The Complete Guide to Hedge Funds and Hedge Fund Strategies

The Complete Guide to Hedge Funds and Hedge Fund Strategies

Daniel Capocci

© Daniel Capocci 2013

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First published 2013 by

PALGRAVE MACMILLAN

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ISBN: 978–1–137–26443–5

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To my son Mateo

Contents

List of Figures

List of Tables

Foreword

Acknowledgements

Preface

1 What Is a Hedge Fund?

1 General definition of hedge funds

2 Hedge funds over time

2.1 The origin of hedge funds

2.2 The growth of the industry from 1949 until today

2.3 Breakdown of the industry into investment strategies

3 Hedge funds around the world

3.1 Hedge funds in the United States and Canada

3.1.1 American hedge fund development

3.1.2 American hedge fund investment strategy

3.1.3 American hedge fund mandate

3.1.4 Canada

3.2 Hedge funds in Europe

3.2.1 Development

3.2.2 European hedge fund development

3.2.3 European hedge fund investment strategies

3.2.4 European hedge fund mandate

3.2.5 European hedge fund localization

3.2.6 Characteristics of the industry

3.2.7 Perspectives

3.3 Hedge funds in Asia

3.3.1 The development of Asian hedge funds

3.3.2 Asian hedge fund investment strategy

3.3.3 Asian hedge fund mandate

3.3.4 Asian hedge fund localization

3.3.5 Hedge funds in Australia: an exception

3.4 Hedge fund development in Eastern Europe

3.4.1 Eastern European hedge fund localization

3.4.2 Eastern European hedge fund investment strategies

3.5 Hedge funds in Latin America

3.5.1 Hedge fund development in Latin America

3.5.2 Latin American hedge fund investment strategies

3.6 Future perspective of the industry

4 A few big names from the hedge fund industry

4.1 George Soros

4.2 Julian Robertson

4.3 Michael Steinhardt

4.4 John Paulson

4.5 Louis Bacon

4.6 Paul Tudor Jones II

4.7 Bruce Kovner

4.8 Steve Cohen

4.9 Alan Howard

4.10 Stephen Feinberg

5 Summary

2 Hedge Fund Characteristics

1 Database providers

1.1 The indices – classifications

1.1.1 Morningstar CISDM

1.1.2 Hedge Fund Research

1.1.3 Dow Jones Credit Suisse

1.1.4 EurekaHedge

1.1.5 Greenwich Alternative

1.1.6 eVestment

1.1.7 BarclayHedge

1.2 The indices – daily indices

2 Constitution of a hedge fund

2.1 Definition of the fund objective

2.2 Investment strategy

2.3 Risk profile

2.4 Risk selection techniques

2.5 Manager

2.6 Management methodology

2.7 Fund domicile

2.8 Distribution

3 The structure of a hedge fund

4 Hedge funds and risk

4.1 Investment risk

4.2 Model risk

4.3 Manager and industry risk

4.4 Portfolio construction risk

4.5 Pricing risk

4.6 Infrastructure and legal risk

4.7 Counterparty risk

4.8 The risk of default

4.9 The liquidity risk

4.10 Operational risk

5 Hedge fund investors

5.1 Typical investors

5.2 Institutional investors

6 The constraints

6.1 Minimum investment

6.2 Liquidity constraints

6.3 The limit of total assets under management

7 The fees

7.1 The classic fee model

7.2 High-water mark and the hurdle rate

7.3 Fee illustration

7.4 Equalization or series of shares

8 Short selling

9 Leverage

10 Gross and net exposition

11 Active trading

12 Other characteristics of the hedge fund industry

12.1 The size of the funds

12.2 Common characteristics

12.3 The use of leverage

12.4 A typical hedge fund

12.5 Hedge funds and investment products

12.6 The dissolution rate

13 Hedge funds and other alternative investment products

14 The strengths and weaknesses of hedge funds

14.1 The strengths

