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A hedge fund is an investment fund open to a limited range of investors

that undertakes a wider range of investment and trading activities than

traditional long-only investment funds, and that, in general, pays a

performance fee to its investment manager. Every hedge fund has its own

investment strategy that determines the type of investments and the

methods of investment it undertakes. Hedge funds, as a class, invest in a

broad range of investments including shares, debt and commodities. Some

people consider the fund created in 1949 by Alfred Winslow Jones to be the

first hedge fund.

As the name implies, hedge funds often seek to hedge some of the risks

inherent in their investments using a variety of methods, most notably short

selling and derivatives. However, the term "hedge fund" has also come to

be applied to certain funds that, as well as (or instead of) hedging certain

risks, use short selling and other "hedging" methods as a trading strategy to

generate a return on their capital.

In most jurisdictions hedge funds are open only to a limited range of

professional or wealthy investors who meet certain criteria set by

regulators, and are accordingly exempted from many regulations that

govern ordinary investment funds. The exempted regulations typically

cover short selling, the use of derivatives and leverage, fee structures, and

the rules by which investors can remove their capital from the fund. Light

regulation and the presence of performance fees are the distinguishing

characteristics of hedge funds.

The net asset value of a hedge fund can run into many billions of dollars,

and the gross assets of the fund will usually be higher still due to leverage.

Hedge funds dominate certain specialty markets such as trading within

derivatives with high-yield ratings and distressed debt.

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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.

For the most part, hedge funds (unlike mutual funds) are unregulated

because they cater to sophisticated investors. In the U.S., laws require that

the majority of investors in the fund be accredited. That is, they must earn a

minimum amount of money annually and have a net worth of more than $1

million, along with a significant amount of investment knowledge. You can

think of hedge funds as mutual funds for the super rich. They are similar to

mutual funds in that investments are pooled and professionally managed,

but differ in that the fund has far more flexibility in its investment

strategies.   

It is important to note that hedging is actually the practice of attempting to

reduce risk, but the goal of most hedge funds is to maximize return on

investment. The name is mostly historical, as the first hedge funds tried to

hedge against the downside risk of a bear market by shorting the market

(mutual funds generally can't enter into short positions as one of their

primary goals). Nowadays, hedge funds use dozens of different strategies,

so it isn't accurate to say that hedge funds just "hedge risk". In fact,

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because hedge fund managers make speculative investments, these

funds can carry more risk than the overall market.

A hedge fund is a term commonly used to describe any fund that isn't a

conventional investment fund - that is, any fund using a strategy or set of

strategies other than investing long in bonds, equities (mutual funds), and

money markets (money market funds). Among these alternative strategies

are:

hedging by selling short -- selling shares without owning them,

hoping to buy them back at a future date at a lower price in the

expectation that their price will drop

using arbitrage - seeking to exploit pricing inefficiencies between

related securities

trading options or derivatives - contracts whose values are based on

the performance of any underlying financial asset, index or other

investment

using leverage - borrowing to try to enhance returns

investing in out-of-favor or unrecognized undervalued securities

(debt or equity)

Attempting to take advantage of the spread between the current

market price and the ultimate purchase price in event driven

situations such as mergers or hostile takeovers.

History

Sociologist, author, and financial journalist Alfred W. Jones is credited

with the creation of the first hedge fund in 1949. Jones believed that price

movements of an individual asset could be seen as having a component due

to the overall market and a component due to the performance of the asset

itself. To neutralize the effect of overall market movement, he balanced his

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portfolio by buying assets whose price he expected to be stronger than the

market and selling short assets he expected to be weaker than the market.

He saw that price movements due to the overall market would be cancelled

out, because, if the overall market rose, the loss on shorted assets would be

cancelled by the additional gain on assets bought and vice-versa. Because

the effect is to 'hedge' that part of the risk due to overall market

movements, this became known as a hedge fund.

Hedge Funds Basics

Investment fund: Money is collected from a group of people and

invested. Foreign Institutional Investors (FIIs), Non-Resident Indians

(NRIs) and persons of Indian Origin (PIOs) invest in securities in primary

and secondary markets in shares, bonds, commodities, currencies etc.

With a minimum investment limit: The investors are high net worth

individuals. Exclusively favoring the crème de la crème, the usual

minimum investment amount is US$ 1, 000,000/ USD 1 million.

Examples

Hedging an agricultural commodity price

A typical hedger might be a commercial farmer. The market values of

wheat and other crops fluctuate constantly as supply and demand for them

vary, with occasional large moves in either direction. Based on current

prices and forecast levels at harvest time, the farmer might decide that

planting wheat is a good idea one season, but the forecast prices are only

that — forecasts. Once the farmer plants wheat, he is committed to it for an

entire growing season. If the actual price of wheat rises greatly between

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planting and harvest, the farmer stands to make a lot of unexpected money,

but if the actual price drops by harvest time, he could be ruined.

If the farmer sells a number of wheat futures contracts equivalent to his

crop size at planting time, he effectively locks in the price of wheat at that

time: the contract is an agreement to deliver a certain number of bushels of

wheat to a specified place on a certain date in the future for a certain fixed

price. The farmer has hedged his exposure to wheat prices; he no longer

cares whether the current price rises or falls, because he is guaranteed a

price by the contract. He no longer needs to worry about being ruined by a

low wheat price at harvest time, but he also gives up the chance at making

extra money from a high wheat price at harvest times.

Facts about Hedge Funds

Estimated to be a $2 trillion industry and growing every year, with

approximately 10,000 active hedge funds. Includes a variety of investment

strategies, some of which use leverage and derivatives while others are

more conservative and employ little or no leverage. Many hedge fund

strategies seek to reduce market risk specifically by shorting equities or

derivatives.

Most hedge funds are highly specialized, relying on the specific expertise

of the manager or management team. Performance of many hedge fund

strategies, particularly relative value strategies, is not dependent on the

direction of the bond or equity markets -- unlike conventional equity or

mutual funds (unit trusts), which are generally 100% exposed to market

risk.

Hedge fund managers are generally highly professional, disciplined and

diligent. Beyond the averages, there are some truly outstanding performers.

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Investing in hedge funds tends to be favored by more sophisticated

investors, including many Swiss and other private banks, who have lived

through, and understand the consequences of, major stock market

corrections. Many endowments and pension funds allocate assets to hedge

funds.

Key Characteristics of Hedge Funds

Hedge funds utilize a variety of financial instruments to reduce risk,

enhance returns and minimize the correlation with equity and bond

markets. Many hedge funds are flexible in their investment options

(can use short selling, leverage, derivatives such as puts, calls,

options, futures, etc.).

Hedge funds vary enormously in terms of investment returns,

volatility and risk. Many, but not all, hedge fund strategies tend to

hedge against downturns in the markets being traded.

Many hedge funds have the ability to deliver non-market correlated

returns.

Many hedge funds have as an objective consistency of returns and

capital preservation rather than magnitude of returns.

Most hedge funds are managed by experienced investment

professionals who are generally disciplined and diligent.

Pension funds, endowments, insurance companies, private banks and

high net worth individuals and families invest in hedge funds to

minimize overall portfolio volatility and enhance returns.

Most hedge fund managers are highly specialized and trade only

within their area of expertise and competitive advantage.

Hedge funds benefit by heavily weighting hedge fund managers’

remuneration towards performance incentives, thus attracting the

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best brains in the investment business. In addition, hedge fund

managers usually have their own money invested in their fund.

Popular Misconception

The popular misconception is that all hedge funds are volatile -- that they

all use global macro strategies and place large directional bets on stocks,

currencies, bonds, commodities, and gold, while using lots of leverage. In

reality, less than 5% of hedge funds are global macro funds. Most hedge

funds use derivatives only for hedging or don't use derivatives at all, and

many use no leverage.

Benefits of Hedge Funds

Many hedge fund strategies have the ability to generate positive

returns in both rising and falling equity and bond markets.

Inclusion of hedge funds in a balanced portfolio reduces overall

portfolio risk and volatility and increases returns.

Huge variety of hedge fund investment styles – many uncorrelated

with each other – provides investors with a wide choice of hedge

fund strategies to meet their investment objectives.

Academic research proves hedge funds have higher returns and lower

overall risk than traditional investment funds.

Hedge funds provide an ideal long-term investment solution,

eliminating the need to correctly time entry and exit from markets.

Adding hedge funds to an investment portfolio provides

diversification not otherwise available in traditional investing.

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Hedge Fund Styles

The predictability of future results shows a strong correlation with the

volatility of each strategy. Future performance of strategies with high

volatility is far less predictable than future performance from strategies

experiencing low or moderate volatility.

Aggressive Growth: Invests in equities expected to experience

acceleration in growth of earnings per share. Generally high P/E ratios, low

or no dividends; often smaller and micro cap stocks which are expected to

experience rapid growth. Includes sector specialist funds such as

technology, banking, or biotechnology. Hedges by shorting equities where

earnings disappointment is expected or by shorting stock indexes. Tends to

be "long-biased." Expected Volatility: High

Distressed Securities: Buys equity, debt, or trade claims at deep

discounts of companies in or facing bankruptcy or reorganization. Profits

from the market's lack of understanding of the true value of the deeply

discounted securities and because the majority of institutional investors

cannot own below investment grade securities. (This selling pressure

creates the deep discount.) Results generally not dependent on the direction

of the markets. Expected Volatility: Low - Moderate

Emerging Markets: Invests in equity or debt of emerging (less mature)

markets that tend to have higher inflation and volatile growth. Short selling

is not permitted in many emerging markets, and, therefore, effective

hedging is often not available, although Brady debt can be partially hedged

via U.S. Treasury futures and currency markets. Expected Volatility: Very

High

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Funds of Hedge Funds: Mix and match hedge funds and other pooled

investment vehicles. This blending of different strategies and asset classes

aims to provide a more stable long-term investment return than any of the

individual funds. Returns, risk, and volatility can be controlled by the mix

of underlying strategies and funds. Capital preservation is generally an

important consideration. Volatility depends on the mix and ratio of

strategies employed. Expected Volatility: Low - Moderate - High

Income: Invests with primary focus on yield or current income rather than

solely on capital gains. May utilize leverage to buy bonds and sometimes

fixed income derivatives in order to profit from principal appreciation and

interest income. Expected Volatility: Low

Macro: Aims to profit from changes in global economies, typically

brought about by shifts in government policy that impact interest rates, in

turn affecting currency, stock, and bond markets. Participates in all major

markets -- equities, bonds, currencies and commodities -- though not

always at the same time. Uses leverage and derivatives to accentuate the

impact of market moves. Utilizes hedging, but the leveraged directional

investments tend to make the largest impact on performance. Expected

Volatility: Very High

Market Neutral - Arbitrage: Attempts to hedge out most market risk

by taking offsetting positions, often in different securities of the same

issuer. For example, can be long convertible bonds and short the underlying

issuer’s equity. May also use futures to hedge out interest rate risk. Focuses

on obtaining returns with low or no correlation to both the equity and bond

markets. These relative value strategies include fixed income arbitrage,

mortgage backed securities, capital structure arbitrage, and closed-end fund

arbitrage. Expected Volatility: Low

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Market Neutral - Securities Hedging: Invests equally in long and

short equity portfolios generally in the same sectors of the market. Market

risk is greatly reduced, but effective stock analysis and stock picking is

essential to obtaining meaningful results. Leverage may be used to enhance

returns. Usually low or no correlation to the market. Sometimes uses

market index futures to hedge out systematic (market) risk. Relative

benchmark index usually T-bills. Expected Volatility: Low

Market Timing: Allocates assets among different asset classes

depending on the manager's view of the economic or market outlook.

