AN INTRODUCTION TO HEDGE FUNDS

A project prepared at Franklin College Switzerland by Alice Gaston, Andrea Borletti, Annabelle Stewart,
Branislav Obradovic, Claudia Lasprilla, Danny Che, Frank Swigonski, Jennifer Ryerson, Jordan Moon,
Juan Felipe Bustamante, Kirsten Abeln, Liva Stokenberga, Marina Louie, and Zachary Mees (2007).

1) Hedge Fund Configurations, Strategies, and Performance

What are hedge funds?

Hedge funds are private investment funds used primarily by wealthy individuals and
institutions to accomplish aggressive investing goals. No specific model defines a
hedge fund since each uses a unique investment style with differing fees, investment
sizes, and leverage options. They are exempt from many of the rules and regulations
governing mutual funds, pension funds, and insurance companies and, in the United
States, they are open to accredited investors only. Restricted by law to no more than
100 investors per fund, many hedge funds set high minimum investment amounts,
ranging from $250,000 to over $1 million. Like traditional mutual funds, investors in a
hedge fund pay a management fee that can vary between 1 and 2 percent, and hedge
funds also collect a percentage of the profits, usually 20 percent.

Alfred Winslow Jones is credited with creating the first hedge fund when he combined
a leveraged long stock position with a portfolio of short stock positions. Investors in
Jones' relatively unknown fund enjoyed large returns and outperformed all other
mutual funds of that era. This style of investment management exploded in popularity
in the late twentieth century with the arrival of derivatives. Today, investors have
access to a broad array of funds with numerous investment styles across the globe.

What are the different strategies a hedge fund uses to invest their money?

There are numerous investment strategies a hedge fund may use to attract and to grow
capital, with the ultimate goal of superior returns through their specific approach.
Examples of investment strategies are:

Equity Market Neutral: The classic strategy of hedge funds. This approach minimizes
inherent securities market risks by combining an array of long and short sales within
the same industry, market, country, etc. that offset one another against the market. In
essence, this creates a hedge against market factors. These funds have many spin-off
strategies such as: convertible arbitrage, fixed income arbitrage, and even risk arbitrage.

Convertible Arbitrage: An investing strategy that involves purchasing a portfolio of

convertible securities, generally convertible bonds, and hedging a portion of the equity
risk by selling short the underlying common stock. In theory, when a stock declines, the
associated convertible bond will decline less, because it is protected by its value as a
fixed-income instrument and it pays interest periodically. This strategy attempts to
exploit profitable opportunity when there is a pricing error made in the conversion
factor of the convertible security. Most managers employ some degree of leverage. The
equity to convertible hedge ratio may range from 30 to 100 percent.

Fixed-Income arbitrage: When using a fixed-income arbitrage strategy, the investor

assumes opposing positions in the market to take advantage of small
price discrepancies while limiting interest rate risk. A manager may utilize leverage to
buy bonds and sometimes fixed income derivatives in order to profit from principal
appreciation and interest income. The most common fixed-income arbitrage strategy is
swap-spread arbitrage. This consists of taking opposing long and short positions in a
swap and a Treasury bond. The primary focus of fixed-income arbitrage is the bond
yield or the interest income and not the capital gains.

Managed Futures: A trend following fund that allocates assets among different
investments depending on the manager's view of the economic or market outlook. By
following general market trends, the hedge fund generates a return profile similar to
that of a call option on the market. Portfolio emphasis may swing widely between asset
classes. Managers profit from large up and down movements using both long and
short positions, resulting in returns similar to that of a straddle. A straddle is composed
of buying a put and call option on the same investment (stock, bond, interest rate, or
index), therefore the gain is directly related to the volatility of the investment. The
more investments fluctuates, the higher the return and vice versa. If its value remains
stable, then the returns on the investment are small if any.

Dedicated Shorts: Sells securities short in anticipation of being able to re-buy them at a
future date at a lower price. Managers asses investment options based on his or her
opinion of the overvaluation of securities, the market, or in anticipation of earnings
disappointments often due to accounting irregularities, new competition, change of
management, etc. Often used as a hedge to offset long-only portfolios and by those
who feel the market is approaching a bearish cycle.

Global Macro: Macro strategies do not focus on individual companies but rather focus
primarily on profiting from shifts in global trends. A fund may be long or short in
various international stock indexes and currencies, and at the same time attempting to
take advantage of assets that are miss-priced relative to global alternatives. This
strategy was made famous by George Soros in 1992. A sub-category of global macro is
the emerging market strategy whereby a hedge fund invests in developing countries
with less mature financial markets, usually in equities.

Event Driven: Also known as “Special Situation” or “Special Opportunity”

strategies. Hedge funds that use an event driven strategy generally invest in companies
that are expecting a large impact on the price of the stock over a short period of time.
These hedge funds try to capitalize on the changing prices of stocks caused by events

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such as corporate restructuring, stock buybacks, bond upgrades, expected earnings
surprises, and any other reason a company's stock price may change, hence the term
“event driven.” There are sub-styles to an event driven hedge fund such as “distressed
securities” and “Risk (Merger) Arbitrage.” In distressed securities, a hedge fund would
wait for an impending reorganization or bankruptcy of a company. In Risk (Merger)
Arbitrage the hedge fund simultaneously buys a company that is being acquired and
sells the short the stock of the acquirer.

