How are hedge funds structured? - Joseph Healey Healthcor

No one hedge fund resembles another, and the name of the game in today’s world of hedge fund investments is diversity. There are any number of strategies used with hedge funds, and many different types of investments to boot (everything from regular stocks and bonds to internet start-ups and currency). Let us not forget that hedge funds located outside of the United States function very differently from those within it! However, there are a few things about the structure of most hedge funds that everyone should know.

·         Hedge funds are private partnerships (or companies) between investors and skilled money managers. Investors do not make the investment decisions regarding the hedge fund portfolio; that is left up to the money manager. There are no assets or employees within the hedge fund – aside from, of course, the investments themselves.

• There are other roles within the hedge fund aside from investor and manager. These may include: administrator, prime broker, and distributor.
•  Depending on where the hedge fund is located, its legal status (including regulations and taxes) may differ greatly. In America, hedge funds are considered private investments and are therefore unregulated (although in some ways that is a misconception; there is indeed regulation for all kinds of investments, including hedge funds. The major difference is that in most cases the SEC does not regulate hedge funds). In offshore locations, the investor is required to pay fees, rather than the money coming from the fund itself. Taxes on offshore hedge funds are also paid out by the investment manager, according to how much they receive for managing the hedge fund.
•  Location really is a huge key to how hedge funds work. While many hedge funds may be technically located offshore, the majority of popular hedge fund managers can be found on shore, near financial hubs.
•  Most hedge funds are designed to be open ended. This means that investors can withdraw their money periodically from the fund, and also add money as time progresses. There may be a requirement for a minimum balance, and of course a requirement to open a hedge fund, but there are typically no other restrictions set on the balance amount. (Frequent withdrawals from hedge funds are not encouraged, however.)
•  Before redemption of the hedge fund, usually profits are not distributed to investors. The profits from hedge funds are typically arranged to be withdrawn either monthly, quarterly, annually, or bi-annually. Individual hedge funds may have specific policies about when money can be withdrawn from the hedge fund.

This was a brief outline of how hedge funds are structured and work. The reality of hedge funds is that they are complicated, diverse investment portfolios. As mentioned above, no hedge fund truly resembles another, even if the specialization of the investment(s) is similar, or if the strategies used are similar. A hedge fund located in New York is going to be very different from one located in London, and even two hedge funds both located in New York are going to be nearly unrecognizable from each other.

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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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hedge funds joseph healey

Hedge fund trends - Healthcor Joseph Healy

Hedge fund trends tend to change over time – hence why they’re trends! Hedge funds themselves have a long and storied history of changing over time; think of the massive diversification into the internet with the Dot Com boom, and more recently, the newest regulations with the Dodd-Frank Act reshaping traditional hedge funds as we know them. Recent hedge fund trends are all over the map (and there is no guarantee that these trends will continue), but here is a small selection:

•  Hedge funds in the early part of 2012 have shown a move toward global markets. The fact that hedge funds have a very large global presence, and that there is virtually no limit to what kind of investments can be made inside of a hedge fund portfolio, means that now is the perfect time to invest in emerging global markets. 
• The uber rich have been careful with their assets lately, seemingly looking to protect themselves against margin calls and looming finance changes. Many hedge funds have taken their assets out of funds in the form of cash. Hedge fund portfolios are still going strong, though, with 2012 seeing the best performance in the beginning of a year since 2006.
• Managed futures are up, as are global macros!
• Larger funds are seeing larger inflows. Small funds are still mostly experiencing redemption, but not the kind of net inflows that larger funds are seeing. The number stands as funds with more than one billion dollars in assets receiving 78% of inflows.
• Hedge funds that beat their ‘peers’ in 2011 had similar results in 2012 – at least thus far. 57% of those peer-beating funds saw net inflows in the first quarter.
• The trend did seem to be that those hedge funds which saw positive results in 2011 continued to do so into 2012. The majority of large hedge funds saw net inflows in the first quarter of 2012, where 63% of mid-size funds with positive performance in 2011 saw net inflows into 2012.
• There was a marked trend of investors who discovered their investments had under-performed shifting out of them and heading for seemingly greener pastures. This is usually the case (no investor typically has the patience to “hang around” an under performing fund), but the numbers were higher in the first quarter of 2012.