14.1.1 Flexibility of techniques

14.1.2 Co-investment by the fund manager

14.1.3 Managers’ capabilities

14.1.4 Absolute return objective

14.1.5 Low correlation with classic investment products

14.2 The weaknesses

14.2.1 High attrition rate

14.2.2 Lack of information

14.2.3 Limited liquidity

14.2.4 A complex and expensive fee structure

14.2.5 Specific risks

14.2.6 Legal constraints

15 Comparison between funds and managed accounts

16 Replication

17 New structures

17.1 Listed funds

17.2 Structured products

17.3 Investable indices

18 Summary

3 Investment Strategies

1 General classification

2 Equity market neutral

2.1 Methodology

2.2 Definition of neutrality

2.3 Quantitatively managed funds

2.4 Risk management

2.5 Illustration

2.5.1 Theoretical illustration

2.5.2 Practical example: Career Education Corporation and Apollo Group

2.5.3 Example: Daimler-Chrysler AG and Ingersoll-Rand Company

2.5.4 TJX Companies and Whole Foods Market, Inc.

2.6 Advantages and drawbacks

2.7 Performance

3 Relative value

3.1 Methodology

3.1.1 Pair trading

3.1.2 Option trading and warrants

3.1.3 Capital structure arbitrage

3.2 Fixed income arbitrage

3.2.1 Risk management

3.3 Illustration

3.3.1 Relative value – theoretical illustration

3.3.2 Relative value – Verizon Communications, Inc.

3.3.3 Fixed income arbitrage – Treasury bond

3.4 Advantages and drawbacks

3.5 Performance

4 Mortgage-backed securities

4.1 The securities

4.2 Methodology

4.3 Risk management

4.4 Illustration

4.5 Advantages and drawbacks

4.6 Performance

5 Convertible arbitrage

5.1 Principles

5.2 Methodology: approach

5.2.1 Markets

5.2.2 Tools

5.2.3 Hedging

5.2.4 Arbitrage

5.3 Methodology: investment strategy

5.4 Specific risks

5.5 Illustration

5.5.1 Seagate Technology

5.5.2 BRE Properties

5.5.3 TEVA Pharmaceuticals

5.6 Advantages and drawbacks

5.7 Performance

5.8 Convertibles in 2004 and synthetic convertibles

6 Event driven

6.1 Methodology

6.2 Special situations

6.3 Activists

6.4 Illustrations

6.4.1 New Skies Technologies

6.4.2 Cumulus Media

6.4.3 Eletrobras

6.5 Advantages and drawbacks

6.6 Performance

7 Merger arbitrage

7.1 Methodology

7.2 Illustrations

7.2.1 Counterbids: Alcan/Rio Tinto

7.2.2 Counterbid: Graham Packaging/Reynolds Group

7.2.3 Cash deal: Redecard/Itaú

7.2.4 Stock-for-stock merger: Giralia Resources/ Atlas Iron

7.2.5 Unsuccessful deal: Rhoen-Klinikum/Fresenius

7.3 Advantages and drawbacks

7.4 Performance

8 Distressed securities

8.1 Sources of difficulties

8.2 Methodology

8.3 Illustration

8.4 Advantages and drawbacks

8.5 Performance

9 PIPE funds

9.1 Methodology

9.2 Types of transaction

9.3 Underlying risks

9.4 Illustrations

9.4.1 Ascent Solar Technologies

9.4.2 Quest Minerals and Mining Corporation

9.4.3 Puda Coal Inc.

9.5 Advantages and drawbacks

9.6 Performance

10 Volatility Arbitrage

10.1 Methodology

10.2 Illustrations

10.3 Advantages and drawbacks

10.4 Performance

11 Multi-strategy

11.1 Methodology

11.2 Illustration

11.3 Advantages and drawbacks

11.4 Performance

12 Asset-based lending

12.1 Methodology

12.1.1 Stock financing

12.1.2 Trade finance

12.1.3 Real estate financing

12.1.4 Corporate direct

12.1.5 Life insurance financing

12.1.6 Vehicle loans

12.1.7 Other sub-strategies

12.2 The risks

12.3 Illustrations

12.3.1 Trade finance

12.3.2 Real estate financing

12.3.3 Legal proceedings financing

12.3.4 Life insurance financing

12.4 Advantages and drawbacks

13 Long/short equity

13.1 Methodology

13.2 Equity non-hedge

13.3 Long/short equity vs. equity market neutral