Do hedge funds show lasting superior performance?

Depending on how one analyzes the data, hedge funds may or may not show lasting
performance. For instance, a recent study concluded that the survivorship bias might
distort performance analysis since only a partial sampling of funds is analyzed. Newer
funds, as well, can claim superior performance based on the ‘instant history bias.’
Generally speaking, funds have an incubation period whereby their managers can
choose when to report the performance of the fund. Since most will choose to report
their performance only after satisfactory results have been obtained, this can create a
positive bias in favor of the hedge funds.

Other studies conclude that hedge funds offer superior performance by hedge fund
managers. It can be difficult, however, to identify successful managers. Additionally,
studies have demonstrated that a manager’s performance-edge lasts only three years,
implying that superior performance of the fund may be limited to three years as well.
Furthermore, the theory of active portfolio management suggests that the erosion
experienced over time during the superior performance of the funds results due to the
combination of two elements: the diminishing returns to scale and the inflow of new
capital. Hedge funds, then, may or may not offer lasting superior performance.

How is the fee structure constructed?

The fee structure refers to the payment managers receive. This fee can vary up to 2 %
annually of the total funds under management, up to 40% of the fund’s profits, and
reimbursement of all expenses of the fund including all legal, marketing, accounting,
and auditing costs.

How does the risk/reward profile for hedge funds differ from the traditional
investments?

In evaluating the risk / reward profile, one must remember that opinions differ on the
risks associated with hedge funds. The risk associated with traditional investment is
directly related to the financial markets while the risk associated with hedge funds is
more complex. Since hedge funds are largely unregulated investments, there is a
certain degree of business risk on the part of the manager which can be nearly but not

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completely eliminated by proper research. A second perception related to hedge funds
is that they are not correlated to traditional assets that diminishes their risk and allows
for the diversifying of traditional portfolios.

Risk assessments are conducted by the hedge fund managers in order to evaluate the
overall risk of the hedge fund. In this way, investors learn how much capital is at risk,
where losses might arise, and what the expected returns are. More transparency in the
fund allows investors to make better decisions about what risks to take and where to
allocate their resources. All hedge fund managers have three elements in common.
First, they are all stockholders who are concentrated on satisfying their client’s needs.
Second, they have a well-defined philosophy for investing. Finally, managers must
know how to respond dynamically to market conditions using the correct rules,
principles, and guidelines.

2) Hedge Fund Activism and Corporate Governance

What is hedge fund activism?

Hedge fund activism is considered a strategy whereby a fund purchases a five percent
or greater stake in a publicly-traded firm with the stated intent of influencing the firm’s
policies in the hope of benefiting from an increase in the firms share prices. Unlike
mutual funds, hedge funds are largely unregulated, allowing them to engage in more
activist policies than other investment strategies. With the growing number of hedge
funds and decreasing industry returns, hedge fund activism has flourished, sparking a
debate about the role hedge funds play in the corporate governance of firms.

What impact does hedge fund activism have on the corporate governance of firms?

Hedge funds may attempt to alter the corporate governance of the targeted firm in
numerous ways depending on their specific ends. For instance, they may seek to gain
representation on the firm’s board in order to alter its strategic operations.
Alternatively, funds may desire share repurchases by the firm or prevent on ongoing
merger by a third party to safeguard their own investments. Finally, hedge funds may
force a takeover of the targeted firm, sometimes by the fund itself.

While hedge funds may engage in activist policies, it is not necessarily to improve the
performance of the firm. In some cases, after gaining control of the firm’s agenda, the
hedge fund may increase the debt load of firms. As a self-interested entity, the fund
and its managers may push the firm beyond its optimal size in order to achieve their
own objectives. Furthermore, hedge funds might pursue policies against a firm’s
management. Generally speaking, however, hedge funds do not seek to acquire total
control of the firm but instead usually takes a minority position in the firm to lobby for
specific changes in governance.

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3) Hedge Fund Risks
Are systemic risks inherent in hedge funds?

Moral Hazard: The moral hazards accompanied with hedge fund investment managers
involve taking larger than average risks in order to generate larger profits. Many
believe that the inclination to take these risks is furthered by the use of high-water-mark
contracts that only pay the performance fee to the managers if he or she has succeeded
in exceeding the previously achieved maximum share value. The intention of the high-
water-mark contract is supposed to link the manager's interests more closely to those of
investors and to reduce the incentive for managers to seek volatile trades, but it can
generate the opposite effect as well.

Market Abuse: Since hedge funds remain largely unregulated, the possibility for system
exploitation is high. The architectural organization of the financial system is designed
in a hub-and-spoke with a few critical and central nodes. This allows for the few banks
that make up the center nodes to take advantage of their position, creating the illusion
that they are too big to fail. Regulating such entities is difficult since market authorities
like the Securities and Exchange Commission (SEC) are national entities while most
hedge fund corporations are multinational, resulting in the failure of authorities to keep
an extended influence on the corporations.