One of the biggest changes of 2011, leading into 2012, is the continued implementation of the government’s insider trading charges and other legal actions. Some funds have closed, many managers are under investigation, and some funds are doing poorly in general due to the continued investigation and allegations. While it is true that some funds have had a rough year so far, a good portion of funds are seeing decent to good profits on their invested assets. It remains to be seen if these positive trends 

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hedge fund joe healey

Hedge fund indices - Healthcor Joe Healey

Like many other types of investments, hedge funds have indices that track the industry. There are some differences between hedge fund indices and more traditional investment indices, as hedge funds are considered private investments, and more than that, they are mostly all illiquid. This poses some issues with the reliability indices; how comprehensive, and thus satisfactory, are they, really? This is part of why several different methods of hedge fund indexing have been created over the years.

Regardless of whether or not hedge fund indices are fully satisfactory, there is no question that they exist, and that people use them. There are generally three types of hedge fund indices, and these include:

•   Non-investable indices – Using a hedge fund database from which to measure performance, non-investable indices are the oldest type of hedge fund indices used. The databases use weighted mean, medium, and mean in order to measure performance. No one database will represent all funds, which means that no one database is the same as another; every single performance result will be different. This is an issue that some have with the reliability of non-investable indices. Another issue that some have with them is that they are subject to a lot of bias. For one, database reporting is voluntary, which in some cases may lead to self-selection bias. Additionally, hedge funds may come and go (fail and succeed, if you will) annually, which changes the database selection significantly every year.
• Investable indices –the main goal of an investable index is to eradicate some of the bias and issues raised with using a non-investable index. The main method it does this is by making the index return available to all shareholders. In an investable index, the index provider/manager will select certain funds to develop something somewhat like a “fund of hedge funds” portfolio. The investments created by the index provider must be accepted by any hedge funds, in order to be properly investable.
•  Hedge fund replication – this is more of a statistical look at how hedge funds have performed, analyzing past returns in order to make models of how hedge funds will perform under various circumstances with different assets. The model(s) can be used to make an actual portfolio of assets, and thus makes the index investable. Of the three types of hedge fund indices mentioned here, hedge fund replication is probably the newest. One of the pitfalls that goes along with this index form being so new is that there is very little history or data to support its usefulness in practice – especially when one considers the private, rarely disclosed nature of hedge funds themselves.

This is essentially the beginning of what hedge fund indices entail. They are meant to give investors – and the financial market as a whole – a view of what average returns on hedge funds are, and how they change throughout time. Even though there is some question as to the reliability of hedge fund indices, given that most of the data found within is self-disclosed and therefore very limited, they are popular and continue to grow.

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hedge funds joe healy - What are the regulations regarding hedge funds in other countries besides the U.S.?

Regulation of hedge funds does differ when taken outside of the boundaries of the United States. However, much of the regulation on hedge funds throughout the world does resemble the regulation in the US. In Europe, for example, the primary method is to regulate the financial advisors/managers of the funds. The managers are required to register with the FSA (the Financial Services Authority). Within the European Union, there have been some differences with regulation between different countries, but the hard and fast rule is that EU fund managers are required to register.

Recently, something called the Directive on Alternative Investment Fund Managers, or AIFMD, was passed by the EU to better monitor the activities of hedge fund managers. Countries within the EU are required to adopt the practices of AIFMD by 2013. It is quite an undertaking for every hedge fund manager within the European Countries to comply with the regulations in AIFMD, but AIFMD has made certain allowances to make the transition easier. For example, they have introduced a sort of passport that enables any hedge funds authorized in a country in the EU to operate throughout the entire EU.