13.4 Illustration

13.4.1 Clip Corporation

13.4.2 Barnes & Noble, Inc.

13.5 Advantages and drawbacks

13.6 Performance

14 Emerging markets

14.1 Methodology

14.2 Illustrations

14.2.1 Billabong

14.2.2 Li & Fung

14.3 Advantages and drawbacks

14.4 Performance

15 Sector funds

15.1 Methodology

15.2 Illustrations

15.2.1 Pediatrix Medical Group

15.2.2 Triad Hospitals, Inc.

15.2.3 Host Hotels and Resorts, Inc.

15.3 Advantages and drawbacks

15.4 Performance

16 Credit/high yield

16.1 Methodology

16.2 Correlation trading

16.3 Illustration

16.4 Advantages and drawbacks

16.5 Performance

17 Short selling

17.1 Methodology

17.2 Illustrations

17.2.1 Okamura

17.2.2 New Century Financial

17.3 Advantages and drawbacks

17.4 Performance

18 Macro

18.1 Principles

18.2 Methodology

18.3 Illustrations

18.3.1 Loosening of monetary conditions

18.3.2 Yen–dollar carry trade

18.3.3 Sector consolidation

18.4 Advantages and drawbacks

18.5 Performance

19 Commodity trading advisors

19.1 Methodology

19.2 Short-term traders

19.3 Illustrations

19.3.1 Trend-following strategy

19.3.2 Moving-average strategy

19.3.3 Two-entry model

19.4 Advantages and drawbacks

19.5 Performance

20 Fund of funds

20.1 Why funds of funds?

20.2 Methodology

20.3 The choice of a fund of funds

20.4 Advantages and drawbacks

20.5 Performance

21 Other investment strategies

21.1 Closed-end fund arbitrage

21.1.1 Illustration – Gartmore European Investment Trust

21.1.2 Illustration – JPM Fleming Overseas

21.1.3 Advantages and drawbacks

21.2 Electricity trading

21.3 Option arbitrage

21.4 Weather funds

21.5 Wine investing

21.6 MLP

22 Summary

Appendix A: Bond rating

Appendix B: Convertibles basics

Appendix C: Duration, modified duration and convexity

Appendix D: Hedge Fund Research Indices construction

Appendix E: The Greeks

4 Hedge Fund Performance Over Time

1 Data

1.1 Specific features of hedge fund data

1.2 Biases

1.3 The indices

2 Performance of the hedge fund industry

3 Hedge fund performance and volatility by strategy

3.1 Statistical analysis

3.2 Graphical analysis

3.2.1 Beta

3.2.2 Risk–return trade-off

3.2.3 Extended risk measure

3.2.4 Omega

3.2.5 Normality triangles

3.2.6 Probability return distribution

4 Performance during extreme market conditions

5 Academic research

6 Return decomposition

7 Inserting hedge funds into a classical portfolio

8 Correlation analysis

8.1 Correlation between hedge funds and classical markets

8.2 Correlation between hedge fund strategies

8.2.1 Monthly data

8.2.2 Daily data

9 Summary

5 Hedge Funds, LTCM and Recent Crises

1 Long-term capital management

1.1 The situation in September 1998

1.1.1 The losses of Soros et al.

1.1.2 Fixed-income arbitrage

1.2 Long-term capital management

1.3 History of the bailout

1.4 Why was the fund saved?

1.5 The effects and the questions still open

1.5.1 The effects

1.5.2 Questions still open

1.6 Subsequent developments

2 Hedge funds and financial crisis

2.1 The exchange rate mechanism crisis of 1992

2.2 The bond market turbulence of 1994

2.3 The Tequila crisis of 1994–95

2.4 The Asian crisis of 1997–98

2.4.1 The facts

2.4.2 The role of hedge fund in the crisis

2.4.3 The fundamentals

2.4.4 Conclusion

2.5 The subprime crisis of 2007

2.5.1 The basis

2.5.2 The role of hedge funds

2.6 The liquidity crisis that followed the subprime crisis

2.7 Conclusion

3 Summary

6 Hedge Funds, Regulation and Mutual Funds

1 Hedge fund regulation

1.1 The principles

1.2 North America

1.2.1 The United States

1.2.2 Canada

1.3 Europe

1.3.1 Alternative UCITS

