Hedge fund

Ahedge fundis apooledinvestment fundthat holdsliquidassets and that makes use of complextradingandrisk managementtechniques to improve investment performance and insulate returns frommarket risk.Among theseportfolio techniquesareshort sellingand the use ofleverageandderivative instruments.In the United States,financial regulationsrequire that hedge funds be marketed only toinstitutional investorsandhigh-net-worth individuals.

Hedge funds are consideredalternative investments.Their ability to use leverage and more complex investment techniques distinguishes them from regulated investment funds available to the retail market, commonly known asmutual fundsandETFs.They are also considered distinct fromprivate equity fundsand other similarclosed-end fundsas hedge funds generally invest in relativelyliquid assetsand are usuallyopen-ended.This means they typically allow investors to invest and withdraw capital periodically based on the fund'snet asset value,whereas private-equity funds generally invest inilliquid assetsand return capital only after a number of years.Other than a fund's regulatory status, there are no formal or fixed definitions of fund types, and so there are different views of what can constitute a "hedge fund".

Although hedge funds are not subject to the many restrictions applicable to regulated funds, regulations were passed in the United States and Europe following thefinancial crisis of 2007–2008with the intention of increasing government oversight of hedge funds and eliminating certain regulatory gaps.While most modern hedge funds are able to employ a wide variety offinancial instrumentsand risk management techniques,they can be very different from each other with respect to their strategies, risks, volatility and expected return profile. It is common for hedge fund investment strategies to aim to achieve a positivereturn on investmentregardless of whether markets are rising or falling ( "absolute return"). Hedge funds can be considered risky investments; the expected returns of some hedge fund strategies are less volatile than those of retail funds with high exposure to stock markets because of the use of hedging techniques. Research in 2015 has shown that hedge fund activism can have significant real effects on target firms, including improvements in productivity and efficient reallocation of corporate assets. Moreover, these interventions often lead to increased labor productivity, although the benefits may not fully accrue to workers in terms of increased wages or work hours.

A hedge fund usually pays its investment manager a management fee (typically, 2% per annum of the net asset value of the fund) and aperformance fee(typically, 20% of the increase in the fund's net asset value during a year).Hedge funds have existed for many decades and have become increasingly popular. They have now grown to be a substantial portion of theasset managementindustry,with assets totaling around $3.8 trillion as of 2021.

Etymology

The word "hedge", meaning a line of bushes around the perimeter of a field, has long been used as a metaphor for placing limits on risk.Early hedge funds sought to hedge specific investments against general market fluctuations byshortingother, similar assets.Nowadays, however, many different investment strategies are used, many of which do not "hedge" risk.

History

During the USbull marketof the 1920s, there were numerous privateinvestment vehiclesavailable to wealthy investors. Of that period, the best known today is the Graham-Newman Partnership, founded byBenjamin Grahamand his long-time business partner Jerry Newman.This was cited byWarren Buffettin a 2006 letter to theMuseum of American Financeas an early hedge fund,and based on other comments from Buffett,Janet Tavakolideems Graham'sinvestment firmthe first hedge fund.

The sociologistAlfred W. Jonesis credited with coining the phrase "hedgedfund "and is credited with creating the first hedge fund structure in 1949.Jones referred to his fund as being "hedged", a term then commonly used onWall Streetto describe the management ofinvestment riskdue to changes in thefinancial markets.

In the 1970s, hedge funds specialized in a single strategy with most fund managers following thelong/short equitymodel. Many hedge funds closed during therecession of 1969–1970and the1973–1974 stock market crashdue to heavy losses. They received renewed attention in the late 1980s.

Cumulative hedge fund and other risk asset returns (1997–2012)

During the 1990s, the number of hedge funds increased significantly with the1990s stock market rise,the aligned-interest compensation structure (i.e.,common financial interests), and the promise of above average returnsas likely causes. Over the next decade, hedge fund strategies expanded to include credit arbitrage,distressed debt,fixed income,quantitative,and multi-strategy.USinstitutional investors,such as pension andendowment funds,began allocating greater portions of theirportfoliosto hedge funds.

During the first decade of the 21st century, hedge funds gained popularity worldwide, and, by 2008, the worldwide hedge fund industry held an estimated US$1.93 trillion inassets under management(AUM).However, thefinancial crisis of 2007–2008caused many hedge funds to restrict investor withdrawals and their popularity and AUM totals declined.AUM totals rebounded and in April 2011 were estimated at almost $2 trillion.As of February 2011,61% of worldwide investment in hedge funds came from institutional sources.

In June 2011, the hedge fund management firms with the greatest AUM wereBridgewater Associates(US$58.9 billion),Man Group(US$39.2 billion),Paulson & Co.(US$35.1 billion),Brevan Howard(US$31 billion), andOch-Ziff(US$29.4 billion).Bridgewater Associates had $70 billion in assets under management as of March 2012.At the end of that year, the 241 largest hedge fund firms in the United States collectively held $1.335 trillion.In April 2012, the hedge fund industry reached a record high of US$2.13 trillion total assets under management.In the middle of the 2010s, the hedge fund industry experienced a general decline in the "old guard" fund managers. Dan Loeb called it a "hedge fund killing field" due to the classic long/short falling out of favor because of unprecedented easing bycentral banks.The USstock marketcorrelation became untenable toshort sellers.The hedge fund industry today has reached a state of maturity that is consolidating around the larger, more established firms such as Citadel, Elliot, Millennium, Bridgewater, and others. The rate of new fund start ups is now outpaced by fund closings.

In July 2017, hedge funds recorded their eighth consecutive monthly gain in returns with assets under management rising to a record $3.1 trillion.