Obviously Europe is not the only place aside from the United States that participates in hedge fund activities. An incredibly popular option for those abroad, and even for a portion of American citizens, is to run the hedge funds through offshore locations. This includes Bermuda, the British Islands, Dublin, the Cayman Islands, and many more locations.Any hedge fund that is run through an offshore location has to comply with the individual regulations there. Offshore hedge funds are quite different from other types of hedge funds; one example of this difference is the fact that the funds are valued as net asset value (NAV), not as account balances as with domestic funds.

In South Africa, registration with and approval from the Financial Services Board (FSB) is required for hedge fund managers. Also in South Africa, much emphasis is placed on local investment rather than international. In Singapore, hedge funds are less regulated and have fewer licensing requirements than other Asian hedge fund “hot spots,” such as Hong Kong. Singapore is a popular hedge fund location for this reason.

Recently, the Dodd-Frank Act was passed in the United States. This act has wide reaching implications and may change the nature of hedge funds throughout the world. Those international hedge funds that have more than twenty-five million dollars with fifteen or more American managers or investors must register with SEC. Managers who are registered with SEC are also required to file and keep information about managed assets up to date with the SEC as well.

This is only the beginning of overseas regulation for hedge funds. However, it illustrates that there is still a focus on regulating investment managers rather than the investments themselves. Hedge funds are popular globally, and there is a good amount of cross over investment from countries with financial hubs. Some seek to take advantage of the opportunities presented by offshore accounts, but new regulation may be changing some of that activity.

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healthcor joe healey

Controversies and debates about hedge funds - Joseph Healy

There are several debates and controversies on the subject of hedge funds. A good deal of the debate has to do with the fact that there is supposedly systemic risk when dealing with hedge funds. Also, a good deal of attention is paid to the fact that there is very little transparency required with hedge funds, as they are considered private investments, and have limited regulation compared to other types of investments.

Critics of hedge funds have claimed that the nature of these high risk investments could lead to a domino effect in the financial sector with catastrophic results. Systemic risk refers to the collapse of the entire financial system, and so it may be difficult for some to picture one failed hedge fund or failed hedge fund company bringing the entire system down. However, people who feel that – if such a failure should happen, and it should be noted that failure has happened on scales both big and small – a major failure could occur with one hedge fund, and be seen in hedge funds that are similar. Many pro-hedge fund people debate this claim of systemic risk, because failure has already occurred in many hedge funds, and the result was that the financial system was nowhere near systemic failure. When a hedge fund does fail, they are typically leveraged low and the market as a whole can weather the failure fairly easily. In fact, dozens of hedge funds failed during the financial crisis – and there was still not systemic failure.

The other major issue that is up for debate is transparency. The lack of disclosure that is required regarding hedge funds is deeply troubling to some people, who argue that this atmosphere of secrecy can perpetuate fraud. In many cases, the investors themselves have very limited information on what the hedge fund managers are actually doing. An example of issues with transparency would be that many American hedge funds do not rely on third parties to perform crucial tasks, such as administration or acting as custodian of assets, and this has been shown to lead to conflict of interest, and in some cases even fraud. There have been several high profile arrests made of people who have engaged in fraudulent behaviors or schemes with regards to running hedge funds.

Another issue regarding hedge funds is the fact that it is extremely difficult to track performance statistics. Between the fact that the majority of hedge funds were not required to submit performance findings, and the fact that there is a restriction against public advertisement and offerings (leading to a reticence or outright refusal of fund managers to willingly put the performance information out to the public), it is incredibly difficult to comprehensively study how hedge funds perform on average. Individual funds can be studied, but many remain a relative mystery.

These are just some of the controversies and debates surrounding hedge funds. Hedge funds are a subject of some scrutiny after the financial crisis of recent years. The SEC, for example, is scrutinizing the possibility of insider trading within hedge funds; it remains to be seen, but there is always a chance that regulation will be strengthened for hedge funds.

healthcor joe healy

healthcor joseph healy