Portfolio emphasis may swing widely between asset classes.

Unpredictability of market movements and the difficulty of timing entry

and exit from markets add to the volatility of this strategy. Expected

Volatility: High

Opportunistic: Investment theme changes from strategy to strategy as

opportunities arise to profit from events such as IPOs, sudden price changes

often caused by an interim earnings disappointment, hostile bids, and other

event-driven opportunities. May utilize several of these investing styles at a

given time and is not restricted to any particular investment approach or

asset class. Expected Volatility: Variable

Multi Strategy: Investment approach is diversified by employing

various strategies simultaneously to realize short- and long-term gains.

Other strategies may include systems trading such as trend following and

various diversified technical strategies. This style of investing allows the

manager to overweight or underweight different strategies to best capitalize

on current investment opportunities. Expected Volatility: Variable

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Short Selling: Sells securities short in anticipation of being able to re-

buy them at a future date at a lower price due to the manager's assessment

of the overvaluation of the securities, or the market, or in anticipation of

earnings disappointments often due to accounting irregularities, new

competition, change of management, etc. Often used as a hedge to offset

long-only portfolios and by those who feel the market is approaching a

bearish cycle. High risk. Expected Volatility: Very High

Special Situations: Invests in event-driven situations such as mergers,

hostile takeovers, reorganizations, or leveraged buyouts. May involve

simultaneous purchase of stock in companies being acquired, and the sale

of stock in its acquirer, hoping to profit from the spread between the current

market price and the ultimate purchase price of the company. May also

utilize derivatives to leverage returns and to hedge out interest rate and/or

market risk. Results generally not dependent on direction of market.

Expected Volatility: Moderate

Value: Invests in securities perceived to be selling at deep discounts to

their intrinsic or potential worth. Such securities may be out of favor or

underfollowed by analysts. Long-term holding, patience, and strong

discipline are often required until the ultimate value is recognized by the

market. Expected Volatility: Low - Moderate

What is a Fund of Hedge Funds?

o A diversified portfolio of generally uncorrelated hedge funds.

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o May be widely diversified, or sector or geographically

focused.

o Seeks to deliver more consistent returns than stock portfolios,

mutual funds, unit trusts or individual hedge funds.

o Preferred investment of choice for many pension funds,

endowments, insurance companies, private banks and high-

net-worth families and individuals.

o Provides access to a broad range of investment styles,

strategies and hedge fund managers for one easy-to-administer

investment.

o Provides more predictable returns than traditional investment

funds.

o Provides effective diversification for investment portfolios.

Benefits of a Hedge Fund of Funds

o Provides an investment portfolio with lower levels of risk and

can deliver returns uncorrelated with the performance of the

stock market.

o Delivers more stable returns under most market conditions due

to the fund-of-fund manager’s ability and understanding of the

various hedge strategies.

o Significantly reduces individual fund and manager risk.

o Eliminates the need for time-consuming due diligence

otherwise required for making hedge fund investment

decisions.

o Allows for easier administration of widely diversified

investments across a large variety of hedge funds.

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o Allows access to a broader spectrum of leading hedge funds

that may otherwise be unavailable due to high minimum

investment requirements.

o Is an ideal way to gain access to a wide variety of hedge fund

strategies, managed by many of the world’s premier

investment professionals, for a relatively modest investment.

Industry size

Estimates of industry size vary widely due to the lack of central statistics,

the lack of a single definition of hedge funds and the rapid growth of the

industry. As a general indicator of scale, the industry may have managed

around $2.5 trillion at its peak in the summer of 2008. The credit crunch

has caused assets under management (AUM) to fall sharply through a

combination of trading losses and the withdrawal of assets from funds by

investors. Recent estimates find that hedge funds have more than $2 trillion

in AUM

Facts about the Hedge Fund Industry

Estimated to be a $1 trillion industry and growing at about 20% per

year with approximately 8350 active hedge funds.

Includes a variety of investment strategies, some of which use

leverage and derivatives while others are more conservative and

employ little or no leverage. Many hedge fund strategies seek to

reduce market risk specifically by shorting equities or through the

use of derivatives.

Most hedge funds are highly specialized, relying on the specific

expertise of the manager or management team.

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Performance of many hedge fund strategies, particularly relative

value strategies, is not dependent on the direction of the bond or

equity markets -- unlike conventional equity or mutual funds (unit

trusts), which are generally 100% exposed to market risk.

Many hedge fund strategies, particularly arbitrage strategies, are

limited as to how much capital they can successfully employ before

returns diminish. As a result, many successful hedge fund managers

limit the amount of capital they will accept.

Hedge fund managers are generally highly professional, disciplined

and diligent.

Their returns over a sustained period of time have outperformed

standard equity and bond indexes with less volatility and less risk of

loss than equities.

Beyond the averages, there are some truly outstanding performers.

Investing in hedge funds tends to be favored by more sophisticated

investors, including many Swiss and other private banks that have

lived through, and understand the consequences of, major stock

market corrections.

An increasing number of endowments and pension funds allocate

assets to hedge funds.

Largest hedge fund managers

The 25 largest hedge fund managers had $519.7 billion in assets under

management as of December 31, 2009. The largest manager is JP Morgan

Chase ($53.5 billion) followed by Bridgewater Associates ($43.6 billion),

Paulson & Co. ($32 billion), Brevan Howard ($27 billion), and Soros Fund

Management ($27 billion).

Fees

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A hedge fund manager will typically receive both a management fee and a

performance fee (also known as an incentive fee) from the fund. A typical

manager may charge fees of "2 and 20", which refers to a management fee

of 2% of the fund's net asset value each year and a performance fee of 20%

of the fund's profit

Management fees

As with other investment funds, the management fee is calculated as a

percentage of the funds net asset value. Management fees typically range

from 1% to 4% per annum, with 2% being the standard figure.

Management fees are usually expressed as an annual percentage, but

calculated and paid monthly or quarterly.

The business models of most hedge fund managers provide for the

management fee to cover the operating costs of the manager, leaving the

performance fee for employee bonuses. However, the management fees for

large funds may form a significant part of the manager's profits.

Management fees associated with hedge funds have been under much

scrutiny, with several large public pension funds calling on managers to

reduce fees.

Performance fees

Performance fees (or "incentive fees") are one of the defining

characteristics of hedge funds. The manager's performance fee is calculated

as a percentage of the fund's profits, usually counting both realized and

unrealized profits. By incentivizing the manager to generate returns,

performance fees are intended to align the interests of manager and investor

more closely than flat fees do. In the business models of most managers,

the performance fee is largely available for staff bonuses and so can be

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extremely lucrative for managers who perform well. Several publications

publish annual estimates of the earnings of top hedge fund managers.

Typically, hedge funds charge 20% of returns as a performance fee.

However, the range is wide with highly regarded managers charging higher

fees. For example Steven Cohen's SAC Capital Partners charges a 35-50%

performance fee, while Jim Simons' Medallion Fund charged a 45%

performance fee.

Average incentive fees have declined since the start of the financial crisis,

with the decline being more pronounced in funds of hedge funds (FOFs).

Incentive fees for single manager funds fell to 19.2 percent (versus 19.34

percent in Q1 08) while FOFs fell to 6.9 percent (versus 8.05 percent in Q1

08). The average incentive fee for funds launched in 2009 was 17.6 percent,

1.6 percent below the broader industry average.

Performance fees have been criticized by many people, including notable

investor Warren Buffett, who believe that, by allowing managers to take a

share of profit but providing no mechanism for them to share losses,

performance fees give managers an incentive to take excessive risk rather

than targeting high long-term returns. In an attempt to control this problem,

fees are usually limited by a high water mark. Ironically, Mr. Buffett

charged incentive fees until his firm was very large.

As the hedge fund remuneration structure is highly attractive it has been

remarked that hedge funds are best viewed "... not as a unique asset class

but as a unique ‘fee structure’.

High water marks

A high water mark (or "loss carry forward provision") is often applied to a

performance fee calculation. This means that the manager receives

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performance fees only on increases in the net asset value (NAV) of the fund

in excess of the highest net asset value it has previously achieved. For

example, if a fund were launched at a NAV per share of $100, which then

rose to $120 in its first year, a performance fee would be payable on the

$20 return for each share. If the next year it dropped to $110, no fee would

be payable. If in the third year the NAV per share rose to $130, a

performance fee would be payable only on the $10 profit from $120 (the

high water mark) to $130, rather than on the full return during that year

from $110 to $130.

High water marks are intended to link the manager's interests more closely

to those of investors and to reduce the incentive for managers to seek

volatile trades. If a high water mark is not used, a fund that ends alternate

years at $100 and $110 would generate a performance fee every other year,

enriching the manager but not the investors.

The mechanism does not provide complete protection to investors: A

manager who has lost a significant percentage of the fund's value may close

the fund and start again with a clean slate, rather than continue working for

no performance fee until the loss has been made up for. This tactic is

dependent on the manager's ability to persuade investors to trust him or her

with their money in the new fund.

Hurdle rates

Some managers specify a hurdle rate, signifying that they will not charge a

performance fee until the fund's annualized performance exceeds a

benchmark rate, such as T-bill yield, LIBOR or a fixed percentage. This

links performance fees to the ability of the manager to provide a higher

return than an alternative, usually lower risk, investment.

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With a "soft" hurdle, a performance fee is charged on the entire annualized

return if the hurdle rate is cleared. With a "hard" hurdle, a performance fee

is only charged on returns above the hurdle rate. Prior to the credit crisis of

2008, demand for hedge funds tended to outstrip supply, making hurdle

rates relatively rare.

Withdrawal / Redemption fees

Some funds charge investors a redemption fee (or "withdrawal fee" or

"surrender charge") if they withdraw money from the fund. A redemption

fee is often charged only during a specified period of time (typically a year)

following the date of investment, or only to withdrawals representing a

specified portion of an investment.

The purpose of the fee is to discourage short-term investment in the fund,

thereby reducing turnover and allowing the use of more complex, illiquid

or long-term strategies. The fee may also dissuade investors from

withdrawing funds after periods of poor performance.

Unlike management and performance fees, redemption fees are usually

retained by the fund and therefore benefit the remaining investors rather

than the manager.

Strategies

Hedge funds employ many different trading strategies, which are classified

in many different ways, with no standard system used. A hedge fund will

typically commit itself to a particular strategy, particular investment types

and leverage limits via statements in its offering documentation, thereby

giving investors some indication of the nature of the particular fund.

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Each strategy can be said to be built from a number of different elements:

Style: global macro, directional, event-driven, relative value

(arbitrage), managed futures (CTA)

Market: equity, fixed income, commodity, currency

Instrument: long/short, futures, options, swaps

Exposure: directional, market neutral

Sector: emerging market, technology, healthcare etc.

Method: discretionary/qualitative (where the individual investments

are selected by managers), systematic/quantitative (or "quant" -

where the investments are selected according to numerical methods

using a computerized system)

Diversification: multi-manager, multi-strategy, multi-fund, multi-

market

The four main strategy groups are based on the investment style and have

their own risk and return characteristics. The most common label for a

hedge fund is "long/short equity", meaning that the fund takes both long

and short positions in shares traded on public stock exchanges.

Hedge fund risk

Investing in certain types of hedge fund can be a riskier proposition than

investing in a regulated fund, despite a "hedge" being a means of reducing

the risk of a bet or investment. Many hedge funds have some of these

characteristics:

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Leverage - in addition to money invested into the fund by investors, a

hedge fund will typically borrow money or trade on margin, with certain

funds borrowing sums many times greater than the initial investment. If a

hedge fund has borrowed $9 for every $1 received from investors, a loss of

only 10% of the value of the investments of the hedge fund will wipe out

100% of the value of the investor's stake in the fund, once the creditors

have called in their loans. In September 1998, shortly before its collapse,

Long-Term Capital Management had $125 billion of assets on a base of $4

billion of investors' money, a leverage of over 30 times. It also had off-

balance sheet positions with a notional value of approximately $1 trillion.