Notable hedge fund managers

Tom Steyer,hedge-fund manager ofNextGen America

George Soros,fund manager ofQuantum Group of Funds

Ray Dalio,fund manager ofBridgewater Associates

• John MeriwetherofLong-Term Capital Management,most successful returns from 27% to 59% through 1993 to 1998 until its collapse and liquidation.
• George SorosofQuantum Group of Funds
• Ray DalioofBridgewater Associates,the world's largest hedge fund firm with US$160 billion inassets under managementas of 2017
• Steve CohenofPoint72 Asset Management,formerly known as founder of SAC Capital Advisors
• John PaulsonofPaulson & Co.,whose hedge funds as of December 2015 had $19 billion assets under management
• David TepperofAppaloosa Management
• Paul Tudor JonesofTudor Investment Corporation
• Daniel OchofOch-Ziff Capital Management Groupwith more than $40 billion in assets under management in 2013
• Israel EnglanderofMillennium Management, LLC
• Leon Coopermanof Omega Advisors
• Michael PlattofBlueCrest Capital Management(UK), Europe's third-largest hedge-fund firm
• James DinanofYork Capital Management
• Stephen MandelofLone Pine Capitalwith $26.7 billion under management at end June 2015
• Larry Robbinsof Glenview Capital Management with $9.2 billion of assets under management as of July 2014
• Glenn DubinofHighbridge Capital Management
• Paul SingerofElliott Management Corporation,an activist hedge fund with more than US$23 billion in assets under management in 2013,and a portfolio worth $8.1 billion as of the first quarter of 2015
• Michael HintzeofCQSwith $14.4 billion of assets under management as of June 2015
• David EinhornofGreenlight Capitalas the top 20 billionaire hedge fund managers.
• Bill AckmanofPershing Square Capital ManagementLP
• Kenneth GriffinofCitadelwith over $62 billion in assets under management as of December 2022.

Strategies

A prospectus from the US

Hedge fund strategies are generally classified among four major categories:global macro,directional,event-driven,andrelative value(arbitrage).Strategies within these categories each entail characteristic risk and return profiles. A fund may employ a single strategy or multiple strategies for flexibility,risk management,or diversification.The hedge fund'sprospectus,also known as anoffering memorandum,offers potential investors information about key aspects of the fund, including the fund's investment strategy, investment type, andleveragelimit.

The elements contributing to a hedge fund strategy include the hedge fund's approach to the market, the particular instrument use, themarket sectorthe fund specializes in (e.g.,healthcare), the method used to select investments, and the amount of diversification within the fund. There are a variety of market approaches to differentasset classes,includingequity,fixed income,commodity,andcurrency.Instruments used include equities, fixed income,futures,options,andswaps.Strategies can be divided into those in which investments can be selected by managers, known as "discretionary/qualitative", or those in which investments are selected using a computerized system, known as "systematic/quantitative".The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager, or a combination.

Sometimes hedge fund strategies are described as "absolute return"and are classified as either"market neutral"or" directional ". Market neutral funds have less correlation to overall market performance by" neutralizing "the effect of market swings whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.

Global macro

Main article:Global macro

Hedge funds using a global macro investing strategy take largepositionsin share, bond, or currency markets in anticipation of globalmacroeconomic eventsin order to generate arisk-adjusted return.Global macro fund managers use macroeconomic ( "big picture" ) analysis based on global market events and trends to identify opportunities for investment that would profit from anticipated price movements. While global macro strategies have a large amount of flexibility (due to their ability to use leverage to take large positions in diverse investments in multiple markets), the timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns.Global macro is often categorized as a directional investment strategy.

Global macro strategies can be divided into discretionary and systematic approaches. Discretionary trading is carried out by investment managers who identify and select investments, whereassystematic tradingis based onmathematical modelsand executed bysoftwarewith limited human involvement beyond the programming and updating of the software. These strategies can also be divided intotrendor counter-trend approaches depending on whether the fund attempts to profit from followingmarket trend(long or short-term) or attempts to anticipate and profit from reversals in trends.

Within global macro strategies, there are further sub-strategies including "systematic diversified", in which the fund trades in diversified markets, or sector specialists such as "systematic currency", in which the fund trades inforeign exchange marketsor any other sector specialisation.Other sub-strategies include those employed bycommodity trading advisors(CTAs), where the fund trades infutures(oroptions) incommoditymarkets or in swaps.This is also known as a "managed future fund".CTAs trade in commodities (such as gold) and financial instruments, includingstock indices.They also take both long and short positions, allowing them to make profit in both market upswings and downswings.Most global macro managers tends to be a CTA from a regulatory perspective and the main divide is between systematic and discretionary strategies. A classification framework for CTA/Macro Strategies can be found in the reference.

Directional

Schematic representation of short selling in two steps. The short sellerborrows sharesand immediately sells them. The short seller then expects the price to decrease, when the seller can profit by purchasing the shares to return to the lender.

Directional investment strategies use market movements, trends, or inconsistencies when picking stocks across a variety of markets. Computer models can be used, or fund managers will identify and select investments. These types of strategies have a greater exposure to the fluctuations of the overall market than do market neutral strategies.Directional hedge fund strategies include US and internationallong/short equityhedge funds, wherelong equitypositions are hedged withshort salesof equities or equityindexoptions.

Within directional strategies, there are a number of sub-strategies. "Emerging markets"funds focus on emerging markets such as China and India,whereas "sector funds" specialize in specific areas including technology, healthcare, biotechnology, pharmaceuticals, energy, and basic materials. Funds using a "fundamental growth" strategy invest in companies with moreearningsgrowth than the overallstock marketor relevant sector, while funds using a "fundamental value"strategy invest in undervalued companies.Funds that usequantitativeandfinancial signal processingtechniques for equitytradingare described as using a "quantitative directional" strategy.Funds using a "short bias"strategy take advantage of declining equity prices using short positions.

Event-driven

Main article:Event-driven investing

Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event.An event-driven investment strategy finds investment opportunities in corporate transactional events such as consolidations,acquisitions,recapitalizations,bankruptcies,andliquidations.Managers employing such a strategy capitalize onvaluationinconsistencies in the market before or after such events, and take a position based on the predicted movement of thesecurityor securities in question. Largeinstitutional investorssuch as hedge funds are more likely to pursue event-driven investing strategies than traditional equity investors because they have the expertise and resources to analyze corporate transactional events for investment opportunities.

Corporate transactional events generally fit into three categories:distressed securities,risk arbitrage,andspecial situations.Distressed securitiesinclude such events as restructurings,recapitalizations,andbankruptcies.A distressed securities investment strategy involves investing in the bonds or loans of companies facing bankruptcy or severe financial distress, when thesebondsorloansare being traded at adiscountto their value. Hedge fund managers pursuing the distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds purchasing distressed debt may prevent those companies from going bankrupt, as such an acquisition detersforeclosureby banks.While event-driven investing, in general, tends to thrive during abull market,distressed investing works best during abear market.

Risk arbitrageormerger arbitrageincludes such events asmergers,acquisitions, liquidations, andhostile takeovers.Risk arbitrage typically involves buying and selling the stocks of two or more merging companies to take advantage of market discrepancies between acquisition price and stock price. The risk element arises from the possibility that the merger or acquisition will not go ahead as planned; hedge fund managers will use research and analysis to determine if the event will take place.

