Hedge fund trends 2012 - Joseph Healey

It may be beneficial for financial experts, and for investors and their money managers, to track hedge fund trends regularly. While the up and down nature of the financial market (even the hedge fund market, which promises absolute returns), it can be incredibly useful to analyze trends and attempt to see what will be happening in the future. The issue with trends, of course, is that they come and go, and with sometimes volatile hedge funds, they can do so very quickly. Still, here is a brief look at some of the most recent trends in the hedge fund market, looking specifically at the first quarter of 2012. 

By the nature of tracking trends, we must look back into 2011 to see what has changed – and what has carried over – from then. The most noticeable carry-over is the fact that bigger hedge fund investments seem to be doing the best. Smaller hedge funds are not seeing the same large returns, and in some cases may not be breaking even. Along with the continued asset rising of large funds, one of the trends that are noticeable in the first quarter of 2012 is the fact that hedge funds themselves are increasing. During the first three months of the new year alone, hedge funds increased by an average of over four and a half percent. 

Another trend that experts are keeping their eyes on is the fact that global investing is coming out on top. Emerging markets seem to be the place to invest, now, and it shows no signs of changing any time soon. Global funds saw great advances in assets during the first quarter of 2012 for sure.

Going back to performance in 2011 having an impact on 2012, it seems as though much of the positive performance seen now can be attributed to 2011. Net flow from 2011 that went to large funds made up one hundred and thirty-six percent.

While there have definitely been some “highs” in the trends of 2012 (and 2011), the fact is it wouldn’t be the investment market without a few lows. There have been some significant issues with some major hedge fund players; Paulson & Co has been having difficulty, and fell in 2001 from a summer month thirty-five billion (and change) to around twenty-eight billion in December. Paulson & Co are definitely not the only ones having trouble. 

Overall, the beginning of 2012 looks to be promising. With new capital pouring in to the hedge fund market, and the best performance the market has seen at the beginning of a year since way back in 2006, it seems as though hedge funds may be in for a great year. However, it is always important to keep tracking hedge fund trends, especially the negative ones. The wise investor or fund manager knows better than to trust calm waters for very long; things can, as mentioned before, change very quickly, and a complacent hedge fund is one that will see loss. Typically, hedge funds must be managed aggressively.

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Controversies and debates about hedge funds - joe healy

Hedge funds have seen their share of debate and controversy over the years, but none so much as after the year 1998. That was when Long-Term Capital Management, a speculative hedge fund in Connecticut, failed and required bailout from other financial companies and institutions. The failure of LTCM, which had been using absolute return strategies, shook up the financial industry, and many were gravely concerned about the future of hedge funds. When information about LTCM’s practices, including evidence of tax avoidance, became public knowledge, the media, the general public, and even some of the financial sector were up in arms about ramifications to the hedge fund industry.

Some saw the collapse of Long-Term Capital Management, and their alleged illegal activities, as a sign of pending doom for many other hedge funds. The bailout, which was under the supervision of the Federal Reserve, ended up costing financial institutions over three and a half billion dollars – and it was a desperate measure to stop the rest of the financial market from experiencing difficulties. The ultimate losses of LTCM cost around four and a half billion dollars, and the hedge fund eventually went under in 2000. With such a huge scare, and such a huge bailout, there was great concern about systemic risk (the whole financial system failing). Any hedge funds who acted similarly to LTCM were considered, by some, to be at risk of failure. Multiple hedge funds requiring bailout to stave off systemic risk was a very real possibility at the time. However, LTCM was the major failure and the biggest bailout to date, and there has not been any systemic failure before or after LTCM.

The fear of systemic risk is far from the only criticism that hedge funds have seen. A major concern with critics is the fact that there is so little transparency required in hedge funds. For one, it makes it difficult to track average performance of hedge funds when so few comprehensively disclose information. For another, a lack of transparency can mean a bigger opportunity for fraud, and there have been several big cases of fraud in the last several years that critics cite as evidence that there should be more disclosure and more regulation. However, hedge funds remain private investments, and are not – in most circumstances – required to divulge information to a third party. There is also a concern of conflict of interest in cases where Americans do not use third parties to act as custodians or administrators of their funds; in some such cases of proven conflict of interest, there have been allegations of fraud and securities violations.

Hedge funds may be debated in the public realm, and may be occasionally subjected to new rules and regulations, but it remains fairly unregulated compared to other investment types. Unless hedge funds are some day no longer considered private investments, there is no sign of this changing in a major way. The SEC does investigate allegations of insider trading and other fraudulent activities when it can, but it is not as involved with hedge funds as many would prefer.

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What are the regulations regarding hedge funds in the United States? - Joseph Healy

While the average person might hear the word “unregulated” tossed around in regards to hedge funds inside of the United States, this is technically untrue. Yes, hedge funds are considered private investments, and therefore investors and hedge fund managers (either as partnerships or as a company) do not have to register with the SEC (Securities and Exchanges Commission). However, there are some exceptions to that rule, and most importantly, hedge funds cannot legally be fully unregulated.

First of all, some of the multiple exceptions to hedge funds not being required to report information to the Securities and Exchanges Commission include:

•  Even though a fund can have unlimited investors, if they number more than four hundred and ninety-nine in total, they must register their securities with the SEC, according to the Securities Exchange Act of 1934.
•  If a hedge fund wants to advertise or make public offerings, they must sell said offerings under the private offerings rule of SEC. This requires either filing a registration statement with SEC, or adversely following the private placement rules under the Securities Act of 1933.
•  If a hedge fund adviser who is registered with the SEC wishes to charge a performance or an incentive fee, all investors must meet the standards for qualification set forth by the Investment Advisers Act of 1940 Rule 205–3.

