Hedge Funds

HEDGE FUNDS

INDEX1

Hedge Funds

Sr. No. Content Page No.

01 Introduction 3

02 Selected Definitions Of "Hedge Fund" 4

03 Key Characteristics Of Hedge Funds 5

04 Facts About The Hedge Fund Industry 6

05 The Growth Of Hedge Funds 7

06 Notable Hedge Fund Management Companies 10

07 Why Hedge Funds Are Attractive? 10

08 Information Should Investor Seek Before Investing In A

Hedge Fund Or A Fund Of Hedge Funds?

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09 Hedging Strategies 14

10 Benefits Of Hedge Funds 14

11 Hedge Fund Styles 15

12 Advantages Of Hedge Funds Over Mutual Funds 18

13 Impact Of Hedge Funds On Capital Market 19

14 Role Of Hedge Funds In The Capital Markets 20

15 Investor Protection 22

16 The Federal Reserve And Hedge Funds 23

17 Bibliography 29

INTRODUCTION2

Hedge Funds

The term 'hedge fund' is used to describe a wide variety of institutional investors

employing a diverse set of investment strategies. Although there is no formal definition of

'hedge fund,' hedge funds are largely defined by what they are not and by the regulations to

which they are not subject. As a general matter, the term 'hedge fund' refers to

unregistered, private investment partnerships for wealthy sophisticated investors (both

natural persons and institutions) that use some form of leverage to carry out their

investment strategies.

The term 'hedge fund' is undefined, including in the federal securities laws. Indeed,

there is no commonly accepted universal meaning. As hedge funds have gained stature and

prominence, though, 'hedge fund' has developed into a catch-all classification for many

unregistered privately managed pools of capital. These pools of capital may or may not

utilize the sophisticated hedging and arbitrage strategies that traditional hedge funds

employ, and many appear to engage in relatively simple equity strategies. Basically, many

'hedge funds' are not actually hedged, and the term has become a misnomer in many cases.

Hedge funds engage in a variety of investment activities. They cater to sophisticated

investors and are not subject to the regulations that apply to mutual funds geared toward

the general public. Fund managers are compensated on the basis of performance rather

than as a fixed percentage of assets. 'Performance funds' would be a more accurate

description.

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Hedge Funds

SELECTED DEFINITIONS OF "HEDGE FUND"

"Hedge fund" is an expression believed to have been first applied in 1949 to a fund managed

by Alfred Winslow Jones.1 Mr. Jones's private investment fund combined both long and short

equity positions to "hedge" the portfolio's exposure to movements in the market. Today,

hedge funds are no longer defined by a particular strategy and often do not "hedge" in the

economic sense. The following is a selection of definitions and descriptions of the term

"hedge fund" showing the diversity of views among commentators.

"The term 'hedge fund' is commonly used to describe a variety of different types of

investment vehicles that share some common characteristics. Although it is not statutorily

defined, the term encompasses any pooled investment vehicle that is privately organized,

administered by professional money managers, and not widely available to the public."

--THE PRESIDENT'S WORKING GROUP ON FINANCIAL

MARKETS, HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF

LONG-TERM CAPITAL MANAGEMENT 1 (1999).

"The term 'hedge fund' refers generally to a privately offered investment vehicle that pools

the contributions of its investors in order to invest in a variety of asset classes, such as

securities, futures contracts, options, bonds, and currencies."

--THE SECRETARY OF THE TREASURY, THE BOARD OF

GOVERNORS OF THE FEDERAL RESERVE SYSTEM, THE

SECURITIES AND EXCHANGE COMMISSION, A REPORT TO

CONGRESS IN ACCORDANCE WITH § 356(c) OF THE USA

PATRIOT ACT OF 2001 (2002).

"A hedge fund can be broadly defined as a privately offered fund that is administered by a

professional investment management firm (or 'hedge fund manager'). The word 'hedge'

refers to a hedge fund's ability to hedge the value of the assets it holds (e.g., through the use

of options or the simultaneous use of long positions and short sales). However, some hedge

funds engage only in 'buy and hold' strategies or other strategies that do not involve hedging

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Hedge Funds

in the traditional sense. In fact, the term 'hedge fund' is used to refer to funds engaging in

over 25 different types of investment strategies .…"

--MANAGED FUNDS ASSOCIATION, HEDGE FUND

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 best brains in the investment

business. In addition, hedge fund managers usually have their own money invested

in their fund.

