Exploding the myths: Just what are hedge funds?

Not all hedge funds are complex, risky and secretive, says Jacqueline Meziani of Standard & Poor's.
By Jacqueline Meziani, Director of Global Development, New York, Standard & PoorÆs

In today's financial markets, hedge funds have sparked the interest of many institutions looking for enhanced returns on their money. Despite all the attention hedge funds have attracted, however, there still exists a great deal of misunderstanding among investors about what they are and how they work. "Hedge fund" has become a catchall phrase that is often used incorrectly, implying a homogeneous investment class, whereas, in reality, the term describes a wide variety of investment vehicles.

The only thing that most hedge funds have in common is that they are private investment companies. Typically, they are set up as limited partnerships or as offshore corporations to receive favorable tax treatment. They are exempt from SEC regulation under the Investment Company Act of 1940, as long as they meet certain requirements, such as having no more than 99 investors or selling their funds only to qualified institutional purchasers that have $5 million or more in investable assets.

But this is where the similarities end. Each hedge fund has its own investment strategy and level of risk. In addition, hedge fund managers are not required by US law to disclose their full list of investment holdings to investors. Even if they were, however, many investors wouldn't be able to adequately evaluate the risk of those holdings without lengthy explanations, since a hedge fund can invest in exotic derivatives or utilise complex arbitrage and leveraging strategies.

Although the mainstream popularity of hedge funds is a new phenomenon, niche investment managers have been doing what hedge funds do since the late 1940s. It's only in the last few years that large institutions and pension plans with significant assets have turned a keen eye toward investing in them, to expand their investment universe. It's impossible to know the exact amount invested in hedge funds each year, since there is no centralised regulation or reporting authority. But most industry professionals would agree that more than $200 billion went into hedge funds globally in 2005. It's important for investors to understand the true nature of anything with this much financial clout. Here, then, are some questions and answers that should help separate fact from myth.

Frequently Asked Questions
What are hedge funds?
In the US, a hedge fund is a private investment vehicle that can use a wide range of strategies and tools to seek performance and manage risk. Because hedge funds are loosely regulated, participation in them can only be offered to investors who, in theory, are wealthy enough to absorb the risks that they may present. The SEC defines such an investorû-which it calls an accredited investor--as having a net worth of at least one $1 million or who made at least $200,000 each year for the past two years ($300,000 with a spouse, if married) and expects to reasonably maintain the same level of income. Since hedge funds can't by law solicit members of the general public, they aren't permitted to publish "public information." The accrediting process for investors is a key difference that separates traditional mutual funds and hedge funds.

Another distinction between traditional mutual funds and hedge funds is the level and type of fees charged to investors. A mutual fund prospectus follows a format determined by the SEC to describe all shareholder fees and itemise the annual fund operating expenses. Furthermore, the SEC places limits on certain kinds of fees and costs. A hedge fund, on the other hand, can charge a performance-based fee. Currently, this averages around 20% of the return above a predetermined baseline.

Other countries have different requirements for hedge funds and their investors, which are constantly evolving. However, most have some level of restriction regarding hedge fund participation by individual investors.

How do hedge funds invest?
Hedge funds can generally be classified into three main categories of investing: arbitrage, directional/tactical, and event driven. Arbitrage strategies seek to exploit mispricing between a pair of assets such as stocks or bonds of US. or non-US issuers. This is generally accomplished by entering into two simultaneous transactions: the purchase of an undervalued security and the selling short of an overvalued security. Therefore, the hedge fund's ability to turn a profit should not depend upon a rise in the markets or in the price of specific securities, but, instead, upon the change in the relationship of the two securities. Since this strategy attempts to capture relatively small mispricings between two securities, managers engaged in arbitrage strategies often use moderate to substantial leverage to produce attractive rates of return. Examples of arbitrage strategies include equity market neutral funds, fixed income arbitrage funds, or convertible arbitrage funds.

Directional or tactical strategies involve using either directional themes or discretionary investment themes or both to speculate on the direction of currency, commodity, equity, and bond markets. Macro funds consist of directional (i.e., net long or net short bias) positions in a variety of global assets designed to profit from macroeconomic changes. Managed futures funds use quantitative models to benefit from market trends. Equity long/short hedge funds, which generally exhibit a directional bias, are also included in this group.

Event-driven managers try to exploit profitable opportunities based on the occurrence or non-occurrence of a specific transaction or corporate action such as a merger, spin-off, restructuring, bankruptcy, or other major change. They seek to profit by capturing the price differential between the current market price of a security and its expected future value based on the occurrence of a corporate reorganisation event. For example, merger arbitrage involves buying the stock of the target company and hedging by selling short the stock of the acquiring company. This works because usually, when a deal is announced, the purchase price that the acquiring company will pay to buy its target exceeds the current trading price of the target company. The merger arbitrageur often bets that the acquisition will happen and cause the target company's price to converge (rise) to the purchase price that the acquiring company will pay. Sub-classifications of this approach include merger arbitrage, distressed issuer, and special situation funds.

What are some common myths surrounding hedge funds?
There are many myths surrounding what hedge funds really are. The first is that hedge funds are an asset class. Rather, they are a structure for investing, with the vast majority investing in traditional securities, including equities and fixed income. The difference is that hedge funds have discretion to use a wider array of investment tools. For example, compared with equity mutual funds, which typically only deal with "long" position investments, hedge funds can invest both "long" and "short." Ultimately, though, they face the same equity market uncertainties as other investors, including sector risk, large versus small cap exposure, and style exposure.

Another common myth is that hedge funds are very risky. The reality is that some funds are and some are not. When people think of risk, the first thing that comes to mind is investment risk. Some hedge funds control risk very well and are relatively stable in nature. These types of funds consistently have much lower volatility than an S&P 500 index fund. On the other hand, some hedge funds take on greater risk in an attempt to maximize returns. For example, a managed futures fund will often have high volatility as it seeks to take advantage of pricing trends and outperform. But many managed futures funds also have been able to deliver returns when traditional portfolios need it the most, which is when the equity markets are falling.

There are other risks related to hedge funds, however, such as operational risk. Many hedge funds are small and don't have the infrastructure of a large asset manager or investment bank. Their focus is on trading to bring returns to investors. People often start a hedge fund because they wish to be independent or have a novel investment approach, not because they are necessarily adept at running such support functions as transaction processing, accounting, or compliance. In fact, there is a large and growing business providing these services on an outsourced basis.

Another myth is that hedge funds always outperform other investments. Hedge funds have a wider variety of tools at their disposal to seek returns and control risk, but they are still exposed to the same underlying factors that affect the markets. Some tools, however, such as leverage, can magnify the return or the loss, thus creating boom or bust media headlines. The reality is that most hedge funds will seek to give up some upside in order to minimize the downside and perform in between, with better risk-adjusted returns than the market overall.

Still another myth is that hedge funds are secretive. In fact, they are prohibited by law from soliciting or advertising to the general public and can only solicit an individual who has been determined to be accredited and with whom the hedge fund has a pre-existing relationship. Compare this with mutual fund 12b-1 fees, which are specifically set aside to subsidise marketing and distribution to the public and, thus, are a de facto encouragement to advertise.

Beyond the secrecy of data on investment returns, a bigger issue is the ability of hedge fund investors to know what a fund invests in. An investor's desire for transparency may conflict with the manager's desire to conceal trades or strategies, as revealing them may disrupt trading or allow others to mimic the strategy. Increasingly, the compromise solution is for hedge fund investors to receive information either from the manager directly or from outside service providers that indicates the hedge fund's exposures to selected types of market risks, which then can be compared with the investor's existing portfolio.

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