Short selling - due to the nature of short selling, the losses that can be

incurred on a losing bet are in theory limitless, unless the short position

directly hedges a corresponding long position. Ordinary funds very rarely

use short selling in this way.

Appetite for risk - hedge funds are more likely than other types of funds

to take on underlying investments that carry high degrees of risk, such as

high yield bonds, distressed securities, and collateralized debt obligations

based on sub-prime mortgages.

Lack of transparency - hedge funds are private entities with few public

disclosure requirements. It can therefore be difficult for an investor to

assess trading strategies, diversification of the portfolio, and other factors

relevant to an investment decision.

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Lack of regulation - hedge fund managers are, in some jurisdictions,

not subject to as much oversight from financial regulators as regulated

funds, and therefore some may carry undisclosed structural risks.

Short volatility - certain hedge fund strategies involve writing out of the

money call or put options. If these expire in the money the fund may make

large losses.

Investors in hedge funds are, in most countries, required to be sophisticated

investors who are assumed to be aware of these risks, and willing to take

these risks because of the corresponding rewards: Leverage amplifies

profits as well as losses; short selling opens up new investment

opportunities; riskier investments typically provide higher returns; secrecy

helps to prevent imitation by competitors; and being unregulated reduces

costs and allows the investment manager more freedom to make decisions

on a purely commercial basis.

One approach to diagnosing hedge fund risk is operational due diligence.

Hedge fund structure

A hedge fund is a vehicle for holding and investing the money of its

investors. The fund itself has no employees and no assets other than its

investment portfolio and cash. The portfolio is managed by the investment

manager, which is the actual business and has employees.

As well as the investment manager, the functions of a hedge fund are

delegated to a number of other service providers. The most common

service providers are:

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Prime broker – prime brokerage services include lending money, acting

as counterparty to derivative contracts, lending securities for the purpose of

short selling, trade execution, clearing and settlement. Many prime brokers

also provide custody services. Prime brokers are typically parts of large

investment banks.

Administrator – the administrator typically deals with the issue and

redemption of interests and shares, calculates the net asset value of the

fund, and performs related back office functions. In some funds,

particularly in the U.S., some of these functions are performed by the

investment manager, a practice that gives rise to a potential conflict of

interest inherent in having the investment manager both determine the

NAV and benefit from its increase through performance fees. Outside of

the U.S., regulations often require this role to be taken by a third party.

Distributor - the distributor is responsible for marketing the fund to

potential investors. Frequently, this role is taken by the investment

manager.

Domicile

The legal structure of a specific hedge fund – in particular its domicile and

the type of legal entity used – is usually determined by the tax environment

of the fund’s expected investors. Regulatory considerations will also play a

role. Many hedge funds are established in offshore financial centres so that

the fund can avoid paying tax on the increase in the value of its portfolio.

An investor will still pay tax on any profit it makes when it realizes its

investment, and the investment manager, usually based in a major financial

centre, will pay tax on the fees that it receives for managing the fund.

Around 60% of the numbers of hedge funds in 2009 were registered in

offshore locations. The Cayman Islands was the most popular registration

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location and accounted for 39% of the number of global hedge funds. It

was followed by Delaware (US) 27%, British Virgin Islands 7% and

Bermuda 5%. Around 5% of global hedge funds are registered in the EU,

primarily in Ireland and Luxembourg.

Investment manager locations

In contrast to the funds themselves, investment managers are primarily

located onshore in order to draw on the major pools of financial talent and

to be close to investors. With the bulk of hedge fund investment coming

from the U.S. East coast – principally New York City and the Gold Coast

area of Connecticut – this has become the leading location for hedge fund

managers. It was estimated there were 7,000 investment managers in the

United States in 2004.

London is Europe’s leading centre for hedge fund managers, with three-

quarters of European hedge fund investments, about $400 billion, at the end

of 2009. Asia, and more particularly China, is taking on a more important

role as a source of funds for the global hedge fund industry. The UK and

the U.S. are leading locations for management of Asian hedge funds' assets

with around a quarter of the total each.

The legal entity

Limited partnerships are principally used for hedge funds aimed at US-

based investors who pay tax, as the investors will receive relatively

favorable tax treatment in the US. The general partner of the limited

partnership is typically the investment manager (though is sometimes an

offshore corporation) and the investors are the limited partners. Offshore

corporate funds are used for non-U.S. investors and U.S. entities that do not

pay tax (such as pension funds), as such investors do not receive the same

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tax benefits from investing in a limited partnership. Unit trusts are typically

marketed to Japanese investors. Other than taxation, the type of entity used

does not have a significant bearing on the nature of the fund.

Many hedge funds are structured as master-feeder funds. In such a

structure, the investors will invest into a feeder fund, which will, in turn,

invest all of its assets into the master fund. The assets of the master fund

will then be managed by the investment manager in the usual way. This

allows several feeder funds (e.g. an offshore corporate fund, a U.S. limited

partnership and a unit trust) to invest into the same master fund, allowing

an investment manager the benefit of managing the assets of a single entity

while giving all investors the best possible tax treatment.

The investment manager, which will have organized the establishment of

the hedge fund, may retain an interest in the hedge fund, either as the

general partner of a limited partnership or as the holder of “founder shares”

in a corporate fund. Founder shares typically have no economic rights and

voting rights over only a limited range of issues, such as selection of the

investment manager. The fund’s strategic decisions are taken by the board

of directors of the fund, which is independent but generally loyal to the

investment manager.

Open-ended nature

Hedge funds are typically open-ended, in that the fund will periodically

issue additional partnership interests or shares directly to new investors, the

price of each being the net asset value (“NAV”) per interest/share. To

realize the investment, the investor will redeem the interests or shares at the

NAV per interest/share prevailing at that time. Therefore, if the value of the

underlying investments has increased (and the NAV per interest/share has

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therefore also increased) then the investor will receive a larger sum on

redemption than it paid on investment. Investors do not typically trade

shares or interests among themselves and hedge funds do not typically

distribute profits to investors before redemption. This contrasts with a

closed-ended fund, which has a limited number of shares which are traded

among investors, and which distributes its profits.

Side pockets

Where a hedge fund holds assets that are hard to value reliably or are

relatively illiquid (in comparison to the redemption terms of the fund

itself), the fund may employ a "side pocket". A side pocket is a mechanism

whereby the fund segregates the illiquid assets from the main portfolio of

the fund and issues investors with a new class of interests or shares which

participate only in the assets in the side pocket. Those interests/shares

cannot be redeemed by the investor. Once the fund is able to sell the side

pocket assets, the fund will generally redeem the side pocket

interests/shares and pay investors the proceeds.

Side pockets are designed to address issues relating to the need to value an

investor's holding in the fund if they choose to redeem. If an investor

redeems when certain assets cannot be valued or sold, the fund cannot be

confident that the calculation of his redemption proceeds would be

accurate. Moreover, his redemption proceeds could only be obtained by

selling the liquid assets of the fund. If the illiquid assets subsequently

turned out to be worth less than expected, the remaining investors would

bear the full loss while the redeemed investor would have borne none. Side

pockets therefore allow a fund to ensure that all investors in the fund at the

time the relevant assets became illiquid will bear any loss on them equally

and allow the fund to continue subscriptions and redemptions in the

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meantime in respect of the main portfolio. A similar problem, inverted,

applies to subscriptions during the same period.

Side pockets are most commonly used by funds as an emergency measure.

They were used extensively following the collapse of Lehman Brothers in

September 2008, when the market for certain types of assets held by hedge

funds collapsed, preventing the funds from selling or obtaining a market

value for the assets.

Specific types of fund may also use side pockets in the ordinary course of

their business. A fund investing in insurance products, for example, may

routinely side pocket securities linked to natural disasters following the

occurrence of such a disaster. Once the damage has been assessed, the

security can again be valued with some accuracy.

Listing of Hedge Funds

Corporate hedge funds sometimes list their shares on smaller stock

exchanges, such as the Irish Stock Exchange, as this provides a low level of

regulatory oversight that is required by some investors. Shares in the listed

hedge fund are not generally traded on the exchange.

A fund listing is distinct from the listing or initial public offering (“IPO”)

of shares in an investment manager. Although widely reported as a "hedge-

fund IPO", the IPO of Fortress Investment Group LLC was for the sale of

the investment manager, not of the hedge funds that it managed.

Regulatory issues

Part of what gives hedge funds their competitive edge, and their cachet in

the public imagination is that they straddle multiple definitions and

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categories; some aspects of their dealings are well-regulated, while others

are unregulated or at best quasi-regulated.

U.S. regulation

The typical public investment company in the United States is required to

be registered with the U.S. Securities and Exchange Commission (SEC).

Mutual funds are the most common type of registered investment

companies. Aside from registration and reporting requirements, investment

companies are subject to strict limitations on short-selling and the use of

leverage. There are other limitations and restrictions placed on public

investment company managers, including the prohibition on charging

incentive or performance fees.

Although hedge funds are investment companies, they have avoided the

typical regulations for investment companies because of exceptions in the

laws. The two major exemptions are set forth in Sections 3(c) 1 and 3(c) 7

of the Investment Company Act of 1940. Those exemptions are for funds

with 100 or fewer investors (a "3(c) 1 Fund") and funds where the investors

are "qualified purchasers" (a "3(c) 7 Fund"). A qualified purchaser is an

individual with over US$5,000,000 in investment assets. (Some

institutional investors also qualify as accredited investors or qualified

purchasers.) A 3(c)1 Fund cannot have more than 100 investors, while a

3(c)7 Fund can have an unlimited number of investors. The Securities Act

of 1933 disclosure requirements apply only if the company seeks funds

from the general public, and the quarterly reporting requirements of the

Securities Exchange Act of 1934 are only required if the fund has more

than 499 investors. A 3(c)7 fund with more than 499 investors must register

its securities with the SEC.

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In order to comply with 3(c)(1) or 3(c)(7), hedge funds raise capital via

private placement under the Securities Act of 1933, and normally the shares

sold do not have to be registered under Regulation D. Although it is

possible to have non-accredited investors in a hedge fund, the exemptions

under the Investment Company Act, combined with the restrictions

contained in Regulation D, effectively require hedge funds to be offered

solely to accredited investors. An accredited investor is an individual

person with a minimum net worth of $1,000,000 or, alternatively, a

minimum income of US$200,000 in each of the last two years and a

reasonable expectation of reaching the same income level in the current

year. For banks and corporate entities, the minimum net worth is

$5,000,000 in invested assets.

There have been attempts to register hedge fund investment managers.

There are numerous issues surrounding these proposed requirements. A

client who is charged an incentive fee must be a "qualified client" under

Advisers Act Rule 205-3. To be a qualified client, an individual must have

US$750,000 in assets invested with the adviser or a net worth in excess of

US$1.5 million, or be one of certain high-level employees of the

investment adviser.

In December 2004, the SEC issued a rule change that required most hedge

fund advisers to register with the SEC by February 1, 2006, as investment

advisers under the Investment Advisers Act. The requirement, with minor

exceptions, applied to firms managing in excess of US$25,000,000 with

over 14 investors. The SEC stated that it was adopting a "risk-based

approach" to monitoring hedge funds as part of its evolving regulatory

regimen for the burgeoning industry. The new rule was controversial, with

two commissioners dissenting. The rule change was challenged in court by

a hedge fund manager, and, in June 2006, the U.S. Court of Appeals for the

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District of Columbia overturned it and sent it back to the agency to be

reviewed. See Goldstein v. SEC. In response to the court decision, in 2007

the SEC adopted Rule 206(4)-8. Rule 206(4)-8, 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.

