Hedge Fund

Hedging Fund & Its Impact On Capital Market
CONTENTS
Sr.No. 1. 2. 3. !. #. %. 7. *. . 1/. 11. Particulars Introduction Characteristics Of Hedge Funds Growth Of Hedge Funds Hedge Fund "ata $enefits Of Hedge Funds &or'ings Of Hedge Funds (is's In)ol)ed In Hedge Funds I+,act Of Hedge Funds In Ca,ital -ar'et (ole Of Hedge Funds In Ca,ital S.ste+ In)estor Protection 0he Federal (eser)e 1 Hedge Funds Page No. 1. 7. . 12. 21. 27. 32. !#. !*. #/. #2.
Hedging Fund & Its Impact On Capital Market INTRODUCTION 0he ter+ 2hedge fund2 is used to descri3e a wide )ariet. of institutional in)estors e+,lo.ing a di)erse set of in)est+ent strategies. 4lthough there is no for+al definition of 2hedge fund52 hedge funds are largel. defined 3. what the. are not and 3. the regulations to which the. are not su36ect. 4s a general +atter5 the ter+ 2hedge fund2 refers to unregistered5 ,ri)ate in)est+ent ,artnershi,s for wealth. so,histicated in)estors 73oth natural ,ersons and institutions8 that use so+e for+ of le)erage to carr. out their in)est+ent strategies. 0he ter+ 2hedge fund2 is undefined5 in the federal securities laws. Indeed5 there is co++onl. acce,ted uni)ersal +eaning. 4s funds ha)e gained stature and ,ro+inence5 2hedge fund2 has de)elo,ed into a catch9all classification for +an. unregistered ,ri)atel. ,ools of ca,ital. 0hese ,ools of ca,ital +a. or utili:e the so,histicated hedging and ar3itrage that traditional hedge funds e+,lo.5 and +an. hedged5 and the ter+ has 3eco+e a +isno+er in +an. cases. Hedge funds engage in a )ariet. of in)est+ent acti)ities. 0he. cater to so,histicated in)estors and are not su36ect to the regulations that a,,l. to +utual funds geared toward the general ,u3lic. Fund +anagers are co+,ensated on the 3asis of ,erfor+ance rather than as a fi<ed ,ercentage of assets. 2Perfor+ance funds2 would 3e a +ore accurate descri,tion. +anaged +a. not strategies a,,ear to including no hedge though5
engage in relati)el. si+,le e;uit. strategies. $asicall.5 +an. 2hedge funds2 are not actuall.
Selected Definitions of "Hedge Fund"
"Hedge fund" is an expression believed to have been first applied in 1949 to a fund managed by Alfred Winslow Jones.1 r. Jones!s private investment fund "ombined both long and short e#uity positions to "hedge" the portfolio!s exposure to movements in the mar$et. %oday& hedge funds are no longer defined by a parti"ular strategy and often do not "hedge" in the e"onomi" sense. %he following is a sele"tion of definitions and des"riptions of the term "hedge fund" showing the diversity of views among "ommentators. "%he term !hedge fund! is "ommonly used to des"ribe a variety of different types of investment vehi"les that share some "ommon "hara"teristi"s. Although it is not statutorily defined& the term en"ompasses any pooled investment vehi"le that is privately organi'ed& administered by professional money managers& and not widely available to the publi"." --THE PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS, HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT 1 (1999). "%he term !hedge fund! refers generally to a privately offered investment vehi"le that pools the "ontributions of its investors in order to invest in a variety of asset "lasses& su"h as se"urities& futures "ontra"ts& options& bonds& and "urren"ies." --THE SECRETARY OF THE TREASURY, THE BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, THE SECURITIES AND EXCHANGE COMMISSION, A REPORT TO
Hedging Fund & Its Impact On Capital Market CONGRESS IN ACCORDANCE WITH 356(c) OF THE USA PATRIOT ACT OF 2001 (2002). "A hedge fund "an be broadly defined as a privately offered fund that is administered by a professional investment management firm (or !hedge fund manager!). %he word !hedge! refers to a hedge fund!s ability to hedge the value of the assets it holds (e.g.& through the use of options or the simultaneous use of long positions and short sales). However& some hedge funds engage only in !buy and hold! strategies or other strategies that do not involve hedging in the traditional sense. *n fa"t& the term !hedge fund! is used to refer to funds engaging in over +, different types of investment strategies .-" --MANAGED FUNDS ASSOCIATION, HEDGE FUND FAQs 1 (2003). "%here is no universally a""epted meaning of the expression !hedge fund!. indeed& many "ompeting (and sometimes partially "ontradi"ting) definitions exist. %he term first "ame into use in the 19,/s to des"ribe any investment fund that used in"entive fees& short0selling& and leverage. A summary definition fre#uently used in offi"ial se"tor reports is !any pooled investment vehi"le that is privately organised& administered by professional investment managers& and not widely available to the publi"!. %he term "an also be defined by "onsidering the "hara"teristi"s most "ommonly asso"iated with hedge funds. 1sually& hedge funds2
are organised as private investment partnerships or offshore investment "orporations. use a wide variety of trading strategies involving position0ta$ing in a range of mar$ets. employ an assortment of trading te"hni#ues and instruments& often in"luding short0 selling& derivatives and leverage.
pay performan"e fees to their managers. and
Have an investor base "omprising wealthy individuals and institutions and a relatively high minimum investment limit (set at 1341//&/// or higher for most funds)." 99FIN4NCI4= S>(?IC>S 4@0HO(I0A 7@NI0>" BING"O-85 H>"G> F@N"S 4N" 0H> FS45 "ISC@SSION P4P>( 1%5 at * 72//28.
"5riginally set up to !hedge bets! or insure against "urren"y or interest rate ris$s& hedge funds have sin"e ta$en on a mu"h wider remit& investing in assets ranging from e#uities and fixed interest sto"$s to derivatives and "ommodities. %heir aim is to ma$e absolute returns& that is to ma$e performan"e returns irrespe"tive of whi"h way the mar$ets are going. 6ather li$e derivative funds& hedge funds use derivative instruments or gearing (borrowing against the fund!s assets) to gain greater exposure to their investments or to prote"t against losses." --ROBERT B. MILROY, STANDARD & POOR'S GUIDE TO OFFSHORE INVESTMENT FUNDS 28 (2000).
"%he term !hedge fund! was in use as early as the 197/s to des"ribe a new spe"ulative investment vehi"le that used sophisti"ated hedging and arbitrage te"hni#ues in the "orporate e#uities mar$et. *n the late 197/s& former 3e"urities and 8x"hange 9ommissioner Hugh 5wens des"ribed !hedge funds! as !private investment partnerships whi"h employ the investment te"hni#ues of leveraging and hedging.! *n the 19:/s and 19;/s& the a"tivities of similar types of funds broadened into a range of finan"ial instruments and a"tivities .- %he term !hedge fund! does not have a pre"ise definition& but it has been used to refer generally to a "adre of private investment partnerships that are engaged in a"tive trading and arbitrage of a range of different se"urities and "ommodities."
Hedging Fund & Its Impact On Capital Market --DEPARTMENT OF THE TREASURY, SECURITIES AND EXCHANGE COMMISSION, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, JOINT REPORT ON THE GOVERNMENT SECURITIES MARKET, at B-64 (1992) (citing HUGH OWENS, SECURITIES AND EXCHANGE COMMISSIONER, A REGULATOR LOOKS AT SOME UNREGULATED INVESTMENT COMPANIES: THE EXOTIC FUNDS, REMARKS BEFORE THE NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION (Oct. 21, 1969)).
A hedge fund is a "private investment partnership (for 1.3. investors) or an off0shore investment "orporation (for non01.3. or tax0exempt investors) in whi"h the general partner has made a substantial personal investment& and whose offering memorandum allows for the fund to ta$e both long and short positions& use leverage and derivatives& and investment in many mar$ets. Hedge funds often ta$e large ris$s on spe"ulative strategies& in"luding <program trading& selling short& swap& and arbitrage=. A fund need not employ all of these tools all of the time. it must merely have them at its disposal." --JOHN DOWNES AND JORDAN ELLIOTT GOODMAN, BARRON'S, FINANCE & INVESTMENT HANDBOOK 358 (5th ed. 1998).
Hedging Fund & Its Impact On Capital Market "%here is no pre"ise definition of the term !hedge fund&! and one will not be found in the federal or state se"urities laws. %he term was first used to des"ribe private investment funds that "ombine both long and short e#uity positions within a single leveraged portfolio. *t is generally believed that the first su"h fund to employ this approa"h was an investment partnership organi'ed in 1949 by Alfred Winslow Jones - Hedge funds are no longer defined by the strategy they pursue. While a number of today!s funds pursue the hedged e#uity strategy of Jones& numerous different investment styles are embra"ed by hedge funds .- Hedge funds are defined more by their form of organi'ation and manner of operation than by the substan"e of their finan"ial strategies." --Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). ">i$e mutual funds& hedge funds pool investors! money and invest those funds in finan"ial instruments in an effort to ma$e a positive return. However& unli$e mutual funds& hedge funds are not registered with the 389. %his means that hedge funds are sub?e"t to very few regulatory "ontrols. *n addition& many hedge fund managers are not re#uired to register with the 389 and therefore are not sub?e"t to regular 389 oversight. @e"ause of this la"$ of regulatory oversight& hedge funds histori"ally have been available to a""redited investors and large institutions& and have limited their investors through high investment minimums (e.g.& 41 million). any hedge funds see$ to profit in all $inds of mar$ets by pursuing leveraging and other spe"ulative investment pra"ti"es that may in"rease the ris$ of investment loss." --SECURITIES AND EXCHANGE COMMISSION, HEDGING YOUR BETS: A HEADS UP ON HEDGE FUNDS AND FUNDS OF HEDGE FUNDS, available at http://www.sec.gov/answers/hedge.htm.
Hedging Fund & Its Impact On Capital Market "!Hedge fund! is a general& non0legal term used to des"ribe private& unregistered investment pools that traditionally have been limited to sophisti"ated& wealthy investors. Hedge funds are not mutual funds and& as su"h& are not sub?e"t to the numerous regulations that apply to mutual funds for the prote"tion of investors 0 in"luding regulations re#uiring a "ertain degree of li#uidity& regulations re#uiring that mutual fund shares be redeemable at any time& regulations prote"ting against "onfli"ts of interest& regulations to assure fairness in the pri"ing of fund shares& dis"losure regulations& regulations limiting the use of leverage& and more." --SECURITIES AND EXCHANGE COMMISSION, INVEST WISELY: AN INTRODUCTION TO MUTUAL FUNDS, available at http://www.sec.gov/investor/pubs/inwsmf.htm.
"A hedge fund is an a"tively managed investment fund that see$s attra"tive absolute return. *n pursuit of their absolute return ob?e"tive& hedge funds use a wide variety of investment strategies and tools. Hedge funds are designed for a small number of large investors& and the manager of the fund re"eives a per"entage of the profits earned by the fund. Hedge fund managers are a"tive managers see$ing absolute return." --ROBERT A. JAEGER, ALL ABOUT HEDGE FUNDS, at x (2003) (Perhaps in a bit of his own hedging, Jaeger calls his definition "provisional."). Key Characteristics of Hedge Funds
Hedge funds utili:e a )ariet. of financial instru+ents to reduce ris'5 enhance returns and +ini+i:e the correlation with e;uit. and 3ond +ar'ets. -an. hedge funds are fle<i3le in their in)est+ent o,tions 7can use short selling5 le)erage5 deri)ati)es such as ,uts5 calls5 o,tions5 futures5 etc.8.
Hedge funds )ar. enor+ousl. in ter+s of in)est+ent returns5 )olatilit. and ris'. -an.5 3ut not all5 hedge fund strategies tend to hedge against downturns in the +ar'ets 3eing traded.
-an. hedge funds ha)e the a3ilit. to deli)er non9+ar'et correlated returns. -an. hedge funds ha)e as an o36ecti)e consistenc. of returns and ca,ital ,reser)ation rather than +agnitude of returns. -ost hedge funds are +anaged 3. e<,erienced in)est+ent ,rofessionals who are generall. disci,lined and diligent. Pension funds5 endow+ents5 insurance co+,anies5 ,ri)ate 3an's and high net worth indi)iduals and fa+ilies in)est in hedge funds to +ini+i:e o)erall ,ortfolio )olatilit. and enhance returns.
-ost hedge fund +anagers are highl. s,eciali:ed and trade onl. within their area of e<,ertise and co+,etiti)e ad)antage. Hedge funds 3enefit 3. hea)il. weighting hedge fund +anagersC re+uneration towards ,erfor+ance incenti)es5 thus attracting the 3est 3rains in the in)est+ent 3usiness. In addition5 hedge fund +anagers usuall. ha)e their own +one. in)ested in their fund.
Facts About the Hedge Fund Industry
>sti+ated to 3e a D1 trillion industr. and growing at a3out 2/E ,er .ear with a,,ro<i+atel. *3#/ acti)e hedge funds. Includes a )ariet. of in)est+ent strategies5 so+e of which use le)erage and deri)ati)es while others are +ore conser)ati)e and e+,lo. little or no le)erage. -an. hedge fund strategies see' to reduce +ar'et ris' s,ecificall. 3. shorting e;uities or through the use of deri)ati)es.
-ost hedge funds are highl. s,eciali:ed5 rel.ing on the s,ecific e<,ertise of the +anager or +anage+ent tea+.
Perfor+ance of +an. hedge fund strategies5 ,articularl. relati)e )alue strategies5 is not de,endent on the direction of the 3ond or e;uit. +ar'ets 99 unli'e con)entional e;uit. or +utual funds 7unit trusts85 which are generall. 1//E e<,osed to +ar'et ris'.
-an. hedge fund strategies5 ,articularl. ar3itrage strategies5 are li+ited as to how +uch ca,ital the. can successfull. e+,lo. 3efore returns di+inish. 4s a result5 +an. successful hedge fund +anagers li+it the a+ount of ca,ital the. will acce,t.
Hedge fund +anagers are generall. highl. ,rofessional5 disci,lined and diligent. 0heir returns o)er a sustained ,eriod of ti+e ha)e out,erfor+ed standard e;uit. and 3ond inde<es with less )olatilit. and less ris' of loss than e;uities. $e.ond the a)erages5 there are so+e trul. outstanding ,erfor+ers. In)esting in hedge funds tends to 3e fa)ored 3. +ore so,histicated in)estors5 including +an. Swiss and other ,ri)ate 3an's that ha)e li)ed through5 and understand the conse;uences of5 +a6or stoc' +ar'et corrections.
4n increasing nu+3er of endow+ents and ,ension funds allocate assets to hedge funds.
The growth of hedge funds
In the entire financial ser)ices area5 the sector showing the +ost growth is clearl. the area of hedge funds. &hile 3ro'erage co++issions continue to decline5 in)est+ent 3an'ing fees start to co+e under ,ressure and the entire financial ser)ices industr. worries a3out intensified regulator. scrutin.5 the hedge fund industr. with its ra,id growth stands out fro+ the crowd. New funds are starting u, e)er. wee' and +an. are 3eginning with an e<cess of a 3illion dollars under +anage+ent fro+ da. one. 0he a+ount of +one. under +anage+ent with hedge funds has gone u, four ti+es 3etween 1 % and 2//! and is e<,ected to further tri,le 3etween now and 2/1/ to o)er D2.7 trillion. Pu3lic funds5 endow+ents5 and cor,orate s,onsors ha)e all increased their allocations to hedge funds within the conte<t of an increased allocation towards alternati)e in)est+ents +ore generall.. 0his +o)e towards increased in)est+ents in real estateF,ri)ate e;uit.Fhedge funds 7alternati)e in)est+ents8 is dri)en 3. the need for a higher return to co+,ensate for the e<,ected lower returns fro+ +ore con)entional in)est+ent strategies focused
Hedging Fund & Its Impact On Capital Market on @S 3onds and e;uities. 0here is also a clear desire a+ong this in)estor 3ase to 3e +ore focused on a3solute9return strategies rather than relati)e return. Gi)en the current le)el of allocations +ost of these large long9ter+ in)estors ha)e towards alternati)e in)est+ents5 and their ,rofessed long9ter+ target allocation5 the flow of funds to these asset classes will re+ain strong. One of the intriguing de)elo,+ents in the hedge fund world is the clear desire and a3ilit. of the newer funds to charge higher fees and i+,ose +ore stringent ter+s on in)estors. No longer are funds charging a 1 ,er cent +anage+ent fee and 2/ ,er cent of ,rofits 99 the nor+ for the first generation of funds set u, in the earl. to +id 1 /s. 4s ,er an interesting stud. done 3. -organ Stanle.2s ,ri+e 3ro'erage unit5 a3out a third of the funds o,ening in the ,ast si< +onths are charging a 2 ,er cent +anage+ent fee and 2/ ,er cent of ,rofits or higher5 while the +a6orit. are charging a 1.# ,er cent +anage+ent fee and 2/ ,er cent of ,rofits. -an. of the new funds ha)e +ore stringent loc'9u,s and stiff ,enalties if .ou redee+ earl.5 as well as +odified high9 water +ar's. 0he hedge fund 3usiness thus see+s to ha)e the uni;ue characteristic of 3eing ,ossi3l. the onl. 3usiness that I 'now of wherein new ,la.ers 7+ost of who+ are un,ro)en8 ha)e the a3ilit. to charge +ore and get 3etter ter+s than the esta3lished o,erators. 0his i+,lies a negati)e franchise )alue for the esta3lished large fund co+,le<es which ha)e sur)i)ed and ,ros,ered through the .ears. Gi)en that +ost of the 3est hedge fund co+,le<es are closed to new in)estors5 the new gu.s see+ to 3e ta'ing ad)antage of the huge de+and9su,,l. +is+atch for ;ualit. +one. +anagers. 0here is a feeding fren:. currentl. under wa. in the world of alternati)e in)est+ents and clients are ,a.ing u, the higher fees for fear of 3eing loc'ed out fro+ these funds at a later date5 if the. actuall. sur)i)e and grow. One reason wh. the new 3o.s are focusing +ore on fees and loc'9u,s could 3e the difficult. all hedge funds are ha)ing in generating ade;uate al,ha 7e<cess return8 to ensure an ade;uate ,a.out for the+sel)es. In a stud. done 3. -organ Stanle. on the e<cess returns generated 3. hedge funds o)er the last decade5 this trend of declining returns was )er. a,,arent. In the stud. the. defined
Hedging Fund & Its Impact On Capital Market e<cess returns as the return of the Hedge Fund research co+,osite o)er one +onth =I$O( 7a ,ro<. for cash returns8. In the 1 #9 7 ,eriod5 e<cess returns were 1! ,er centG these returns ha)e consistentl.
declined dro,,ing to as low as # ,er cent in 2//19/3 and ha)e dro,,ed further since. 0he current huge inflows into funds focused on e+erging +ar'ets +a'e sense if .ou loo' at ,erfor+ance nu+3ers o)er the ,ast three .ears. Hedge funds focused on the e+erging +ar'ets had the 3est returns with an 1* ,er cent annual return during 2//19/!5 closel. followed 3. distressed de3t focused funds at 17 ,er cent. -ore con)entional hedge fund strategies of tech at / ,er cent and ris' ar3itrage at 3 ,er cent annual return lagged far 3ehind. Gi)en the constant inflows into new hedge funds5 clients do not .et see+ to 3e 3othered a3out ,a.ing higher and higher fees for lower returns5 3ut this is a discussion that I a+ sure will co+e u, at so+e stage in +ost in)est+ent co++ittees. 4t so+e stage if the hedge fund co++unit. continues to show declining al,ha 7e<cess returns85 clients will need to ;uestion whether the ,roliferation of hedgies has reduced returns 3ecause the field has 3eco+e too co+,etiti)e. 0he 3eaut. of the hedge fund 3usiness and the reason wh. the u,ward drift in fee structure is e)en +ore sur,rising is the ease of entr. of new ,la.ers into the ga+e. 0he a)erage long short hedge fund needs onl. a3out si< 3ac' office staff ,er 3illion dollars5 while a glo3al +acro fund needs a3out 11 ,eo,le for a fund of si+ilar si:e 7-organ Stanle. sur)e.8. 0he t.,ical long short @S e;uit. +anager has onl. nine in)est+ent ,rofessionals and three in the 3ac' office. 0hese funds are also not reall. regulated and ha)e )er. li+ited disclosure re;uire+ents5 if an.. 0he start9u, costs of these )ehicles are also +ini+al and +ost funds will 3e a3le to 3rea' e)en at su3 D1// +illion in assets under +anage+ent. 0here is no other industr. that I a+ aware of where e<it and entr. are as si+,le. Hedge funds till date in 2//# ha)e had a tough .earG there ha)e 3een few strong trends to ca,italise on and +ost funds are struggling to show a ,ositi)e return. If the hedge fund industr. ends the .ear flat or e)en 7god for3id8 negati)e after disa,,ointing relati)e ,erfor+ance in 2//3 and 6ust a3out a)erage nu+3ers in 2//!5 so+e of the +ore so,histicated clients +a. +igrate
Hedging Fund & Its Impact On Capital Market 3ac' to +ore con)entional for+s of in)esting with lower fee structures. Hedge funds are clearl. here to sta.5 and continue to attract the 3est talent 3ecause of their ,a.out structuresG howe)er5 their a3ilit. to continue to co++and a ,re+iu+ fee structure will e)entuall. 3e li+ited 3. their a3ilit. to differentiate the+sel)es fro+ their long9onl. 3rethren on the ,erfor+ance front.
Hedge fund data Top performing funds 0he to, #/ ,erfor+ing hedge funds5 3ased on a)erage annual return o)er the ,re)ious three .ears5 were ran'ed 3. $arron2s Online in Octo3er 2//7 7Hedge Fund #/8. 0he to, 1/ are as followsH