1.3.2 AIF & AIFM

1.3.3 United Kingdom

1.3.4 Germany

1.3.5 Luxembourg

1.3.6 Italy

1.3.7 Switzerland

1.3.8 France

1.3.9 Ireland

1.3.10 Malta

1.3.11 Spain

1.4 Australia

1.5 Offshore jurisdictions

1.5.1 Cayman Islands

1.5.2 British Virgin Islands

2 Hedge funds vs. mutual funds

2.1 Management – prospectus, short selling, leverage, liquidity and securities used

2.2 Associated costs – fees and others

2.3 Communication

2.4 Typical investors

2.5 Asset manager registration

2.6 Audit

2.7 Directors

3 Hedge funds vs. mutual funds: the other main differences

3.1 Personal investment

3.2 Objectives

3.3 Securities used

3.4 Investment strategies

3.5 Size of the industries

3.6 Comparative summary

4 Portfolio diversification

5 Summary

Conclusion

Appendix: The CAIA Association

Notes

Bibliography

Index

List of Figures

List of Tables

Foreword

Since the middle of the 20th century, wealthy individuals have invested their capital alongside talented traders in opaque, lightly regulated investment vehicles designed to safeguard investor anonymity and to allow capital accumulation in relative privacy, in contrast to publicly available regulated vehicles such as mutual funds. These exclusive, opaque investment vehicles, managed by eclectic investment professionals, have come to be referred to as hedge funds.

Since the turn of the century, anecdotal evidence has revealed a steady increase in the allocations of institutional investors in hedge funds. Institutional investors, in contrast to private investors, prefer transparency, emphasize corporate governance, and demand regulatory compliance from their third-party managers. In addition, they generally prefer moderate risk-adjusted returns, and stress persistency rather than periodic out-sized returns and their attendant volatility. This is a significant change in the clientele of the hedge fund industry – a change that affects both the return and risk profile of hedge funds as well as hedge fund managers’ business models.

Despite these changes and the 2008 financial crisis, the hedge fund industry has flourished, accumulating substantial amounts of capital from these diverse investors. What is it about hedge funds that attracts investors and continues to do so consistently over decades? Daniel Capocci’s book gives us important clues to answering this question. It provides valuable insights into hedge fund strategies and a framework for assessing hedge fund products.

Chapter 1 offers some illuminating vignettes of a number of legendary hedge fund managers, beginning with Alfred Winslow Jones’s fund in 1949. The brief history of these hedge fund legends hints at how successful hedge fund managers not only have to navigate through dynamic, and at times stormy, investment environments, but must also evolve their business models to adapt to changing investor demands and regulations. Daniel’s balanced approach, illustrating difficult concepts by way of well chosen examples and statistical evidence, sets the framework for an effective, comprehensive description of complex hedge fund investment strategies in the subsequent chapters.

The second and fourth chapters of the book take the investors perspective and ask the questions: How have hedge funds performed? And what should I be wary of? Anecdotal evidence suggests that institutional investors prefer large, well-capitalized hedge fund firms. For investors considering investing in a hedge fund, Daniel provides a helpful checklist of risks they should be aware of – risk factors cover both strategy risk as well as operational risk.