Special situations are events that impact the value of a company's stock, including therestructuringof a company or corporate transactions includingspin-offs,sharebuy backs,security issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company's equity and equity-related instruments.

Other event-driven strategies include credit arbitrage strategies, which focus on corporatefixed incomesecurities; an activist strategy, where the fund takes large positions in companies and uses the ownership to participate in the management; a strategy based on predicting the final approval of newpharmaceutical drugs;and legal catalyst strategy, which specializes in companies involved in major lawsuits.

Relative value

Main article:Relative value (economics)

Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, theunderlying securityor the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical,technical,orfundamentaltechniques.Relative value is often used as a synonym formarket neutral,as strategies in this category typically have very little or no directional market exposure to the market as a whole.Other relative value sub-strategies include:

• Fixed income arbitrage:exploit pricing inefficiencies between related fixed income securities.
• Equity market neutral:exploit differences in stock prices by beinglongandshortin stocks within the same sector, industry, market capitalization, country, which also creates a hedge against broader market factors.
• Convertible arbitrage:exploit pricing inefficiencies betweenconvertible securitiesand the correspondingstocks.
• Asset-backed securities (fixed-income asset-backed):fixed income arbitragestrategy usingasset-backed securities.
• Credit long/short: the same as long/short equity, but incredit marketsinstead of equity markets.
• Statistical arbitrage:identifying pricing inefficiencies between securities through mathematical modelling techniques
• Volatility arbitrage:exploit the change involatility,instead of the change in price.
• Yield alternatives: non-fixed income arbitragestrategies based on the yield, instead of the price.
• Regulatory arbitrage: exploit regulatory differences between two or more markets.
• Risk arbitrage:exploit market discrepancies between acquisition price and stock price.
• Value investing:buying securities that appear underpriced by some form of fundamental analysis.

Miscellaneous

In addition to those strategies within the four main categories, there are several strategies that do not entirely fit into these categories.

• Fund of hedge funds(multi-manager): a hedge fund with a diversified portfolio of numerous underlying single-manager hedge funds.
• Multi-manager: a hedge fund wherein the investment is spread along separate sub-managers investing in their own strategy.
• Multi-strategy: a hedge fund using a combination of different strategies.
• 130-30 funds:equity funds with 130% long and 30% short positions, leaving a net long position of 100%.
• Risk parity:equalizing risk by allocating funds to a wide range of categories while maximizing gains through financial leveraging.
• AI-driven: using sophisticatedmachine learningmodels and sometimesbig data.

Risk

For an investor who already holds large quantities of equities and bonds, investment in hedge funds may provide diversification and reduce the overall portfolio risk.Managers of hedge funds often aim to produce returns that are relativelyuncorrelatedwith market indices and are consistent with investors' desired level of risk.Whilehedgingcan reduce some risks of an investment it usually increases others, such asoperational riskandmodel risk,so overall risk is reduced but cannot be eliminated. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than theS&P 500between 1993 and 2010.

Risk management

Investors in hedge funds are, in most countries, required to be qualified investors who are assumed to be aware of theinvestment risks,and accept these risks because of the potentialreturnsrelative to those risks. Fund managers may employ extensiverisk managementstrategies in order to protect the fund and investors. According to theFinancial Times,"big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management."Hedge fund managers that hold a large number of investment positions for short periods are likely to have a particularly comprehensive risk management system in place, and it has become usual for funds to have independent risk officers who assess and manage risks but are not otherwise involved in trading.A variety of different measurement techniques and models are used to estimate risk according to the fund's leverage, liquidity, and investment strategy.Non-normality of returns, volatility clustering and trends are not always accounted for by conventional risk measurement methodologies and so in addition tovalue at riskand similar measurements, funds may use integrated measures such asdrawdowns.

In addition to assessing the market-related risks that may arise from an investment, investors commonly employoperational due diligenceto assess the risk that error orfraudat a hedge fund might result in a loss to the investor. Considerations will include the organization and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund's ability to develop as a company.

Transparency, and regulatory considerations

Since hedge funds are private entities and have few publicdisclosurerequirements, this is sometimes perceived as alack of transparency.Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/orregistrationrequirements as other financial investment managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud.New regulations introduced in the US and the EU as of 2010 required hedge fund managers to report more information, leading to greater transparency.In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and external regulatory requirements.The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology, positions, and leverage exposure.

Risks shared with other investment types

Hedge funds share many of the same types of risk as other investment classes, includingliquidity riskand manager risk.Liquidityrefers to the degree to which an asset can be bought and sold or converted to cash; similar to private-equity funds, hedge funds employ alock-up periodduring which an investor cannot remove money.Manager risk refers to those risks which arise from the management of funds. As well as specific risks such asstyle drift,which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors includevaluation risk,capacity risk,concentration risk,andleverage risk.Valuation risk refers to the concern that thenet asset value(NAV) of investments may be inaccurate;capacity risk can arise from placing too much money into one particular strategy, which may lead to fund performance deterioration;and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group ofcorrelatedfunds.These risks may be managed through defined controls overconflict of interest,restrictions on allocation of funds,and set exposure limits for strategies.

Many investment funds useleverage,the practice ofborrowingmoney, trading onmargin,or usingderivativesto obtain market exposure in excess of that provided by investors' capital. Although leverage can increase potential returns, the opportunity for larger gains is weighed against the possibility of greater losses.Hedge funds employing leverage are likely to engage in extensive risk management practices.In comparison withinvestment banks,hedge fund leverage is relatively low; according to aNational Bureau of Economic Researchworking paper, the average leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.

Some types of funds, including hedge funds, are perceived as having a greaterappetite for risk,with the intention of maximizing returns,subject to therisk toleranceof investors and the fund manager. Managers will have an additional incentive to increase risk oversight when their own capital is invested in the fund.

Fees and remuneration

Fees paid to hedge funds

Hedge fund management firms typically charge their funds both amanagement feeand aperformance fee.

Management fees are calculated as a percentage of the fund'snet asset valueand typically range from 1% to 4% per annum, with 2% being standard.They are usually expressed as an annual percentage, but calculated and paid monthly or quarterly. Management fees for hedge funds are designed to cover the operating costs of the manager, whereas the performance fee provides the manager's profits. However, due toeconomies of scalethe management fee from larger funds can generate a significant part of a manager's profits, and as a result some fees have been criticized by some public pension funds, such asCalPERS,for being too high.