1. (4$ S,ecial Situations Fund 7(4$ Ca,ital5 =ondon8 9 !7.% E 2. 0he Children2s In)est+ent Fund 70he Children2s In)est+ent Fund =ondon8 9 !!.27E -anage+ent5
3. Highland C"O O,,ortunit. Fund 7Highland Ca,ital -anage+ent5 "allas8 9 !3. *E !. $0( Glo3al O,,ortunit. Fund5 Class " 7Salida Ca,ital5 0oronto8 9 !3.!2E #. S( Phoenicia Fund 7Sloane (o3inson5 =ondon8 9 !3.1/E %. 4tticus >uro,ean Fund 74tticus -anage+ent5 New Aor'8 9 !/.7%E 7. Gradient >uro,ean Fund 4 7Gradient Ca,ital Partners5 =ondon8 9 3 .1*E *. Polar Ca,ital Paragon 43solute (eturn Fund 7Polar Ca,ital Partners5 =ondon8 9 3*.//E . Paulson >nhanced Partners Fund 7Paulson 1 Co.5 New Aor'8 9 37. 7E
1/. Fire3ird Glo3al Fund 7Fire3ird -anage+ent5 New Aor'8 9 37.1*E
$ecause of the una)aila3ilit. of relia3le figures5 the to, #/ list e<cludes funds such as (enaissance 0echnologies2 (enaissance -edallion Fund and >S= In)est+ents2 >S= Partners 7each thought to ha)e returned an a)erage of o)er 3#E in the ,re)ious 3 .ears8 and funds 3. S4C Ca,ital and 4,,aloosa -anage+ent5 which +ight otherwise ha)e +ade the list. 0he list also e<cludes funds with a net asset )alue of less than D2#/ +illion. 0he returns are net of fees.
Top earners Institutional In)estor +aga:ine annuall. ran's to,9earning hedge fund +anagers. >arnings fro+ a hedge fund are si+,l. 1//E of the ca,ital gains on the +anager2s own e;uit. sta'e in the fund ,lus the +anager2s share of the ,erfor+ance fee 7usuall. 2/E to #/E 7de,ending on ,olic.8 of the gains on the other in)estors2 ca,ital8. 0he 2//! to, earner was >dward =a+,ert of >S= In)est+ents Inc. who earned D1./2 3illion during the .ear 7P( Newswire lin'8. 0he 2//# to, earner was Ia+es Harris Si+ons with an earning of D1.% 3illion according to 4l,ha +aga:ine.J1*K Howe)er5 0rader -onthl. re,orted that Si+ons onl. earned a3out D1 3illion and that the to, earner was instead 0. $oone Pic'ens with an esti+ated earning of o)er D1.# 3illion during the .ear.J1 K 0he full to, 1/ list of hedge fund earners according to Trader Monthly Magazine. includesH

1. 0. $oone Pic'ens 9 esti+ated 2//# earnings D1.#3n L 2. Ste)en 4. Cohen5 S4C Ca,ital 4d)isers 9 D13n L 3. Ia+es H. Si+ons5 (enaissance 0echnologies Cor,. 9 D //+ 9 D13n

!. Paul 0udor Iones5 0udor In)est+ent Cor,. 9 D*//+ 9 D //+ #. Ste,hen Fein3erg5 Cer3erus Ca,ital -anage+ent 9 D#// 9 D%//+ %. $ruce Bo)ner5 Ca<ton 4ssociates 9 D#//+ 9 D%//+ 7. >ddie =a+,ert5 >S= In)est+ents 9 D#//+ 9 D%//+ *. "a)id >. Shaw5 ". >. Shaw 1 Co. 9 D!//+ 9 D#//+ . Ieffre. Gendell5 0ontine Partners 9 D3//+ 9 D!//+ 1/. =ouis $acon5 -oore Ca,ital -anage+ent 9 D3//+ 9 D3#/+
0he 2//% to, earner was Iohn 4rnold according to Trader Monthly Magazine. 0he list includesH

1. Iohn ". 4rnold5 Houston5 0e<as9 of Centauras >nerg.9 D1.#92$ 2. Ia+es Si+ons5 >ast Setau'et5 New Aor'9 of (enaissance 0echnologies Cor,.9 D1.#92$ 3. >ddie =a+,ert5 Greenwich5 Connecticut9 of >S= In)est+ents9 D191.#$
Notable hedge fund management companies So+eti+es also 'nown as alternati)e in)est+ent +anage+ent co+,anies.

4+aranth 4d)isors $ridgewater 4ssociates Ca<ton 4ssociates Centaurus >nerg. Citadel In)est+ent Grou, ". >. Shaw 1 Co. Fortress In)est+ent Grou, Gold+an Sachs 4sset -anage+ent =ong 0er+ Ca,ital -anage+ent -an Grou, Pirate Ca,ital ==C

