Hedge Fund Basics

Hedge funds are the mysterious strangers of the investment world. While mutual funds are more widely known as an investment strategy, hedge funds have maintained their mystique through a number of ways. In this article, I will describe what type of investment vehicle hedge funds are, give the history, touch upon some of the strategies hedge funds employ, and discuss some of the current trends and issues facing the industry. Lastly, I’ll provide a formula for estimating a hedge fund manager’s compensation.

Description
Hedge funds are private investment instruments that usually are formed as limited partnerships, with the general partner being the founder and manager of the fund and the limited partners the investors. They have a steep minimum investment requirement – approximately $250,000 to $10 million – and, for first time investors, the money can’t be withdrawn for at least one year.

Such a high investment minimum for hedge funds ensures the exclusion of the more general investing public. Hedge funds are used as an investing tool primarily by institutional investors and “accredited investors,” which are those individuals “with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year” or a “person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase.”

By not advertising and by not having their product accessible except to a select group, hedge funds are exempt from the regulations that apply to investment categories that are open to the general public. “This freedom from regulation permits hedge funds to engage in leverage and other sophisticated investment techniques to a much greater extent than mutual funds.”

Exceptions to this, however, are hedge fund managers who trade in futures, and who must register with the Commodity Futures Trading Commission, Another exception is a hedge fund manager who registers their funds as limited liability companies, which must register with the U.S. Securities and Exchange Commission.

Background
Alfred W. Jones is the founder of hedge funds, which he created in 1949 as a means to “eliminate a part of the market risk involved in holding long stock positions by short-selling other stocks. Jones was the first to use short sales, leverage and incentive fees in combination.”

Hedge funds had an up and down ride in the ensuing years. In 1992, they were brought into the spotlight when hedge fund manager George Soros sold short on the British pound and made $1 billion in a matter of days.

Hedge Fund Strategies
Hedge funds employ a number of approaches to invest money, some riskier than others. Some of the more popular are: fund of funds, a type of hedge fund that puts its money into other hedge funds; long/short equity (selling short on some stocks to protect long positions on others), currently one of the most popular types of hedge funds; and macro or global strategies, which makes investments based on trends in global economies.

Current Trends/Issues
While it’s hard to gauge an unregulated industry, business insiders estimate that the funds have approximately $600 billion in assets – and growing. Hedge funds had minimal losses during 2002, as opposed to the 20% public markets have dropped in the same year. Some estimates venture that the hedge fund industry will grow to about $1 trillion by 2004.

In the post 9/11, post Enron world, when corporations and the world of finance have come under fire, changes were deemed necessary to the hedge fund industry. Shortly after the terrorist attacks on Sept. 11, 2001, the USA PATRIOT (Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism) Act of 2001 was enacted, focusing on hedge funds and other “unregistered investment companies” because of the possible susceptibility “to abuse by money launderers because of the liquidity of their interests and their structure”. The segments of the Act that will impact hedge funds are: Section 312 (requiring information be obtained on foreign investors, individual and organizational, with private banking and/or correspondent accounts with a U.S. financial institution), Section 326 (U.S. financial institutions must obtain written identification verification) and Section 352 (unregistered investment companies must adopt an “anti-money laundering program”). It is anticipated that these regulations will become applicable to the hedge fund industry in April or May 2003.

Hedge Fund Managers' Compensation
So how does a prospect researcher evaluate a hedge fund manager’s remuneration?
The general partner usually receives an incentive fee, which is typically 20% of the net profits of the fund (this is variable, however, and is determined in the partnership agreement). Also, the incentive fee is based solely on performance; if the fund makes money, the general partners receive 20%; if the fund stays the same or loses money, they don’t get their fee. Additionally, the general partners charge an administrative fee, which is typically 1% of the net asset value for the year and, which also may be performance based. After the general partner takes his share, the remaining profits or losses are distributed amongst the limited partners based on ownership percentage.

There you have it – an extremely basic overview of a rapidly evolving industry. It will be interesting to see how hedge funds will be affected by the imminent regulatory changes and how that might enable prospect researchers to access a wealth of information that was once shrouded in mystery.