In February 2007, the President's Working Group on Financial Markets

rejected further regulation of hedge funds and said that the industry should

instead follow voluntary guidelines. In November 2009 the House

Financial Services Committee passed a bill that would allow states to

oversee hedge funds and other investment advisors with $100m or less in

assets under management, leaving larger investment managers up to the

Securities and Exchange Commission. Because the SEC currently regulates

advisers with $25m or more under management, the bill would shift 43% of

these companies, or roughly 710, back over to state oversight.

Comparison to U.S. private equity funds

Hedge funds are similar to private equity funds in many respects. Both are

lightly regulated, private pools of capital that invest in securities and

compensate their managers with a share of the fund's profits. Most hedge

funds invest in relatively liquid assets, and permit investors to enter or

leave the fund, perhaps requiring some months notice. Private equity funds

invest primarily in very illiquid assets such as early-stage companies and so

investors are "locked in" for the entire term of the fund. Hedge funds often

invest in private equity companies' acquisition funds.

Between 2004 and February 2006, some hedge funds adopted 25-month

lock-up rules expressly to exempt themselves from the SEC's new

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registration requirements and cause them to fall under the registration

exemption that had been intended to exempt private equity funds.

Comparison to U.S. mutual funds

Like hedge funds, mutual funds are pools of investment capital (i.e., money

people want to invest). However, there are many differences between the

two, including:

Mutual funds are regulated by the SEC, while hedge funds are not

A hedge fund investor must be an accredited investor with certain

exceptions (employees, etc.)

Mutual funds must price and be liquid on a daily basis

Some hedge funds that are based offshore report their prices to the

Financial Times, but for most there is no method of ascertaining pricing on

a regular basis. In addition, mutual funds must have a prospectus available

to anyone that requests one (either electronically or via U.S. postal mail),

and must disclose their asset allocation quarterly, whereas hedge funds do

not have to abide by these terms.

Hedge funds also ordinarily do not have daily liquidity, but rather "lock up"

periods of time where the total returns are generated (net of fees) for their

investors and then returned when the term ends, through a pass through

requiring CPAs and U.S. Tax W-forms. Hedge fund investors tolerate these

policies because hedge funds are expected to generate higher total returns

for their investors versus mutual funds.

Recently, however, the mutual fund industry has created products with

features that have traditionally been found only in hedge funds.

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Mutual funds that utilize some of the trading strategies noted above have

appeared. Grizzly Short Fund (GRZZX), for example, is always net short,

while Arbitrage Fund (ARBFX) specializes in merger arbitrage. Such funds

are SEC regulated, but they offer hedge fund strategies and protection for

mutual fund investors.

Also, a few mutual funds have introduced performance-based fees, where

the compensation to the manager is based on the performance of the fund.

However, under Section 205(b) of the Investment Advisers Act of 1940,

such compensation is limited to so-called "fulcrum fees". Under these

arrangements, fees can be performance-based so long as they increase and

decrease symmetrically.

For example, the TFS Capital Small Cap Fund (TFSSX) has a management

fee that behaves, within limits and symmetrically, similarly to a hedge fund

"0 and 50" fee: A 0% management fee coupled with a 50% performance fee

if the fund outperforms its benchmark index. However, the 125 BP base fee

is reduced (but not below zero) by 50% of underperformance and increased

(but not to more than 250 BP) by 50% of outperformance.

Proposed U.S. regulation

Hedge funds are exempt from regulation in the United States. Several bills

have been introduced in the 110th Congress (2007–08), however, relating

to such funds. Among them are:

S. 681, a bill to restrict the use of offshore tax havens and abusive tax

shelters to inappropriately avoid Federal taxation;

H.R. 3417, which would establish a Commission on the Tax

Treatment of Hedge Funds and Private Equity to investigate

imposing regulations;

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S. 1402, a bill to amend the Investment Advisors Act of 1940, with

respect to the exemption to registration requirements for hedge

funds; and

S. 1624, a bill to amend the Internal Revenue Code of 1986 to

provide that the exception from the treatment of publicly traded

partnerships as corporations for partnerships with passive-type

income shall not apply to partnerships directly or indirectly deriving

income from providing investment adviser and related asset

management services.

S. 3268, a bill to amend the Commodity Exchange Act to prevent

excessive price speculation with respect to energy commodities. The

bill would give the federal regulator of futures markets the resources

to detect, prevent, and punish price manipulation and excessive

speculation.

None of the bills has received serious consideration yet.

UK regulation

Hedge funds managed by UK hedge fund managers are always

incorporated outside the UK, usually in an offshore location such as the

Cayman Islands, and are not directly regulated by the UK authorities.

However, a hedge fund manager based in the UK is required to be

authorized and regulated by the UK's Financial Services Authority, and

accordingly the UK hedge fund industry is regulated.

As the UK is part of the European Union, the UK hedge fund industry will

also be affected by the EU's Directive on Alternative Investment Fund

Managers.

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Offshore regulation

Many offshore centers are keen to encourage the establishment of hedge

funds. To do this they offer some combination of professional services, a

favorable tax environment, and business-friendly regulation. Major centers

include Cayman Islands, Dublin, Luxembourg, British Virgin Islands, and

Bermuda. The Cayman Islands have been estimated to be home to about

75% of world’s hedge funds, with nearly half the industry's estimated

$1.225 trillion.

Hedge funds have to file accounts and conduct their business in compliance

with the requirements of these offshore centres. Typical rules concern

restrictions on the availability of funds to retail investors (Dublin),

protection of client confidentiality (Luxembourg) and the requirement for

the fund to be independent of the fund manager.

Hedge Fund Indices

There are many indices that track the hedge fund industry, and these fall

into three main categories. In their historical order of development they are

Non-investable, Investable and Clone.

In traditional equity investment, indices play a central and unambiguous

role. They are widely accepted as representative, and products such as

futures and ETFs provide investable access to them in most developed

markets. However hedge funds are illiquid, heterogeneous and ephemeral,

which makes it hard to construct a satisfactory index. Non-investable

indices are representative, but, due to various biases, their quoted returns

may not be available in practice. Investable indices achieve liquidity at the

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expense of limited representativeness. Clone indices seek to replicate some

statistical properties of hedge funds but are not directly based on them.

None of these approaches is wholly satisfactory.

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 of biases.

Funds’ participation in a database is voluntary, leading to self-selection bias

because 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 means that there are many new

entrants and many departures each year, which raises the problem of

survivorship 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

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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, and

most seriously they may under-represent more successful managers.

Hedge Fund Replication

The most recent addition to the field approach 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.

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However, they rely on a statistical modeling process. As replication indices

have a relatively short history it is not yet possible to know how reliable

this process will be in practice, although initially indications are that much

of hedge fund returns can be replicated in this manner without the problems

of illiquidity, transparency and fraud that exist in direct hedge fund

investments.

Debates and Controversies

Systemic risk

Hedge funds came under heightened scrutiny as a result of the failure of

Long-Term Capital Management (LTCM) in 1998, which necessitated a

bailout coordinated (but not financed) by the U.S. Federal Reserve. Critics

have charged that hedge funds pose systemic risks highlighted by the

LTCM disaster. The excessive leverage (through derivatives) that can be

used by hedge funds to achieve their return is outlined as one of the main

factors of the hedge funds' contribution to systemic risk.

The ECB (European Central Bank) issued a warning in June 2006 on hedge

fund risk for financial stability and systemic risk: "... the increasingly

similar positioning of individual hedge funds within broad hedge fund

investment strategies is another major risk for financial stability, which

warrants close monitoring despite the essential lack of any possible

remedies. Some believe that broad hedge fund investment strategies have

also become increasingly correlated, thereby further increasing the potential

adverse effects of disorderly exits from crowded trades." However the ECB

statement has been disputed by parts of the financial industry.

The potential for systemic risk was highlighted by the near-collapse of two

Bear Stearns hedge funds in June 2007. The funds invested in mortgage-

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backed securities. The funds' financial problems necessitated an infusion of

cash into one of the funds from Bear Stearns but no outside assistance. It

was the largest fund bailout since Long Term Capital Management's

collapse in 1998. The U.S. Securities and Exchange Commission is

investigating.

Transparency

As private, lightly regulated entities, hedge funds are not obliged to

disclose their activities to third parties. This is in contrast to a regulated

mutual fund (or unit trust), which will typically have to meet regulatory

requirements for disclosure. An investor in a hedge fund usually has direct

access to the investment advisor 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 $50,000.

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Some hedge funds, mainly American, do not use third parties either as the

custodian of their assets or as their administrator (who will calculate the

NAV of the fund). This can lead to conflicts of interest, and in extreme

cases can assist fraud. In a recent example, Kirk Wright of International

Management Associates has been accused of mail fraud and other securities

violations which allegedly defrauded clients of close to $180 million. In

December 2008, Bernard Madoff was arrested for running a $50 billion

Ponzi scheme. While Madoff did not run a hedge fund, his case clearly

does illustrate the value of independent verification of assets.

Market capacity

Alpha appears to have been becoming rarer for two related reasons. First,

the increase in traded volume may have been reducing the market

anomalies that are a source of hedge fund performance. Second, the

remuneration model is attracting more managers, which may dilute the

talent available in the industry, though these causes are disputed.

U.S. investigations

In June 2006, the Senate Judiciary Committee began an investigation into

the links between hedge funds and independent analysts. The U.S.

Securities and Exchange Commission (SEC) is also focusing resources on

investigating insider trading by hedge funds.

Performance measurement

Performance statistics are hard to obtain because of restrictions on

advertising and the lack of centralized collection. However summaries are

occasionally available in various journals.

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The question of how performance should be adjusted for the amount of risk

that is being taken has led to literature that is both abundant and

controversial. Traditional indicators (Sharpe, Treynor, Jensen) work best

when returns follow a symmetrical distribution. In that case, risk is

represented by the standard deviation. Unfortunately, hedge fund returns

are not normally distributed, and hedge fund return series are auto

correlated. Consequently, traditional performance measures suffer from

theoretical problems when they are applied to hedge funds, making them

even less reliable than is suggested by the shortness of the available return

series.

Several innovative performance measures have been introduced in an

attempt to deal with this problem: Modified Sharpe ratio by Gregoriou and

Gueyie (2003), Omega by Keating and Shadwick (2002), Alternative

Investments Risk Adjusted Performance (AIRAP) by Sharma (2004), and

Kappa by Kaplan and Knowles (2004). However, there is no consensus on

the most appropriate absolute performance measure, and traditional

performance measures are still widely used in the industry.

Are all hedge funds speculative and risky?

A majority of the funds stress on returns. At the other extreme, for the

highly risk-averse investor, there is a whole group of funds that emphasizes

low volatility. Some managers do an excellent job of keeping volatility

down close to government-bond level but handily beating bond returns.

E.g.: Relative benchmark index used for Market neutral security hedging is

usually T-bills.