(enaissance 0echnologies S4C Ca,ital 4d)isors Soros Fund -anage+ent -arshall &ace
Why hedge funds are attractive? 0here are a large nu+3er of in)est+ent )ehicles that offer .ou good and sta3le returns. Products li'e di)ersified +utual funds5 3lue chi, stoc's and ,ro,ert. are so+e of the+. $ut for high net worth indi)iduals 7HNIs85 there are +ore routes5 es,eciall. in the international +ar'ets. Here we loo' at one such )ehicle5 na+el. hedge funds. 4 hedge fund is a co++on ter+ used to descri3e ,ri)ate unregistered in)est+ent ,artnershi,s. Since +ost of the+ are not registered with financial regulators in their countries of origin5 the. do not need to +eet the eligi3ilit. re;uire+ents to register as institutional in)estors. 0his is good in a wa. 3ut could turn sour as well 3ecause there are no guidelines 3inding the+. 4t ,resent5 there are no hedge funds o,erating out of India. $ut internationall.5 there are a large nu+3er of such funds. 0hese funds are )er. +anager9centric as the entire onus of their success or failure falls on the fund +anager2s a3ilit. to e<,loit e<isting +ar'et conditions. No wonder then that the. charge a fi<ed fee of around 2 ,er cent a .ear of assets under +anage+ent5 along with a )er. high ,rofit sharing ,ercentage5 which is +ostl. 2/ ,er cent. Of course5 the. ha)e to assure returns as well. 0hus5 ,rofit sharing +a. start on the returns o)er and a3o)e sa.5 the first 1/ ,er cent returns. 0he fee is also 3ased on a high water+ar'ing conce,t5 which +eans that the fund +anager is entitled to a share of ,rofits the first ti+e. 0hereafter5 if the fund incurs losses and then recou,s5 the fund +anager will not 3e entitled to an. share of the recou,ed losses. 0he ne<t ti+e he will 3e entitled is when he 3eats his earlier ,erfor+ance.
Hedging Fund & Its Impact On Capital Market Howe)er5 gi)en the ,lethora of o,,ortunities worldwide5 the fund +anager has the lu<ur. of +a'ing in)est+ent decisions in stoc's5 3onds5 co++odities5 currencies etc. 0he 3asic idea is to generate aggressi)e returns. 0he +ost i+,ortant feature of hedge funds is that the. see' to deli)er a3solute5 rather than 3ench+ar'ed returns. For e<a+,le5 e;uit. +utual funds are 3ench+ar'ed against an inde< li'e the Nift. or $S> 2//5 or a 3an'ing sector +utual fund could 3ench+ar' its returns against the 3an'ing inde< on a stoc' e<change and can show the in)estors how +uch 3etterFworse he has ,erfor+ed. Howe)er5 hedge funds +anagers do not ha)e an. such lu<uries. Since the. are not regulated5 +ost countries do not allow the+ to raise +one. fro+ the general ,u3lic through a ,ros,ectus or ad)ertise+ents. 4 few are registered with the regulators in their countries 3ecause their +ain in)estors are uni)ersities5 ,ension funds and insurance co+,anies. -ost of the +ar'eting is done through in)est+ent ad)isors or ,ersonal contacts5 with their +ain in)estors 3eing restricted to so,histicated HNIs. &ith the (eser)e $an' of India JGet MuoteK 7($I8 allowing Indian residents to in)est u, to D2//5/// a3road ,er head a .ear5 it is another o,,ortunit. for HNIs to ta, these funds as the +ini+u+ li+it of +an. of the+ start fro+ D1//5///. $ut .ou need to re+e+3er that the a+ount in)ested is not )er. li;uid and +a. 3e su36ect to a loc'9in ,eriod5 with ;uarterl.5 half9.earl. or .earl. e<it windows. 0hose see'ing to in)est in hedge funds can a,,roach a wealth +anager5 securities 3ro'er or in)est+ent consultant a3road5 who can ad)ise the+ on the a)aila3le o,tions and select the hedge fund the. wish to in)est in5 3ased on its trac' record and +anage+ent st.le. 4fter that the. can a,,roach their 3an' in India to arrange for the foreign re+ittance to the hedge fund. &hene)er the. wish to redee+ their in)est+ent5 as ,er+itted 3. the hedge fund5 the. can re,atriate the ,roceeds to India into their 3an' account.
What information should I seek if I am considering investing in a hedge fund or a fund of hedge funds?
Read a fund's prospectus or offering memorandum and related materials. -a'e sure .ou understand the le)el of ris' in)ol)ed in the fund2s in)est+ent strategies and ensure that the. are suita3le to .our ,ersonal in)esting goals5 ti+e hori:ons5 and ris' tolerance. 4s with an. in)est+ent5 the higher the ,otential returns5 the higher the ris's .ou +ust assu+e.
Understand how a fund's assets are valued. Funds of hedge funds and hedge funds +a. in)est in highl. illi;uid securities that +a. 3e difficult to )alue. -oreo)er5 +an. hedge funds gi)e the+sel)es significant discretion in )aluing securities. Aou should understand a fund2s )aluation ,rocess and 'now the e<tent to which a fund2s securities are )alued 3. inde,endent sources.
Ask uestions a!out fees. Fees i+,act .our return on in)est+ent. Hedge funds t.,icall. charge an asset +anage+ent fee of 192E of assets5 ,lus a N,erfor+ance feeN of 2/E of a hedge fund2s ,rofits. 4 ,erfor+ance fee could +oti)ate a hedge fund +anager to ta'e greater ris's in the ho,e of generating a larger return. Funds of hedge funds t.,icall. charge a fee for +anaging .our assets5 and so+e +a. also include a ,erfor+ance fee 3ased on ,rofits. 0hese fees are charged in addition to an. fees ,aid to the underl.ing hedge funds.
Understand an" limitations on "our right to redeem "our shares. Hedge funds t.,icall. li+it o,,ortunities to redee+5 or cash in5 .our shares 7e.g.5 to four ti+es a .ear85 and often i+,ose a Nloc'9u,N ,eriod of one .ear or +ore5 during which .ou cannot cash in .our shares.
Research the !ackgrounds of hedge fund managers. Bnow with who+ .ou are in)esting. -a'e sure hedge fund +anagers are ;ualified to +anage .our +one.5 and find out whether the. ha)e a disci,linar. histor. within the securities industr.. Aou can get this infor+ation 7and +ore8 3. re)iewing the ad)iserCs For+ 4"?. Aou can search for and )iew a fir+Cs For+ 4"? using the S>CCs In)est+ent 4d)iser Pu3lic "isclosure 7I4P"8 we3site. Aou also can get co,ies of For+ 4"? for indi)idual ad)isers and fir+s fro+ the in)est+ent ad)iser5 the S>CCs Pu3lic (eference (oo+5 or 7for ad)isers with less than D2# +illion in assets under +anage+ent8 the state securities regulator where the ad)iser2s ,rinci,al ,lace of 3usiness is located. If .ou donCt find the in)est+ent ad)iser fir+ in the S>CCs I4P" data3ase5 3e sure to call .our state securities regulator or search the N4S"2s $ro'erChec' data3ase for an. infor+ation the. +a. ha)e.
#on't !e afraid to ask uestions. Aou are entrusting .our +one. to so+eone else. Aou should 'now where .our +one. is going5 who is +anaging it5 how it is 3eing in)ested5 how .ou can get it 3ac'5 what ,rotections are ,laced on .our in)est+ent and what .our rights are as an in)estor. In addition5 .ou +a. wish to read N4S"Cs in)estor alert5 which descri3es so+e of the high costs and ris's of in)esting in funds of hedge funds.
What protections do I have if I purchase a hedge fund? Hedge fund in)estors do not recei)e all of the federal and state law ,rotections that co++onl. a,,l. to +ost registered in)est+ents. For e<a+,le5 .ou won2t get the sa+e le)el of disclosures fro+ a hedge fund that .ou2ll get fro+ registered in)est+ents. &ithout the disclosures that the securities laws re;uire for +ost registered in)est+ents5 it can 3e ;uite difficult to )erif. re,resentations .ou +a. recei)e fro+ a hedge fund. Aou should also 3e aware that5 while the S>C +a. conduct e<a+inations of an. hedge fund +anager that is registered as an in)est+ent ad)iser under the In)est+ent 4d)isers 4ct5 the S>C and other securities regulators generall. ha)e li+ited a3ilit. to chec' routinel. on hedge fund acti)ities. 0he S>C can ta'e action against a hedge fund that defrauds in)estors5 and we ha)e 3rought a nu+3er of fraud cases in)ol)ing hedge funds. Co++onl. in these cases5 hedge fund ad)isers +isre,resented their e<,erience and the fund2s trac' record. Other cases were classic NPon:i sche+es5N where earl. in)estors were ,aid off to +a'e the sche+e loo' legiti+ate. In so+e of the cases we ha)e 3rought5 the hedge funds sent ,hon. account state+ents to in)estors to ca+ouflage the fact that their +one. had 3een stolen. 0hat2s wh. it is e<tre+el. i+,ortant to thoroughl. chec' out e)er. as,ect of an. hedge fund .ou +ight consider as an in)est+ent.
Hedging Strategies &ide ranges of hedging strategies are a)aila3le to hedge funds. For e<a+,leH
Selling short 9 selling shares without owning the+5 ho,ing to 3u. the+ 3ac' at a future date at a lower ,rice in the e<,ectation that their ,rice will dro,. @sing ar3itrage 9 see'ing to e<,loit ,ricing inefficiencies 3etween related securities 9 for e<a+,le5 can 3e long con)erti3le 3onds and short the underl.ing issuerCs e;uit.. 0rading o,tions or deri)ati)es 9 contracts whose )alues are 3ased on the ,erfor+ance of an. underl.ing financial asset5 inde< or other in)est+ent. In)esting in antici,ation of a s,ecific e)ent 9 +erger transaction5 hostile ta'eo)er5 s,in9 off5 e<iting of 3an'ru,tc. ,roceedings5 etc. In)esting in dee,l. discounted securities 9 of co+,anies a3out to enter or e<it financial distress or 3an'ru,tc.5 often 3elow li;uidation )alue. -an. of the strategies used 3. hedge funds 3enefit fro+ 3eing non9correlated to the direction of e;uit. +ar'ets
Popular Misconception 0he ,o,ular +isconce,tion is that all hedge funds are )olatile 99 that the. all use glo3al +acro strategies and ,lace large directional 3ets on stoc's5 currencies5 3onds5 co++odities5 and gold5 while using lots of le)erage. In realit.5 less than #E of hedge funds are glo3al +acro funds. -ost
Hedging Fund & Its Impact On Capital Market hedge funds use deri)ati)es onl. for hedging or don2t use deri)ati)es at all5 and +an. use no le)erage.
Benefits of Hedge Funds
-an. hedge fund strategies ha)e the a3ilit. to generate ,ositi)e returns in 3oth rising and falling e;uit. and 3ond +ar'ets. Inclusion of hedge funds in a 3alanced ,ortfolio reduces o)erall ,ortfolio ris' and )olatilit. and increases returns. Huge )ariet. of hedge fund in)est+ent st.les O +an. uncorrelated with each other O ,ro)ides in)estors with a wide choice of hedge fund strategies to +eet their in)est+ent o36ecti)es.
4cade+ic research ,ro)es hedge funds ha)e higher returns and lower o)erall ris' than traditional in)est+ent funds. Hedge funds ,ro)ide an ideal long9ter+ in)est+ent solution5 eli+inating the need to correctl. ti+e entr. and e<it fro+ +ar'ets. 4dding hedge funds to an in)est+ent ,ortfolio ,ro)ides di)ersification not otherwise a)aila3le in traditional in)esting.
Hedge Fund Styles 0he ,redicta3ilit. of future results shows a strong correlation with the )olatilit. of each strateg.. Future ,erfor+ance of strategies with high )olatilit. is far less ,redicta3le than future ,erfor+ance fro+ strategies e<,eriencing low or +oderate )olatilit..
Hedging Fund & Its Impact On Capital Market Aggressive $rowth% In)ests in e;uities e<,ected to e<,erience acceleration in growth of earnings ,er share. Generall. high PF> ratios5 low or no di)idendsG often s+aller and +icro ca, stoc's which are e<,ected to e<,erience ra,id growth. Includes sector s,ecialist funds such as technolog.5 3an'ing5 or 3iotechnolog.. Hedges 3. shorting e;uities where earnings disa,,oint+ent is e<,ected or 3. shorting stoc' inde<es. 0ends to 3e Nlong93iased.N ><,ected ?olatilit.H &igh #istressed Securities% $u.s e;uit.5 de3t5 or trade clai+s at dee, discounts of co+,anies in or facing 3an'ru,tc. or reorgani:ation. Profits fro+ the +ar'et2s lac' of understanding of the true )alue of the dee,l. discounted securities and 3ecause the +a6orit. of institutional in)estors cannot own 3elow in)est+ent grade securities. 70his selling ,ressure creates the dee, discount.8 (esults generall. not de,endent on the direction of the +ar'ets. ><,ected ?olatilit.H 'ow ( )oderate Emerging )arkets% In)ests in e;uit. or de3t of e+erging 7less +ature8 +ar'ets that tend to ha)e higher inflation and )olatile growth. Short selling is not ,er+itted in +an. e+erging +ar'ets5 and5 therefore5 effecti)e hedging is often not a)aila3le5 although $rad. de3t can 3e ,artiall. hedged )ia @.S. 0reasur. futures and currenc. +ar'ets. ><,ected ?olatilit.H *er" &igh +unds of &edge +unds% -i< and +atch hedge funds and other ,ooled in)est+ent )ehicles. 0his 3lending of different strategies and asset classes ai+s to ,ro)ide a +ore sta3le long9ter+ in)est+ent return than an. of the indi)idual funds. (eturns5 ris'5 and )olatilit. can 3e controlled 3. the +i< of underl.ing strategies and funds. Ca,ital ,reser)ation is generall. an i+,ortant consideration. ?olatilit. de,ends on the +i< and ratio of strategies e+,lo.ed. ><,ected ?olatilit.H 'ow ( )oderate ( &igh ,ncome% In)ests with ,ri+ar. focus on .ield or current inco+e rather than solel. on ca,ital gains. -a. utili:e le)erage to 3u. 3onds and so+eti+es fi<ed inco+e deri)ati)es in order to ,rofit fro+ ,rinci,al a,,reciation and interest inco+e. ><,ected ?olatilit.H 'ow
Hedging Fund & Its Impact On Capital Market )acro% 4i+s to ,rofit fro+ changes in glo3al econo+ies5 t.,icall. 3rought a3out 3. shifts in go)ern+ent ,olic. that i+,act interest rates5 in turn affecting currenc.5 stoc'5 and 3ond +ar'ets. Partici,ates in all +a6or +ar'ets 99 e;uities5 3onds5 currencies and co++odities 99 though not alwa.s at the sa+e ti+e. @ses le)erage and deri)ati)es to accentuate the i+,act of +ar'et +o)es. @tili:es hedging5 3ut the le)eraged directional in)est+ents tend to +a'e the largest i+,act on ,erfor+ance. ><,ected ?olatilit.H *er" &igh
)arket Neutral ( Ar!itrage% 4tte+,ts to hedge out +ost +ar'et ris' 3. ta'ing offsetting ,ositions5 often in different securities of the sa+e issuer. For e<a+,le5 can 3e long con)erti3le 3onds and short the underl.ing issuers e;uit.. -a. also use futures to hedge out interest rate ris'. Focuses on o3taining returns with low or no correlation to 3oth the e;uit. and 3ond +ar'ets. 0hese relati)e )alue strategies include fi<ed inco+e ar3itrage5 +ortgage 3ac'ed securities5 ca,ital structure ar3itrage5 and closed9end fund ar3itrage. ><,ected ?olatilit.H 'ow )arket Neutral ( Securities &edging% In)ests e;uall. in long and short e;uit. ,ortfolios generall. in the sa+e sectors of the +ar'et. -ar'et ris' is greatl. reduced5 3ut effecti)e stoc' anal.sis and stoc' ,ic'ing is essential to o3taining +eaningful results. =e)erage +a. 3e used to enhance returns. @suall. low or no correlation to the +ar'et. So+eti+es uses +ar'et inde< futures to hedge out s.ste+atic 7+ar'et8 ris'. (elati)e 3ench+ar' inde< usuall. 093ills. ><,ected ?olatilit.H 'ow )arket Timing% 4llocates assets a+ong different asset classes de,ending on the +anager2s )iew of the econo+ic or +ar'et outloo'. Portfolio e+,hasis +a. swing widel. 3etween asset classes. @n,redicta3ilit. of +ar'et +o)e+ents and the difficult. of ti+ing entr. and e<it fro+ +ar'ets add to the )olatilit. of this strateg.. ><,ected ?olatilit.H &igh Opportunistic% In)est+ent the+e changes fro+ strateg. to strateg. as o,,ortunities arise to ,rofit fro+ e)ents such as IPOs5 sudden ,rice changes often caused 3. an interi+