Theperformance feeis typically 20% of the fund's profits during any year, though performance fees range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits.Performance fees have been criticized byWarren Buffett,who believes that because hedge funds share only the profits and not the losses, such fees create an incentive for high-risk investment management. Performance fee rates have fallen since the start of thecredit crunch.

Almost all hedge fund performance fees include a "high water mark"(or" loss carryforward provision "), which means that the performance fee only applies to net profits (i.e.,profits after losses in previous years have been recovered). This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather than attempt to recover the losses over a number of years without a performance fee.

Some performance fees include a "hurdle",so that a fee is only paid on the fund's performance in excess of abenchmarkrate (e.g.,LIBOR) or a fixed percentage.The hurdle is usually tied to a benchmark rate such as Libor or the one-year Treasury bill rate plus a spread.A "soft" hurdle means the performance fee is calculated on all the fund's returns if the hurdle rate is cleared. A "hard" hurdle is calculated only on returns above the hurdle rate.By example the manager sets a hurdle rate equal to 5%, and the fund return 15%, incentive fees would only apply to the 10% above the hurdle rate.A hurdle is intended to ensure that a manager is only rewarded if the fund generates returns in excess of the returns that the investor would have received if they had invested their money elsewhere.

Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year), or when withdrawals exceed a predetermined percentage of the original investment.The purpose of the fee is to discourage short-term investing, reduce turnover, and deter withdrawals after periods of poor performance. Unlike management fees and performance fees, redemption fees are usually kept by the fund and redistributed to all investors.

Remuneration of portfolio managers

Hedge fund management firms are often owned by theirportfolio managers,who are therefore entitled to any profits that the business makes. As management fees are intended to cover the firm's operating costs, performance fees (and any excess management fees) are generally distributed to the firm's owners as profits. Funds do not tend to report compensation, and so published lists of the amounts earned by top managers tend to be estimates based on factors such as the fees charged by their funds and the capital they are thought to have invested in them.Many managers have accumulated large stakes in their own funds and so top hedge fund managers can earn extraordinary amounts of money, perhaps up to $4 billion in a good year.

Earnings at the very top are higher than in any other sector of the financial industry,and collectively the top 25 hedge fund managers regularly earn more than all 500 of the chief executives in theS&P 500.Most hedge fund managers are remunerated much less, however, and if performance fees are not earned then small managers at least are unlikely to be paid significant amounts.

In 2011, the top manager earned $3 billion, the tenth earned $210 million, and the 30th earned $80 million.In 2011, the average earnings for the 25 highest-compensated hedge fund managers in the United States was $576 millionwhile the mean total compensation for all hedge fund investment professionals was $690,786 and the median was $312,329. The same figures for hedge fund CEOs were $1,037,151 and $600,000, and for chief investment officers were $1,039,974 and $300,000, respectively.

Of the 1,226 people on theForbesWorld's Billionaires List for 2012,36 of the financiers listed "derived significant chunks" of their wealth from hedge fund management.Among the richest 1,000 people in the United Kingdom, 54 were hedge fund managers, according to theSunday TimesRich List for 2012.

A portfolio manager risks losing his past compensation if he or she engages ininsider trading.InMorgan Stanley v. Skowron,989 F. Supp. 2d 356 (S.D.N.Y. 2013), applying New York'sfaithless servantdoctrine, the court held that a hedge fund's portfolio manager engaging in insider trading in violation of his company's code of conduct, which also required him to report his misconduct, must repay his employer the full $31 million his employer paid him as compensation during his period of faithlessness.The court called the insider trading the "ultimate abuse of a portfolio manager's position".The judge also wrote: "In addition to exposing Morgan Stanley to government investigations and direct financial losses, Skowron's behavior damaged the firm's reputation, a valuable corporate asset."

Structure

A hedge fund is aninvestment vehiclethat is most often structured as anoffshore corporation,limited partnership,orlimited liability company.The fund is managed by aninvestment managerin the form of an organization or company that is legally and financially distinct from the hedge fund and its portfolio ofassets.Many investment managers utilize service providers for operational support.Service providers include prime brokers, banks, administrators, distributors, and accounting firms.

Prime broker

Prime brokerscleartradesand provide leverage and short-termfinancing.They are usually divisions of large investment banks.The prime broker acts as acounterpartytoderivative contracts,and lends securities for particular investment strategies, such aslong/short equitiesandconvertible bond arbitrage.It can providecustodial servicesfor the fund's assets, and trade execution and clearing services for the hedge fund manager.

Administrator

Hedge fund administratorsare typically responsible forvaluationservices, and oftenoperations,andaccounting.

Calculation of thenet asset value( "NAV" ) by the administrator, including the pricing of securities at current market value and calculation of the fund's income and expense accruals, is a core administrator task, because it is the price at which investors buy and sell shares in the fund.The accurate and timely calculation of NAV by the administrator is vital.The case ofAnwar v. Fairfield Greenwich(SDNY 2015) is the major case relating to fund administrator liability for failure to handle its NAV-related obligations properly.There, the hedge fund administrator and other defendants settled in 2016 by paying theAnwarinvestor plaintiffs $235 million.

Administratorback officesupport allows fund managers to concentrate on trades.Administrators also processsubscriptionsand redemptions and perform various shareholder services.Hedge funds in the United States are not required to appoint an administrator and all of these functions can be performed by an investment manager.A number ofconflict of interestsituations may arise in this arrangement, particularly in the calculation of a fund's net asset value.Most funds employ externalauditors,thereby arguably offering a greater degree of transparency.

Auditor

An auditor is an independentaccountingfirm used to perform a completeauditthe fund'sfinancial statements.The year-end audit is performed in accordance with thestandard accounting practicesenforced within the country in which the fund it established, typicallyUS GAAPor theInternational Financial Reporting Standards(IFRS).The auditor may verify the fund's NAV andassets under management(AUM).Some auditors only provide "NAV lite" services, meaning that the valuation is based on prices received from the manager rather than an independent assessment.

Distributor

A distributor is anunderwriter,broker,dealer,or other person who participates in the distribution of securities.The distributor is also responsible for marketing the fund to potential investors. Many hedge funds do not have distributors, and in such cases, the investment manager will be responsible for the distribution of securities and marketing, though many funds also useplacement agentsand broker-dealers for distribution.

