These are lightly regulated private investment funds, characterized by unconventional strategies. Normally organized as limited partnerships

Origin and Development

Hedge funds date back to 1949. The innovation was ment to sell short some shares while buying some others, thus hedging market risk. While most hedge funds still trade long against short quite a few do not trade stocks at all.

Funds are pooled in the partnership and a general partner or manager makes all the decisions based on a strategy outlined in offering documents.

The manager receives a management fee and a performance fee. The management fee is a percentage of the amount of the assets under management, and the performance fee is calculated on the basis of the fund's profits.

A minimum bencmark is normally fixed, under which the manager does not receive any performance fees. The fee structures of hedge funds vary, but the annual management fee is typically 20% of the profits of the fund plus 2% of AuM. very successful manager may demand and get higher fees.

A typical hedge fund company includes U.S and offshore hedge funds. This allows managers to attract capital worldwide.

Flows and levels

Total AuM of the hedge fund industry were estimated end 2005 at $1.13trillion up 13% year on year. Because hedge funds normally leverage with debt, the positions taken in financial markets are larger than their AuM, which makes it difficult to calculate the overall exposure of hedge funds. The number of hedge funds reached end 2005 around 8,500.

Most of the hedge funds are registered offshore in locations like Cayman Islands followed by British Virgin Islands and Bermuda. The US was in the same year with 34% of the funds the most popular onshore location, followed by Asian countries with 12% and EU countries with 9%.

End 2005 75% of European hedge fund were managed from London while Sydney, Australia was the most important centre for Asia Pacific hedge funds.

Strategies

The bulk of hedge funds are engaged in "long / short" equity strategies. But quite a few hedge funds use also other instruments like short selling, arbitrage, trading derivatives, investing in undervalued securities, trading commodity and FX contracts, and attempting to take advantage of the spread between current market price and the ultimate purchase price in mergers. These instruments are mostly leveraged with using debt.

When strategies become too complex they may acquire a risk of catastrophic losses as eg in the case of Long Term Capital Management, which went nearly bust. 

Risk arbitrage

Sideeffect of the popularity of the early hedge funds was a dramatic increase in all of the non-standard investment strategies. There are mainly seven broad classifications of hedge funds: (1) event driven, (2) fixed-income arbitrage, (3) global convertible bond arbitrage, (4) equity market-neutral, (5) long/short equity, (6) global macros, and (7) commodity trading. 

Regulation

Hedge funds like to operate as unregistered investment companies. As a result, interests in a hedge fund cannot be offered or advertised to the general public. They are limited to individuals who “have it”, means either "accredited investors" with income of US$200,000 per year or net worth of US$1,0mio or "qualified purchasers" owning at least US$5,0mio in qualified investments. As limited partnership a hedge fund can not have more than 499 investors.

Trade off for hedge funds is that they have fewer investors, but have also few government imposed restrictions on their investment strategies. Most hedge funds are pursuing relatively risky strategies as risk reward must be high for them.

Renowned hedge funds have nowadays well developed investment processes and operational infrastructures. 

Recent US regulatory developments

Since February 2006 new rules by the SEC require most hedge fund advisers to register with the SEC under the Investment Advisers Act. This requirement applies to firms managing more than US$30,0mio and allows the fund to open to new investors. The SEC has adopted a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the industry. But while the will is welcome, the reality is different, as the SEC currently has neither the staff nor expertise to monitor all the existing hedge funds in the needed way.

Funds of funds

This kind of fund invests only in other investment funds (e.g. hedge funds) rather than trading assets. Because some U.S. funds of funds may be registered with the SEC, they can accept investments from individuals who are not accredited investors or qualified purchasers, and often have lower investment minimums.

But they are expensive. Funds of funds carry an additional fee, typically a 1% management fee and, optionally a 10% performance fee in addition of the fees for the underlying funds. Besides lower mininum investment hurdles and diversification, some funds of funds also add value by dynamic allocation to different hedge funds strategies, such as Long/Short Equities, Event Driven, Distressed Debt, Convertible Arbitrage, Statistical Arbitrage, Macro and Multi-Strategies. 

Comparison to Private Equity funds

Hedge funds are similar to private equity funds, such as venture capital funds, in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in very liquid assets, and permit investors to enter or leave the fund easily. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund.

Hedge funds often invest in private equity companies' acquisition funds.

Between 2004 and February 2006, some U.S. hedge funds adopted 25 month lock-up rules expressly to exempt themselves from the SEC's new registration requirements. They now fall under the registration exemption drafted to exempt private equity funds. 

Comparison to Mutual funds

Like hedge funds, mutual funds are pools of investment capital. However, mutual funds are highly regulated by the SEC. Mutual funds cannot compensate managers based on the performance of the fund, which many believe dilutes the incentive of the fund managers to perform.  

Hedge fund privacy

Hedge funds do not have to disclose their activities to third parties. This is in contrast to a fully regulated Mutual Fund or Unit Trust which will typically have to meet disclosure obligations. The hedge funds are typically domiciled in an offshore jurisdiction, e.g. the Cayman Islands which have been estimated to home ca 75% of world’s hedge funds,

Investors in hedge funds enjoy a higher level of disclosure than investors in mutual funds including detailed discussions of risks assumed, significant positions, and investors usually have direct access to the investment advisors of the funds. This high level of disclosure is not available to non-investors, hence the notion of privacy attached to hedge funds.

There are no official hedge fund statistics. An industry consulting group reported at the end of the second quarter 1003 that there were 5660 hedge funds world wide managing $665 billion. At the same time the US mutual fund sector held assets of $7.818 trillion.

The combination of privacy and rich investors means that hedge funds are a target for criticism whenever markets move against some group's interests. For example, hedge funds were widely blamed for the speculative run-up in the bond market that preceded the global bond crisis of 1994, although the major players in the bond spree were actually large commercial and investment banks. 

Managers of hedge funds belong certainly to the top income class. Earnings from a hedge fund are 100% of the capital gains on the manager's own equity stake in the fund plus 20% to 50% of the gains on the other investors' capital.

The 2004 top earner was with $1.02bn Edward Lampert followed in 2005 by T. Boone Pickens with an income of $1.5billion

Criticism

Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital Management in 1998, which had to be bailed out by the Federal Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster.

Critics also maintain that hedge fund performance has suffered as aggregate asset sizes have climbed.

Some observers noted that hedge funds systematically underperform the market averages. They contend that hedge fund indexes, particularly prior to 1995, were often statistically faulty and overstated hedge fund performance.

Criticism was also heaped upon hedge funds by investigative journalist According to them hedge funds have evolved into little more than high-fee Mutual Funds.

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