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Hedge Funds

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.

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.

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Hedge Funds

THE GROWTH OF HEDGE FUNDS

In the entire financial services area, the sector showing the most growth is clearly the area

of hedge funds. While brokerage commissions continue to decline, investment banking fees

start to come under pressure and the entire financial services industry worries about

intensified regulatory scrutiny, the hedge fund industry with its rapid growth stands out

from the crowd. New funds are starting up every week and many are beginning with an

excess of a billion dollars under management from day one. The amount of money under

management with hedge funds has gone up four times between 1996 and 2004 and is

expected to further triple between now and 2010 to over $2.7 trillion. Public funds,

endowments, and corporate sponsors have all increased their allocations to hedge funds

within the context of an increased allocation towards alternative investments more

generally. This move towards increased investments in real estate/private equity/hedge

funds (alternative investments) is driven by the need for a higher return to compensate for

the expected lower returns from more conventional investment strategies focused on US

bonds and equities. There is also a clear desire among this investor base to be more focused

on absolute-return strategies rather than relative return. Given the current level of

allocations most of these large long-term investors have towards alternative investments,

and their professed long-term target allocation, the flow of funds to these asset classes will

remain strong.

One of the intriguing developments in the hedge fund world is the clear desire and

ability of the newer funds to charge higher fees and impose more stringent terms on

investors. No longer are funds charging a 1 per cent management fee and 20 per cent of

profits -- the norm for the first generation of funds set up in the early to mid 1990s. As per

an interesting study done by Morgan Stanley's prime brokerage unit, about a third of the

funds opening in the past six months are charging a 2 per cent management fee and 20 per

cent of profits or higher, while the majority are charging a 1.5 per cent management fee and

20 per cent of profits. Many of the new funds have more stringent lock-ups and stiff

penalties if you redeem early, as well as modified high-water marks.

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Hedge Funds

The hedge fund business thus seems to have the unique characteristic of being

possibly the only business that I know of wherein new players (most of whom are unproven)

have the ability to charge more and get better terms than the established operators. This

implies a negative franchise value for the established large fund complexes which have

survived and prospered through the years. Given that most of the best hedge fund

complexes are closed to new investors, the new guys seem to be taking advantage of the

huge demand-supply mismatch for quality money managers. There is a feeding frenzy

currently under way in the world of alternative investments and clients are paying up the

higher fees for fear of being locked out from these funds at a later date, if they actually

survive and grow.

One reason why the new boys are focusing more on fees and lock-ups could be the difficulty

all hedge funds are having in generating adequate alpha (excess return) to ensure an

adequate payout for themselves.

In a study done by Morgan Stanley on the excess returns generated by hedge funds

over the last decade, this trend of declining returns was very apparent. In the study they

defined excess returns as the return of the Hedge Fund research composite over one month

LIBOR (a proxy for cash returns).

In the 1995-97 period, excess returns were 14 per cent; these returns have

consistently declined dropping to as low as 5 per cent in 2001-03 and have dropped further

since.

The current huge inflows into funds focused on emerging markets make sense if you

look at performance numbers over the past three years.

Hedge funds focused on the emerging markets had the best returns with an 18 per

cent annual return during 2001-04, closely followed by distressed debt focused funds at 17

per cent. More conventional hedge fund strategies of tech at 0 per cent and risk arbitrage at

3 per cent annual return lagged far behind. Given the constant inflows into new hedge

funds, clients do not yet seem to be bothered about paying higher and higher fees for lower

returns, but this is a discussion that I am sure will come up at some stage in most

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investment committees. At some stage if the hedge fund community continues to show

declining alpha (excess returns), clients will need to question whether the proliferation of

hedgies has reduced returns because the field has become too competitive.