Hedging Fund & Its Impact On Capital Market earnings disa,,oint+ent5 hostile 3ids5 and other e)ent9dri)en o,,ortunities. -a. utili:e se)eral of these in)esting st.les at a gi)en ti+e and is not restricted to an. ,articular in)est+ent a,,roach or asset class. ><,ected ?olatilit.H *aria!le )ulti Strateg"% In)est+ent a,,roach is di)ersified 3. e+,lo.ing )arious strategies si+ultaneousl. to reali:e short9 and long9ter+ gains. Other strategies +a. include s.ste+s trading such as trend following and )arious di)ersified technical strategies. 0his st.le of in)esting allows the +anager to o)erweight or underweight different strategies to 3est ca,itali:e on current in)est+ent o,,ortunities. ><,ected ?olatilit.H *aria!le Short Selling% Sells securities short in antici,ation of 3eing a3le to re3u. the+ at a future date at a lower ,rice due to the +anager2s assess+ent of the o)er)aluation of the securities5 or the +ar'et5 or in antici,ation of earnings disa,,oint+ents often due to accounting irregularities5 new co+,etition5 change of +anage+ent5 etc. Often used as a hedge to offset long9onl. ,ortfolios and 3. those who feel the +ar'et is a,,roaching a 3earish c.cle. High ris'. ><,ected ?olatilit.H *er" &igh Special Situations% In)ests in e)ent9dri)en situations such as +ergers5 hostile ta'eo)ers5 reorgani:ations5 or le)eraged 3u.outs. -a. in)ol)e si+ultaneous ,urchase of stoc' in co+,anies 3eing ac;uired5 and the sale of stoc' in its ac;uirer5 ho,ing to ,rofit fro+ the s,read 3etween the current +ar'et ,rice and the ulti+ate ,urchase ,rice of the co+,an.. -a. also utili:e deri)ati)es to le)erage returns and to hedge out interest rate andFor +ar'et ris'. (esults generall. not de,endent on direction of +ar'et. ><,ected ?olatilit.H )oderate *alue% In)ests in securities ,ercei)ed to 3e selling at dee, discounts to their intrinsic or ,otential worth. Such securities +a. 3e out of fa)or or under followed 3. anal.sts. =ong9 ter+ holding5 ,atience5 and strong disci,line are often re;uired until the ulti+ate )alue is recogni:ed 3. the +ar'et. ><,ected ?olatilit.H 'ow ( )oderate
Advantages of Hedge Funds over Mutual Funds
Hedge funds are e<tre+el. fle<i3le in their in)est+ent o,tions 3ecause the. use financial instru+ents generall. 3e.ond the reach of +utual funds5 which ha)e S>C regulations and disclosure re;uire+ents that largel. ,re)ent the+ fro+ using short selling5 le)erage5 concentrated in)est+ents5 and deri)ati)es. 0his fle<i3ilit.5 which includes use of hedging strategies to ,rotect downside ris'5 gi)es hedge funds the a3ilit. to 3est +anage in)est+ent ris's. 0he strong results can 3e lin'ed to ,erfor+ance incenti)es in addition to in)est+ent fle<i3ilit.. @nli'e +an. +utual fund +anagers5 hedge fund +anagers are usuall. hea)il. in)ested in a significant ,ortion of the funds the. run and shares the rewards as well as ris's with the in)estors. NIncenti)e feesN re+unerate hedge fund +anagers onl. when returns are ,ositi)e5 whereas +utual funds ,a. their financial +anagers according to the )olu+e of assets +anaged5 regardless of ,erfor+ance. 0his incenti)e fee structure tends to attract +an. of &all StreetCs 3est ,ractitioners and other financial e<,erts to the hedge fund industr.. In the last nine .ears5 the nu+3er of hedge funds has risen 3. a3out 2/ ,ercent ,er .ear and the rate of growth in hedge fund assets has 3een e)en +ore ra,id. Currentl.5 there are esti+ated to 3e a,,ro<i+atel. *3#/ hedge funds +anaging D1 trillion. &hile the nu+3er and si:e of hedge funds are s+all relati)e to +utual funds5 their growth reflects the i+,ortance of this alternati)e in)est+ent categor. for institutional in)estors and wealth. indi)idual in)estors.
Hedge Funds Out,erfor+ -utual Funds in Falling >;uit. -ar'ets VAN U.S. Hedge Morningstar Average Fund Index '.'0& $%.)0& '.%0& 5.00& $0.(0& $!.'0& $+.!0& '.!0& 0.%0& %.00& $'.*0& $!.!0& $%.(0& $!.*0& $%.+0& !.*0& .!0& $!0.%0& Equity Mutua Fund $'.(0& $!5.*0& $0.#0& $0.)0& $%.'0& $'.+0& $!5.00& $%.'0& $%.+0& 0.+0& $).(0& $!'.)0& $!).'0& $!0.)0& $!+.+0& $!.)0& $'.'0& $!!5.)0&
S&P 500 !"#0 %"#0 '"#! !"#' !"#* *"#* %"#( %"## '"00 %"00 *"00 !"0! %"0! '"0' %"0' %"0* !"05 ,ota $%& $!%.)0& $0.'0& $'.50& $%.(0& $0.0'& $#.#0& $+.'0& $'.)0& $!.00& $).(0& $!!.#0& $!*.)0& $!%.*0& $!).%0& $'.%0& $'.5#& $!!%.0!&
"uring the last 1* .ears5 the S1P #// Inde< has had 17 negati)e ;uarters5 totaling a negati)e return of 113./1E. "uring those negati)e ;uarters5 the a)erage @.S. e;uit. +utual fund had a total negati)e return of 11#.7E5 while the a)erage hedge fund had a total negati)e return of onl. 1/.3E5 dis,la.ing the a3ilit. of hedge funds to ,reser)e ca,ital in falling e;uit. +ar'ets.
ABOUT WORKINGS OF HEDGE FUNDS 4 hedge fund is a ,ri)ate in)est+ent fund charging a ,erfor+ance fee and t.,icall. o,en to onl. a li+ited range of ;ualified in)estors. In the @nited States5 hedge funds are o,en to accredited in)estors onl.. $ecause of this restriction5 the. are usuall. e<e+,t fro+ an. direct regulation 3. regulator. 3odies. 4lfred &inslow Iones is credited with in)enting hedge funds in 1 ! . J1K 4s a hedge fund2s in)est+ent acti)ities are li+ited onl. 3. the contracts go)erning the ,articular fund5 it can +a'e greater use of co+,le< in)est+ent strategies such as short selling5 entering into futures5 swa,s and other deri)ati)e contracts and le)erage. 4s their na+e i+,lies5 hedge funds often see' to offset ,otential losses in the ,rinci,al +ar'ets the. in)est in 3. hedging )ia an. nu+3er of +ethods. Howe)er5 the ter+ Nhedge fundN has co+e in +odern ,arlance to 3e o)erused and ina,,ro,riatel. a,,lied to an. a3solute9return fund O +an. of these so9called Nhedge fundsN do not actuall. hedge their in)est+ents. Hedge funds ha)e ac;uired a re,utation for secrec.. @nli'e o,en9to9the9,u3lic NretailN funds 7e.g.5 @.S. +utual funds8 which +ar'et freel. to the ,u3lic5 in +ost countries5 hedge funds are s,ecificall. ,rohi3ited fro+ +ar'eting to in)estors who are not ,rofessional in)estors or indi)iduals with sufficient ,ri)ate wealth. 0his li+its the infor+ation a hedge fund can legall. release. 4dditionall.5 di)ulging a hedge fund2s +ethods could unreasona3l. co+,ro+ise their 3usiness interestsG this li+its the infor+ation a hedge fund would want to release. Since hedge fund assets can run into +an. 3illions of dollars and will usuall. 3e +ulti,lied 3. le)erage5 their swa. o)er +ar'ets5 whether the. succeed or fail5 is ,otentiall. su3stantial and there is a continuing de3ate o)er whether the. should 3e +ore thoroughl. regulated. Industry In 2//#5 43solute (eturn +aga:ine found there were 1 % hedge funds with D1 3illion or +ore in assets5 with a co+3ined D7!3 3illion under +anage+ent 9 the )ast +a6orit. of the industr.2s
Hedging Fund & Its Impact On Capital Market esti+ated D1 trillion in assets.J2K Howe)er5 according to hedge fund ad)isor. grou, Hennessee5 total hedge fund industr. assets increased 3. D21# 3illion in 2//% to D1.!!2 trillion5 u, 17.#E on a .ear earlier5 an esti+ate for 2//# see+ingl. at odds with Absolute 6eturn. 4s large institutional in)estors ha)e entered the hedge fund industr. the total asset le)els continue to rise. 0he 2//* Hedge Fund 4sset Flows 1 0rends (e,ort J!K ,u3lished 3. HedgeAund.net and *nstitutional *nvestor Bews esti+ates total industr. assets reached D2.%* trillion in M3 2//7. Fees @suall. the hedge fund +anager will recei)e 3oth a +anage+ent fee and a ,erfor+ance fee 7also 'nown as an incenti)e fee8. Perfor+ance fees are closel. associated with hedge funds5 and are intended to incenti)i:e the in)est+ent +anager to ,roduce the largest returns ,ossi3le. Management fees 4s with other in)est+ent funds5 the +anage+ent fee is calculated as a ,ercentage of the net asset )alue of the fund at the ti+e when the fee 3eco+es ,a.a3le. -anage+ent fees t.,icall. range fro+ 1E to !E ,er annu+5 with 2E 3eing the standard figure. 0herefore5 if a fund has D1 3illion of assets at the .ear end and charges a 2E +anage+ent fee5 the +anage+ent fee will 3e D2/ +illion in total. -anage+ent fees are usuall. calculated annuall. and ,aid +onthl.. Performance fees Perfor+ance fees5 which gi)e a share of ,ositi)e returns to the +anager5 are one of the defining characteristics of hedge funds. In contrast to retail in)est+ent fir+s5 ,erfor+ance fees are ,rohi3ited in the @.S. for stoc' 3ro'ers.J"itation neededK 4 hedge fund2s ,erfor+ance fee is calculated as a ,ercentage of the fund2s ,rofits5 counting 3oth unreali:ed ,rofits and actual reali:ed trading ,rofits. Perfor+ance fees e<ist 3ecause in)estors are usuall. willing to ,a. +anagers +ore generousl. when the in)estors ha)e the+sel)es +ade +one.. For +anagers who ,erfor+ well the ,erfor+ance fee is e<tre+el. lucrati)e.
Hedging Fund & Its Impact On Capital Market 0.,icall.5 hedge funds charge 2/E of gross returns as a ,erfor+ance fee5 3ut again the range is wide5 with highl. regarded +anagers de+anding higher fees. In ,articular5 Ste)en Cohen2s S4C Ca,ital Partners charges a #/E incenti)e fee 73ut no +anage+ent fee8 and Ii+ Si+ons2 (enaissance 0echnologies Cor,. charged a #E +anage+ent fee and a !!E incenti)e fee in its flagshi, -edallion Fund 3efore returning all in)estors2 ca,ital and running solel. on its e+,lo.ees2 +one.. J"itations neededK -anagers argue that ,erfor+ance fees hel, to align the interests of +anager and in)estor 3etter than flat fees that are ,a.a3le e)en when ,erfor+ance is ,oor. Howe)er5 ,erfor+ance fees ha)e 3een critici:ed 3. +an. ,eo,le5 including nota3le in)estor &arren $uffett5 for gi)ing +anagers an incenti)e to ta'e e<cessi)e ris' rather than targeting high long9ter+ returns. In an atte+,t to control this ,ro3le+5 fees are usuall. li+ited 3. a high water +ar' and so+eti+es 3. a hurdle rate. 4lternati)el.5 the in)est+ent +anager +ight 3e re;uired to return ,erfor+ance fees when the )alue of the fund dro,s. 0his ,ro)ision is so+eti+es called a Pclaw93ac'.C
High water marks 4 NHigh water +ar'N is often a,,lied to a ,erfor+ance fee calculation.J#K 0his +eans that the +anager does not recei)e ,erfor+ance fees unless the )alue of the fund e<ceeds the highest net asset )alue it has ,re)iousl. achie)ed. For e<a+,le5 if a fund was launched at a net asset )alue 7N4?8 ,er share of D1//5 which then rose to D13/ in its first .ear5 a ,erfor+ance fee would 3e ,a.a3le on the D3/ return for each share. If the ne<t .ear it dro,,ed to D12/5 no fee is ,a.a3le. If in the third .ear the N4? ,er share rises to D1!35 a ,erfor+ance fee will 3e ,a.a3le onl. on the e<tra D13 return fro+ D13/ to D1!3 rather than on the full return fro+ D12/ to D1!3. 0his +easure is intended to lin' the +anager2s interests +ore closel. to those of in)estors and to reduce the incenti)e for +anagers to see' )olatile trades. If a high water +ar' is not used5 a fund that ends alternate .ears at D1// and D11/ would generate ,erfor+ance fee e)er. other .ear5 enriching the +anager 3ut not the in)estors. Howe)er5 this +echanis+ does not ,ro)ide co+,lete ,rotection to in)estorsH a +anager who has lost +one. +a. si+,l. decide to close the
Hedging Fund & Its Impact On Capital Market fund and start again with a clean slate 99 ,ro)ided that he can ,ersuade in)estors to trust hi+ with their +one.. 4 high water +ar' is so+eti+es referred to as a N=oss Carr.forward Pro)ision.N Poorl. ,erfor+ing funds fre;uentl. close down rather than wor' without fees5 as would 3e re;uired 3. their high water +ar' ,olicies. J%K Hurdle rates So+e funds also s,ecif. a hurdle rate5 which signifies that the fund will not charge a ,erfor+ance fee until its annuali:ed ,erfor+ance e<ceeds a 3ench+ar' rate5 such as 093ills or a fi<ed ,ercentage5 o)er so+e ,eriod. 0his lin's ,erfor+ance fees to the a3ilit. of the +anager to do 3etter than the in)estor would ha)e done if he had ,ut the +one. elsewhere. Funds which s,ecif. a soft hurdle rate charge a ,erfor+ance fee 3ased on the entire annuali:ed return. Funds which use a hard hurdle rate onl. charge a ,erfor+ance fee on returns a3o)e the hurdle rate. 0hough logicall. a,,ealing5 this ,ractice has di+inished as de+and for hedge funds has outstri,,ed su,,l. and hurdles are now rare.J"itations neededK Strategies Hedge funds are no longer a ho+ogeneous class. @nder certain circu+stances5 an in)estor or hedge fund can co+,letel. hedge the ris's of an in)est+ent5 lea)ing ,ure ,rofit.J"itation neededK For e<a+,le5 at one ti+e it was ,ossi3le for e<change traders to 3u. shares of5 sa.5 I$- on one e<change and si+ultaneousl. sell the+ on another e<change5 lea)ing ,ure ,rofit.J"itation neededK Co+,etition a+ong in)estors has leached awa. such ,rofits5 lea)ing hedge fund +anagers with trades that are ,artiall. hedged5 at 3est. 0hese trades still contain residual ris's which can 3e considera3le. So+e st.les of hedge fund in)esting5 such as glo3al +acro in)esting5 +a. in)ol)e no hedging at all. Strictl. s,ea'ing5 it is not accurate to call such funds hedge funds5 3ut that is current usage.
Hedging Fund & Its Impact On Capital Market 0he 3ul' of hedge funds descri3e the+sel)es as long F short e;uit.5 3ut +an. different a,,roaches are used ta'ing different e<,osures5 e<,loiting different +ar'et o,,ortunities5 using different techni;ues and different instru+entsH
Glo3al +acro O see'ing related assets that ha)e de)iated fro+ so+e antici,ated relationshi,. 4r3itrage O see'ing assets that are +is,riced relati)e to related assets.
o
Con)erti3le ar3itrage O 3etween a con)erti3le 3ond and the sa+e co+,an.2s e;uit.. Fi<ed inco+e ar3itrage O 3etween related 3onds. (is' ar3itrage O 3etween securities whose ,rices a,,ear to i+,l. different ,ro3a3ilities for one e)ent. Statistical ar3itrage 7or 3tatArb8 O 3etween securities that ha)e de)iated fro+ so+e statisticall. esti+ated relationshi,. "eri)ati)e ar3itrage O 3etween a deri)ati)e and its securit.. Short 3ias O e+,hasi:ing or solel. using short ,ositions. >;uit. +ar'et neutral O +aintaining a close 3alance 3etween long and short ,ositions.
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=ong F short e;uit. O generic ter+ co)ering all hedged in)est+ent in e;uities.
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>)ent dri)en O s,eciali:ed in the anal.sis of a ,articular 'ind of e)ent.