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Value in mean/variance efficient portfolios

According to Modern Portfolio Theory, rational investors will seek to hold

portfolios that are mean/variance efficient (that is, portfolios offer the

highest level of return per unit of risk, and the lowest level of risk per unit

of return). One of the attractive features of hedge funds (in particular

market neutral and 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 three reasons why one might not wish to allocate a high

proportion of assets into hedge funds. These reasons are:

1. Hedge funds are highly individual and it is hard to estimate the likely

returns or risks;

2. Hedge funds’ low correlation with other assets tends to dissipate

during stressful market events, making them much less useful for

diversification than they may appear; and

3. Hedge fund returns are reduced considerably by the high fee

structures 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

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that the hedge funds incurred no performance fees. The result from this

second optimization was an allocation of 74% to hedge funds.

The other factor reducing the attractiveness of hedge funds in a diversified

portfolio is that they tend to under-perform during equity bear 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

was down 9.87%. According to the same index series, even "dedicated

short bias" funds had a return of -6.08% during September 2008. In other

words, even though low average correlations may appear to make hedge

funds attractive this may not work in turbulent period, for example around

the collapse of Lehman Brothers in September 2008.

Hedge funds posted disappointing returns in 2008, but the average hedge

fund return of -18.65% (the HFRI Fund Weighted Composite Index return)

was far better than the returns generated by most assets other than cash.

The S&P 500 total return was -37.00% in 2008, and that was one of the

best performing equity indices in the world. Several equity markets lost

more than half their value. Most foreign and domestic corporate debt

indices also suffered in 2008, posting losses significantly worse than the

average hedge fund. Mutual funds also performed much worse than hedge

funds in 2008. According to Lipper, the average U.S. domestic equity

mutual fund decreased 37.6% in 2008. The average international equity

mutual fund declined 45.8%. The average sector mutual fund dropped

39.7%. The average China mutual fund declined 52.7% and the average

Latin America mutual fund plummeted 57.3%. Real estate, both residential

and commercial, also suffered significant drops in 2008. In summary,

hedge funds outperformed many similarly-risky investment options in

2008.

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Notable Hedge Fund Firms

Amaranth Advisors

Bridgewater Associates

Citadel Investment Group

D.E. Shaw

Fortress Investment Group

GLG Partners

Long-Term Capital Management

Man Group

Marshall Wace

Renaissance Technologies

SAC Capital Advisors

Soros Fund Management

The Children's Investment Fund Management (TCI)

In the hedge-fund kingdom, global macro funds can be compared to

grizzlies. Aiming to profit from changes in global economies, and using

leverage and derivatives to accentuate the impact of market moves, such

funds are not for the faint of heart. They can be enormously profitable, but

are volatile, not terribly predictable, and can also produce occasional

sudden falls. For example, during the first quarter of 1994 hedge-fund

superstar Michael Steinhardt (whose funds produced an average annual

return of 24 percent over several decades) bet European interest rates would

decline, causing bonds to rise. Instead, his funds lost 29 percent when the

Fed raised interest rates in the U.S., causing European interest rates to kick

up. I compare macro funds to grizzlies not only to highlight these common

aggressive characteristics but to point out that like grizzlies, macro hedge

funds are only one species in a wide universe – and that they differ from

other hedge funds as much as grizzlies differ from other animals.

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Hedge Fund Association

Founded in 1995, by Dion Friedland, when global hedge fund assets were

just approaching the $250 billion mark, The Hedge Fund Association™

(HFA) is a not-for-profit international group of industry professionals with

a mission to provide a forum for thought leaders, innovators, practitioners

and investors who are shaping the way business is conducted in the global

hedge fund industry. With the maturity and institutionalization of the global

hedge fund industry, the HFA advocates for the industry by giving voice to

the issues affecting the industry through the education of investors, the

media, regulators and legislators.

Membership in the HFA includes hedge fund firms, global financial

institutions with hedge fund offerings including retail and private banks,

asset management firms and broker dealers, investors including funds of

hedge funds, family offices, public and private pension funds, endowments

and foundations, high net worth individuals, allocators, and the industry’s

service providers including prime brokers, administrators, custodians,

auditors, lawyers, risk managers, technologists and third party marketers.

Risk & Reward Comparisons Hedge Funds vs. Traditional

Assets

The normal view is that hedge funds are highly risky - that they all use

global macro strategies and place large directional bets on stocks,

currencies, bonds, commodities, and gold, while using lots of leverage.

Even though the inference of gambling is not usually correct, it is easily

made when viewed in the context of tools used- like leverage and short

selling. These are perceived by most investors as purely speculative tools.

But many hedge funds successfully employ them to increase performance

while actively managing risk. Most hedge funds use derivatives only for

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hedging or don't use derivatives at all, and many use no leverage. The

reality is that less than 5% of hedge funds are global macro funds causing

speculative waves and contagions, like Quantum, Tiger, and Strome.

Estimated to be growing at about 20% per year, there are between 4,000

and 5,000 active hedge funds in this industry. Measured against major

equity and bond indices, global hedge fund indices do indeed appear more

attractive, with lower volatility and higher return. But there is a wide range

of outcomes, and history is full of people who thought they had found the

alchemist's stone - some magical ingredient that turns dross into gold.

Indeed, in 1998, John Meriwether, the anti-hero of Michael Lewis' book

Liars Poker, bet his firm, Long Term Capital Management (LTCM), on the

theories espoused by his partners, the Nobel prize-winning economists,

Robert Merton and Myron Scholes, and lost. LTCM was a hedge fund,

founded by Meriwether in 1994, engaged in arbitraging pricing differentials

in the bond markets, through betting on convergence in the prices of similar

assets. The theory worked very well - for a time - but when differentials

blew out, the firm's highly leveraged positions quickly lost money,

necessitating an eventual bail-out by a group of banks. LTCM had nearly

$1 trillion in bad investments, but only $2 billion in assets that it could sell

to pay off its debts. Its borrowing in the 1997 alone averaged between 50

and 100 times its asset base, and it borrowed from the biggest of banks and

brokerage houses in the world, thereby endangering a banking system

already rocked by losses in Russia and the Far East.

Advantages of Hedge Funds vs. Mutual Funds

Hedge funds are extremely flexible in their investment options because

they use financial instruments generally beyond the reach of mutual funds,

which have SEC regulations and disclosure requirements that largely

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prevent them from using short selling, leverage, concentrated investments,

and derivatives.

This flexibility, which includes use of hedging strategies to protect

downside risk, gives hedge funds the ability to best manage investment

risks. The strong results can be linked to performance incentives in addition

to investment flexibility. Unlike many mutual fund managers, hedge fund

managers are usually heavily invested in a significant portion of the funds

they run and share the rewards as well as risks with the investors.

"Incentive fees" remunerate hedge fund managers only when returns are

positive, whereas mutual funds pay their financial managers according to

the volume of assets managed, regardless of performance. This incentive

fee structure tends to attract many of Wall Street’s best practitioners and

other financial experts to the hedge fund industry.

In the last nine years, the number of hedge funds has risen by about 20

percent per year and the rate of growth in hedge fund assets has been even

more rapid. Currently, there are estimated to be approximately 8350 hedge

funds managing $1 trillion. While the number and size of hedge funds are

small relative to mutual funds, their growth reflects the importance of this

alternative investment category for institutional investors and wealthy

individual investors.

Where is Investcorp Bank BSC in the Hedge Funds market?

Investcorp, the asset manager specializing in alternative investments, has

won the Hedge Fund of Funds Leader of the Year award at the prestigious

Alternative Investment News hedge fund industry awards organized by the

international Publication Institutional Investor. Investcorp's hedge fund

team beat four other highly regarded fund of funds on the short list.

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The award was presented in New York this week at a ceremony that

celebrated the achievements of the hedge fund industry. The awards were

judged by a panel of experts from leading institutions including JP Morgan,

Goldman Sachs and Bear Stearns. The judges cited Investcorp's penetration

of the U.S. institutional market, its growth in assets under management and

its new single manager platform as the critical success factors. Deepak

Gurnani and Ibrahim Gharghour, co-heads of Asset Management at

Investcorp, both expressed their delight at receiving this recognition.

Deepak Gurnani said: "It is a great tribute to be recognized by our industry

peers as well as by the premier awards in the hedge fund industry. This is

testament to the long term achievements of Investcorp's hedge fund

business over the past nine years and our success in building a strong

business, not least in establishing leading risk management processes to set

us apart from other providers.' Ibrahim Gharghour added: 'This award also

recognizes our substantial recent progress in the United States, where we

have attracted substantial US institutional money into our programme. In

addition, last year, we set up a single manager platform and have already

partnered with two high profile groups, Interlachen Capital Group and Cura

Capital Management, in order to provide our investors greater variety and

access to leading specialist funds.

Investcorp is one of the leading institutional investors in hedge funds with

approximately $4.6 billion under management, of which $1.7 billion is

proprietary investment.

Hedge Fund Market Structure:

i) Operational Structure:

Hedge funds are usually not operated in-house by their employees. They

are just investment vehicles owned by investors and sponsors (or limited

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and general parents) and rely on external service providers to conduct the

funds day-to-day business, including managing the fund portfolio and

providing administrative services. So for this type of operation structure,

hedge funds establish relationships with all the necessary industry service

providers:

1- The sponsors and the investors:

The sponsor is the creator of the fund and he will typically hold a member

of the founder shares in the fund; that is as we talked early (page 1) the

sponsor will be the general partner and the investor will be the limited

partner.

2- The Manager or Management Company:

He/she is responsible for office overhead, and is usually established in a

major onshore financial center as London or New York.

3- The Investment Adviser:

The role of investment advisor is simply to give professional advice on the

funds investment in a way that is consistent with the funds investment

objectives and policies, the investment adviser may be a part of the same

overall organization as the hedge fund he serves, or he may be unrelated to

it.

4-The board of directors:

The board of directory is responsible for monitoring the overall operations

of the fund.

5-The fund administrator:

His primary task is to ensure accurate calculation of the net asset value at

regular time interval called break periods.

6- The Custodian:

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The custodian’s primary responsibilities include safekeeping of the fund’s

assets, clearing and settlings all trades and monitoring corporate actions

such as dividend payments and proxy-related information.

7- The legal advisor or lawyer:

The legal adviser or lawyer assists the hedge fund with any tax code and/or

legal matters, and ensure compliance with domestic investment regulations

as well as with regulations of countries where the fund is distributed.

8- The auditors:

The auditors’ role is to ensure that the hedge fund is in compliance with\

accounting practices and any applicable laws, and to verify the annual

financial statement, if any.

9- The registrar and transfer agent:

He/she keeps and updates a register of shareholders of the hedge fund. He

also processes and takes necessary actions for subscriptions and

withdrawals of shares in the fund, as well as for the payment of any

dividends and distributions.

10- The Prime Broker:

The role of prime brokers goes beyond just replacing the hedge funds back

office. Rather, they should be seen as full service providers across the core

functions of execution and operation for example:

- Clearing the trades.

- Acting as global custodian.

- Margin financing.

- Securities lending.

ii) Organization Structure:

Hedge funds also need to set up efficient organizational structures.

1- Side-by-side and master/feeders:

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In side by side structures, also called mirror funds or clone funds, several

funds having identical or substantially similar investment policies invest in

parallel in a group of cloned portfolio. These portfolios usually share a

common investment adviser, portfolio managers and a custodian or

administrator, and the cloning process essentially consists in facilitating

bunched trades among the cloned funds and rebalancing cloned funds that

have experienced different cash flows.

The master/feeder structure is an efficient alternative to side-by-side funds.

In this structure a series of funds (called feeders) sell shares to investors

under the 12 terms of their prospectus and contribute their respective

proceeds to another fund (called the master fund) rather than investing

directly.

2- Managed accounts.

3- Umbrella funds.