Domicile and taxation

The legal structure of a specific hedge fund, in particular itsdomicileand the type oflegal entityin use, is usually determined by the tax expectations of the fund's investors.Regulatory considerationswill also play a role. Many hedge funds are established inoffshore financial centersto avoid adverse tax consequences for its foreign and tax-exempt investors.Offshore fundsthat invest in the US typically paywithholding taxeson certain types of investment income, but not UScapital gains tax.However, the fund's investors are subject to tax in their own jurisdictions on any increase in the value of their investments.This tax treatment promotes cross-border investments by limiting the potential for multiple jurisdictions to layer taxes on investors.

US tax-exempt investors (such aspension plansandendowments) invest primarily in offshore hedge funds to preserve theirtax exemptstatus and avoid unrelated businesstaxable income.The investment manager, usually based in a major financial center, pays tax on its management fees per the tax laws of the state and country where it is located.In 2011, half of the existing hedge funds were registered offshore and half onshore. TheCayman Islandswas the leading location for offshore funds, accounting for 34% of the total number of global hedge funds. The US had 24%,Luxembourg10%,Ireland7%, theBritish Virgin Islands6%, andBermudahad 3%.

Hedge funds take advantage of a tax loopole called carried interest to get around paying too much in taxes by fancy legalistic maneouvres on their part.

Basket options

Deutsche Bank and Barclays created special options accounts for hedge fund clients in the banks' names and claimed to own the assets, when in fact the hedge fund clients had full control of the assets and reaped the profits. The hedge funds would then execute trades – many of them a few seconds in duration – but wait until just after a year had passed to exercise the options, allowing them to report the profits at a lower long-term capital gains tax rate.

— Alexandra Stevenson. July 8, 2015.The New York Times

The USSenate Permanent Subcommittee on Investigationschaired byCarl Levinissued a 2014 report that found that from 1998 and 2013, hedge funds avoided billions of dollars in taxes by using basket options. TheInternal Revenue Servicebegan investigatingRenaissance Technologiesin 2009, and Levin criticized the IRS for taking six years to investigate the company. Using basket options Renaissance avoided "more than $6 billion in taxes over more than a decade".

These banks and hedge funds involved in this case used dubious structured financial products in a giant game of 'let's pretend,' costing the Treasury billions and bypassing safeguards that protect the economy from excessive bank lending for stock speculation.

— Carl Levin.2015. Senate Permanent Subcommittee on Investigations

A dozen other hedge funds along with Renaissance Technologies usedDeutsche Bank's andBarclays' basket options.Renaissance argued that basket options were "extremely important because they gave the hedge fund the ability to increase its returns by borrowing more and to protect against model and programming failures".In July 2015, the United States Internal Revenue claimed hedge funds used basket options "to bypass taxes on short-term trades". These basket options will now be labeled as listed transactions that must be declared on tax returns, and a failure to do would result in a penalty.

Investment manager locations

In contrast to the funds themselves, investment managers are primarily locatedonshore.The United States remains the largest center of investment with US-based funds managing around 70% of global assets at the end of 2011.As of April 2012, there were approximately 3,990 investment advisers managing one or more private hedge funds registered with theSecurities and Exchange Commission.New York City and theGold Coastarea ofConnecticutare the leading locations for US hedge fund managers.

London was Europe's leading center for hedge fund managers, but since theBrexitreferendum some formerly London-based hedge funds have relocated to other European financial centers such asFrankfurt,Luxembourg,Paris,andDublin,while some other hedge funds have moved their European head offices back to New York City.Before Brexit, according to EuroHedge data, around 800 funds located in the UK had managed 85% of European-based hedge fund assets in 2011.Interest in hedge funds in Asia has increased significantly since 2003, especially in Japan, Hong Kong, and Singapore.After Brexit, Europe and the US remain the leading locations for the management of Asian hedge fund assets.

Legal entity

Hedge fund legal structures vary depending on location and the investor(s). US hedge funds aimed at US-based, taxable investors are generally structured aslimited partnershipsor limited liability companies. Limited partnerships and otherflow-through taxationstructures assure that investors in hedge funds are not subject to both entity-level and personal-level taxation.A hedge fund structured as a limited partnership must have ageneral partner.The general partner may be an individual or a corporation. The general partner serves as the manager of the limited partnership, and hasunlimited liability.The limited partners serve as the fund's investors, and have no responsibility for management or investment decisions. Their liability is limited to the amount of money they invest for partnership interests.As an alternative to a limited partnership arrangement, U.S. domestic hedge funds may be structured aslimited liability companies,with members acting as corporate shareholders and enjoying protection from individual liability.

By contrast,offshorecorporate funds are usually used for non-US investors, and when they are domiciled in an applicable offshoretax haven,no entity-level tax is imposed.Many managers of offshore funds permit the participation of tax-exempt US investors, such aspensions funds,institutional endowments,andcharitable trusts.As an alternative legal structure, offshore funds may be formed as anopen-endedunit trustusing an unincorporatedmutual fundstructure.Japanese investors prefer to invest inunit trusts,such as those available in the Cayman Islands.

The investment manager who organizes the hedge fund may retain an interest in the fund, either as the general partner of a limited partnership or as the holder of "founder shares" in a corporate fund.For offshore funds structured as corporate entities, the fund may appoint aboard of directors.The board's primary role is to provide a layer of oversight while representing the interests of the shareholders.However, in practice board members may lack sufficient expertise to be effective in performing those duties. The board may include both affiliated directors who are employees of the fund and independent directors whose relationship to the fund is limited.

Types of funds

• Open-endedhedge funds continue to issue shares to new investors and allow periodic withdrawals at thenet asset value( "NAV" ) for each share.
• Closed-endedhedge funds issue a limited number of tradeable shares at inception.
• Shares ofListedhedges funds are traded onstock exchanges,such as theIrish Stock Exchange,and may be purchased by non-accredited investors.

Side pockets

A side pocket is a mechanism whereby a fund compartmentalizes assets that are relativelyilliquidor difficult to value reliably.When an investment is side-pocketed, its value is calculated separately from the value of the fund's main portfolio.Because side pockets are used to hold illiquid investments, investors do not have the standard redemption rights with respect to the side pocket investment that they do with respect to the fund's main portfolio.Profits or losses from the investment are allocated on apro ratabasis only to those who are investors at the time the investment is placed into the side pocket and are not shared with new investors.Funds typically carry side pocket assets "at cost" for purposes of calculating management fees and reporting net asset values. This allows fund managers to avoid attempting a valuation of the underlying investments, which may not always have a readily availablemarket value.