Chapter 3 tackles the core subject of this book: How do hedge fund managers make their money? Or What is inside their investment toolbox? If coming up with a definition for hedge funds is difficult, describing hedge fund managers’ investment strategies in a succinct fashion without undue reference to quantitative models is, to say the least, even more challenging. Here Daniel artfully applies the same balanced approach of insightful examples interlaced with empirical data on how different strategy performs taking the reader on an insightful tour into the type of investment opportunities that attract hedge fund managers, how portfolio positions are crafted, and how the investments are managed over time. Through the first decade of the 21st century there has been a continuing trend for the industry’s assets to be concentrated in the hands of a few mega large hedge fund firms. Hedge fund managers are the quintessence of active management, and are certainly no strangers to applying leverage to enhance their bets. This rising trend of risk capital being concentrated in the hands of a small number of leveraged speculators operating in opaque and lightly-regulated investment vehicles inevitably catches the attention of and at times creates discomfort for the regulators. In Chapter 5, Daniel takes the reader through some of that decade’s stressful events in global capital markets. The chapter examines hedge funds performed during crisis conditions and their market impact. The last chapter rounds off the text with a discussion on the issues relating to hedge fund regulations.

Overall, this is an excellent ‘go to’ text for answers to many key questions on the hedge fund industry – answers that are presented with a fine balance between rigorous analysis and intuitive, practical examples.

William Fung, Visiting Research Professor of Finance,

London Business School, and

Vice chairman, CFA Research Foundation.

Acknowledgements

I would like to express my gratitude to my wife Renata Vitórica for her constant support, and to Peter Baker from Palgrave Macmillan for his trust in me.

I would like to thank Jean Bensadoun (York Asset Management Limited), Martin Blum (Ithuba Capital), Andrew Bonita (Bonita Capital Management), David Capocci (Deloitte Luxembourg), Guilherme Carvalho (York Asset Management Limited), Gabriel Catherin (KBL European Private Bankers), Deborah Ceo, Gregory Gregoriou, Maria Dermes (Borsa Italia), Scott Eser (Hedge Fund Research), Fredrik Huhtamäki (Estlander & Partners), Guillaume Jamet (Lyxor Asset Management), Jamie Handwerker (CRM, Llc), Todd Harman (Hedge Fund Research), Marc Mediratta, John Paulson (Paulson), Andrej Rojek (Lydian Asset Management), Joshua Rosenberg (Hedge Fund Research), Bruno Sanglé-Ferrière (Carrousel Capital), Michael Schueller (HVB Alternatives), Patrick Vander Eecken (Pure Capital), Nick Walker (York Asset Management Limited), Diego Wauters (Coriolis Asset Management), and Mark Swickle (Professional Traders Management).

Preface

When I published the first edition of my French book on hedge funds in 2004, I started it with the following sentence:

Today, hedge funds are part of the investment universe of more and more investors, whether they are institutional or private. Not a single week goes by without this term being found in the financial press, either to introduce the concept, to present one or a few of their particularities, to define a strategy, to analyse the regulation in one or a few countries, to present a bankruptcy of a fund or to comment on the performance of the industry or a fund.

The situation has continued to evolve since 2004, and the industry has come of age, with its functioning rules, its events, leaders, success and failures. The strong equity markets of the 2003–2007 period and the increased level of sophistication of financial products available have enabled the industry to continue its development, and new strategies to emerge or consolidate. The liquidity crisis that affected the entire financial system including hedge funds slowed the industry’s growth, but 2009 performance numbers indicate that the situation has stabilized and that the best managers have been able to reposition themselves and come back to the previous highs in less than a year. At the outset, the interest in these funds – almost unknown until the 1990s – comes from the impressive track record of the funds of Soros, Steinhart or Robertson during the 1970s or the 1980s that were reported in financial publications such as Fortune or The Wall Street Journal. From that point onwards, more and more potential investors started to show an interest in hedge funds. But then the failure of Long-Term Capital Management in 1998 damaged the reputation of the whole industry. Since then, hedge funds have often been reported in the press because of a particular positioning (for example the short subprime position taken by some funds), a fraud (such as Madoff) or liquidity or leverage issues.