4- Multiclass/Multiseries Funds.6

1- Hedge Fund Market Size:

If we are going to talk about how big is the hedge fund industry, then it will

definitely a question without an accurate answer because as we know that

SEC doesn’t regulate hedge fund i.e. hedge fund are not required to register

but the SEC estimates, however, that there are between 6,000 and 7,000

funds that manage approximately $600 to $650 billion in assets. The report

predicts that in the next five to 10 years, the assets invested in hedge funds

will exceed $1 trillion.

And that is wonder us to know why hedge fund is exempt from SEC

regulations, the answer is simply is of the hedge funds are only offered to

wealthy individuals and institutions. A combination of statutory provisions

and rules under the 1933 Act and the Investment Company Act for private

rather than public offerings allow for them — and the securities they issue

to investors

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— To remain unregistered. Many funds use the safe harbor in the 1933 Act

that allows them to sell to "accredited investors." These are individuals with

an annual income of $200,000 or more, married couples with a joint

income of $300,000 or more, or individuals with a net worth of $1 million.

2- Key Players

We can divide the key players in two categories, buyers of hedge funds and

provider of hedge funds.

a) Buyers of Hedge Funds:

Current ownership is divided between Wealthy individuals (High Net

Worth Individuals or HNWI) and institutions. And it is divided as follows:

- US HNWI and Europe HNWI.

- US Insurance, US Pensions, Europe insurance, Europe Pensions and US

non-profit.

Now let us have a close look for wealthy individual,

Wealthy individual:

Wealthy individuals (High Net Worth Individuals or HNWI) – individuals

with assets in excess of US$ 1 million - account for over 60% of the

approximately $600bn invested in hedge funds. There are signs that hedge

funds are becoming a standard element in HNWI – not just super wealthy –

portfolios.

b) Provider of Hedge Funds:

1- Very high fees and very high profitability. The typical hedge fund

manager charges a management fee in excess of 1% (versus 40-50 bp on

the typical long only portfolio) and usually is entitled to 20% of the profit if

a certain target return is exceeded.

2- The vast majority of hedge fund managers are located in North America

– largely in the New York and Los Angeles areas. But in Europe – London

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particularly- a large number of companies are starting up. Anecdotal

evidence suggests US managers are opening in larger scale in London.

3- Most advisors noted a specific life cycle for hedge funds. New start ups,

to be viable, had to raise about $20m. If performance is good the fund re-

opens 12 months later and grows to $60-100m. If performance is sustained,

a further 12 months on, the fund can re-open and grow to $300-600m. But

in practice few funds grow beyond the $25-30m size.

4-The credibility of the investment decision making process is critical to

fundraising. The investment managers must have considerable experience

and those with good reputations can raise $250m at launch. Experience in

short selling is critical as are robust risk control measures. There are signs

that with the amount of institutional money facing the market, standards

and expectations on managers are falling. Also we can consider the players

in the previous section as key player in Hedge fund even though some of

them are not directly involved in such things.

3-Competitive Positioning

The hedge fund market has been growing dramatically in recent years.

According to the survey conducted by an American hedge fund research

company, the size of hedge fund market--which was worth US$324 billion

in early 2000--exceeded US$1 trillion for the first time by early January

2005.

Top 100 Hedge Funds

The market’s horrors of 2008 gave way to the pleasures of 2009. John

Paulson’s Paulson Credit Opportunities fund has gained a phenomenal

123% annually over the past three years. The worst-performing member of

Barron’s Top 100 has returned roughly five times what the average hedge

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fund has risen. Currencies (USD, GBP and Euro) refer to specific currency

classes of a fund.

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FINANCIAL CRISIS AND HEDGE FUNDS

In spite of difference of views, the roles played by some of the large hedge

funds have often been associated with major financial crisis that took place

in the 90’s.

East Asian Crisis

The impact of the East Asian crisis which materialized in the middle of

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1997, and the subsequent turbulence that swept the world’s financial

markets over the next 12-18 months, has been significant not only in terms

of the financial, economic and social consequences that these events

wrought on emerging market economies, but also in terms of drawing the

world’s attention to outstanding issues concerning the structure, operation

and regulation of the international financial system. Causes of the crisis

remain among the most contentious issues and continue to be debated at the

academic as well as policy level. The Emerging Markets Committee of

IOSCO identified multiple causes of the East Asian crisis. The Committee

also made a reference to the role played by some hedge funds complex

trading strategies involving futures were thought by some authorities to

have exerted a destabilizing influence on market performance in their

jurisdictions. Currency speculators pursued a so-called “double play” aimed

at playing off the Hong Kong currency board system against the

administrations stock and futures markets. However, subsequent research

could not produce robust evidence implicating the hedge funds for

precipitating the crisis. Researchers have, however, attributed the negative

public perception of the role of hedge fund managers in crisis partly to the

limited information available about what they actually do.

Long Term Capital Management (LTCM)

Another major financial crisis involving a large hedge fund was that of the

huge loss (US $ 4 billion) suffered by LTCM in 1998. LTCM built its

positions on sophisticated arbitrage trading strategies. In addition, it used a

significant degree of leverage to increase its expected return. In August,

and September of 1998, as the global financial crisis worsened, it became

clear to LTCM that many of the assumptions inherent in the arbitrage

positions it held were incorrect. Due to LTCM’s leverage (which at one

point has exceeded 50 to 1), those incorrect assumptions resulted in

substantial losses for the firm and eroded its capital base5. Liquidation of

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LTCM’s positions could have potentially disrupted the financial markets,

resulting in losses for other participants in those markets. Finally, a

consortium of banks worked out a rescue plan facilitated by the Federal

Reserve Bank of New York, acknowledged that LTCM’s potential impact

on the world’s financial markets raises legitimate questions about the

activities of hedge funds in general, as well as the proper role that

regulators should play with respect to those activities. However, he also

asserted that it was too soon to tell whether LTCM’s investment strategies

represent the norm in the hedge funds industry or, whether LTCM was an

overly aggressive player among otherwise responsible market participants.

In response to the near collapse of Long-Term Capital Management, LP

(LTCM), the Technical Committee of the IOSCO formed a special Task

Force on Hedge Funds and Other Highly Leveraged Institutions to address

regulatory issues relating to the activities of highly leveraged institutions

(HLIs) or hedge funds. The Committee in its report underlined that HLIs,

like other institutional investors, can provide benefits to global financial

markets. It also highlighted the combination of characteristics typically

associated with HLIs such as significant leverage, and the legal and other

uncertainties arising out of the extensive operations in offshore centers

posing particular challenges which need to be managed carefully in order to

avoid risks to the financial system. The committee, as a defense against

systemic risk in the market , recommended strong and prudent risk

management processes at the regulated firms with which the HLIs trade.

The Committee also highlighted the importance of transparent disclosure

by the regulated entities dealing with HLIs and HLIs themselves on a

voluntary basis, as a means to maintain market integrity.

In spite of occasional negative perception about the role of hedge funds,

such perceived misdemeanors by certain hedge funds have been considered

more as occasional aberrations than general industry wide behaviour. This

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is also corroborated by the fact that many jurisdictions are gradually

opening up their markets for hedge funds to establish and market their

products.

Further, for the purpose of this paper it must be emphasized here that

allowing access to offshore hedge funds to invest in India through FII route

will not provide any opportunity to them to build up leveraged position

onshore as borrowing by FIIs are not allowed under the terms of RBIs

general permission.

List of Hedge Funds in India

1st Hedge Fund - HFG India Continuum Fund:

Hudson Fairfax Group (HFG) is an investment partnership focused on

India’s aerospace, defense, homeland security and other strategic sectors. It

is based in New York with an advisory office in New Delhi. Its team has

five decades of focused experience in the sector combining investment and

industry expertise. Hudson Fairfax Group, through its predecessor

company, started as an investment advisory firm in 2005. It ran an

investment fund, the HFG India Continuum Fund, which invested in

publicly traded Indian securities. During the operation of its fund, HFG was

a Registered Investment Advisor (RIA) with the U.S. Securities &

Exchange Commission and a Foreign Institutional Investor (FII) with the

Securities & Exchange Board of India.

2nd Hedge Fund - Avatar Investment Management:

Avatar Investment Management is the investment advisor to three funds.

Headquartered in Mauritius, the funds are focused on the Indian public and

private equity markets. In order to meet the approval of various regulatory

bodies around the world, only accredited investors may apply to invest.

3rd Hedge Fund - India Deep Value Fund:

India Investment Advisors, LLC was founded by Robin Rodriguez and Raj

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Agarwal in 2006 to pursue the number of significant investment

opportunities presented by the burgeoning Indian capital and real estate

markets. As a result, the India Deep Value Fund was launched in April

2006. The Fund's Managers seek to achieve long-term capital gains by

acting as pro-active deep value investors in publicly-traded Indian stocks.

4th Hedge Fund - Fair value:

Fair Value Capital is a highly specialized and exclusive Investment

Advisory Firm focused on Deep Value Investment opportunities primarily

in Indian equity markets. It seek absolute, long-term returns for its

investments while minimizing investment risks using a Value oriented

approach towards our investments. Fair Value specializes in Deep Value

Investments in the Indian equity markets.

5th Hedge Fund - India Capital Pvt Ltd

India Capital Pvt. Ltd (India) is a Singapore based investment advisor.

India was formed in 2002 to provide boutique fund management services to

institutions, foundations, family offices and high net-worth individuals. In

July 2003, India launched the India Absolute Return Fund (IARF), a

directional fund investing in India and Indian companies globally. The

principals have a combined over 30 years of experience in researching and

investing in India. In addition to the Singapore office, India has a research

presence in Mumbai, India.

6th Hedge Fund - India Capital Fund:

India Capital Fund SM is an open-ended Investment Company incorporated

in Mauritius which has invested in India since 1994.

7th Hedge Fund - Monsoon Capital Equity Value Fund:

India Capital Fund SM is an open-ended Investment Company incorporated

in Mauritius which has invested in India since 1994. Shares of the India

Capital Fund

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8th Hedge Fund - Karma Capital Management, LLC:

Monsoon Capital is the adviser to onshore and offshore private investment

partnerships and specializes in equity investments in India.

9th Hedge Fund - Atyant Capital

Karma Capital Management LLC is an organization with dedicated

professionals engaged in providing specialist, fundamentally based, alpha-

seeking India Focused products including long-only equity and long-short

products. Our wealth of experience has guided us in offering attractive risk-

adjusted, performance-driven products that take advantage of market

opportunities and meet specific client objectives. From diversified

proprietary fund portfolios to customized programs for a full range of

global institutional investors, our capabilities and product offerings address

the various investment needs of investors around the world.

10th Hedge Fund - Atlantis India Opportunities Fund:

Rahul leads Atyant Capital Advisors, advisor to the Atyant Capital India

Fund. In the last 10 years he’s managed money exclusively in the Indian

markets. His mission is to consistently identify the best 10-15 investment

ideas from among the thousands of publicly-traded Indian corporations.

Rahul’s value-based investment philosophy stands apart due to his belief in

the paramount importance of corporate governance, specifically how

management operates with its minority shareholders in mind. Prior to

Atyant, Rahul spent four years leading Meridian Investments, generating a

430% absolute return for the firm’s high net worth clients.