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"istressed securities O co+,anies that are or +a. 3eco+e 3an'ru,t. (egulation " O distressed co+,anies issuing securities. -erger ar3itrage 9 ar3itrage 3etween an ac;uiring ,u3lic co+,an. and a target ,u3lic co+,an..
Other O the strategies 3elow are so+eti+es considered hedge strategies5 although in se)eral cases usage of the ter+ is de3ata3le.
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>+erging +ar'ets9 this usuall. +eans unhedged5 long ,ositions in s+all o)erseas +ar'ets. Fund of hedge funds 9 unhedged5 long onl. ,ositions in hedge funds 7though the underl.ing funds5 of course5 +a. 3e hedged8. 4dditional le)erage is so+eti+es used.J"itation neededK

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Muantitati)e 13/93/ funds 9 0hrough le)eraging5 13/E of the +one. in)ested in the fund is used to 3u. stoc's. 3/E of the +one. in)ested in the fund is used to short stoc'.
Hedge fund risk In)esting in a hedge fund is considered to 3e a ris'ier ,ro,osition than in)esting in a regulated fund5 des,ite the traditional notion of a NhedgeN 3eing a +eans of reducing the ris' of a 3et or in)est+ent. 0he following are so+e of the ,ri+ar. reasons for the increased ris'H =e)erage 9 in addition to ,utting +one. into the fund 3. in)estors5 a hedge fund will t.,icall. 3orrow +one.5 with certain funds 3orrowing su+s +an. ti+es greater than the initial in)est+ent. &here a hedge fund has 3orrowed D for e)er. D1 in)ested5 a loss of onl. 1/E of the )alue of the in)est+ents of the hedge fund will wi,e out 1//E of the )alue of the in)estor2s sta'e in the fund5 once the creditors ha)e called in their loans. 4t the 3eginning of 1 *5 shortl. 3efore its colla,se5 =ong 0er+ Ca,ital -anage+ent had 3orrowed o)er D2% for each D1 in)ested. Short selling 9 due to the nature of short selling5 the losses that can 3e incurred on a losing 3et are theoreticall. li+itless5 unless the short ,osition directl. hedges a corres,onding long ,osition. 0herefore5 where a hedge fund uses short selling as an in)est+ent strateg. rather than as a hedging strateg. it can suffer )er. high losses if the +ar'et turns against it. 4,,etite for ris' 9 hedge funds are culturall. +ore li'el. than other t.,es of funds to ta'e on underl.ing in)est+ents that carr. high degrees of ris'5 such as high .ield 3onds5 distressed securities and collateralised de3t o3ligations 3ased on su39,ri+e +ortgages. =ac' of trans,arenc. 9 hedge funds are secreti)e entities. It can therefore 3e difficult for an in)estor to assess trading strategies5 di)ersification of the ,ortfolio and other factors rele)ant to an in)est+ent decision. =ac' of regulation 9 hedge funds are not su36ect to as +uch o)ersight fro+ financial regulators5 and therefore so+e +a. carr. undisclosed structural ris's.
Hedging Fund & Its Impact On Capital Market In)estors in hedge funds are willing to ta'e these ris's 3ecause of the corres,onding rewards. =e)erage a+,lifies ,rofits as well as lossesG short selling o,ens u, new in)est+ent o,,ortunitiesG ris'ier in)est+ents t.,icall. ,ro)ide higher returnsG secrec. hel,s to ,re)ent i+itation 3. co+,etitorsG and 3eing unregulated reduces costs and allows the in)est+ent +anager +ore freedo+ to +a'e decisions on a ,urel. co++ercial 3asis.
Legal structure 4 hedge fund is a )ehicle for holding and in)esting the funds of its in)estors. 0he fund itself is not a genuine 3usiness5 ha)ing no e+,lo.ees and no assets other than its in)est+ent ,ortfolio and a s+all a+ount of cash5 and its in)estors 3eing its clients. 0he ,ortfolio is +anaged 3. the in)est+ent +anager5 which has e+,lo.ees and ,ro,ert. and which is the actual 3usiness. 4n in)est+ent +anager is co++onl. ter+ed a Qhedge fundR 7e.g. a ,erson +a. 3e said to Qwor' at a hedge fundR8 3ut this is not technicall. correct. 4n in)est+ent +anager +a. ha)e a large nu+3er of hedge funds under its +anage+ent. Domicile 0he s,ecific legal structure of a hedge fund O in ,articular its do+icile and the t.,e of entit. used O is usuall. deter+ined 3. the ta< en)iron+ent of the fundCs e<,ected in)estors. (egulator. considerations will also ,la. a role. -an. hedge funds are esta3lished in offshore ta< ha)ens so that the fund can a)oid ,a.ing ta< on the increase in the )alue of its ,ortfolio. 4n in)estor will still ,a. ta< on an. ,rofit it +a'es when it realises its in)est+ent5 and the in)est+ent +anager5 usuall. 3ased in a +a6or financial centre5 will ,a. ta< on the fees that it recei)es for +anaging the fund. 4t the end of 2//! ##E of the worldCs hedge funds5 accounting for nearl. two9thirds of total hedge fund assets5 were esta3lished offshore. 0he +ost ,o,ular offshore location was the Ca.+an Islands5 followed 3. the $ritish ?irgin Islands5 $er+uda and the $aha+as. 0he @S was the +ost ,o,ular onshore location5 accounting for 3!E of funds and 2!E of assets. >@ countries
Hedging Fund & Its Impact On Capital Market were the ne<t +ost ,o,ular location with E of funds and 11E of assets. 4sia accounted for the +a6orit. of the re+aining assets.Jcitations neededK The legal entity =i+ited ,artnershi,s are ,rinci,all. used for hedge funds ai+ed at @S93ased in)estors who ,a. ta<5 as the in)estors will recei)e relati)el. fa)ora3le ta< treat+ent in the @S. 0he general ,artner of the li+ited ,artnershi, is t.,icall. the in)est+ent +anager 7though is so+eti+es an offshore cor,oration8 and the in)estors are the li+ited ,artners. Offshore cor,orate funds are used for non9@S in)estors and @S entities that do not ,a. ta< 7such as ,ension funds85 as such in)estors do not recei)e the sa+e ta< 3enefits fro+ in)esting in a li+ited ,artnershi,. @nit trusts are t.,icall. +ar'eted to Ia,anese in)estors. Other than ta<ation5 the t.,e of entit. used does not ha)e a significant 3earing on the nature of the fund.J7K -an. hedge funds are structured as +asterFfeeder funds. In such a structure the in)estors will in)est into a feeder fund which will in turn in)est all of its assets into the +aster fund. 0he assets of the +aster fund will then 3e +anaged 3. the in)est+ent +anager in the usual wa.. 0his allows se)eral feeder funds 7e.g. an offshore cor,orate fund5 a @S li+ited ,artnershi, and a unit trust8 to in)est into the sa+e +aster fund5 allowing an in)est+ent +anager the 3enefit of +anaging the assets of a single entit. while gi)ing all in)estors the 3est ,ossi3le ta< treat+ent. 0he in)est+ent +anager5 which will ha)e organi:ed the esta3lish+ent of the hedge fund5 +a. retain an interest in the hedge fund5 either as the general ,artner of a li+ited ,artnershi, or as the holder of Qfounder sharesR in a cor,orate fund. Founder shares t.,icall. ha)e no econo+ic rights5 and )oting rights o)er onl. a li+ited range of issues5 such as selection of the in)est+ent +anager O +ost of the fundCs decisions are ta'en 3. the 3oard of directors of the fund5 which is self9a,,ointing and inde,endent 3ut in)aria3l. lo.al to the in)est+ent +anager.
Open-ended nature Hedge funds are t.,icall. o,en9ended5 in that the fund will ,eriodicall. issue additional ,artnershi, interests or shares directl. to new in)estors5 the ,rice of each 3eing the net asset )alue 7QN4?R8 ,er interestFshare. 0o realise the in)est+ent5 the in)estor will redee+ the interests or shares at the N4? ,er interestFshare ,re)ailing at that ti+e. 0herefore5 if the )alue of the underl.ing in)est+ents has increased 7and the N4? ,er interestFshare has therefore also increased8 then the in)estor will recei)e a larger su+ on rede+,tion than it ,aid on in)est+ent. In)estors do not t.,icall. trade shares 3etween the+sel)es and hedge funds do not t.,icall. distri3ute ,rofits to in)estors 3efore rede+,tion. 0his contrasts with a closed9ended fund5 which has a li+ited nu+3er of shares which are traded 3etween in)estors5 and which distri3utes its ,rofits.
Listed funds Cor,orate hedge funds often list their shares on s+aller stoc' e<changes5 such as the Irish Stoc' ><change5 in the ho,e that the low le)el of ;uasi9regulator. o)ersight will gi)e co+fort to in)estors and to attract certain funds5 such as so+e ,ension funds5 that ha)e 3ars or ca,s on in)esting in unlisted shares. Shares in the listed hedge fund are not traded on the e<change5 3ut the fundCs +onthl. net asset )alue and certain other e)ents +ust 3e ,u3licl. announced there. 4 fund listing is distinct fro+ the listing or initial ,u3lic offering 7QIPOR8 of shares in an in)est+ent +anager. 4lthough widel. re,orted as a Nhedge9fund IPONJ*K5 the IPO of Fortress In)est+ent Grou, ==C was for the sale of the in)est+ent +anager5 not of the hedge funds that it +anaged.
Hedging Fund & Its Impact On Capital Market Hedge fund management worldwide In contrast to the funds the+sel)es5 hedge fund +anagers are ,ri+aril. located onshore in order to draw on larger ,ools of financial talent. 0he @S >ast coast O ,rinci,all. New Aor' Cit. and the Gold Coast area of Connecticut 7,articularl. Sta+ford and Greenwich8 O is the world2s leading location for hedge fund +anagers with a,,ro<i+atel. dou3le the hedge fund +anagers of the ne<t largest centre5 =ondon. &ith the 3ul' of hedge fund in)est+ent co+ing fro+ the @S5 this distri3ution is natural. =ondon is >uro,eCs leading centre for the +anage+ent of hedge funds. 4t the end of 2//%5 three9;uarters of >uro,ean hedge fund in)est+ents5 totalling D!//3n 7S2//3n85 were +anaged fro+ =ondon5 ha)ing grown fro+ D%13n in 2//2. 4ustralia was the +ost i+,ortant centre for the +anage+ent of 4sia9Pacific hedge funds5 with +anagers located there accounting for a,,ro<i+atel. a ;uarter of the D1!/3n of hedge fund assets +anaged in the 4sia9Pacific region in 2//%.J1/K
Hedging Fund & Its Impact On Capital Market Regulatory Issues Part of what gi)es hedge funds their co+,etiti)e edge5 and their cachet in the ,u3lic i+agination5 is that the. straddle +ulti,le definitions and categoriesG so+e as,ects of their dealings are well9 regulated5 others are unregulated or at 3est ;uasi9regulated. U regulation 0he t.,ical ,u3lic in)est+ent co+,an. in the @nited States is re;uired to 3e registered with the @.S. Securities and ><change Co++ission 7S>C8. -utual funds are the +ost co++on t.,e of registered in)est+ent co+,anies. 4side fro+ registration and re,orting re;uire+ents5 in)est+ent co+,anies are su36ect to strict li+itations on short9selling and the use of le)erage. 0here are other li+itations and restrictions ,laced on ,u3lic in)est+ent co+,an. +anagers5 including the ,rohi3ition on charging incenti)e or ,erfor+ance fees. 4lthough hedge funds fall within the statutor. definition of an in)est+ent co+,an.5 the li+ited9 access5 ,ri)ate nature of hedge funds ,er+its the+ to o,erate ,ursuant to e<e+,tions fro+ the registration re;uire+ents. 0he two +a6or e<e+,tions are set forth in Sections 37c81 and 37c87 of the In)est+ent Co+,an. 4ct of 1 !/. 0hose e<e+,tions are for funds with 1// or fewer in)estors 7a N37c8 1 FundN8 and funds where the in)estors are N;ualified ,urchasersN 7a N37c8 7 FundN8. J%K 4 ;ualified ,urchaser is an indi)idual with o)er @SD#5///5/// in in)est+ent assets. 7So+e institutional in)estors also ;ualif. as accredited in)estors or ;ualified ,urchasers.8 J7K 4 37c81 Fund cannot ha)e +ore than 1// in)estors5 while a 37c87 Fund can ha)e an unli+ited nu+3er of in)estors. $oth t.,es of funds can charge ,erfor+ance or incenti)e fees. In order to co+,l. with 37c8718 or 37c87785 hedge funds are sold )ia ,ri)ate ,lace+ent under the Securities 4ct of 1 33. 0hus interests in a hedge fund cannot 3e offered or ad)ertised to the general ,u3lic5 and are nor+all. offered under (egulation ". 4lthough it is ,ossi3le to ha)e non9accredited in)estors in a hedge fund5 the e<e+,tions under the In)est+ent Co+,an. 4ct5 co+3ined with the restrictions contained in (egulation "5 effecti)el. re;uire hedge funds to 3e offered solel. to accredited in)estors. 4n accredited in)estor is an indi)idual with a +ini+u+ net worth of @S D#5///5/// or5 alternati)el.5 a +ini+u+ inco+e of @SD2//5/// in each of the
Hedging Fund & Its Impact On Capital Market last two .ears and a reasona3le e<,ectation of reaching the sa+e inco+e le)el in the current .ear. 0he regulator. landsca,e for In)est+ent 4d)isors is changing5 and there ha)e 3een atte+,ts to register hedge fund in)est+ent +anagers. 0here are nu+erous issues surrounding these ,ro,osed re;uire+ents. One issue of i+,ortance to hedge fund +anagers is the re;uire+ent that a client who is charged an incenti)e fee +ust 3e a N;ualified clientN under 4d)isers 4ct (ule 2/#93. 0o 3e a ;ualified client5 an indi)idual +ust ha)e @SD7#/5/// in assets in)ested with the ad)iser or a net worth in e<cess of @SD1.# +illion5 or 3e one of certain high9le)el e+,lo.ees of the in)est+ent ad)iser. For the funds5 the tradeoff of o,erating under these e<e+,tions is that the. ha)e fewer in)estors to sell to5 3ut the. ha)e few go)ern+ent9i+,osed restrictions on their in)est+ent strategies. 0he ,resu+,tion is that hedge funds are ,ursuing +ore ris'. strategies5 which +a. or +a. not 3e true de,ending on the fund5 and that the a3ilit. to in)est in these funds should 3e restricted to wealthier in)estors who are ,resu+ed to 3e +ore so,histicated and who ha)e the financial reser)es to a3sor3 a ,ossi3le loss. In "ece+3er 2//!5 the S>C issued a rule change that re;uired +ost hedge fund ad)isers to register with the S>C 3. Fe3ruar. 15 2//%5 as in)est+ent ad)isers under the In)est+ent 4d)isers 4ct. 0he re;uire+ent5 with +inor e<ce,tions5 a,,lied to fir+s +anaging in e<cess of @SD2#5///5/// with o)er 1# in)estors. 0he S>C stated that it was ado,ting a Nris'93ased a,,roachN to +onitoring hedge funds as ,art of its e)ol)ing regulator. regi+en for the 3urgeoning industr.. 0he rule change was challenged in court 3. a hedge fund +anager5 and in Iune 2//%5 the @.S. Court of 4,,eals for the "istrict of Colu+3ia o)erturned it and sent it 3ac' to the agenc. to 3e re)iewed. See Goldstein ). S>C. 4lthough the S>C is currentl. e<a+ining how it can address the Goldstein decision5 co++entators ha)e stated that the S>C currentl. has neither the staff nor e<,ertise to co+,rehensi)el. +onitor the esti+ated *5/// @.S. and international hedge funds. See New Hedge Fund 4d)isor (ule. One of the Co++issioners5 (oel Ca+,os5 has said that the S>C is for+ing internal tea+s that will identif. and e)aluate irregular trading ,atterns or other
Hedging Fund & Its Impact On Capital Market ,heno+ena that +a. threaten indi)idual in)estors5 the sta3ilit. of the industr.5 or the financial world. NIt2s ,rett. clear that we will not 3e 'noc'ing on Jhedge fundK doors )er. often5N Ca+,os told se)eral hundred hedge fund +anagers5 industr. law.ers and others. 4nd e)en if it did5 Nthe S>C will ne)er ha)e the degree of 'nowledge or 3ac'ground that .ou do. In Fe3ruar. 2//75 the President2s &or'ing Grou, on Financial -ar'ets re6ected further regulation of hedge funds and said that the industr. should instead follow )oluntar. guidelines.
Comparison to private equity funds Hedge funds are si+ilar to ,ri)ate e;uit. funds in +an. res,ects. $oth are lightl. regulated5 ,ri)ate ,ools of ca,ital that in)est in securities and co+,ensate their +anagers with a share of the fund2s ,rofits. -ost hedge funds in)est in relati)el. li;uid assets5 and ,er+it in)estors to enter or lea)e the fund5 ,erha,s re;uiring so+e +onths notice. Pri)ate e;uit. funds in)est ,ri+aril. in )er. illi;uid assets such as earl.9stage co+,anies and so in)estors are Nloc'ed inN for the entire ter+ of the fund. Hedge funds often in)est in ,ri)ate e;uit. co+,anies2 ac;uisition funds. $etween 2//! and Fe3ruar. 2//% so+e hedge funds ado,ted 2# +onth loc'9u, rules e<,ressl. to e<e+,t the+sel)es fro+ the S>C2s new registration re;uire+ents and cause the+ to fall under the registration e<e+,tion that had 3een intended to e<e+,t ,ri)ate e;uit. funds.
Hedging Fund & Its Impact On Capital Market Comparison to U.S. mutual funds =i'e hedge funds5 +utual funds are ,ools of in)est+ent ca,ital 7i.e.5 +one. ,eo,le want to in)est8. Howe)er5 there are +an. differences 3etween the two5 includingH

