hedge funds are a blossoming business: they are specialist managers of hedge fund portfolios. The advantage of using these vehicles is that they do much of the hard work for you, finding those funds open for new investment, scrutinising their strategies, and investing in new managers coming onto the market. In addition, you benefit from diversification: spreading your investment across several different managers and strategies. A fund of funds can save you a lot of problems in the long run.

There is an increasing number of fund of hedge fund providers opening their doors at the moment, so investors will have many to choose from. They do not advertise their wares widely: readers are advised to contact their financial adviser or private bank for more information on these.

Fees

Hedge funds will usually charge you a 'front-end' sales fee like a mutual fund would. However, unlike mutual funds, they are more likely to put their money where their mouth is. They charge investors a 'performance' fee, based on any gains they make during the year. Typically, this will be 20% of profits. For example, a fund making 10% per annum will be taking a 2% performance fee. Fund managers may also use the added incentive of a 'high water mark.' This means that any further performance fees will only be charged against gains above and beyond any returns that have already been achieved. You only pay if the fund performs, you are not asked to pay a manager who is losing money, unlike in the mainstream fund management business.

Strategies

Hedge funds pursue a broad range of different investment strategies. The most high profile of these recently has been the long/short equity fund. These funds have the capacity to go 'short' of the market, using options to make money if a share goes down instead of up. This has enabled many of them to make decent returns in a bear market, and has helped to fuel enthusiasm for hedge funds in recent years.

There are a lot of other strategies out there at the moment. Although efforts are made to categorise them, they are as individualistic as the managers who run them.

Value funds and distressed debt funds are in the business of buying securities from companies in trouble, and close to bankruptcy. They will usually try to influence the companies they invest in by becoming a major shareholder (or creditor), in an effort to turn them around. They then sell out, usually at a massive profit, if the share price goes up again.

Market neutral funds make sure their assets do not respond to market swings. They are a good place to invest if you want to preserve capital. Commodity funds take a more proactive approach to speculating in commodity markets, and are usually managed by a commodity trading advisor (CTA).

These are really just a few of the mainstream strategies on offer. More information on the universe of different hedge fund strategies available can be found elsewhere in the Hedge Funds section.

When hedge funds go wrong

Hedge funds, when they do go wrong, can go badly wrong. Bear in mind that you are dealing with a small business when you invest directly into a hedge fund. New funds are constantly appearing and disappearing. Why? Because if a manager thinks he is not going to earn the performance fees he wants from the strategy he is pursuing, he will close the fund and pay off his clients, rather than persevere. Hedge fund managers cannot maintain loss-making funds in the way that a large mutual fund business can.

You may have read about some of the large-scale hedge fund crises that have threatened the very fabric of the global finance system over the last decade or so. This has largely been caused by banks failing to manage their lending and other commitments to hedge funds, and a lack of consultation between individual Wall Street investment banks on lending to particular managers. The US Federal Reserve and the World Bank have been tackling this in the last few years, and ultimately it has been up to them to crack down on irresponsible lending practices by investment banks.

Hedge fund managers are not as open as mutual funds about the strategies they pursue. You, as an investor, may find yourself demanding more information from your manager than he is prepared to give you. This is because managers are defensive about revealing exactly what their investment tactics are: they regard this as proprietary information which they are not happy spreading around in the investment community. As an investor, you are paying for a particular manager's individual style: if he was completely open about it, you could conceivably replicate it yourself.

The problem with the lack of transparency in the hedge fund market, is that funds can be subject to 'style drift.' This happens when a fund manager, keen as he is to earn his performance fee from you the investor, starts changing the investment strategy he originally agreed with you in an effort to keep up his numbers. This could happen, for example, in year two or three of the fund's life, when he has already levied his first performance fee and is having problems beating his 'high water mark'. Regular monitoring and discussions with your manager can help to avoid this, particularly if you are the major investor in a fund. If you are not, but suspect there is some style drift going on, it would help if you could somehow make the major investors aware of this.

Fund managers may not be particularly forthcoming about who their other clients are, so this could be difficult, but coordination by clients should bring even the most obdurate manager to heel. Ultimately, style drift need not be a bad thing, particularly if the fund manager makes you aware of it voluntarily, and you are happy with the changes being made.

Lack of transparency has been, and continues to be, a contributory factor in hedge fund fraud. There have already been several cases in the US of managers using client money to finance lavish lifestyles, and forging the performance figures for their funds to keep investors happy. Managers making hideous losses have also been tempted to do the same in the hopes that they will be able to recoup them. Frequently, the victims of such fraud are private investors, often far too trusting, and less likely to require an independent audit of a fund.

Ironically, the onshore US hedge fund market has been one of the most lightly regulated markets in this respect: fund managers have not been required to use an independent administrator to calculate their fund's value (although most institutional investors will insist on this). Even if there is a specialist fund administrator in the picture, it is still possible for the fund manager to send false data to his administrator, and recent high profile cases have exonerated fund administrators from responsibility. While an independent administrator is a bonus, there is still scope for fraud when an administrator is involved, and little scope for you, the investor, to seek restitution from one. Be vigilant.

Offshore or onshore?

This question really only applies if you are interested in an onshore US hedge fund that is not available offshore, or you are a US-domiciled investor. There are a small number of hedge funds domiciled in other onshore jurisdictions (Canada, for example), but the bulk are either registered in the US or in major offshore centres like the Cayman Islands and Switzerland.

Many US funds will register an offshore 'feeder' fund to collect investments from non-US clients in a tax-friendly manner, so if you are not a US citizen or resident in the US, you may find the fund you want maintains an offshore feeder structure. Failing that, you will have to invest in an onshore US hedge fund, which could have tax implications. Funds managed by US firms will also have stringent due diligence procedures in place to help establish your identity and the source of your funds: if you are not happy with this, restrict yourself to non-US managers. You can find out more about information security and privacy in the Security section of this site.