REGULATORY ISSUE FOR ALLOWING FOREIGN

HEDGE FUNDS IN INDIA

Hedge Funds in India

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With the notification of SEBI (Mutual Fund) Regulations 1993, the asset

management business under private sector took its root in India. In the

same year SEBI, also notified Regulations and Rules governing Portfolio

Managers who pursuant to a contract or arrangement with clients, advise

clients or undertake the management of portfolio of securities or funds of

the client. We have however, no information about any hedge funds

domiciled in India. Further, on account of limited convertibility, offshore

hedge funds have yet to offer their products to Indian investors within

India. Recently, RBI through liberalized remittance scheme, allowed

resident individuals to remit up to US $ 25,000 per year for any current or

capital account transaction. The liberalized scheme will allow Indian

individual investors to explore the possibility of investing in offshore

financial products. Considering the existing limit being only US $ 25,000

per year, Indian market may not be attractive to hedge fund product

marketing. As long as there will be restriction on capital account

convertibility, foreign hedge funds, by virtue of their minimum investment

limit being $ 100,000 or higher, do not seem to be excited to access

investment from Indian investors in India. It may be clearly understood that

the suggestions put forth in the following paragraphs are in no way aimed

at allowing foreign hedge funds to mobilize investment from India by

offering their products to Indian investors. Therefore regulatory issues

related to investor protection have not been considered for this Report.

Some hedge funds have invested in offshore derivative instruments (PNs)

issued by FIIs against underlying Indian securities. Through this route

hedge funs can derive economic benefit of investing in Indian securities

without directly entering the Indian market as FIIs or their sub-accounts.

Through recent amendments to the FII Regulations (Regulation 15A and

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20 A), the regulatory regime has been further strengthened and periodic

disclosures regime has been introduced. As at the end of March, 2004, total

investment by hedge funds. In the offshore derivative instruments

(PNs) against Indian equity, are Rs. 8050 crores which represents about

8% total net equity investments of all FIIs. On the basis of market value,

the hedge funds account for about 5% of the market value of the total assets

held by the FIIs in India.

The current fiscal year (2003-2004) has seen a spectacular increase in FII

activities in Indian market. Till this report is filed FIIs have already

invested US $ 10 bn. during this year alone which is a record. Robust

economic fundamentals, strong corporate earnings and improvement in

market micro structure are driving the FII interest in India. Investors all

over the world are keen to come to Indian market. From informal

discussions with institutional investors including some reputed and well

established hedge funds, one could gauge the extent of interest they have

about Indian markets. During the discussions they have requested whether

India, like other Asian emerging markets, can provide a regulatory

framework that will allow them to directly invest in Indian market in a

transparent manner. In this context, the following approach may be

considered for allowing the well-established hedge funds to invest in Indian

markets as a registered entity under the SEBI (Foreign Institutional

Investors) Regulations, 1995.

Relevant Provisions of FII Regulations:

Though hedge funds are not an excluded category of foreign institutional

investors under the SEBI (FII) Regulations, 1995 they are , however, by

virtue of not being regulated by securities regulators in their place of

incorporation or operations , cannot come as FII under the present

provisions of SEBI (FII) Regulations. Regulation 6 (i) (b) of the FII

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Regulations require an FII applicant to be a regulated entity in its place of

incorporation or operations.

The FII Regulations allow sub-accounts sponsored by registered FIIs to

invest in India. Regulation 2 (k) defines “sub-account” which “includes

foreign corporate or foreign individuals and those institutions, established

or incorporated outside India and those funds, or portfolios, established

outside India, whether incorporated or not, on whose behalf investments are

proposed to be made in India by a foreign institutional investor”.

Further, provisions of the regulation 13 lay down the conditions and

procedure for granting registration to a sub-account of an FII. Hedge

Funds of almost all variations can meet the requirements of sub-accounts if

they are ‘fit and proper’ persons. However, based on (an internal

administrative decision) if an applicant indicates in the application that it is

a hedge fund, the consideration of the application is withheld. Since

granting of registration to FII/sub-accounts is based on the disclosure of

details and on the undertaking given by the applicant in the application

form, it could be possible that a few entities who described their activities

in the application form in terms other than hedge funds could have already

got registration as sub- accounts. However, it must be remembered that all

sub-accounts have to be sponsored by registered FIIs who are required to

be regulated entities by the relevant regulators in their home countries.

Identifying Hedge Funds

As mentioned in earlier paragraphs, hedge funds do not have any

universally accepted definition. Therefore, identifying a hedge fund is the

first challenge that a regulator faces. An approach for identifying hedge

funds, as suggested by IOSCO is to look at the kinds of characteristics of

fund management strategies employed by institutions. Hedge funds would

at least exhibit some of the following characteristics:

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i) Borrowing and leverage restrictions, which are typically included in

Mutual Fund Regulation are not applied, and many (but not all) hedge

funds use high levels of leverage.

ii) Significant performance fees (often in the form or percentage of profits)

are paid to the manager in addition to an annual management fees.

iii) Investors are typically permitted to redeem their interests periodically,

e.g. quarterly, semi-annually or annually;

iv) Often significant ‘own’ funds are invested by manager;

v) Derivatives are used, often for speculative purposes, and there is ability

to short sell securities;

vi) More diverse risks or complex underlying products are involved.

The distinguishing characteristics of hedge funds are not limited to this and

the list may need to adapt depending on the changing market dynamics.

Further, it might be appropriate to also consider the investment strategy

followed by particular funds, such as long/short exposures, leverage and /

or hedging and arbitrage techniques. On the basis of these characteristics, it

will be possible to identify an applicant as a hedge fund.

Investment limits applicable to FIIs:

Chapter II of the SEBI (Foreign Institutional Investors) Regulations, 1995

interalia list out the instruments in which an FII/sub-account can invest.

The regulation does not include currency or commodities as eligible

instruments for investment for the FIIs. Therefore, currency trading or

investment in commodity related financial products will not be an option

for any hedge funds under the present FII Regulations.

The SEBI (Foreign Institutional Investors) Regulations, 1995 also lays

down scrip-wise and fund wise maximum limits a fund can invest. Further,

through circular no. SMD/DC/CIR-11/02 dated February 12, 2002 and

SEBI/DNAD/CIR-21/2004/03/09 dated March 9, 2004 issued by

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Secondary Market Department, position limits for investment by FIIs in

derivatives has been advised. These limits will help diversify the foreign

hedge fund investments and will help in jettisoning concentration in any

specific scrip. The provisions of Chapter III (Regulation 15 (3) (a))

disallows short selling by FIIs and stipulates that all trades by FIIs are

delivery based. The provision will clearly keep the hedge funds if allowed

to invest as FIIs out of short selling at least in the cash segment. It is

therefore, clear that existing provisions in the FII Regulations include

several checks and balances which can keep our market safe from potential

market abuse and manipulation.

Additional Regulatory Concerns:

In view of the increasing popularity among the institutions as well as their

increasing interest in the Indian market, it might be time to provide a

limited window to this growing segment of asset management industry

within the existing framework of the SEBI (Foreign Institutional Investors)

Regulations. While opening up our market one cannot be oblivious to the

special concerns associated with the creative fund management strategies

used by these funds. Thus, the approach adopted in formulating the

following policy suggestions has been that of transparent and regulated

access with abundant caution. Para 4.4 of this section has already outlined

the existing provisions in the SEBI (Foreign Institutional Investors)

Regulations, 1995 and the Guidelines issued by SEBI which an address\ the

concerns related to currency speculations, short selling, scrip wise

concentration in the cash market and excessive positions in the derivative

segment of our market. As mentioned earlier, these types of funds raise

special regulatory concerns which are necessary to be addressed with

special regulatory provisions. In this context, following additional

provisions have been suggested with respect to hedge funds seeking

registration as FII:

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1. The investment adviser to the hedge funds should be a regulated

investment advisor under the relevant Investor Advisor Act or the fund is

registered under Collective Investment Fund Regulations or

Investment Companies Act.

2. At least 20% of the corpus of the fund should be contributed by the

investors such as pension funds, university funds, charitable trusts or

societies, endowments, banks and insurance companies.

The presence of institutional investors in the fund is expected to ensure

better governance on the part of the fund manager and fund administrators.

Further, institutional investors may help fund managers to take a long term

perspective of the market.

3. The fund should be a broad based fund in terms of the SEBI

(Foreign Institutional Investors) Regulations, particularly in terms of the

explanation to Regulation 6 (1) (d).

4. The fund manager or investment adviser must have experience of at least

3 years of managing funds with similar investment strategy that the

applicant fund has adopted. This provision is expected to allow well

managed funds to access our market and at the same time, keep our markets

insulated from the possible adverse effects of ‘trial and errors’ by

uninitiated rookies.

Hedge funds as a whole are becoming an important segment of the asset

management industry and gaining popularity from investors particularly

from the high net worth investors, universities, charitable funds,

endowments, pension funds, insurance and other institutional investors. The

asset under management of the hedge funds are growing on a double digit

rate. All hedge funds are not necessarily speculative funds though most of

them provide an alternative investment options for the investors through

innovative investment strategy.

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The issues discussed and suggestions placed above are intended to widen

the FII window to allow these alternatives invest pools to our securities

markets in a transparent and orderly manner. In addition, the suggestions

also provide for adequate safety measures to address legitimate concerns

associated with these funds. The alternative investment pools if allowed to

investment in Indian markets will be a source of additional liquidity and

will also diversify the pool of foreign investments in Indian market.

Two fast growing emerging markets, India and China are keenly observed

for new investment propositions, particularly investment in hedge funds.

Presence of systematic institutional framework for hedging, regulatory

factors, a well-developed capital economy, liberalized stable economy,

rapid reforms, democratic set-up, good information disclosure standards,

better return on capital have rather favored India score over China as a

superior place for investment in hedge funds.

Investment in hedge funds is a cynosure of interest for sophisticated

investors, wealthy individuals or families and big institutions. They are

class of investors who believe in the finance mantra - higher risk, higher

opportunity investments and higher rewards. Yes, investment in India

focused hedge funds - for those with an appetite for risks, most willing to

take risks in anticipation of explosive reward. Investment in hedge funds in

India has been gaining momentum post 2001-2002. To invest in hedge

funds in India, you need to first understand what they are and how it works.

Overview of Hedge funds in India

Financial experts opine that India has tremendous potential for attracting

global investments in hedge funds. The early entrants into the Indian

markets have recorded encouraging returns which in turn attracted other

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hedge fund players to step in. Renaissance Technologies, Vikram Pandit-

founded Old Lane, DE Shaw, Och-Ziff Capital Management are some

reputed international hedge funds firms in India. Here is a list of hedge

funds operating in India.

India Capital Pvt. Ltd.

India Capital Fund.

India Deep Value Fund

Absolute India Fund (AIF)

Fair Value

Naissance Jaipur (India) Fund

Avatar Investment Management

Passport India Fund

HFG India Continuum Fund

Monsoon Capital Equity Value Fund

Karma Capital Management, LLC

Vasishta South Asia Fund Limited

Atyant Capital

Atlantis India Opportunities Fund

Typical Hedge Fund Investment

Investor chooses and decides hedge fund investment

Subscription amount is paid to the custodian.

Custodian confirms receipt of payment to fund administrator.

Fund administrator instructs issue of share to investor.

Fund administrator issues reports on hedge fund performance.

Investment manager instructs custodian to move funds to prime

broker for investment in market.

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During the process the prime broker and custodian are in direct

contact with fund administrator.

Guide to investing in Hedge Funds in India

Prior to finalizing investment, take couple of months to know about

the hedge fund industry in India. The age of hedge fund industry, the

key players, their worth, the operational risks, the pros and cons of

investing in hedge funds etc

Identify potential hedge funds, refer commercial directories or

databases. Account for your investment goals, risk tolerance level,

amount allocated for investment.

Get to understand the ground realities of regulatory factors, its

implications; how business is run in India all helps.

Read blogs, financial magazines, websites, news articles, white

papers on hedge funds in India. Talk to personnel; preferably interact

with hedge fund managers involved with hedge fund investments and

those who have already invested in hedge funds.