There were several reasons for the media secrecy that for a long time shrouded this type of fund. The first was that the hedge fund industry was small compared to other types of investment products, and it was only at the start of the 1990s that the number of hedge funds increased significantly. Secondly, hedge funds historically took a private form in order to profit from maximum freedom in their management, and that private structure precluded any kind of advertising.¹ Finally, in most jurisdictions there were constraints not only regarding the kind of investors that could invest in the fund but also regarding minimum investments.

More recently, hedge funds have gained much interest because, after a few years of sustained strong performance, the world market faced an almost unlimited fall between April 2000 and December 2002. From that time, many investors looked for new investment opportunities and, in parallel, the academic and financial press started to be more and more interested in hedge funds that globally performed correctly over this difficult period. This phase included an important educational element. Unlike mutual funds, the performance of hedge funds should be measured by definition in absolute terms and not relative to an index. The original aim of the industry was to offer positive returns despite the evolution of the market as a whole. At that time, several academic studies maintained that hedge funds were able to offer returns superior to those offered by classical markets, thanks mainly to their ability to protect the portfolio during financial crisis. This explains why the industry profited from a rapid growth phase over that period of uncertainty and over the years that followed.

Hedge funds as an industry performed strongly until 2007 when the subprime crisis happened. This was an issue for a few funds, but the vast majority were not exposed – and several actually profited from it. The issues started in 2008. The equity strategies were the first to be hit, on the performance side early in the year, as equity markets became volatile. Then the markets became tighter when Bear Stern went bankrupt. Liquidity disappeared from the market once Lehman Brothers failed in September. The liquidity squeeze and the ban on short selling of financials were enough to directly hurt the industry in September but even more in October; this was when the bad press on hedge funds reached its peak. Most funds investing in less liquid strategies had to gate (that is, suspend redemptions) and so investors remained stuck in funds or funds of funds without any possibility of exiting for some time. All in all it cost – but the industry came out much stronger, and the majority of the funds that survived this difficult period recovered within a year or two. In parallel, the industry continued its development through onshore vehicles like UCITS funds or private regulated European onshore funds. The largest players became stronger, and they continue to attract assets while the hedge funds consisting of two guys in a room have vanished. The industry has matured; numbers have been correct since then and growth is back to positive terms.

The academic world started to look at hedge funds in 1997; the first important studies on the subject were published at that time. The pioneers were William Fung and David Hsieh (1997) with their paper called ‘Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds’ and Brown, Goetzmann and Ibbotson (1997) with the paper titled ‘Offshore Hedge Funds: Survival and Performance 1989–1995’. The first authors found that the strategies applied by hedge funds are fundamentally different from those applied by mutual funds. The second team concluded that the majority of hedge fund managers are unable to outperform classical indices. Today, the literature on the subject is important, and several academic journals now specialize in alternative investments; these include the Journal of Alternative Investments and the Quarterly Hedge Fund Journal. The majority of the studies have been possible only thanks to the creation of private hedge fund databases; these were started early in the 1990s with the primary objective of providing information to potential investors.