-utual funds are regulated 3. the S>C5 while hedge funds are not 4 hedge fund in)estor +ust 3e an accredited in)estor with certain e<ce,tions 7e+,lo.ees5 etc.8 -utual funds +ust ,rice and 3e li;uid on a dail. 3asis
So+e hedge funds that are 3ased offshore re,ort their ,rices to the Financial 0i+es5 3ut for +ost there is no +ethod of ascertaining ,ricing on a regular 3asis. 4dditionall.5 +utual funds +ust ha)e a ,ros,ectus a)aila3le to an.one that re;uests the+ 7either electronicall. or )ia @S ,ostal +ail85 and +ust disclose their asset allocation ;uarterl.5 while hedge funds do not ha)e to a3ide 3. these ter+s. Hedge funds also ordinaril. do not ha)e dail. li;uidit.5 3ut rather Nloc' u,N ,eriods of ti+e where the total returns are generated 7net of fees8 for their in)estors and then returned when the ter+ ends5 through a ,assthrough re;uiring CP4s and @S 0a< &9for+s. Hedge fund in)estors tolerate these ,olicies 3ecause hedge funds are e<,ected to generate higher total returns for their in)estors )ersus +utual funds. (ecentl.5 howe)er5 the +utual fund industr. has created ,roducts with features that ha)e traditionall. onl. 3een found in hedge funds. -utual funds ha)e a,,eared which utili:e so+e of the trading strategies noted a3o)e. Gri::l. Short Fund 7G(TTU85 for e<a+,le5 is alwa.s net short5 while 4r3itrage Fund 74($FU8 s,eciali:es in +erger ar3itrage. Such funds are S>C regulated5 3ut the. offer hedge fund strategies and ,rotection for +utual fund in)estors. 4lso5 a few +utual funds ha)e introduced ,erfor+ance93ased fees5 where the co+,ensation to the +anager is 3ased on the ,erfor+ance of the fund. Howe)er5 under Section 2/#738 of the In)est+ent 4d)isers 4ct of 1 !/5 such co+,ensation is li+ited to so9called Nfulcru+ feesN.J1#K
Hedging Fund & Its Impact On Capital Market @nder these arrange+ents5 fees can 3e ,erfor+ance93ased so long as the. increase and decrease s.++etricall.. For e<a+,le5 the 0FS Ca,ital S+all Ca, Fund 70FSSU8 has a +anage+ent fee that 3eha)es5 within li+its and s.++etricall.5 si+ilarl. to a hedge fund N/ and #/N feeH 4 /E +anage+ent fee cou,led with a #/E ,erfor+ance fee if the fund out,erfor+s its 3ench+ar' inde<. Howe)er5 the 12# 3, 3ase fee is reduced 73ut not 3elow :ero8 3. #/E of under,erfor+ance and increased 73ut not to +ore than 2#/ 3,8 3. #/E of out,erfor+ance. Offshore regulation -an. offshore centers are 'een to encourage the esta3lish+ent of hedge funds. 0o do this the. offer so+e co+3ination of ,rofessional ser)ices5 a fa)ora3le ta< en)iron+ent5 and 3usiness9 friendl. regulation. -a6or centers include Ca.+an Islands5 "u3lin5 =u<e+3ourg5 $ritish ?irgin Islands and $er+uda. 0he Ca.+an Islands ha)e 3een esti+ated to 3e ho+e to a3out 7#E of worldCs hedge funds5 with nearl. half the industr.2s esti+ated D1.22# trillion 4@-J11K. Hedge funds ha)e to file accounts and conduct their 3usiness in co+,liance with the re;uire+ents of these offshore centres. 0.,ical rules concern restrictions on the a)aila3ilit. of funds to retail in)estors 7"u3lin85 ,rotection of client confidentialit. 7=u<e+3ourg8 and the re;uire+ent for the fund to 3e inde,endent of the fund +anager. -an. offshore hedge funds5 such as the Soros funds5 are structured as +utual funds rather than as li+ited ,artnershi,s. Hedge Fund Indices 0here are a nu+3er of indices that trac' the hedge fund industr.. 0hese indices co+e in two t.,es5 In)esta3le and Non9in)esta3le5 3oth with su3stantial ,ro3le+s. 0here are also new t.,es of trac'ing ,roduct launched 3. Gold+an Sachs and -errill =.nch5 Nclone indicesN that ai+ to re,licate the returns of hedge fund indices without actuall. holding hedge funds at all. In)esta3le indices are created fro+ funds that can 3e 3ought and sold5 and onl. Hedge Funds that agree to acce,t in)est+ents on ter+s acce,ta3le to the constructor of the inde< are included.
Hedging Fund & Its Impact On Capital Market In)esta3ilit. is an attracti)e ,ro,ert. for an inde< 3ecause it +a'es the inde< +ore rele)ant to the choices a)aila3le to in)estors in ,ractice5 and is ta'en for granted in traditional e;uit. indices such as the S1P#// or F0S>1//. Howe)er5 such indices do not re,resent the total uni)erse of hedge funds and +a. under9re,resent the +ore successful +anagers5 who +a. not find the inde< ter+s attracti)e. Fund inde<es include $arcla.Hedge5 Hedge Fund (esearch5 >ure'ahedge Indices5 Credit Suisse 0re+ont and F0S> Hedge. 0he inde< ,ro)ider selects funds and de)elo,s structured ,roducts or deri)ati)e instru+ents that deli)er the ,erfor+ance of the inde<5 +a'ing in)esta3le indices si+ilar in so+e wa.s to fund of hedge funds ,ortfolios. Non9in)esta3le 3ench+ar's are indicati)e in nature5 and ai+ to re,resent the ,erfor+ance of the uni)erse of hedgefunds using so+e +easure such as +ean5 +edian or weighted +ean fro+ a hedge fund data3ase. 0here are di)erse selection criteria and +ethods of construction5 and no single data3ase ca,tures all funds. 0his leads to significant differences in re,orted ,erfor+ance 3etween different data3ases. Non9in)esta3le indices inherit the data3ases2 shortco+ings5 or strengths5 in ter+s of sco,e and ;ualit. of data. FundsC ,artici,ation in a data3ase is )oluntar.5 leading to Qself re,orting 3iasR 3ecause those funds that choose to re,ort +a. not 3e t.,ical of funds as a whole. For e<a+,le5 so+e do not re,ort 3ecause of ,oor results or 3ecause the. ha)e alread. reached their target si:e and do not wish to raise further +one.. 0his tends to lead to a clustering of returns around the +ean rather than re,resenting the full di)ersit. e<isting in the hedge fund uni)erse. ><a+,les of non9in)esta3le indices include an e;ual weighted 3ench+ar' series 'nown as the HFN 4)erages5 and a re)olutionar. rules 3ased set 'nown as the =eh+an $rothersFHFN Glo3al Inde< Series which le)erages an >nhanced Strateg. Classification S.ste+. 0he short lifeti+es of +an. hedge funds +eans that there are +an. new entrants and +an. de,artures each .ear5 which raises the ,ro3le+ of Qsur)i)orshi, 3iasR. If we e<a+ine onl. funds that ha)e sur)i)ed to the ,resent5 we will o)eresti+ate ,ast returns 3ecause +an. of the worst9 ,erfor+ing funds ha)e not sur)i)ed5 and the o3ser)ed association 3etween fund .outh and fund ,erfor+ance suggests that this 3ias +a. 3e su3stantial. 4s the HF( and CIS"- data3ases 3egan
Hedging Fund & Its Impact On Capital Market in 1 !5 it is li'el. that the. will 3e +ore accurate o)er the ,eriod 1 !F2/// than the Credit
Suisse data3ase5 which onl. 3egan in 2///. &hen a fund is added to a data3ase for the first ti+e5 all or ,art of its historical data is recorded e<9,ost in the data3ase. It is li'el. that funds onl. ,u3lish their results when the. are fa)oura3le5 so that the a)erage ,erfor+ances dis,la.ed 3. the funds during their incu3ation ,eriod are inflated. 0his is 'nown as Ninstant histor. 3iasR or Q3ac'fill 3iasR. In traditional e;uit. in)est+ent5 indices ,la. a central and una+3iguous role. 0he. are widel. acce,ted as re,resentati)e5 and ,roducts such as futures and >0Fs ,ro)ide li;uid access to the+ in +ost de)elo,ed +ar'ets. Howe)er5 a+ong hedge funds no inde< co+3ines these characteristics. In)esta3le indices achie)e li;uidit. at the e<,ense of re,resentati)eness. Non9 in)esta3le indices are re,resentati)e5 3ut their ;uoted returns +a. not 3e a)aila3le in ,ractice. Neither is wholl. satisfactor.. Debates and controversies Pri!acy issues 4s ,ri)ate5 lightl. regulated ,artnershi,s5 hedge funds do not ha)e to disclose their acti)ities to third ,arties. 0his is in contrast to a full. regulated +utual fund 7or unit trust8 which will t.,icall. ha)e to +eet regulator. re;uire+ents for disclosure. 4n in)estor in a hedge fund usuall. has direct access to the in)est+ent ad)isor of the fund5 and +a. en6o. +ore ,ersonalised re,orting than in)estors in retail in)est+ent funds. 0his +a. include detailed discussions of ris's assu+ed and significant ,ositions. Howe)er5 this high le)el of disclosure is not a)aila3le to non9 in)estors5 contri3uting to hedge funds2 re,utation for secrec.. Se)eral hedge funds are co+,letel. N3lac' 3o<N5 +eaning that their returns are uncertain to the in)estor. (estrictions on +ar'eting and the lac' of regulation is that there are no official hedge fund statistics. 4n industr. consulting grou,5 HF( 7hfr.co+85 re,orted at the end of the second ;uarter 2//3 that there are #5%%/ hedge funds world wide +anaging D%%# 3illion. For co+,arison5 at the sa+e ti+e the @S +utual fund sector held assets of D7.*1* trillion 7according to the In)est+ent Co+,an. Institute8.
Hedging Fund & Its Impact On Capital Market Market capacity 4nal.sis of the rather disa,,ointing hedge fund ,erfor+ance in 2//! and 2//# called into ;uestion the alternati)e in)est+ent industr.2s )alue ,ro,osition. 4l,ha +a. ha)e 3een 3eco+ing rarer for two related reasons. First5 the increase in traded )olu+e +a. ha)e 3een reducing the +ar'et ano+alies that are a source of hedge fund ,erfor+ance. Second5 the re+uneration +odel is attracting +ore and +ore +anagers5 which +a. dilute the talent a)aila3le in the industr.. Howe)er5 the +ar'et ca,acit. effect has 3een ;uestioned 3. the >"H>C (is' and 4sset -anage+ent (esearch Centre through a deco+,osition of hedge fund returns 3etween ,ure al,ha5 d.na+ic 3etas5 and static 3etas. &hile ,ure al,ha is generated 3. e<,loiting +ar'et o,,ortunities5 the d.na+ic 3etas de,end on the +anagerCs s'ill in ada,ting the e<,osures to different factors5 and these authors clai+ that these two sources of return do not e<hi3it an. erosion. 0his suggests that the +ar'et en)iron+ent 7static 3etas8 e<,lains a large ,art of the ,oor ,erfor+ance of hedge funds in 2//! and 2//#. ystematic risk Hedge funds ca+e under heightened scrutin. as a result of the failure of =ong90er+ Ca,ital -anage+ent 7=0C-8 in 1 *5 which necessitated a 3ailout coordinated 3. the @.S. Federal (eser)e. Critics ha)e charged that hedge funds ,ose s.ste+ic ris's highlighted 3. the =0Cdisaster. 0he e<cessi)e le)erage 7through deri)ati)es8 that can 3e used 3. hedge funds to achie)e their return is outlined as one of the +ain factors of the hedge funds contri3ution to s.ste+atic ris'. 0he >C$ 7>uro,ean Central $an'8 has issued a warning on hedge fund ris' for financial sta3ilit. and s.ste+ic ris'H N... the increasingl. si+ilar ,ositioning of indi)idual hedge funds within 3road hedge fund in)est+ent strategies is another +a6or ris' for financial sta3ilit. which warrants close +onitoring des,ite the essential lac' of an. ,ossi3le re+edies. 0his ris' is further +agnified 3. e)idence that 3road hedge fund in)est+ent strategies ha)e also 3eco+e increasingl. correlated5 there3. further increasing the ,otential ad)erse effects of disorderl. e<its fro+ crowded trades.N
Hedging Fund & Its Impact On Capital Market 0he 0i+es wrote a3out this re)iewH NIn one of the star'est warnings .et fro+ an official institution o)er the role of the 3urgeoning 3ut secreti)e industr.5 the >C$ sounded a note of alar+ o)er the ,ossi3le re,ercussions fro+ an. colla,se of a hedge fund5 or grou, of funds.N Howe)er5 the >C$ state+ent itself has 3een critici:ed 3. a ,art of the financial research co++unit.. 0hese argu+ents are de)elo,ed 3. the >"H>C (is' and 4sset -anage+ent (esearch CentreH 0he +ain conclusions of the stud. are that Qthe >C$ articleCs conclusion of a ris' of Qdisorderl. e<its fro+ crowded tradesR is 3ased on +ere s,eculation. &hile the ;uestion of s.ste+ic ris' is of i+,ortance5 we do not dis,ose of enough data to relia3l. address this ;uestion at this stageR5 Q it would 3e worthwhile for financial regulators to wor' towards o3taining data on hedge fund le)erage and counter,art. credit ris'. Such data would allow a relia3le assess+ent of the ;uestion of s.ste+ic ris'R5 and Q3esides e)aluating ,otential s.ste+ic ris'5 it should 3e recognised that hedge funds ,la. an i+,ortant role as Q,ro)iders of li;uidit. and di)ersificationR. 0he ,otential for s.ste+ic ris' was highlighted 3. the near9colla,se of two $ear Stearns hedge funds in Iune 2//7. 0he funds in)ested in +ortgage93ac'ed securities. 0he funds2 financial ,ro3le+s necessitated an infusion of cash into one of the funds fro+ $ear Stearns 3ut no outside assistance. It was the largest fund 3ailout since =ong 0er+ Ca,ital -anage+ent2s colla,se in 1 *. 0he @.S. Securities and ><change co++ission is in)estigating.
Performance measurement 0he issue of ,erfor+ance +easure+ent in the hedge fund industr. has led to literature that is 3oth a3undant and contro)ersial. 0raditional indicators 7Shar,e5 0re.nor5 Iensen8 wor' 3est when returns follow a s.++etrical distri3ution. In that case5 ris' is re,resented 3. the standard de)iation. @nfortunatel.5 hedge fund returns are not nor+all. distri3uted5 and hedge fund return series are autocorrelated. Conse;uentl.5 traditional ,erfor+ance +easures suffer fro+ theoretical ,ro3le+s when the. are a,,lied to hedge funds5 +a'ing the+ e)en less relia3le than is suggested 3. the shortness of the a)aila3le return series. Inno)ati)e ,erfor+ance +easures ha)e 3een introduced in an atte+,t to deal with this ,ro3le+H -odified Shar,e ratio 3. Gregoriou and Gue.ie 72//385 O+ega 3. Beating and Shadwic'
Hedging Fund & Its Impact On Capital Market 72//285 4lternati)e In)est+ents (is' 4d6usted Perfor+ance 74I(4P8 3. Shar+a 72//!85 and Ba,,a 3. Ba,lan and Bnowles 72//!8. 4n o)er)iew of these ,erfor+ance +easures is a)aila3le in GVhin5 &.5 2//%5 0he Challenge of Hedge Fund Perfor+ance -easure+entH a 0ool3o< rather than a PandoraCs $o<5 >"H>C (is' and 4sset -anage+ent (esearch Center5 Position Pa,er5 "ece+3er. Howe)er5 there is no consensus on the +ost a,,ro,riate a3solute ,erfor+ance +easure5 and traditional ,erfor+ance +easures are still widel. used in the industr.. (elationshi,s with anal.sts In Iune 2//%. the @.S. Senate Iudiciar. Co++ittee 3egan an in)estigation into the lin's 3etween hedge funds and inde,endent anal.sts5 and other issues related to the funds. Connecticut 4ttorne. General (ichard $lu+enthal testified that an a,,eals court ruling stri'ing down o)ersight of the funds 3. federal regulators left in)estors Nin a regulator. )oid5 without an. disclosure or accounta3ilit..N 0he hearings heard testi+on. fro+5 a+ong others5 Gar. 4guirre5 a staff attorne. who was recentl. fired 3. the S>C. Transparency So+e hedge funds5 +ainl. 4+erican5 do not use third ,arties either as the custodian of their assets or as their ad+inistrator 7who will calculate the N4? of the fund8. 0his can lead to conflicts of interest5 and in e<tre+e cases can assist fraud. In a recent e<a+,le5 Bir' &right of International -anage+ent 4ssociates has 3een accused of +ail fraud and other securities )iolations which allegedl. defrauded clients of close to D1*/ +illion.
Hedging Fund & Its Impact On Capital Market IMPACT OF HEDGE FUNDS ON CAPITAL MARKET 0he hedge fund uni)erse is e<,anding ra,idl.5 with +ore than 753// funds +anaging so+e D1.7 trillion in assets 3. +id92//7. 0he three largest hedge funds each +anages at least D3/ 3illion in in)estors2 assets5 and ha)e esti+ated in)est+ent ,ositions in financial +ar'ets of u, to D1// 3illion. -GI ,ro6ects that the )alue of hedge fund assets under +anage+ent will +ore than dou3le o)er the ne<t fi)e .ears to D3.# trillion. Hedge funds ha)e 3enefited ca,ital +ar'ets 3. increasing li;uidit. and s,urring financial inno)ations. Aet worries ,ersist that their growing si:e and hea). use of 3orrowing could desta3ili:e financial +ar'ets. &hen =ong 0er+ Ca,ital -anage+ent ran into trou3le in 1 a grou, of large 3an's. -ore recentl.5 se)eral +ulti3illion9dollar hedge funds suffered 3ig losses in +id92//7 as rising defaults on su3,ri+e +ortgages caused tur+oil in the de3t and e;uit. +ar'ets. So+e s+aller and +idsi:e funds shut down. So the ;uestion arises againH could a hedge fund +eltdown trigger a 3roader financial9+ar'et crisisW -GI2s research suggests that se)eral de)elo,+ents o)er the ,ast decade +a. ha)e reducedX3ut certainl. not eli+inatedXthe ris's. Hedge funds ha)e ado,ted +ore di)erse trading strategies5 reducing the li'elihood that +an. would fail si+ultaneousl.. 0he 3an's that lend to hedge funds ha)e i+,ro)ed their assess+ent and +onitoring of ris'5 and the. ha)e reasona3le financial cushionsXcollateral and e;uit.Xto ,rotect the+ in case one or +ore of their hedge fund clients were to fail 7as we saw last su++er8. 0he largest hedge funds ha)e 3egun to raise ,er+anent ca,ital in ,u3lic stoc' and 3ond +ar'ets5 while i+,osing +ore restrictions on in)estor withdrawalsXchanges that should i+,ro)e their a3ilit. to weather +ar'et downturns. Once financial9+ar'et +a)eric's5 hedge funds are 6oining the +ainstrea+. *5 the fund2s catastro,hic losses ,ro+,ted the Federal (eser)e to coordinate a D3.% 3illion rescue 3.
Hedging Fund & Its Impact On Capital Market Pri!ate "#uity Pri)ate e;uit. is a relati)el. s+all industr.5 3ut one that has had a dis,ro,ortionatel. large i+,act on the cor,orate world. 0he )alue of ,ri)ate9e;uit.9owned co+,anies is onl. # ,ercent of the )alue of co+,anies listed in the @.S. stoc' +ar'ets 7and 6ust 3 ,ercent in >uro,e8. Howe)er5 ,ri)ate9e;uit. fir+s now account for nearl. one in three +ergers or ac;uisitions. 0hese fir+s ha)e gra33ed ,u3lic attention with a series of huge deals5 including the 3u.outs of energ. giant 0U@ Cor,. for D!# 3illion and health9care co+,an. HC45 Inc.5 for D33 3illion. Pri)ate9e;uit. fir+s are ushering in a new +odel of cor,orate go)ernance5 and the 3est funds i+,ro)e the ,erfor+ance of +an. of the co+,anies the. 3u.. For instance5 one stud. of %/ le)eraged93u.out deals found that two9thirds of the+ i+,ro)ed co+,an. ,erfor+ance and ,osted ris'9ad6usted returns of twice the industr. a)erage. Seeing su,erior returns in co+,anies ta'en ,ri)ate5 shareholders of ,u3licl. listed co+,anies are inclined to scrutini:e the ,erfor+ance of their res,ecti)e +anage+ents +ore closel. and de+and i+,ro)e+ents. 4lthough ,ri)ate9e;uit. funds are so+eti+es accused of see'ing short9ter+ ,rofits5 +ost ,ri)ate9 e;uit. funds in)est on a three9 to fi)e9.ear hori:on5 gi)ing the+ leewa. to engage in root9and9 3ranch cor,orate restructuring. $. adding de3t to an ac;uired co+,an.2s 3alance sheet5 the. force +anagers to hit tough financial targets. 4s the ,ace of 3u.outs ;uic'ened earlier in 2//75 ,ri)ate9e;uit. fir+s caused +an. ,u3lic co+,anies to rethin' their attitudes toward de3t and e;uit.Xin the @nited States5 for instance5 co+,anies ha)e increasingl. 3een choosing to 3u. 3ac' shares5 often ,urchasing the+ ,artl. 3. raising le)els of de3t. 0he recent tightening of credit +ar'ets has co+,licated the financing of so+e recent 3u.out deals and +a. da+,en the flow of in)estor +one. into ,ri)ate9e;uit. fir+s. $ut e)en if growth slows in the short ter+5 -GI ,ro6ects that the industr.2s assets will increase to D1.! trillion 3. 2/12. 4s the industr. e<,ands5 ,ri)ate9e;uit. fir+s will +ature5 consolidate5 and di)ersif. their in)est+ents5 a+,lif.ing their influence on the 3roader cor,orate and financial landsca,e. 0hese new ,ower 3ro'ers are here to sta.5 and the. are increasingl. )enturing into each other2s territor.. Hedge funds are 3u.ing u, co+,anies. 4sian central 3an's are starting to re,licate the
Hedging Fund & Its Impact On Capital Market so)ereign wealth funds of oil e<,orters. Oil e<,orters are creating +ore9so,histicated in)est+ent )ehicles such as ,ri)ate9e;uit. funds. 0he concerns a3out the new ,ower 3ro'ers are genuineXand +a. well 3e 6ustified. $ut we should +a'e 6udg+ents 3ased on the factsXnot out of an e+otional res,onse to ,ower2s ,assing to a new set of actors on the financial stage. 0here is cause for ;ualified o,ti+is+ that the 3enefits of li;uidit.5 inno)ation5 and di)ersification 3rought 3. the new ,la.ers will outweigh the ris's.
Role of Hedge Funds in the Capital Markets