Notice annual events like Hedge funds world India to gain an

assessment of the burgeoning Indian hedge fund industry.

Approach wealth manager in wealth management companies,

securities broker or licensed investment consultant for advice on

hedge fund investments in India.

Understand terms related to hedge funds, remittance, management

fee and performance fee, withdrawal and redemption fees.

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Check the pros and cons of long-term hedge funds vs. short-term

hedge funds.

Ensure your activities are that of an accredited investor (with a net

worth of more than $1 million).

Involve financial advisor in the process of investing in hedge funds

in India.

Maintain direct communication with hedge fund manager.

Check if diverse hedge fund strategies and techniques are put to use.

Receive and file monthly or quarterly updates.

Engage in data mining, keep track of trends.

Check with accountant with regard to tax reporting and implications.

Know your rights, where to seek help in terms of a dissatisfied hedge

fund investment operation, or any other complaint in general that

doesn't confirm with regulations.

Do Hedge Funds Pose Significant Risks for the Economy?

Many hedge funds appear at first glance to have low return volatility

compared to an investment in the stock market. For instance, from February

1994 to August 2004, the average annualized standard deviation of the

monthly returns of fixed income arbitrage hedge funds was 7.76 percent, or

slightly more than half the standard deviation of the Standard & Poor’s 500

return over the 1994–2005 period (Chan, Getmansky, Haas, and Lo, 2006).

However, even funds with a history of low volatility can end up losing

most of their money, an outcome that is almost inconceivable for a mutual

fund. The Long Term Capital Fund had lower volatility than the S&P 500

for almost all its existence, but this low volatility did not prevent it from

losing most of its capital in the span of a month. Regulators are concerned

about the risks of hedge funds for at least four reasons: investor protection,

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risks to financial institutions, liquidity risks, and excess volatility risks. We

review and evaluate these reasons in turn.

The Securities and Exchange Commission wanted to force registration of

hedge fund managers because hedge fund collapses had generated large

losses for their investors, arguably indicating a need for greater investor

protection. Each year, roughly 10 percent of hedge funds die. A fund might

die because the investors withdraw funds following significant losses.

Some funds disappear because fraud or misreporting becomes apparent.

However, aggregate losses from hedge fund fraud seem relatively small.

The SEC brought 51 hedge fund fraud cases from 2000 to 2004. The U.S.

Securities and Exchange Commission (2003) estimates the damages in

these cases to amount to $1.1 billion.

Banking regulators are concerned that hedge funds may create risks to

financial institutions. Hedge funds create credit exposures for financial

institutions in several ways: they borrow, they make securities transactions,

and they are often counterparties in derivatives trades. Because of leverage,

a hedge fund might get in trouble if its assets experience a sharp drop and

the market for these assets lacks liquidity so that the fund cannot exit its

positions. The collapse of a hedge fund could have far-reaching

implications if the fund is large enough. When the Long Term Capital Fund

lost more than $4 billion in August and September 1998, the Federal

Reserve Bank of New York organized a rescue by private banks to avoid

possible widespread damage from a possible disorderly liquidation or

bankruptcy of the fund. However, the debacle at the hedge fund Amaranth

in late 2006 had only a trivial impact on the markets. Nonetheless, the

Amaranth losses led to calls for regulation of hedge funds. For instance, the

New York Times (2006) published an editorial stating that “regulators need

to act now to translate their various calls for hedge-fund oversight into

enforceable rules and, in some instances, into concrete proposals for

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Congress to enact.”Hedge funds rely on their ability to move out of trades

quickly when prices turn against them, which raises an issue of liquidity

risk. If too many funds have set up the same trades, they may not all be able

to exit their positions at the same time. In that case, two adverse

developments can ensue: prices may have to overreact and liquidity may

fall sharply. With low liquidity, hedge funds that rely on trading quickly to

control their risks cannot do so. Hence, such hedge funds become more

risky, which increases threats to financial institutions and can lead to

further overreaction in prices as financial institutions have to reduce their

positions as well.

Further, when hedge funds use leverage, they cannot just ride out a serious

adverse shock; instead, they must reduce their exposures to satisfy the

banks from which they borrowed. As a result, adverse shocks could lead

hedge funds to dump securities and cash out precisely when things are

going poorly, which could make matters worse.

Finally, hedge funds could lead prices to overreact by making trades that

push prices away from fundamental values and lead to excess volatility

risks. Though hedge funds have certainly been accused of creating

volatility, the case that they have done so is far from ironclad. For example,

hedge funds were net buyers during the stock market crash of 1987, so that

they helped stabilize markets at that time (Presidential Task Force on

Market Mechanisms, 1998). During the Asian currency crisis of 1997, the

prime minister of Malaysia attacked George Soros for causing the crisis.

However, an IMF study concluded that hedge fund positions were too small

to have much of an impact on emerging markets (Eichengreen et al., 1998).

Earlier, the same George Soros had apparently taken a $10 billion bet

against the British pound, which effectively forced the British pound out of

the European exchange rate mechanism, and won $1 billion in the process.

There is some evidence that hedge funds did not sell Internet stocks when

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their valuations were high (Brunnermeier and Nagel, 2004), but the

evidence is not completely clear because the data available does not include

various hedges that hedge funds might have used.

How concerned should one be about these four types of risks that hedge

funds supposedly create? Investor protection should not motivate the SEC

to regulate the hedge fund industry, because the small investors who are

supposedly the focus of the SEC are already blocked from investing in

hedge funds. There is no reason to believe that the occasional hedge fund

losses of savvy and well-to-do investors, however painful they may be to

these investors, have a social cost. These investors can choose not to invest

in a fund, and they also have legal recourse against acts of fraud.

The risks posed to financial institutions are real, though often overstated.

Brokers and banks have greatly improved their systems to evaluate their

exposures to hedge funds in recent years. Derivatives contracts are much

better designed for defaults than they were in the past. Financial institutions

are already regulated.

Moreover, a bank that takes on too much risk through a hedge fund could

also take on too much risk with an individual or a proprietary trading desk

that employs hedge fund strategies; in either case, the problem is not

specifically a hedge fund issue, but rather involves the regulation of

financial institutions.

Liquidity risk is a serious issue. Though adverse shocks may force hedge

funds to contract, hedge funds have strong incentives not to be caught in a

situation in which they would have to make distress sales of securities.

Empirically, hedge funds do not have their worst performance when large

shocks affect capital markets (Boyson, Stahel, and Stulz, 2006). It is not

clear how well banks monitor concentration risks in the positions of

investment managers they deal with—be they hedge funds or other

investors. Regulators could encourage them to monitor more actively.

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There is no reason to believe that regulation of hedge funds would be a

more efficient approach.

The fact that hedge funds can cause volatility in prices is a potentially valid

concern, but needs to be based on facts and experience. Hedge funds often

profit by providing liquidity to the markets—by buying securities that are

temporarily depressed because of market disruptions. The role of hedge

funds in making markets more liquid and in reducing market inefficiencies

makes it necessary for those who want to restrict their activities to have a

compelling case that their possible adverse impact on market volatility

outweighs their positive effects. So far, this case has not been made. At the

same time, one should not overstate the extent to which hedge funds make

markets efficient. Though hedge funds do well at eliminating small

discrepancies in prices that can be arbitraged, the liquidity they provide

may disappear quickly in the presence of a systemic shock—and this

liquidity withdrawal may worsen the shock. Further, if asset prices depart

systemically from fundamentals, one cannot count on hedge funds to bring

them back to fundamentals.

The Future of Hedge Funds

Over recent years, the hedge fund industry has grown sharply and

regulatory concerns about the industry have increased. In this section, we

examine the implications of these developments for the industry. We

expect:

1) the hedge fund industry as a whole will perform less well over the next

ten years than over the last ten;

2) the hedge fund industry will become more institutionalized; and

3) the hedge fund industry will become more regulated. These changes will

reduce the gap between mutual funds and hedge funds, but not for all hedge

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funds. Some hedge funds will choose their investors and how they organize

themselves so that they will be less affected by the increasing

institutionalization and regulation of the industry.

Will Hedge Funds Become More Regulated?

Both Europe and the United States have experienced substantial pressure

for increased regulation of hedge funds, for a number of reasons. We earlier

discussed the systemic risk concerns and the investor protection concerns

of regulators. In addition, mutual funds often lobby for more constraints on

hedge funds.

As more money is invested in hedge funds, managers have to branch out in

new strategies, some of which may increase pressure for regulation of

hedge funds.

For example, over the last few years, more hedge funds have become

activist investors. In some countries, such activism has led to demands for

regulation. Some hedge funds have also specialized in lending. Again,

regulatory authorities are unlikely to allow unregulated hedge funds to

compete with regulated banks.

Recently, much concern has arisen from the fact that hedge funds borrow

shares to vote in corporate control contests without bearing the risks of

stock ownership (Hu and Black, 2006)—when a fund borrows shares and

holds them to vote, it pays a fee to the lender, but the lender keeps the price

risk of the shares. Regulations may be enacted to prevent such actions.

Finally, we saw that as hedge funds succeed, strong forces will push them

to become more like financial institutions. However, as hedge fund

management companies compete with regulated financial institutions,

regulated financial institutions seem certain to express concerns about the

lack of a level playing field.

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How Will the Hedge Fund Industry Perform Over the Next

Ten Years?

As discussed earlier, Ibbotson and Chen (2005) estimate the average alpha

of the hedge fund industry to be above 3 percent per year. Large funds

seem to have performed somewhat better. As a rough estimate, suppose that

the value-weighted alpha for hedge funds is 4 percent, net of fees. During

their sample period, the yearly average size of the hedge fund industry is

$262 billion according to one consulting firm. Thus, the skills of hedge

fund managers were contributing on average $10 billion a year to investors.

The industry is now at least three times as large. For the performance of

hedge funds to generate 4 percent net of fees for investors, the skills of

hedge fund managers have to produce an additional $20 billion of alpha.

However, as more money enters the hedge fund industry, it either funds

existing strategies, new strategies that typically cannot be as good as the

ones already implemented, or new managers. More hedge funds chasing the

same price discrepancies means that these discrepancies get eliminated

faster, leading to smaller profits for the funds. Hence, additional money

entering hedge funds in the future will typically not find average returns as

high as in the past.

A clear example of this problem is the recent performance of convertible

arbitrage funds. The typical trade for a convertible arbitrage fund is to buy

convertible bonds issued by a firm and to hedge the purchase with short

sales of the stock of the firm. As more funds buy convertible bonds, the

strategy becomes less profitable because the funds push the price up, so that

the performance of this strategy falls. Not surprisingly, the increase in

convertible arbitrage funds, from 26 in 1994 to 145 in 2003 according to

one database, eventually led to poor performance and a drop in the number

of such funds.

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Bibliography

Websites:-

http://en.wikipedia.org/wiki/Hedge_fundhttp://www.investopedia.com/terms/h/hedgefund.asphttp://www.hedgefund.net/hfn_public/default.aspxhttp://www.magnum.com/hedgefunds/abouthedgefunds.asphttp://www.investorwords.com/2296/hedge_fund.htmlhttp://www.hedgefundintelligence.com/http://www.hedgeco.net/hedgeducation/hedge-fund-articles/http://www.hedgefundtools.com/http://hedgefundproductions.com/http://www.thehedgefundjournal.com/http://www.thehfa.org/http://www.thehedgefundjournal.com/http://www.hedgefund-index.com/

Books:-

1) All About Hedge Funds: The Easy Way To Get Started by Robert Jaeger

2) Hedge Funds For Dummies by Ann C. Logue3) Investment Strategies of Hedge Funds by Filippo Stefanini

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