This book aims to cover hedge funds and the hedge fund industry in detail. I will start the process from scratch by answering the question ‘What is a hedge fund?’ In Chapter 1, I approach the subject with a broad scope. Chapter 2 goes into more detail by focusing on the characteristics of hedge funds; this chapter gives you all the tools required to understand the particularities that can appear in the hedge fund world. Chapter 3, the heart of the book, presents every hedge fund strategy one by one and illustrates each of them, first with many figures and tables to convert words into visual concepts, and, more importantly, with one or more practical examples. Chapter 4 focuses on the performance of hedge funds over time. I report a series of statistics, and cover various time periods to give you a good sense of how the industry functions as a whole and also how strategies tend to perform over time. Chapter 5 covers hedge funds in difficult times. We start with the failure and bailout of Long-Term Capital Management in 1998, before analysing the role and potential impact of hedge funds on the financial markets during the financial crises of the last 20 years. Finally, Chapter 6 has two main objectives. First, the regulation of hedge funds and its evolution. This aspect is of particular importance because regulation is what enables the industry to continue its growth. Second, the differences between hedge fund and mutual funds; these differences cover not only legal niceties but, more importantly, structure and many other points. All in all, the many aspects of the hedge fund world are covered. Once you reach the last page of this book, I trust that your knowledge of this industry will have broadened significantly.

1

What Is a Hedge Fund?

This chapter aims to define hedge funds in a broad sense, listing and defining elements common to all such funds that explain why these investment products are grouped within what is called the hedge fund industry. The first section of this chapter gives a general definition of hedge funds. The second section describes the birth of the industry and its development over the years. The third focuses on the geographical development of hedge funds, and the fourth presents the big names of the industry. We end this chapter with a description of the future perspective of the industry, and we present a theory on its state of maturity.

1  General definition of hedge funds

In the financial semantic field, the verb to hedge means to cover or spread risks. In contrast to what we might think, not all hedge funds have the objective of neutralizing one or several sources of risk; today this term includes a variety of funds that use non-traditional management strategies. There is no legal definition of these funds, but practically every author or specialist has a definition that ranges from the general to the very precise. So, many definitions of hedge funds exist; we report on a few of these below.

According to the Alternative Investment Management Association (AIMA), hedge funds are difficult to define. The association does nevertheless include a definition in its glossary:

There is no standard international/legal definition though they may have all or some of the following characteristics: May use some form of short asset exposure; may use derivatives and/or more diverse risks or complex underlying products are involved; may use some form of leverage, measured by gross exposure of underlying assets exceeding the amount of capital in the fund; Funds charge a fee based on the performance of the fund relative to an absolute return benchmark as well as a management fee; investors are typically permitted to redeem their interest only periodically, e.g. quarterly or semi-annually; often, the manager is a significant investor alongside other fund investors.

The Hedge Fund Association (HFA), an international not-for-profit industry trade and non-partisan lobbying organization devoted to advancing transparency, development and trust in alternative investments, gives the following definition on its website:¹

Hedge funds refer to funds that can use one or more alternative investment strategies, including hedging against market downturns, investing in asset classes such as currencies or distressed securities, and utilizing return-enhancing tools such as leverage, derivatives, and arbitrage. At a time when world stock markets appear to have reached excessive valuations and may be due for further correction, hedge funds provide a viable alternative to investors seeking capital appreciation as well as capital preservation in bear markets. The vast majority of hedge funds make consistency of return, rather than magnitude, their primary goal.

Hedge Fund Research, Inc. (HFR), a hedge fund database provider specializing in alternative investments, states:²

[A] structure that usually takes a limited partnership or an offshore legal form. This structure is paid by a performance fee that is based on the fund profits. Exemptions exist and include a limit in the number of participants that should all be accredited or institutional. All hedge funds are not the same; managers are usually specialized in one of the investment strategies that are applied using a hedge fund structure.

Investopedia.com provides the following definition:³

An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.

The Securities and Exchange Commission recently defined hedge funds as:⁴

Any private fund (other than a securitized asset fund):

(a) with respect to which one or more investment advisers (or related persons of investment advisers) may be paid a performance fee or allocation calculated by taking into account unrealized gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses);

(b) that may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or

(c) that may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration).

On the basis of the definitions given above and many others, and arising from my own experience, please see below a general definition of hedge funds that is in accordance with the industry:

A Hedge Fund is an investment limited partnership (private) that uses a broad range of instruments like short selling, derivatives, leverage or arbitrage on different markets. Generally, the managers of the fund invest some of their own money in the fund and are paid by performance-related commissions. These funds require high minimum investments and their access is limited. These funds apply particularly to individual investors or to institutions with high financial resources.