Principle-Agent Problem: The fee structure of hedge funds is said to favor heavily the
managers since it does not matter if the fund loses or gains the manager will still earn a
return, potentially creating a principal-agent problem. One of the biggest steps to
combat any possibility of a principle-agent problem is to manage managerial wealth
inside the fund. By directly involving the managers with the fund, the incentive of
managers to incur too much risk is counterbalanced to some extent by the increased
exposure to downside risk engendered by this aspect of the partnership structure. This
arrangement also makes it harder for managers to leave the fund.

Do less qualified investors increase the risk associated with hedge funds?

Over the last decade, there has been a substantial increase in the number of households
with a net annual income exceeding one million dollars, a trend which may have
increased the number of unsophisticated investors operating in the market. Some argue
that unsophisticated investors may be more susceptible to fraud since they are unaware
of the rules and regulations governing hedge funds and specific hedge fund strategies.
As well, since investors generally act as the regulators of the fund, the more
sophisticated the investor, the more sophisticated the fund and vice versa. This trend,
in turn, may increase systemic risks of hedge funds overall.

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Is the banking sector exposed to hedge funds risks?

Some argue that the global banking sector is exposed to systemic risks created by hedge
funds. It is commonly accepted that historically hedge funds have yielded double-digit
returns at the cost of high systemic risks that affect the banking industry. Numerous
researchers have attempted to quantify this impact though varying measures such as
illiquidity risk exposure, nonlinear factor models for hedge fund and banking-sector
indexes.

Illiquidity risk exposure: Illiquidity risk is the forced liquidation of hedge fund
portfolio, which can lead to widespread panic. The more illiquid the portfolio, the
larger the price impact will be. If many funds face this problem at once, (become highly
correlated) it can quickly turn into a global financial crisis.

Nonlinear factor models: The asymmetries found in the model for hedge funds make it
clear that they do not follow a linear model as most other investments. Because of this,
hedge fund investors must understand the nonlinear factor models in order to reap
safely the profits of hedge funds.

Because of the symbiotic relationship that exists between banks and hedge funds, the
risk exposures of the hedge fund industry have a material impact on the banking sector,
resulting in new sources of systemic risks. These high risk exposures are proven to
have high material impact on the banking sector are based mainly on hedge fund and
banking indexes but also illiquidity risk measures and nonlinear factor models.

4) Hedge Fund Regulations

Should hedge funds be regulated?

Some argue that hedge funds should be regulated due to their potentially high systemic
risk. However, hedge fund laws in the United States are best described as a patchwork
of exemptions rather than an effective regulatory scheme. These exemptions allow
hedge funds to avoid registering as an investment company with the Security Exchange
Commission (SEC) under the Securities Act of 1933. The most important characteristic
of hedge funds is the exclusion of ‘retail investors’ in favor of ‘whole sale’ or
‘accredited’ investors who have an annual income of over $200,000 or a net-worth of $1
million. Additionally, hedge funds limit the total number of investors in the fund. The
manager of a hedge fund is legally considered a ‘private advisor’ often with fewer than
15 clients a year. Were it not for these exceptions, a hedge fund would be subject to the
same rules and regulations of mutual funds. Instead, they are regulated by nothing
more than private contracts with their investors and the market discipline of their
creditors.

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Since hedge funds are exclusively open to ‘sophisticated’ investors with a net worth
over a million dollars, many suggest these investors do not need protection. It is also
evident that there are more cases of fraud in regulated markets, than in the hedge fund
market. Nonetheless, the SEC gave three reasons for pursuing tighter regulations on
hedge funds: the phenomenal growth of hedge funds and the increased impact of hedge
fund managers on the US markets; an increase in fraud cases involving hedge fund
advisers; and an increase in exposure of unsophisticated small investors to the risks of
hedge fund investing.

Who restricts access to Hedge Funds?

Because of the substantial risks involved in unregulated, complex, and leveraged

investments, hedge funds are normally open only to professional, institutional or
otherwise accredited investors. This restriction is often implemented through limits on
participating investors or minimum investment amounts. Minimum investment levels
for hedge funds are usually high, implicitly dictated by legal limits on the number of
investors who are not high net worth individuals (“qualified purchasers” or “accredited
investors”), and restrictions on promotion and advertising. The Securities and
Exchange Commission (SEC) and Financial Services Authority (FSA) requirement of
private placement for hedge funds means that they tend to be exclusive clubs with a
comparatively small number of well-heeled investors.

From the perspective of the fund manager, having a small number of clients, usually
limited to 100 in total, with relatively large investments keeps client servicing costs low.
This allows him or her to concentrate more on trading and less on client servicing and
fund promotion. Most hedge funds only accept accredited investors; although up to 35
non-accredited investors can be accepted. As private offerings, hedge funds are not
permitted to advertise or generally solicit new investors. The regulatory framework
that generally governs hedge stems almost entirely from the mid 20th century from one
of the following: Securities Act of 1933; Investment Company Act of 1940; and
Investment Advisers Act of 1940. Presently, no modern legislation has been passed
concerning the governance or regulation of hedge funds in the twenty-first century.

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