Side pockets were widely used by hedge funds during thefinancial crisis of 2007–2008amidst a flood of withdrawal requests. Side pockets allowed fund managers to lay away illiquid securities until market liquidity improved, a move that could reduce losses. However, as the practice restricts investors' ability to redeem their investments it is often unpopular and many have alleged that it has been abused or applied unfairly.The SEC also has expressed concern about aggressive use of side pockets and has sanctioned certain fund managers for inappropriate use of them.

Regulation

Hedge funds must abide by the national, federal, and state regulatory laws in their respective locations. The U.S. regulations and restrictions that apply to hedge funds differ from those that apply to its mutual funds.Mutual funds, unlike hedge funds and other private funds, are subject to theInvestment Company Act of 1940,which is a highly detailed and extensive regulatory regime.According to a report by theInternational Organization of Securities Commissions,the most common form of regulation pertains to restrictions onfinancial advisersand hedge fund managers in an effort to minimize client fraud. On the other hand, U.S. hedge funds are exempt from many of the standard registration and reporting requirements because they only accept accredited investors.In 2010, regulations were enacted in the US and European Union which introduced additional hedge fund reporting requirements. These included the U.S.'sDodd-Frank Wall Street Reform Actand EuropeanAlternative Investment Fund Managers Directive.

In 2007, in an effort to engage inself-regulation,14 leading hedge fund managers developed a voluntary set ofinternational standardsinbest practiceand known as theHedge Fund Standardsthey were designed to create a "framework of transparency, integrity and good governance" in the hedge fund industry.TheHedge Fund Standards Boardwas set up to prompt and maintain these standards going forward, and by 2016 it had approximately 200 hedge fund managers and institutional investors with a value of US$3tn investment endorsing the standards.TheManaged Funds Associationis a US-basedtrade association,while the Alternative Investment Management Association is the primarily European counterpart.

United States

Hedge funds within the US are subject to regulatory, reporting, and record-keeping requirements.Many hedge funds also fall under the jurisdiction of theCommodity Futures Trading Commission,and are subject to rules and provisions of the 1922Commodity Exchange Act,which prohibits fraud and manipulation.TheSecurities Act of 1933required companies to file a registration statement with the SEC to comply with itsprivate placementrules before offering their securities to the public,and most traditional hedge funds in the United States are offered effectively as private placement offerings.TheSecurities Exchange Act of 1934required a fund with more than 499 investors to register with the SEC.TheInvestment Advisers Act of 1940contained anti-fraud provisions that regulated hedge fund managers and advisers, created limits for the number and types of investors, and prohibitedpublic offerings.The Act also exempted hedge funds from mandatory registration with theSECwhen selling to accredited investors with a minimum of US$5 million in investment assets. Companies and institutional investors with at least US$25 million in investment assets also qualified.

In December 2004, the SEC began requiring hedge fund advisers, managing more than US$25 million and with more than 14 investors, to register with the SEC under the Investment Advisers Act.The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regime for the burgeoning industry.The new rule was controversial, with two Commissioners dissenting,and was later challenged in court by a hedge fund manager. In June 2006, theU.S. Court of Appeals for the District of Columbiaoverturned the rule and sent it back to the agency to be reviewed.In response to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the earlier-challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity.Hedge fund managers with at least US$100 million in assets under management are required to file publicly quarterly reports disclosing ownership of registered equity securities and are subject to public disclosure if they own more than 5% of the class of any registered equity security.Registered advisers must report their business practices and disciplinary history to the SEC and to their investors. They are required to have written compliance policies, achief compliance officer,and their records and practices may be examined by the SEC.

The U.S.'sDodd-Frank Wall Street Reform Actwas passed in July 2010and requires SEC registration of advisers who manage private funds with more than US$150 million in assets.Registered managers must file Form ADV with the SEC, as well as information regarding their assets under management and trading positions.Previously, advisers with fewer than 15 clients were exempt, although many hedge fund advisers voluntarily registered with the SEC to satisfy institutional investors.Under Dodd-Frank, investment advisers with less than US$100 million in assets under management became subject to state regulation.This increased the number of hedge funds under state supervision.Overseas advisers who managed more than US$25 million were also required to register with the SEC.The Act requires hedge funds to provide information about their trades and portfolios to regulators including the newly createdFinancial Stability Oversight Council.In this regard, most hedge funds and other private funds, including private-equity funds, must file Form PF with the SEC, which is an extensive reporting form with substantial data on the funds' activities and positions.Under the "Volcker Rule",regulators are also required to implement regulations for banks, their affiliates, andholding companiesto limit their relationships with hedge funds and to prohibit these organizations fromproprietary trading,and to limit their investment in, and sponsorship of, hedge funds.

Europe

Within the European Union (EU), hedge funds are primarily regulated through their managers.In the United Kingdom, where 80% of Europe's hedge funds are based,hedge fund managers are required to be authorised and regulated by theFinancial Conduct Authority(FCA).Each country has its own specific restrictions on hedge fund activities, including controls on use of derivatives in Portugal, and limits on leverage in France.

In the EU, managers are subject to theEU's Directive on Alternative Investment Fund Managers(AIFMD). According to the EU, the aim of the directive is to provide greater monitoring and control of alternative investment funds.AIFMD requires all EU hedge fund managers to register with national regulatory authoritiesand to disclose more information, on a more frequent basis. It also directs hedge fund managers to hold larger amounts of capital. AIFMD also introduced a "passport" for hedge funds authorised in one EU country to operate throughout the EU.The scope of AIFMD is broad and encompasses managers located within the EU as well as non-EU managers that market their funds to European investors.An aspect of AIFMD which challenges established practices in the hedge funds sector is the potential restriction of remuneration through bonus deferrals andclawbackprovisions.

Offshore

Some hedge funds are established inoffshore centres,such as theCayman Islands,Dublin,Luxembourg,SingaporetheBritish Virgin Islands,andBermuda,which have different regulationsconcerning non-accredited investors, client confidentiality, and fund manager independence.

South Africa

In South Africa, investment fund managers must be approved by, and register with, the Financial Services Board (FSB).

Performance

Measurement

Performance statistics for individual hedge funds are difficult to obtain, as the funds have historically not been required to report their performance to a central repository, and restrictions against public offerings and advertisement have led many managers to refuse to provide performance information publicly. However, summaries of individual hedge fund performance are occasionally available in industry journalsand databases.