As for other regulation that hedge funds are subjected to, compliance with the SEC is only the beginning. One of the most efficient ways to keep track of hedge funds, and to try and keep a handle on potential fraud, is to make stringent rules for investors. Investors must meet a specific set of criterion (and some of this will vary depending upon state) before they can begin to invest. For example, investors who meet a qualified purchaser qualification will have five million dollars as a bare minimum in investment assets. An investment company would need a minimum of twenty-five million dollars in order to qualify. 

Even though the regulations for hedge funds are quite lax compared to some other types of investments – and keep in mind this is because hedge funds are considered private investments – they are indeed regulated. Fraud is a very real possibility in any investment scenario, and when such large sums are dealt with in hedge funds, schemes and fraud can occur and must be prevented. There have been several high profile cases of hedge fund schemes in the news over the last several years, and that has drawn both media and public attention onto the fact that hedge funds have a very unique regulatory status. In fact, there have been several attempts (mostly by the Securities and Exchanges Commission) to bring more regulation to hedge funds, including a rule change that required all hedge fund advisers to register under the Investment Advisers Act. This rule change was subsequently contested, overturned, and sent back to the SEC for review. Some are eager to regulate hedge funds, and some continue to hotly contest the practice.

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Are there risks with hedge funds? - joe healey

There are many risks that go along with hedge fund investments. To begin with, hedge funds often deal with large investment amounts, and while profitable returns on those amounts are highly satisfactory, when there is investment loss, it can be significant. Another aspect to keep in mind with hedge fund risks is the fact that they are considered alternative investment products, which are typically known to be high risk. 

Skilled managers do their best to see big returns on the invested money. They may use a variety of methods when managing the hedge fund portfolio -- and this can include leveraging, which is another method that has a steep risk. Leveraging makes investors big profits very quickly, but on the other side of the coin, it can also lead to big losses. Remember that hedge funds are primarily illiquid, unregulated (though the company/money manager must adhere to all trading laws, and the majority of investors must meet specific requirements to open up a hedge fund, the hedge fund itself is not regulated), and may involve hedging against market downturns. While there is often potential to see profitable returns even when the market is unstable, there is still risk.

Another issue with hedge fund risks that should be addressed is transparency. As hedge funds are private investments, the money manager (either a partner or a company/team) is not required in many cases to disclose valuation information, important tax information, and even the underlying investments themselves. Some of this information will be released to the investor, yes – but not always when the investor would find it crucial. The investor may not even know what information is useful to them in determining how the money manager is doing; the money manager is the one with skill and knowledge, and the investor relies on them for their expertise. If the money manager does not disclose information, it may stop the investor from knowing exactly how precarious their investment is. Many investors who would receive the information, and also understand it, may want the manager to make changes, or may consider taking their business elsewhere. The money managers have autonomy to make decisions without much disclosure, and in some cases, this can have negative consequences.

Hedge fund investments can be volatile. There are ups and downs in the vast majority of these investments, and it is up to the money manager to make the majority of decisions without much input from the investor. Putting that much power into a company or a person’s hands comes with its own set of risks; people are not foolproof, not matter how skilled they appear to be. Then you add in how tumultuous the market can be, especially when it comes to commodity trading, global markets, and other unstable situations, all of which are common to hedge fund investments. Investors must trust in the money manager to make aggressive decisions as to the “health” of their hedge fund portfolio, and sometimes the money manager will not deliver satisfactory results. 

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How are hedge funds structured? - Joseph Healy

No one hedge fund is structured like any other. There are a number of factors that come into play, mostly having to do with what state (or even country) the hedge fund is located in, the hedge fund manager’s practices, policies, and specific skill set, and of course the amount of money in the fund itself. Furthermore, the diversity of the investments in the hedge fund changes the structure of the hedge fund as well; a typical, well-managed portfolio has more than one type of investment at a time. In a way, hedge fund investments can be “mixed and matched” in order to achieve the best results. Investment managers can use a risk parity strategy with one investment, and on another use fixed income arbitrage, for example.

Typically, a hedge fund is comprised of an investor (either an individual or a company), and the investor enters into a partnership with the hedge fund money manager – or (when there are multiple parties) else enters into a company with the manager. Once established, the hedge fund company will make investments; this is the hands-on part of the partnership or company. The investor virtually has no role in the investment process, and is not nearly as involved in the decision making, business practices part of the hedge fund.

Other people may provide services in a hedge fund as well. These may include a distributor, who primarily markets the funds to investors; a prime broker, who do the majority of the work with lending money and securities; and an administrator, who handles the withdrawals and subscriptions of investors. This is a very basic outline of what various people within the hedge fund may do, and every hedge fund is different. A hedge fund never has any employees or assets other than the investments within the fund itself.

The taxation and regulation of hedge funds varies greatly depending on the location of the fund itself. For example, hedge funds in America are considered very loosely regulated (they typically do not have to report to SEC, for one). A lot of hedge fund companies take advantage of tax opportunities by establishing the fund in an offshore financial center, so that the investor pays taxes on the portfolio, and it doesn’t come out of the fund itself. However, despite many hedge funds being technically located offshore, a lot of investment managers are located onshore.

Legally, hedge funds are usually formed as limited partnerships, or limited liability companies. The general partner is the investment/money manager, and the limited partner(s) is the investor themselves. Hedge funds are considered private investments and are not held up to the same amount of regulation that other investments are. While hedge funds are often referred to as “unregulated,” the fact is that there is some regulation that has to take place by law – it is simply different than regulation for other types of investment. An example of how hedge fund regulation functions is that investors are heavily scrutinized and must meet certain criteria before being approved.

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