0he role that hedge funds are ,la.ing in ca,ital +ar'ets cannot 3e ;uantified with an. ,recision. 4 funda+ental ,ro3le+ is that the definition of a hedge fund is i+,recise5 and distinctions 3etween hedge funds and other t.,es of funds are increasingl. ar3itrar.. Hedge funds often are characteri:ed as unregulated ,ri)ate funds that can ta'e on significant le)erage and e+,lo. co+,le< trading strategies using deri)ati)es or other new financial instru+ents. Pri)ate e;uit. funds are usuall. not considered hedge funds5 .et the. are t.,icall. unregulated and often le)erage significantl. the co+,anies in which the. in)est. =i'ewise5 traditional asset +anagers +ore and +ore are using deri)ati)es or are in)esting in structured securities that allow the+ to ta'e on le)erage or esta3lish short ,ositions. 4lthough se)eral data3ases on hedge funds are co+,iled 3. ,ri)ate )endors5 the. co)er onl. the hedge funds that )oluntaril. ,ro)ide data. Conse;uentl.5 the data are not co+,rehensi)e. Further+ore5 3ecause the funds that choose to re,ort +a. not 3e re,resentati)e of the total ,o,ulation of hedge funds5 generali:ations 3ased on these data3ases +a. 3e +isleading. "ata collected 3. the Securities and ><change Co++ission 7S>C8 fro+ registered ad)isers to hedge funds are not co+,rehensi)e either. 0he ,ri+ar. ,ur,ose of registration is to ,rotect in)estors 3. discouraging hedge fund fraud. 0he S>C does not re;uire an ad)iser to a hedge fund5 regardless of how large it is5 to register if the fund does not ,er+it in)estors to redee+ their interests within two .ears of ,urchasing the+. &hile registration of ad)isers of such funds +a. well 3e unnecessar. to discourage fraud5 the e<clusion fro+ the data3ase of funds with long loc'9u, ,eriods +a'es the data less useful for ;uantif.ing the role that hedge funds are ,la.ing in the ca,ital +ar'ets. >)en if a fund is included in a ,ri)ate data3ase or its ad)iser is registered with the S>C5 the infor+ation a)aila3le is ;uite li+ited. 0he onl. ;uantitati)e infor+ation that the S>C currentl. collects is total assets under +anage+ent. Pri)ate data3ases t.,icall. ,ro)ide assets under +anage+ent as well as so+e li+ited infor+ation on how the assets are allocated a+ong in)est+ent strategies5 3ut the. do not ,ro)ide detailed 3alance sheets. So+e data3ases ,ro)ide infor+ation on fundsC use of le)erage5 3ut their definition of le)erage is often unclear. 4s hedge
Hedging Fund & Its Impact On Capital Market funds and other +ar'et ,artici,ants increasingl. use financial ,roducts such as deri)ati)es and securiti:ed assets that e+3ed le)erage5 con)entional +easures of le)erage ha)e 3eco+e +uch less useful. -ore +eaningful econo+ic +easures of le)erage are co+,le< and highl. sensiti)e to assu+,tions a3out the li;uidit. of the +ar'ets in which financial instru+ents can 3e sold or hedged. 4lthough the role of hedge funds in the ca,ital +ar'ets cannot 3e ,recisel. ;uantified5 the growing i+,ortance of that role is clear. 0otal assets under +anage+ent are usuall. re,orted to e<ceed D1 trillion. Further+ore5 hedge funds can le)erage those assets through 3orrowing +one. and through their use of deri)ati)es5 short ,ositions5 and structured securities. 0heir +ar'et i+,act is further +agnified 3. the e<tre+el. acti)e trading of so+e hedge funds. 0he trading )olu+es of these funds re,ortedl. account for significant shares of total trading )olu+es in so+e seg+ents of fi<ed inco+e5 e;uit.5 and deri)ati)es +ar'ets. In )arious ca,ital +ar'ets5 hedge funds clearl. are increasingl. conse;uential as ,ro)iders of li;uidit. and a3sor3ers of ris'. For e<a+,le5 a stud. of the +ar'ets in @.S. dollar interest rate o,tions indicated that ,artici,ants )iewed hedge funds as a significant sta3ili:ing force. In ,articular5 when the o,tions and other fi<ed inco+e +ar'ets were under stress in the su++er of 2//35 the willingness of hedge funds to sell o,tions following a s,i'e in o,tions ,rices hel,ed restore +ar'et li;uidit. and li+it losses to deri)ati)es dealers and in)estors in fi<ed9rate +ortgages and +ortgage93ac'ed securities. Hedge funds re,ortedl. are significant 3u.ers of the ris'ier e;uit. and su3ordinated tranches of collaterali:ed de3t o3ligations 7C"Os8 and of asset9 3ac'ed securities5 including securities 3ac'ed 3. nonconfor+ing residential +ortgages. 4t the sa+e ti+e5 howe)er5 the growing role of hedge funds has gi)en rise to ,u3lic ,olic. concerns. 0hese include concerns a3out whether hedge fund in)estors can ,rotect the+sel)es ade;uatel. fro+ the ris's associated with such in)est+ents5 whether hedge fund le)erage is 3eing constrained effecti)el.5 and what ,otential ris's the funds ,ose to the financial s.ste+ if their le)erage 3eco+es e<cessi)e.
$n!estor Protection
Hedge funds and their in)est+ent ad)isers historicall. were e<e+,t fro+ +ost ,ro)isions of the federal securities laws. 0hose laws effecti)el. allow onl. institutions and relati)el. wealth. indi)iduals to in)est in hedge funds. Such in)estors argua3l. are in a ,osition to ,rotect the+sel)es fro+ the ris's associated with hedge funds. Howe)er5 in recent .ears hedge funds re,ortedl. ha)e 3een +ar'eted increasingl. to a less wealth. clientele. Further+ore5 ,ension funds5 +an. of whose 3eneficiaries are not wealth.5 ha)e increased in)est+ents in hedge funds. Concerns a3out the ,otential direct and indirect e<,osures of less wealth. in)estors fro+ hedge fund in)est+ents and hedge fund fraud contri3uted to the S>CCs decision in "ece+3er 2//! to re;uire +an. ad)isers to hedge funds that are offered to @.S. in)estors to register with the co++ission. 0he S>C 3elie)es that the e<a+ination of registered hedge fund ad)isers will deter fraud. $ut fraud is )er. difficult to unco)er5 e)en through on9site e<a+inations. 0herefore5 it is critical that in)estors do not )iew the S>C registration of ad)isers as an effecti)e su3stitute for their own due diligence in selecting funds and their own +onitoring of hedge fund ,erfor+ance. -ost institutional in)estors ,ro3a3l. understand this well. In a sur)e. se)eral .ears ago of @.S. endow+ents and foundations5 7/ ,ercent of the res,ondents said that a hedge fund ad)iserCs registration or lac' of registration with the S>C had no effect on their decision a3out whether or not to in)est 3ecause the institutions conducted their own due diligence. In the case of ,ension funds5 s,onsors and ,ension fund regulators should ensure that ,ension funds conduct a,,ro,riate due diligence with res,ect to all their in)est+ents5 not 6ust their in)est+ents in hedge funds. Pension funds and other institutional in)estors see+ to ha)e a growing a,,etite for a )ariet. of alternati)es to holding stoc's and 3onds5 including real estate5 ,ri)ate e;uit. and co++odities5 and in)est+ents in hedge funds are onl. one +eans of gaining e<,osures to those alternati)e assets. 0he registration of hedge fund ad)isers si+,l. cannot ,rotect ,ension fund 3eneficiaries fro+ the failures of ,lan s,onsors to carr. out their fiduciar. res,onsi3ilities.
Hedging Fund & Its Impact On Capital Market 4s for indi)idual in)estors5 the inco+e and wealth criteria that define eligi3le in)estors in hedge funds una)oida3l. are a crude test for so,histication. If indi)iduals with relati)el. little wealth increasingl. 3eco+e the )icti+s of hedge fund fraud5 it +a. 3eco+e a,,ro,riate to tighten the criteria for an indi)idual to 3e considered an eligi3le in)estor. "%cessi!e Le!erage and ystemic &isk
0he near failure of the hedge fund =ong90er+ Ca,ital -anage+ent 7=0C-8 in Se,te+3er 1 illustrated the ,otential for a large hedge fund to 3eco+e e<cessi)el. le)eraged and raised
concerns that a forced li;uidation of large ,ositions held 3. a highl. le)eraged institution would create s.ste+ic ris' 3. e<acer3ating +ar'et )olatilit. and illi;uidit.. In our +ar'et93ased econo+.5 the ,ri+ar. +echanis+ that regulates fir+sC le)erage is the +ar'et disci,line i+,osed 3. creditors and counter,arties. >)en when the go)ern+ent has o)ersight of le)erage5 as in the case of 3an's and 3ro'er9dealers5 such o)ersight is intended to su,,le+ent +ar'et disci,line rather than to re,lace it. In the case of =0C-5 howe)er5 +ar'et disci,line 3ro'e down. In the wa'e of the =0C- e,isode5 the PresidentCs &or'ing Grou, on Financial -ar'ets considered how 3est to constrain e<cessi)e le)erage 3. hedge funds. 0he &or'ing Grou, concluded that hedge fundsC le)erage could 3e constrained +ost effecti)el. 3. ,ro+oting +easures that enhance +ar'et disci,line 3. i+,ro)ing credit ris' +anage+ent 3. hedge fundsC counter,arties and creditors5 nearl. all of which are regulated 3an's and securities fir+s. 0he &or'ing Grou, ter+ed this a,,roach Qindirect regulationR of hedge funds. 0he &or'ing Grou, considered the alternati)e of direct go)ern+ent regulation of hedge funds5 3ut it concluded that de)elo,ing a regulator. regi+e for hedge funds would ,resent for+ida3le challenges in ter+s of cost and effecti)eness. It 3elie)ed that indirect regulation would address concerns a3out s.ste+ic ris's fro+ hedge funds +ost effecti)el. and would a)oid the ,otential attendant costs of direct regulation.
The 'ederal &eser!e and Hedge 'unds
0he PresidentCs &or'ing Grou, +ade a series of reco++endations for i+,ro)ing +ar'et disci,line on hedge funds. 0hese included reco++endations for i+,ro)e+ents in credit ris' +anage+ent ,ractices 3. the 3an's and securities fir+s that are hedge fundsC counter,arties and creditors and i+,ro)e+ents in su,er)isor. o)ersight of those 3an's and securities fir+s. 4s a regulator of 3an's and 3an' holding co+,anies5 the Federal (eser)e has wor'ed with other do+estic and international regulators to i+,le+ent the necessar. i+,ro)e+ents in su,er)isor. o)ersight. (egulator. coo,eration is essential in this area 3ecause hedge fundsC ,rinci,al creditors and counter,arties include foreign 3an's as well as @.S. 3an's and securities fir+s. In Ianuar. 1 5 the $asel Co++ittee on $an'ing Su,er)ision 7$C$S8 ,u3lished a set of
reco++endations for sound ,ractices for +anaging counter,art. credit ris's to hedge funds and other highl. le)eraged institutions. 4round the sa+e ti+e5 the Federal (eser)e5 the S>C5 and the 0reasur. "e,art+ent encouraged a grou, of twel)e +a6or 3an's and securities fir+s to for+ a Counter,art. (is' -anage+ent Polic. Grou, 7C(-PG85 which in Iul. 1 issued its own co+,le+entar. reco++endations for i+,ro)ing counter,art. ris' +anage+ent ,ractices. 0he $C$S sound ,ractices ha)e 3een incor,orated into Federal (eser)e su,er)isor. guidance and e<a+ination ,rocedures a,,lica3le to 3an'sC ca,ital +ar'et acti)ities. In general ter+s5 routine su,er)isor. re)iews of counter,art. ris' +anage+ent ,ractices with res,ect to hedge funds and other counter,arties see' to ensure that 3an's 718 ,erfor+ a,,ro,riate due diligence in assessing the 3usiness5 ris' e<,osures5 and credit standing of their counter,artiesG 728 esta3lish5 +onitor5 and enforce a,,ro,riate ;uantitati)e ris' e<,osure li+its for each of their counter,artiesG 738 use a,,ro,riate s.ste+s to +easure and +anage counter,art. credit ris'G and 7!8 de,lo. a,,ro,riate internal controls to ensure the integrit. of their ,rocesses for +anaging counter,art. credit ris'. $esides conducting routine re)iews and continuall. +onitoring counter,art. credit e<,osures5 the Federal (eser)e ,eriodicall. ,erfor+s targeted re)iews of the credit ris' +anage+ent ,ractices of 3an's that are +a6or hedge fund counter,arties. 0hese targeted re)iews e<a+ine in de,th the 3an'sC ,ractices against the $C$S and Federal (eser)e sound ,ractices guidance and the C(-PG reco++endations.
Hedging Fund & Its Impact On Capital Market 4ccording to su,er)isors and +ost +ar'et ,artici,ants5 counter,art. ris' +anage+ent has i+,ro)ed significantl. since the =0C- e,isode in 1 *. Howe)er5 since that ti+e5 hedge funds ha)e greatl. e<,anded their acti)ities and strategies in an en)iron+ent of intense co+,etition for hedge fund 3usiness a+ong 3an's and securities fir+s. Further+ore5 so+e hedge funds are a+ong the +ost acti)e in)estors in new5 +ore9co+,le< structured financial ,roducts5 for which )aluation and ris' +easure+ent are challenging 3oth to the funds the+sel)es and to their counter,arties. Counter,arties and su,er)isors need to ensure that co+,etiti)e ,ressures do not result in an. significant wea'ening of counter,art. ris' +anage+ent and that ris' +anage+ent ,ractices are e)ol)ing as necessar. to address the increasing co+,le<it. of the financial instru+ents used 3. hedge funds. 0he Federal (eser)e has also sought to li+it hedge fundsC ,otential to 3e a source of s.ste+ic ris' 3. ensuring that the clearing and settle+ent infrastructure that su,,orts the +ar'ets in which the funds trade is ro3ust. ?er. acti)e trading 3. hedge funds has contri3uted significantl. to the e<traordinar. growth in the ,ast se)eral .ears of the +ar'ets for credit deri)ati)es. 4 Iul. 2//# re,ort 3. a new Counter,art. (is' -anage+ent Polic. Grou, 7C(-PG II8 called attention to the fact that the clearing and settle+ent infrastructure for credit deri)ati)es 7and o)er9the9counter deri)ati)es generall.8 had not 'e,t ,ace with the )olu+e of trading. In ,articular5 a 3ac'log of unsigned trade confir+ations was growing5 and the acce,tance 3. dealers of assign+ents of trades 3. one counter,art. without the ,rior consent of the other5 des,ite trade docu+entation re;uire+ents for such consent5 was 3eco+ing wides,read. 0o address these and other concerns a3out the clearing and settle+ent of credit deri)ati)es5 in Se,te+3er 2//# the Federal (eser)e $an' of New Aor' 3rought together fourteen +a6or @.S. and foreign deri)ati)es dealers and their su,er)isors. 0he su,er)isors collecti)el. +ade clear their concerns a3out the ris's created 3. the infrastructure wea'nesses and as'ed the dealers to de)elo, ,lans to address those concerns. &ith su,er)isors ,ro)iding co++on incenti)es for the collecti)e actions that were necessar.5 the dealers ha)e +ade re+ar'a3le ,rogress since last Se,te+3er. 0he ,ractice of unauthori:ed assign+ents has al+ost ceased5 and dealers are now e<,editiousl. res,onding to re;uests for the authori:ation of assign+ents. For the fourteen dealers as a grou,5 total credit deri)ati)e confir+ations outstanding for +ore than thirt. da.s fell 7/ ,ercent 3etween Se,te+3er 2//# and -arch 2//%. 0he reduction in outstanding
Hedging Fund & Its Impact On Capital Market confir+ations was +ade ,ossi3le in ,art 3. +ore wides,read and intensi)e use of an electronic confir+ation9,rocessing s.ste+ o,erated 3. the "e,ositor. 0rust and Clearing Cor,oration 7"0CC8. 0he dealers ha)e wor'ed with their largest and +ost acti)e clients5 +ost of which are hedge funds5 to ensure that the. can electronicall. confir+ trades in credit deri)ati)es. $. -arch 2//%5 % ,ercent of the fourteen dealersC credit deri)ati)es trades were 3eing confir+ed electronicall.5 u, fro+ !7 ,ercent last Se,te+3er. Su,er)isors and +ar'et ,artici,ants agree that further ,rogress is needed5 and in -arch the fourteen dealers co++itted the+sel)es to achie)ing 3. Octo3er 315 2//%5 a Qstead. stateR ,osition for the industr.. 0he stead. state will in)ol)e 718 the creation of a largel. electronic +ar'et,lace in which all trades that can 3e ,rocessed electronicall. will 3eG 728 the creation 3. "0CC of an industr. trade infor+ation warehouse and su,,ort infrastructure to standardi:e and auto+ate ,rocessing of e)ents throughout each contractCs lifeG 738 new ,rocessing standards for those trades that cannot 3e confir+ed electronicall.G and 7!8 the creation of an auto+ated ,latfor+ to su,,ort notifications and consents with res,ect to trade assign+ents. 0he ,rinci,al trade association for the hedge fund industr. has stated its su,,ort for ,lans e+3odied in the dealersC co++it+ents. Hedge funds clearl. are 3eco+ing +ore i+,ortant in the ca,ital +ar'ets as sources of li;uidit. and holders and +anagers of ris'. $ut as their i+,ortance has grown5 so too ha)e concerns a3out in)estor ,rotection and s.ste+ic ris'. 0he S>C 3elie)es that the e<a+ination of registered hedge ad)isers will deter fraud. $ut in)estors +ust not )iew S>C regulation of ad)isers as an effecti)e su3stitute for their own due diligence in selecting funds and their own +onitoring of hedge fund ,erfor+ance. 4fter the =0C- e,isode5 the PresidentCs &or'ing Grou, on Financial -ar'ets considered how 3est to address concerns a3out ,otential s.ste+ic ris's fro+ e<cessi)e hedge fund le)erage. 0he &or'ing Grou, concluded that hedge fundsC le)erage could 3e constrained +ost effecti)el. 3. ,ro+oting +easures that enhance +ar'et disci,line 3. i+,ro)ing credit ris' +anage+ent 3. fundsC counter,arties and creditors5 nearl. all of which are regulated 3an's and securities fir+s. 0he &or'ing Grou, considered the alternati)e of direct go)ern+ent regulation of hedge funds
Hedging Fund & Its Impact On Capital Market 3ut concluded that it would 3e +ore costl. and would 3e less effecti)e than an a,,roach focused on strengthening +ar'et disci,line. 0he Federal (eser)e has 3een see'ing to ensure a,,ro,riate +ar'et disci,line on hedge funds 3. wor'ing with other regulators to ,ro+ote effecti)e counter,art. ris' +anage+ent 3. hedge fundsC counter,arties and creditors. It has also sought to li+it the ,otential for hedge funds to 3e a source of s.ste+ic ris' 3. ensuring that the clearing and settle+ent infrastructure that su,,orts the +ar'ets in which the. trade is ro3ust. 1. ><a+,les of hedge fund data3ases include 0rading 4d)isors Selection S.ste+ 704SS85 Centre for International Securities and "eri)ati)es -ar'ets 7CIS"-8 Hedge Fund "ata3ase5 and Hedge Fund (esearch "ata3ase. 2. 0he co++ission decided not to re;uire such funds to register 3ecause it had not encountered significant ,ro3le+s with fraud at ,ri)ate e;uit. or )enture ca,ital funds5 which are si+ilar in so+e res,ects to hedge funds 3ut usuall. re;uire in)estors to +a'e long9ter+ co++it+ents of ca,ital. 3. For a discussion of the definition and construction of econo+icall. +eaningful +easures of le)erage5 see a,,endi< 4 in Counter,art. (is' -anage+ent Polic. Grou, 71 9ounterparty 6is$ anagement Cra"ti"es 7New Aor'H C(-PG5 Iune8. 85 *mproving
!. So+e of these esti+ates +a. dou3le count in)est+ents in funds of funds. 4t the end of last .ear5 and e<cluding fund of funds5 the 04SS data3ase included funds that had D 7 .3 3illion in assets. Of course5 not all funds are included in this data3ase. #. Greenwich 4ssociates esti+ates that hedge funds in 2//! accounted for 2/ to 3/ ,ercent of trading )olu+es in +ar'ets for 3elow9in)est+ent9grade de3t5 credit deri)ati)es5 collaterali:ed de3t o3ligations5 e+erging9+ar'et 3onds5 and le)eraged loans5 and */ ,ercent of trading in distressed de3t. See Greenwich 4ssociates 72//!85 Hedge Aunds2 %he 8nd of the @eginningD 7Greenwich 4ssociates5 "ece+3er8. 0hese esti+ates were 3ased on inter)iews with hedge funds and other institutional in)estors that Greenwich 4ssociates conducted fro+ Fe3ruar. through 4,ril 2//!.
0he last few .ears ha)e 3een good to in)estors5 in)est+ent funds5 and the -14 +ar'et. Now5 in another indication that the ,art. +a. 3e o)er5 ca,ital in)estors are showing signs of retreating fro+ hedge funds. In res,onse5 hedge funds are +a'ing new offers and i+,ro)ed ter+s in order to woo the in)estors that su,,ort the+. 4fter two ,ro+inent $ear Sterns funds s,eciali:ing in su3,ri+e +ortgages colla,sed5 other hedge funds in the sa+e +ar'et 3egan seeing re;uests fro+ in)estors see'ing to redee+ their in)est+ent. 0he crunch in the su3,ri+e +ortgage +ar'et was followed 3. a decline in the o)erall a)aila3ilit. of credit and 3. falling share ,rices on the stoc' +ar'et. Since credit and share )alues are i+,ortant factors in the -14 +ar'et,lace5 the recent high ,ace of +erger and ac;uisition deal acti)it. is e<,ected to slow5 creating a challenge for funds that in)est in stoc's and ac;uisitions. So+e of the hedge fund sector2s ,ro+inent ,la.ers5 including 4M( Ca,ital -anage+ent5 High3ridge Ca,ital -anage+ent5 "> Shaw5 and Gold+an Sachs5 ha)e recentl. seen hea). losses. In)estors5 ranging fro+ wealth. indi)iduals to chief in)est+ent officers for endow+ents and trusts5 are 3eco+ing +ore cautious a3out ris'. In)est+ent funds are ,re,aring for the ,ossi3ilit. that new in)estors +a. 3e difficult to find and current in)estors +a. as' for their +one. 3ac'. BB( Financial Holdings5 an affiliate of Bohl3erg Bra)is (o3erts 1 Co.5 stated that it could lose u, to D2 / 3illion in its in)est+ents 3ecause in)estor faith in +ortgages has 3een sha'en. Advertisement =arge9scale rede+,tions could dri)e hedge funds to sell off assets 3elow )alue in order to create the li;uidit. necessar. to return ca,ital to in)estors. 0he greatest de+and for rede+,tions will li'el. 3e seen 3. hedge funds focused on su3,ri+e +ortgage in)est+ents and ;uantitati)e funds. Muantitati)e hedge funds5 which select in)est+ents 3ased on co+,uter93ased +odels and ;uantitati)e anal.sis5 3egan ,osting stee, losses in late Iul. and earl. 4ugust5 when the su3,ri+e +ortgage crash triggered a crisis of confidence in credit +ar'ets.