One estimate is that the average hedge fund returned 11.4% per year,representing a 6.7% return above overall market performance before fees, based on performance data from 8,400 hedge funds.Another estimate is that between January 2000 and December 2009 hedge funds outperformed other investments and were substantially less volatile, with stocks falling an average of 2.62% per year over the decade and hedge funds rising an average of 6.54% per year; this was an unusually volatile period with both the 2001-2002dot-com bubbleand arecession beginning mid 2007.However, more recent data show that hedge fund performance declined and underperformed the market from about 2009 to 2016.

Hedge funds performance is measured by comparing their returns to an estimate of their risk.Common measures are theSharpe ratio,Treynor measureandJensen's Alpha.These measures work best when returns follownormal distributionswithoutautocorrelation,and these assumptions are often not met in practice.

New performance measures have been introduced that attempt to address some of theoretical concerns with traditional indicators, including: modifiedSharpe ratios;theOmega ratiointroduced by Keating and Shadwick in 2002;Alternative Investments Risk Adjusted Performance (AIRAP) published by Sharma in 2004;and Kappa developed by Kaplan and Knowles in 2004.

Sector-size effect

There is a debate over whetherAlpha(the manager's skill element in performance) has been diluted by the expansion of the hedge fund industry. Two reasons are given. First, the increase in traded volume may have been reducing themarket anomaliesthat are a source of hedge fund performance. Second, the remuneration model is attracting more managers, which may dilute the talent available in the industry.

Hedge fund indices

Indicesplay a central and unambiguous role in traditional asset markets, where they are widely accepted as representative of their underlying portfolios. Equity and debtindex fundproducts provide investable access to mostdeveloped marketsin these asset classes.

Hedge fund indices are more problematic. The typical hedge fund is not traded on exchange, will accept investments only at the discretion of the manager, and does not have an obligation to publish returns. Despite these challenges, Non-investable, Investable, and Clone indices have been developed.

Non-investable indices

Non-investable indices are indicative in nature and aim to represent the performance of some database of hedge funds using some measure such as mean, median, or weighted mean from a hedge fund database. The databases have diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different indices.

Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list ofbiases.Funds' participation in a database is voluntary, leading toself-selection biasbecause those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money.

The short lifetimes of many hedge funds mean that there are many new entrants and many departures each year, which raises the problem ofsurvivorship bias.If we examine only funds that have survived to the present, we will overestimate past returns because many of the worst-performing funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial.

When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favorable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias" or "backfill bias".

Investable indices

Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. To create an investable index, the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. When investors buy these products the index provider makes the investments in the underlying funds, making an investable index similar in some ways to a fund of hedge funds portfolio.

To make the index investable, hedge funds must agree to accept investments on the terms given by the constructor. To make the index liquid, these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. This means that investable indices do not represent the total universe of hedge funds. Most seriously, they under-represent more successful managers, who typically refuse to accept such investment protocols.

Hedge fund replication

The most recent addition to the field approaches the problem in a different manner. Instead of reflecting the performance of actual hedge funds, they take a statistical approach to the analysis of historic hedge fund returns and use this to construct a model of how hedge fund returns respond to the movements of various investable financial assets. This model is then used to construct an investable portfolio of those assets. This makes the index investable, and in principle, they can be as representative as the hedge fund database from which they were constructed. However, these clone indices rely on a statistical modelling process. Such indices have too short a history to state whether this approach will be considered successful.

Closures

In March 2017, HFR – a hedge fund research data and service provider – reported that there were more hedge-fund closures in 2016 than during the 2009 recession. According to the report, several large public pension funds pulled their investments in hedge funds, because the funds' subpar performance as a group did not merit the high fees they charged.

Despite the hedge fund industry topping $3 trillion for the first time ever in 2016, the number of new hedge funds launched fell short of levels before thefinancial crisis of 2007–2008.There were 729 hedge fund launches in 2016, fewer than the 784 opened in 2009, and dramatically fewer than the 968 launches in 2015.

Debates and controversies

Systemic risk

Systemic riskrefers to the risk of instability across the entirefinancial system,as opposed to within a single company. Such risk may arise following a destabilizing event or events affecting a group offinancial institutionslinked through investment activity.Organizations such as theEuropean Central Bankhave charged that hedge funds pose systemic risks to the financial sector,and following the failure of hedge fundLong-Term Capital Management(LTCM) in 1998 there was widespread concern about the potential for systemic risk if a hedge fund failure led to the failure of its counterparties. (As it happens, no financial assistance was provided to LTCM by theUS Federal Reserve,so there was no direct cost to US taxpayers,but a largebailouthad to be mounted by a number of financial institutions.)

However, these claims are widely disputed by the financial industry,who typically regard hedge funds as "small enough to fail",since most are relatively small in terms of the assets they manage and operate with low leverage, thereby limiting the potential harm to the economic system should one of them fail.Formal analysis of hedge fund leverage before and during thefinancial crisis of 2007–2008suggests that hedge fund leverage is both fairly modest andcounter-cyclicalto the market leverage of investment banks and the larger financial sector.Hedge fund leverage decreased prior to the financial crisis, even while the leverage of other financial intermediaries continued to increase.Hedge funds fail regularly, and numerous hedge funds failed during the financial crisis.In testimony to theUS House Financial Services Committeein 2009,Ben Bernanke,theFederal ReserveBoard Chairman said he "would not think that any hedge fund or private-equity fund would become a systemically critical firm individually".

This does leave the possibility that hedge funds collectively might contribute to systemic risk if they exhibitherd or self-coordinating behavior,perhaps because many hedge funds make losses in similar trades. This coupled with the extensive use of leverage could lead to forced liquidations in a crisis.

Hedge funds are also closely connected to their prime brokers, typically investment banks, which could contribute to their instability in a crisis, though this works both ways and failingcounterpartybanks can freeze hedge funds assets, asLehman Brothersdid in 2008.

An August 2012 survey by theFinancial Services Authorityconcluded that risks were limited and had reduced as a result,inter alia,of largermarginsbeing required by counterparty banks, but might change rapidly according to market conditions. In stressed market conditions, investors might suddenly withdraw large sums, resulting in forced asset sales. This might cause liquidity and pricing problems if it occurred across a number of funds or in one large highly leveraged fund.

Transparency

Hedge funds are structured to avoid most directregulation(although their managers may be regulated), and are not required to publicly disclose their investment activities, except to the extent that investors generally are subject to disclosure requirements. This is in contrast to a regulated mutual fund orexchange-traded fund,which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment adviser of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, while some hedge funds have very limited transparency even to investors.