This definition specifies many characteristics from the hedge fund industry, although not all of these will always be present at the level of individual funds. This definition does not give any information on the investment strategy applied by the investment team. This is in line with what we can find for mutual funds. The term investment fund does not give the investor information about what the fund is doing and/or if it is invested in shares, bonds or in derivatives. It does not confirm whether or not the fund has a geographical focus. But as we will see in the section relative to the origin of the industry, the situation was very different at the dawn of the industry. Every term in this definition has its importance; we will briefly cover these one by one, then explore each of them individually in detail later.

Hedge funds generally take the legal form of a private investment vehicle. Historically, the private structure arose from the fact that in the United States hedge fund managers had to comply with certain specific rules in order to limit the number of constraints on their management. Such constraints include, for example, restrictions regarding advertising or access being limited to high net worth individuals or professional investors. Such limitations tend to be standard even if some hedge fund strategies have been made available in a regulated onshore UCITS format in Europe. This means that the private structure is no longer an exclusive rule by which to define hedge funds, at least in Europe; however, in the US hedge funds are still proposed as private investments.

Hedge funds tend to invest in classic financial instruments such as equities and bonds, but their investment range is not always restricted to such securities. The use of more sophisticated instruments, including derivatives such as options (including exotic ones), futures, swaps, credit default swaps (CDS), warrants or convertible bonds, are common. Typically, they also use original and more complex investment techniques such as short selling⁵ or arbitrage. Depending on the investment strategy and their investment styles, managers may also tend to take the opportunity of using leverage.⁶ This part of the definition illustrates the level of freedom that managers tend to retain; the scope here is very broad, as some managers may only invest in equities by combining long and short positions in a market-neutral portfolio, while others will consider a wide range of different asset classes, including stocks, bonds and derivatives, and short-sell equities, take short positions in credit through CDS and combine naked, long, short, and some arbitrage or relative value positions.

Another characteristic of the definition is that hedge fund managers are paid mainly through performance-related fees, and that they invest a – usually significant – part of their personal cash holdings in their fund. This has been the case historically, and has become standard. Investors see that as an alignment of interest; when managers have their own money invested alongside that of investors, they are more involved and incentivized to deliver. The risk is that managers that have not co-invested with their clients could focus more on the management fee and on raising the asset rather than on delivering. While originally hedge funds involved only a 20 per cent performance-related commission, today management fees are also imposed, ranging between one and two per cent.

The last part of the definition stresses that hedge funds have been created for high net worth individuals and institutional investors. This arises from the fact that in most countries investments in individual hedge funds are limited to high net worth individuals, complying with strict rules. This constraint comes from the rules governing public funds that can be sold to any customer, but are restricted regarding the investment securities used, and cannot have sophisticated investment techniques applied to them. This rule protects the smaller investors; richer investors are likely to be more sophisticated, or they can pay for advice if needed; they can also afford a greater level of risk in their investments. Investment in hedge funds via funds of hedge funds is, however, usually allowed thanks to the diversification of individual fund risks.

At the outset, those general characteristics were the only constraints defining hedge funds. As the industry grew, however, and as managers tended to start applying comparable investment techniques and offering a similar profile, funds became grouped by investment strategy.⁷ The world of hedge funds is highly diversified in terms of strategies, and the differences between (and sometimes within) the strategies are usually important. Hedge fund investment strategies are defined by the instruments used and on the basis of the markets on which the corresponding funds are active. The funds’ risk profile will be very variable, based on the markets in which the strategy is implemented, the level of leverage allowed, the concentration and the instruments used. The range of strategies available has broadened over the last two to three decades, and certain strategies have had their moments of glory: in the 1980s and 1990s, macro funds aroused most interest not only from investors but also from the press; during the