Well. Last September / October 2008, I posted a blog on ‘Hedge Funds may have to watch out next’. While I was revisiting this blog couple of days before, I noticed some portions were not clearly visible. I went to the edit mode, made the necessary corrections and posted again. But the said blog instead of appearing with the old date, appeared with the new (recent) date. I was a bit surprised and I could not do anything.

In response to this blog, I received a couple of requests from our readers, asking me to provide some basic inputs on Hedge Funds. Hence this blog.

What are Hedge Funds?

Investment pools, mainly for rich individuals and large institutions that can take risks as they play both sides of various stock, bond, or currency markets.

Loosely regulated private pools of investment capital that can invest in both cash and derivative markets on a leveraged basis for the benefit of their investors.

Any pooled investment vehicle that is privately organized, administered by professional investment managers, and not usually available to the public.

Turbocharged mutual funds for the benefit of big-money clients in a world of relatively few rules and regulations.

A catch-all term for private investment partnerships of any kind, with almost any strategy, be it shoot the moon or play it safe with a broad range of risk and return objectives.

Private partnerships wherein the manager or general partner has a significant personal stake in a fund and is free to operate in a variety of markets and to utilize investments and strategies with variable long / short exposure and degrees of leverage

Average size of Hedge Funds

A 2007 survey showed that the average size of investment in a hedge fund was $40 million, with pension funds, endowments, and foundations above that average and high net worth individuals somewhat below

Special features of Hedge Funds

Hedge Funds are also widely known as alternative investments vehicles and they are usually contrasted to traditional ones, namely mutual funds.

The key distinguishing feature of hedge funds is that performance is derived not primarily from the returns of the underlying markets (beta) but predominantly from managers’ skill (alpha).

Traditional Funds Vs Hedge Funds

Traditional products typically...

• Invest long only
• Are not leveraged
• Have a lower, ad valorem fee structure
• Do not encourage co-investment
• Are restricted in using derivatives
• Often have a limited investment universe
• Are required to stay fully invested
• Have a relative return objective
• Are frequently heavily regulated

Hedge funds typically…

• Invest both long and short
• Are leveraged
• Have a high, performance-based fee structure
• Normally require co-investment by fund manager
• Are able to use futures and other derivatives
• Have a broad investment universe
• Can have large cash allocations
• Have an absolute return objective
• Investor access regulated, but the product itself is unregulated

Potential risks of hedge fund investing

Hedge funds are usually formed as partnerships and are therefore not subject to the type of regulation for mutual funds or more widely available investment vehicles. This is why investors in hedge funds must meet higher minimum net worth and / or income levels than investors in other investment vehicles.

Because reporting standards are less stringent for hedge funds than mutual funds or separate accounts, the industry historically has suffered from occasional incidents of accounting irregularities and lack of transparency.

This makes the consulting and due diligence process extremely important for hedge fund investing compared with that for other assets where managers are more highly regulated

Benefits of hedge funds

It is believed that hedge funds will play a more central part in asset allocations by investors for three reasons:

- Access to top investment talent and proprietary strategies

- Enhanced risk/return potential in combination with traditional portfolios

- Enhanced return potential and risk management during choppy or non directional markets

Selection criteria in choosing a Hedge Fund

Five key operational considerations

- Experience of operational personnel

- Compliance

- Internal controls and procedures

- Quality of service providers

- Portfolio pricing

o Valuation transparency

o Prince consistency

o An independent valuation process

Five Key Areas of Concern for an investor in Hedge Fund

- Disclosure
- Investment policy
- Commercial policy
- Performance measurement
- Disclosure to lenders

- Valuation
- Separation of duties
- Illiquid assets

- Risk management
- Risk framework
- Portfolio risk
- Operational risk
- Third party services

- Fund Governance

- Shareholder conduct (including activism)
- Market abuse
- Shareholder conduct: proxy voting
- Shareholder conduct: disclosure of derivative positions
- Shareholder conduct: borrowed stock

Key Terminology and definitions

Board of Trustees. The body formed to act as guardian or custodian of the Standards.
Signatories. Hedge fund managers who agree to adopt the Standards and to conform to them.
Comply or explain. Signatories to the Standards must either comply with each of the Standards or explain that they intend not to comply with a particular Standard and why.
Conform. A hedge fund manager conforms to the Standards if it either complies or explains in respect of each Standard.
Endorsement. Relates to third parties such as investors, fund governing bodies, suppliers to and users of the industry, rating agencies, consultants and trade associations who accept the merits of the process, and are likely to note whether managers are signatories to, and adopt and conform to, the Standards when dealing with them.

Best practices

- An hedge fund firm must conduct its business with integrity

- An hedge fund firm must conduct its business with due skill, care and diligence

- An hedge fund firm must take reasonable care to organize and control its affairs responsibly and effectively, with adequate risk management systems

- An hedge fund firm must maintain adequate financial resources

- An hedge fund firm must observe proper standards of market conduct

- An hedge fund firm must pay due regard to the interests of its customers and treat
them fairly

- An hedge fund firm must pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading

- An hedge fund firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client

- An hedge fund firm must take reasonable care to ensure the suitability of its advice and discretionary decisions for any customer who is entitled to rely upon its judgment

- An hedge fund firm must arrange adequate protection for clients‘ assets when it is responsible for them

- An hedge fund firm must deal with its regulators in an open and cooperative way, and must disclose to the regulatory authority appropriately anything relating to the firm of which the regulatory authority would reasonably expect notice

I believe, to a certain extent, I have succeeded in demystifying Hedge Funds.