Funds may choose to report some information in the interest of recruiting additional investors. Much of the data available in consolidated databases is self-reported and unverified.A study was done on two major databases containing hedge fund data. The study noted that 465 common funds had significant differences in reported information (e.g.,returns, inception date, net assets value, incentive fee, management fee, investment styles, etc.) and that 5% of return numbers and 5% of NAV numbers were dramatically different.With these limitations, investors have to do their own research, which may cost on the scale of US$50,000 for a fund that is not well-established.

A lack of verification of financial documents by investors or by independent auditors has, in some cases, assisted infraud.In the mid-2000s, Kirk Wright of International Management Associates was accused ofmail fraudand other securities violationswhich allegedly defrauded clients of close to US$180 million.In December 2008,Bernard Madoffwas arrested for running a US$50 billionPonzi schemethat closely resembled a hedge fund and was incorrectlydescribed as one.Several feeder hedge funds, of which the largest wasFairfield Sentry,channeled money to it. Following the Madoff case, the SEC adopted reforms in December 2009 that subjected hedge funds to an audit requirement.

The process of matching hedge funds to investors has traditionally been fairly opaque, with investments often driven by personal connections or recommendations of portfolio managers.Many funds disclose their holdings, strategy, and historic performance relative to market indices, giving investors some idea of how their money is being allocated, although individual holdings are often not disclosed.Investors are often drawn to hedge funds by the possibility of realizing significant returns, or hedging againstvolatilityin the market. The complexity and fees associated with hedge funds are causing some to exit the market –CalPERS,the largest pension fund in the US, announced plans to completely divest from hedge funds in 2014.Some services are attempting to improve matching between hedge funds and investors: HedgeZ is designed to allow investors to easily search and sort through funds;iMatchative aims to match investors to funds through algorithms that factor in an investor's goals and behavioral profile, in hopes of helping funds and investors understand the how their perceptions and motivations drive investment decisions.

Links with analysts

In June 2006, prompted by a letter fromGary J. Aguirre,theU.S. Senate Judiciary Committeebegan an investigation into the links between hedge funds and independent analysts. Aguirre was fired from his job with the SEC when, as lead investigator ofinsider tradingallegations againstPequot Capital Management,he tried to interviewJohn Mack,then being considered forchief executive officeratMorgan Stanley.The Judiciary Committee and theUS Senate Finance Committeeissued a scathing report in 2007, which found that Aguirre had been illegally fired in reprisalfor his pursuit of Mack, and in 2009 the SEC was forced to re-open its case against Pequot. Pequot settled with the SEC for US$28 million, andArthur J. Samberg,chief investment officerof Pequot, was barred from working as an investment advisor.Pequot closed its doors under the pressure of investigations.

The systemic practice of hedge funds submitting periodic electronic questionnaires to stock analysts as a part of market research was reported byThe New York Timesin July 2012. According to the report, one motivation for the questionnaires was to obtain subjective information not available to the public and possible early notice of trading recommendations that could produce short-term market movements.

Value in a mean/variance efficient portfolio

According tomodern portfolio theory,rational investors will seek to hold portfolios that are mean/variance efficient (that is, portfolios that offer the highest level of return per unit of risk). One of the attractive features of hedge funds (in particularmarket neutraland similar funds) is that they sometimes have a modest correlation with traditional assets such as equities. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers, reducing overall portfolio risk.

However, there are at least three reasons why one might not wish to allocate a high proportion of assets into hedge funds. These reasons are:

• Hedge funds are highly individual, making it hard to estimate the likely returns or risks.
• Hedge funds' correlation with other assets tends to rise during stressful market events, making them much less useful for diversification in bad times than they may appear in good times.
• Hedge fund returns are reduced considerably by the high fees that are typically charged.

Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in investor portfolios, but this is disputed for example by Mark Kritzman who performed a mean-variance optimization calculation on an opportunity set that consisted of a stock index fund, a bond index fund, and ten hypothetical hedge funds.The optimizer found that a mean-variance efficient portfolio did not contain any allocation to hedge funds, largely because of the impact of performance fees. To demonstrate this, Kritzman repeated the optimization using an assumption that the hedge funds took no performance fees. The result from this second optimization was an allocation of 74% to hedge funds.

Hedge funds tend to perform poorly during equitybear markets,just when an investor needs part of their portfolio to add value.For example, in January–September 2008, the Credit Suisse/Tremont Hedge Fund Index returned -9.87%.According to the same index series, even "dedicated short bias" funds returned −6.08% in September 2008, whenLehman Brotherscollapsed.

See also

• Activist shareholder
• Alternative investment
• Naked Capitalism
• Corporate governance
• Fund governance
• Investment banking
• List of hedge funds
• Vulture fund

Further reading

• Thomas P. Lemke, Gerald T. Lins, Kathryn L. Hoenig & Patricia S. Rube,Hedge Funds and Other Private Funds: Regulation and Compliance(Thomson West 2014 ed.).
• Thomas P. Lemke & Gerald T. Lins,Regulation of Investment Advisers(Thomson West 2014 ed.).
• Thomas P. Lemke, Gerald T. Lins & A. Thomas Smith III,Regulation of Investment Companies(Matthew Bender 2014 ed.).
• Partnoy, Frank;Thomas, Randall S. (20 September 2006). "Gap Filling, Hedge Funds, and Financial Innovation".Brookings-Nomura Papers on Financial Services.SSRN931254.
• Marcel Kahan & Edward B. Rock, 'Hedge Funds in Corporate Governance and Corporate Control' (2007) 155 University of Pennsylvania Law Review 1021
• Makrem Boumlouka, 'Regulation and Transparency in US OTC Derivative Markets',Original Thoughts Series #1,August 2010, Hedge Fund SocietyHedge Fund Society
• Boyson, Nicole M.; Stahel, Christof W.; Stulz, Rene M. (2010). "Hedge Fund Contagion and Liquidity Shocks".The Journal of Finance.65(5): 1789–1816.doi:10.1111/j.1540-6261.2010.01594.x.S2CID17421154.
• Stowell, David (2010).An Introduction to Investment Banks, Hedge Funds, and Private Equity: The New Paradigm.Academic Press.
• Strachman, Daniel A. (2014).The Fundamentals of Hedge Fund Management: How to Successfully Launch and Operate a Hedge Fund, Second Edition.Wiley.