Hedging Fund & Its Impact On Capital Market Hedge funds are not sitting ;uietl.5 waiting for their in)estors to ,ull out. Sentinel -anage+ent Grou, Inc.5 stating that it cannot +eet its in)estors2 re;uests to withdraw their +one. without selling in)est+ents at a stee, discount5 has fro:en a D1.# 3illion fund. Funds at $ear Sterns5 $raddoc' Financial5 and @nited Ca,ital -ar'ets ha)e also ta'en actions to sus,end rede+,tions. Sentinel -anage+ent has re,ortedl. as'ed regulators for ,er+ission to sus,end rede+,tions as well. -an. hedge funds i+,ose Ngates5N rule structures that li+it the a+ount of assets withdrawn in a gi)en ;uarter. 0hese strictures hel, li+it the i+,act that sudden in)est+ent withdrawals can ha)e on +ar'ets as the funds would otherwise ha)e to sell of assets at discount rates in order to +eet the withdrawal re;uests. In the +idst of all the concern5 in)est+ent 3an'ing giant Gold+an Sachs is +a'ing efforts to draw in)estors to its Glo3al >;uit. O,,ortunities hedge fund5 after stoc' +ar'et losses wi,ed out a3out D1.! 3illion of its assets. Gold+an is offering sur,rising ter+s to new ,artici,ants in the fund 9 Gold+an is wai)ing the fund2s +anage+ent fee and cutting its ,erfor+ance fees in half. Pre)iousl.5 Glo3al >;uit. in)estors ,aid two ,ercent of assets ,er .ear as a +anage+ent fee and 2/ ,ercent of ,rofits as an incenti)e fee. 0he new deal doesn2t i+,ose an. incenti)e fees until the fund a,,reciates 3. ten ,ercent. Gold+an will then 'ee, ten ,ercent of the fund2s ,rofits a3o)e that threshold. 0here is a catch5 howe)er. Glo3al >;uit.2s e<isting in)estors can withdraw their +one. +onthl. with 1# da.s notice. New in)estors +a. not withdraw for si< +onths. 0he deal is clear9 l. structured to draw in)estors with the resources and confidence to co++it for a longer in)est+ent ,eriod. 0he 3an'ing giant has an interest in 'ee,ing the fund going. Gold+an has in)ested a3out D2 3illion of its own +one. in the fund. 4fter its recent +ar'et losses5 the fund has a3out D3.% 3illion in assets. 0he fund2s )alue has declined since Iul. 2//%5 so e<isiting in)estors are not currentl. 3eing charged the 2/ ,ercent ,erfor+ance fee. 0he fee will 3e a,,lied when the funds ,erfor+ance sur,asses its highest le)el fro+ last .ear.
Hedging Fund & Its Impact On Capital Market It is too earl. to tell whether new strategies will sa)e hedge funds. It is e;uall. difficult to ,redict 6ust how great the in)estor withdrawal will 3e. $ut the eas. ride is definitel. o)er5 and the road ahead is li'el. to get rough.
THREE MAIN ISSUE DISCUSS
A. From a regulatory point of view, what are the key risks posed by hedge funds? B. What is the appropriate regulatory response to these risks? C. What is the approach being taken by the nternational !rganisation of "ecurities Commissions to hedge funds, focusing in particular on its work on valuation policies and pricing procedures for hedge fund portfolios?
Hedging Fund & Its Impact On Capital Market +rom a regulator" perspective- what are the ke" risks posed !" hedge funds. $efore turning to the ris's that are ,articular to hedge funds and hedge fund +anagers5 it is worth stressing that the FS4 3elie)es fir+l. that a regulator should onl. inter)ene in +ar'ets where the +ar'et is failing to deli)er acce,ta3le outco+es5 and where the costs of inter)ention are 6ustified 3. the 3enefits to 3e deli)ered 3. regulation. -oreo)er5 we are not a regulator who considers it sensi3le or desira3le to deli)er a regulator. regi+e that guarantees that failures will ne)er occur. 4 non9:ero failure regi+e of the sort we o,erate acce,ts that fir+s will fro+ ti+e to ti+e fail. &hile we ai+ to +ini+ise the i+,act of failures which arise fro+ regulator. 3reaches5 we +ust acce,t that fir+s will +a'e errors of 3usiness 6udge+ent5 ti+ing5 or strateg. or si+,l. fail to +easure u, to the co+,etition. In an. )i3rant and successful +ar'et,lace so+e 3usinesses +ust fail5 and this realit. hel,s dri)e standards higher for those who succeed. 0he 4+aranth case is in so+e res,ects an interesting e<a+,le of what I +ean5 and I digress for 6ust a +o+ent longer. 0here are in;uiries underwa. and it is not ,ossi3le to co++ent definiti)el.5 3ut there are as,ects of this colla,se that suggest that the o)erall regulator. fra+ewor' did o,erate in an effecti)e +anner. 0he losses were catastro,hic for the fir+ and sudden5 3ut the o)erall i+,act on the +ar'et relati)el. insignificant. 0he ,ri+e 3ro'ers in)ol)ed a,,ear all to ha)e had +ore than ade;uate collateral5 and the ,ositions of 4+arath a,,ear to ha)e 3een li;uidated or transferred without undue disru,tion to trading in the sector or its underl.ing ,h.sical +ar'ets. Iudging fro+ the infor+ation a)aila3le to in)estors 3efore the colla,se5 there +a. 3e interesting ;uestions for fund of hedge fund +anagers and other in)estors in the fund to as' the+sel)es a3out whether the colla,se could ha)e 3een foreseen5 so there +a. 3e lessons to 3e learned a3out due diligence ,erfor+ed 3. hedge fund in)estors. $ut no one should e<,ect that hedge funds will ne)er lose +one. or forget that the. indeed +a. fro+ ti+e to ti+e disa,,ear. 0his is ,art of the ris'Freward fra+ewor' that underlies all financial +ar'ets. =et +e return then to the ;uestion of what the FS4 considers are the 'e. regulator. ris's arising in res,ect of hedge funds and those who +anage and ,ro)ide ser)ices to the+. I a+ s,ea'ing therefore of ris's that arise to our regulator. o36ecti)es of ,ro,ortionate in)estor ,rotection and +aintenance of +ar'et confidence. Once we ha)e identified the 'e. ris's5 we +ust deter+ine the
Hedging Fund & Its Impact On Capital Market li'elihood of the+ cr.stallising5 in order to decide whether there are an. ,ro,ortionate +itigating actions that we or indeed others +ight 3e 3est ,laced to ta'e.
,f these are the principal risks- what then is the appropriate response for a regulator to them. Firstl.5 I +ust e+,hasise the FS4 is not see'ing to authorise and regulate the funds the+sel)es5 which at ,resent are located outside our 6urisdiction. Our a,,roach is to +itigate the ris's through our e<isting authorit. o)er hedge fund +anagers and the 3ro'erFdealers who ,ro)ide ,ri+e 3ro'erage ser)ices to the funds. &e do not consider that the assertion of e<tra9territorial 6urisdiction is a necessar. or desira3le regulator. inter)ention in this +ar'et. &ith this in +ind5 the FS4 set u, a centre of hedge fund e<,ertise in Octo3er 2//#. 4 ,riorit. of this tea+ has 3een to enhance our o)ersight of 31 of the largest hedge fund +anagers in the @B 7accounting for #/E of assets +anaged8. 0hese +anagers ha)e a dedicated su,er)isor in regular contact with the fir+s and underta'ing ,eriodic ris' assess+ents to de)elo, indi)idual ris' +itigation ,lans with the+. =ower i+,act fir+s are su36ect to 3aseline +onitoring through regulator. returns and other t.,es of alerts and +ar'et intelligence. 0he centre of e<,ertise ad)ises and where rele)ant ta'es the lead on the FS4 res,onse to an. hedge fund cases. Further+ore5 it underta'es the+atic su,er)ision5 co)ering a wide range of entities that ha)e hedge fund +andates irres,ecti)e of where within the FS4 that grou, or fir+ is ,ri+aril. su,er)ised O the a,,roach is designed to address the ris's ,osed to our o36ecti)es 3. the industr. as a whole. 0hat2s how we ha)e organised our resources5 3ut now let +e deal with our res,onse to the s,ecific ris's to our o36ecti)es I outlined earlier.
Hedging Fund & Its Impact On Capital Market /0 )arket disruption1s"stemic issues In 2//!5 we esta3lished a regular si< +onthl. sur)e. on the e<,osures to hedge funds of the +ain =ondon 3ased 3an's that ,ro)ide ,ri+e 3ro'erage ser)ices. 0he ai+ of this sur)e. is to enhance our understanding of ,ri+e 3ro'erage and to gather data on the e<,osures of the fir+s to +a6or hedge funds5 either )ia ,ri+e 3ro'erage or )ia the trading of O0C deri)ati)es. 0he sur)e. targets the largest Pri+e $ro'ers 7currentl. 1# fir+s8 with 2 +ain data re;uestsG the first loo's at their credit e<,osures to hedge funds5 the second focuses on the ,ri+e 3ro'er 3usiness. 0he ;uantitati)e 3enefits of the sur)e. ha)e wor'ed in tande+ with ;ualitati)e su,,ortG it has ad)anced su,er)isor. discourse with fir+s5 ,articularl. those with large ris' e<,osures5 and encouraged the i+,ro)e+ent of ris' +anage+ent s.ste+s in the ,ri+e 3ro'ers the+sel)es. &e are conscious of the i+,ortance to hedge fund +anagers of a s+all nu+3er of )er. large ,ri+e 3ro'ers5 who ,ro)ide 3oth financial gearing and o,erational su,,ort to the hedge fund +anagers. 0hese ,ri+e 3ro'ers are institutions with which we at the FS4 alread. ha)e a close regulator. relationshi,5 and we ha)e used this to de)elo, a +uch i+,ro)ed understanding of the ,osition of these 3an's )is9Y9)is hedge funds. So what are the headline findings thus farW Our 4,ril 2//% sur)e. showedH
4ssets under +anage+ent had grown5 on an e;uit. 3asis5 3. 2 E ,er cent to D! ! 3illionG
4ggregate a)erage le)erage had grown slightl. fro+ to 2.2# to 2.3 G 0wo ,ri+e 3ro'ers continued to account for 6ust o)er half the sector2s total e<,osure to hedge fundsG 4)erage e<cess collateral re+ains unchanged at 1// ,er centG No fund with +a6or e<,osures co+,ara3le to =0C- has 3een identified. Generall.5 the funds2 gearing was significantl. lower than =0C-5 which was le)eraged at 2#H1 until earl. 1 an. fund was 1#H1 *5 and #/H1 3. the ti+e of its colla,se. Present le)erage on a)erage as re)ealed 3. our sur)e. is 2.!H1. 0he highest gearing of
&e found that e<,osures of the ,ri+e 3ro'ers to the hedge funds were 3oth li+ited in a3solute a+ount and relati)e to ca,ital5 and were in general full. collateralised5 as was e)ident as noted in the 4+aranth colla,se.
4 word a3out the li+itations of this sur)e.. &ith two e<ce,tions5 our infor+ation co)ers onl. e<,osures 3oo'ed in =ondon5 so we do not ha)e and do not ,ur,ort to ha)e the total glo3al ,icture in res,ect of these ,ri+e 3ro'ers or indeed of an. underl.ing hedge fund. Nonetheless5 we consider that this infor+ation5 which does co)er a su3stantial ,ercentage of the glo3al +ar'et5 is a good indicator of the ,resent ,osition. &e are also discussing with the ,ri+e 3ro'ers and other regulators whether5 and if so how5 this )oluntar. sur)e. +ight 3e e<tended internationall..
20 )arket ,ntegrit" Our focus on +ar'et integrit. has two strands. Firstl.5 see'ing to deter a3use. Credi3le deterrence has four 'e. co+,onents O ,ro9acti)e sur)eillance of li'el. 2hot s,ots52 a +odern transaction anal.sis s.ste+5 industr. coo,eration to ensure a stead. flow of infor+ation5 and an effecti)e enforce+ent ,rogra++e. It is worth +entioning that we ha)e 3een de)oting significant su,er)isor. efforts to enhancing +anagers2 s.ste+s and ,rocedures for dealing with ,rice sensiti)e infor+ation. &e ha)e 3een acti)e in encouraging an i+,ro)e+ent of the hedge fund +anagersC ,rocedures in this area. &e ha)e also not hesitated to ta'e enforce+ent action where warranted and ha)e identified +ar'et a3use as an enforce+ent ,riorit. for the organisation going forward.
30 A co(ordinated glo!al approach to reducing credit derivatives !acklogs &e5 together with regulators in other +a6or financial centres 9 nota3l. the @S Federal (eser)e and the S>C 9 3eca+e )er. concerned a3out significant trade confir+ation 3ac'logs in the credit deri)ati)e +ar'ets last .ear. In assessing this ris'5 we 3eca+e aware that the assign+ent of trades 3. hedge funds5 without ,rior a,,ro)al or e)en notification of their counter,art.5 was significantl. contri3uting to this 3ac'log. Our res,onse has 3een to wor' as a grou, to set targets
Hedging Fund & Its Impact On Capital Market and encourage the 3an's to i+,ro)e. 0his a,,roach has ,ro)ed effecti)e5 with )er. significant reductions in 3ac'logs alread. achie)ed5 and +ore still on the wa..
40 Transparenc"1 side letters &e +ade clear in our ,olic. state+ent on hedge fund issues that a failure 3. a @B 3ased hedge fund +anager to +a'e ade;uate disclosures of +aterial side letters would a+ount to a 3reach of Princi,le 1 of our Princi,les for $usinesses. 0his is one of our core ,rinci,les5 and states that a fir+ +ust conduct its 3usiness with integrit.. 4s a +ini+u+5 we would e<,ect acce,ta3le +ar'et ,ractice to 3e for +anagers to ensure that all in)estors are infor+ed when a +aterial side letter is granted. 4I-4 has recentl. ,u3lished industr. guidance on the disclosure of side letters. &e ha)e re)iewed the guidance and confir+ed that we will ta'e it into account when e<ercising our regulator. functions5 although this cannot affect the rights of third ,arties. In su++ar.5 fir+s will 3e re;uired to disclose the e<istence of side letters which contain Q+aterial ter+sR5 and the nature of such ter+s5 where the fir+ is a ,art. to the side letters. -aterial 0er+s focus essentiall. on granting +ore fa)oura3le treat+ent than other holders of the sa+e class of share or interest and there3. conferring an ad)antage in res,ect of rede+,tion or the right to redee+. &e will 3e conducting so+e the+atic wor' to test the +ar'etCs res,onse to these standards in the near future.
50 Retailisation &e ,u3lished a discussion ,a,er last .ear on the ,ossi3ilit. of o,ening the @B retail +ar'et to a wider range of alternati)e in)est+ent ,roducts. &e ha)e decided to consult on the creation of an on9shore fund of hedge funds and other unauthorised funds regi+e. Gi)en the increasing ,enetration of the @B retail +ar'et 3. alternati)e in)est+ent )ehicles5 it see+ed ano+alous that there was no si+ilar on9shore )ehicle that was +ore widel. a)aila3le to the retail +ar'et5 and which would 3enefit fro+ so+e of the structural and in)est+ent ,rotections that characterised regulated in)est+ent funds on shore. &e will 3e ,u3lishing our consultation ,a,er in the first ;uarter of the New Aear.
60 )is(valuation of comple7 illi uid instruments1fraud
Hedging Fund & Its Impact On Capital Market Internationall.5 we ha)e 3een at the forefront of wor' a+ong regulators on the issue of )aluations. I a+ chairing a su39co++ittee of the International Organisation of Securities Co++issions5 which is loo'ing to de)elo, a set of good ,ractice ,rinci,les for the )aluation ,olicies and ,ricing ,rocedures of hedge fund ,ortfolios. &e ha)e 3een gi)en a +andate fro+ the IOSCO 0echnical Co++ittee and e<,ect to ,u3lish our re,ort at the annual +eeting in -u+3ai in 4,ril of 2//7. 0his is a ris' that I thin' deser)es a fuller treat+ent5 and I turn to that now as +. third +a6or ,oint in toda.Cs re+ar's.
8hat is ,OSCO's approach to hedge fund valuation risks. ?aluation of the ,ortfolio of assets of an in)est+ent fund is not a to,ic of uni;ue interest to hedge funds. (egulators around the world ha)e long sought to ensure that the net asset )alue of ,u3lic traded funds such as +utual funds and @CI0S in >uro,e is rigorousl. controlled to ensure that fair )alue is achie)ed for the underl.ing in)estors dealing in the funds. $ut IOSCO decided to focus on hedge funds in ,articular 3ecause of a nu+3er of factors and ris's that are ,articularl. heightened in hedge funds. First5 as widel. recognised5 hedge funds ha)e grown at an astonishing rate in recent .ears and ha)e e+erged as a )er. i+,ortant co+,onent of glo3al ca,ital +ar'ets. 0he. +a'e a +a6or contri3ution to the inno)ation5 li;uidit. and efficienc. of the ca,ital +ar'ets and as such ha)e a central ,lace in the health and soundness of financial +ar'ets internationall.. Second5 hedge funds often deal in asset classes that can 3e hard to ,rice +a'ing their strategies and ,ortfolios difficult to )alue. 4I-4 esti+ated that in 2//! so+e 2/E of Hedge Fund strategies were in hard to )alue securities 7for e<a+,le distressed de3t5 e+erging +ar'ets5 fi<ed inco+e ar3itrage8. -oreo)er5 an in)estor in a fund which focuses on 6ust one of these strategies +a. ha)e a 1//E e<,osure to hard9to9)alue assets.
Hedging Fund & Its Impact On Capital Market 0hird5 hedge funds often utili:e su3stantial le)erage in their trading5 ,otentiall. +agnif.ing the i+,act of a ,ricing +is9+ar'. Fourth5 the ,erfor+ance 3ased re+uneration of hedge fund +anagers5 cou,led with difficult9to9 )alue assets and in so+e cases self9ad+inistration of the funds5 can create )er. su3stantial conflicts of interest in the ,ricing of assets. Fifth5 in the case of so+e highl. illi;uid assets5 it is )irtuall. i+,ossi3le to find a co+,letel. o36ecti)e ,ricing source5 forcing reliance u,on +odels or o3ser)ed or i+,lied ,rices 3ased u,on the 6udg+ent of +ar'et ,artici,ants5 none of who+ +a. 3e disinterested in the transaction. =ast5 3ut 3. no +eans least5 it is esti+ated that in 2//#5 )aluation9related losses in hedge funds glo3all. totalled so+e D1.% 3illion dollars. Poor )aluation controls in co+3ination with wea' internal ,rocedures were e<,loited to +isre,resent hedge fund )alues and co++it fraud. 0his was a wa'e u, call to industr. and the regulators to the real dangers of sli,shod )aluation ,olicies and ,ricing ,ractices.
8hat is ,OSCO doing a!out this. 4s I +entioned5 I a+ chairing an IOSCO su39co++ittee that is loo'ing to de)elo, good ,ractice )aluation ,olicies and ,ricing ,rocedures for hedge fund +anagers. @nusuall. for IOSCO5 the su39co++ittee includes industr. re,resentati)es as contri3uting +e+3ers of the su39co++ittee5 wor'ing with us hand9in9hand throughout the ,rocess. 0he. include a s+all nu+3er of re,resentati)es fro+ hedge fund +anagers5 fund of hedge fund +anagers5 ,ri+e 3ro'ers5 auditors5 ad+inistrators and third ,art. ,ricing ,ro)iders. 0he grou, is +andated to de)elo, a single set of )aluation ,rinci,les with a reasona3le le)el of granularit.. &ithout gi)ing too +uch awa. at this stage of our wor'5 .ou should e<,ect us to 3e focusing on the e<istence of ro3ust5 written ,olicies and ,rocedures5 the effecti)e da.9to9da. o,eration of the+5 the role of the hedge fund +anager5 the role of inde,endent ,arties in ,roducing andFor )erif.ing ,rices5 and ade;uac. of disclosure to in)estors5 a+ong other 'e. issues.
Hedging Fund & Its Impact On Capital Market =et +e stress that we are not see'ing to rein)ent the wheel here. 0here is a good deal of e<cellent ,ractice out in the +ar'et alread.. 4s .ou would e<,ect5 +an. institutional in)estors and funds of hedge funds underta'e ;uite de+anding due diligence in res,ect of their in)est+ents in hedge funds. &e want to encourage the s,read of that good ,ractice. In addition5 international trade associations li'e 4I-4 and the -anaged Funds 4ssociation in the @S ha)e alread. underta'en su3stantial wor' in this area and continue to do so. -oreo)er5 acade+ics and industr. e<,erts ha)e ,u3lished a good deal a3out )aluation issues for illi;uid assets5 and we ha)e ta'en that wor' on 3oard as well. Our ai+ is to ,roduce a set of ,rinci,les that are ,ractical5 and can 3e used 3. in)estors as a guide in real9life interactions with hedge fund +anagers5 and ha)e the added 3enefit of endorse+ent 3. the international regulator. co++unit.. &e ho,e that will +a'e a +eaningful contri3ution to an e)ol)ing glo3al standard for sound )aluation ,olicies and ,ricing ,rocedures in the hedge fund sector.
9,9',O$RA:&;

Hedge Fund

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Hedge Fund

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Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

Selected Definitions of "Hedge Fund"

pay performan"e fees to their managers. and

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

Facts About the Hedge Fund Industry

Hedging Fund & Its Impact On Capital Market

The growth of hedge funds

Hedging Fund & Its Impact On Capital Market

1/. Fire3ird Glo3al Fund 7Fire3ird -anage+ent5 New Aor'8 9 37.1*E

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

Benefits of Hedge Funds

Hedging Fund & Its Impact On Capital Market

Advantages of Hedge Funds over Mutual Funds

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

>)ent dri)en O s,eciali:ed in the anal.sis of a ,articular 'ind of e)ent.

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

Role of Hedge Funds in the Capital Markets

Hedging Fund & Its Impact On Capital Market

Hedging Fund & Its Impact On Capital Market

The 'ederal &eser!e and Hedge 'unds

Hedging Fund & Its Impact On Capital Market

THREE MAIN ISSUE DISCUSS

Hedging Fund & Its Impact On Capital Market

60 )is(valuation of comple7 illi uid instruments1fraud

Hedging Fund & Its Impact On Capital Market

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