The beauty of the hedge fund business and the reason why the upward drift in fee

structure is even more surprising is the ease of entry of new players into the game. The

average long short hedge fund needs only about six back office staff per billion dollars, while

a global macro fund needs about 11 people for a fund of similar size (Morgan Stanley

survey). The typical long short US equity manager has only nine investment professionals

and three in the back office. These funds are also not really regulated and have very limited

disclosure requirements, if any. The start-up costs of these vehicles are also minimal and

most funds will be able to break even at sub $100 million in assets under management.

There is no other industry that I am aware of where exit and entry are as simple.

Hedge funds till date in 2005 have had a tough year; there have been few strong

trends to capitalise on and most funds are struggling to show a positive return. If the hedge

fund industry ends the year flat or even (god forbid) negative after disappointing relative

performance in 2003 and just about average numbers in 2004, some of the more

sophisticated clients may migrate back to more conventional forms of investing with lower

fee structures. Hedge funds are clearly here to stay, and continue to attract the best talent

because of their payout structures; however, their ability to continue to command a

premium fee structure will eventually be limited by their ability to differentiate themselves

from their long-only brethren on the performance front.

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Hedge Funds

NOTABLE HEDGE FUND MANAGEMENT COMPANIES

Sometimes also known as alternative investment management companies.

• Amaranth Advisors

• Bridgewater Associates

• Caxton Associates

• Centaurus Energy

• Citadel Investment Group

• D. E. Shaw & Co.

• Fortress Investment Group

• Goldman Sachs Asset Management

• Long Term Capital Management

• Man Group

• Pirate Capital LLC

• Renaissance Technologies

• SAC Capital Advisors

• Soros Fund Management

• Marshall Wace

WHY HEDGE FUNDS ARE ATTRACTIVE?

There are a large number of investment vehicles that offer you good and stable returns.

Products like diversified mutual funds, blue chip stocks and property are some of them. But

for high net worth individuals (HNIs), there are more routes, especially in the international

markets. Here we look at one such vehicle, namely hedge funds. A hedge fund is a common

term used to describe private unregistered investment partnerships. Since most of them are

not registered with financial regulators in their countries of origin, they do not need to meet

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the eligibility requirements to register as institutional investors. This is good in a way but

could turn sour as well because there are no guidelines binding them. At present, there are

no hedge funds operating out of India. But internationally, there are a large number of such

funds.

These funds are very manager-centric as the entire onus of their success or failure falls on

the fund manager's ability to exploit existing market conditions. No wonder then that they

charge a fixed fee of around 2 per cent a year of assets under management, along with a

very high profit sharing percentage, which is mostly 20 per cent. Of course, they have to

assure returns as well. Thus, profit sharing may start on the returns over and above say, the

first 10 per cent returns. The fee is also based on a high watermarking concept, which

means that the fund manager is entitled to a share of profits the first time. Thereafter, if the

fund incurs losses and then recoups, the fund manager will not be entitled to any share of

the recouped losses. The next time he will be entitled is when he beats his earlier

performance.

However, given the plethora of opportunities worldwide, the fund manager has the luxury

of making investment decisions in stocks, bonds, commodities, currencies etc. The basic

idea is to generate aggressive returns. The most important feature of hedge funds is that

they seek to deliver absolute, rather than benchmarked returns. For example, equity mutual

funds are benchmarked against an index like the Nifty or BSE 200, or a banking sector

mutual fund could benchmark its returns against the banking index on a stock exchange and

can show the investors how much better/worse he has performed. However, hedge funds

managers do not have any such luxuries.

Since they are not regulated, most countries do not allow them to raise money from the

general public through a prospectus or advertisements. A few are registered with the

regulators in their countries because their main investors are universities, pension funds and

insurance companies.

Most of the marketing is done through investment advisors or personal contacts, with their

main investors being restricted to sophisticated HNIs. With the Reserve Bank of India [Get

Quote] (RBI) allowing Indian residents to invest up to $200,000 abroad per head a year, it is

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another opportunity for HNIs to tap these funds as the minimum limit of many of them start

from $100,000. But you need to remember that the amount invested is not very liquid and

may be subject to a lock-in period, with quarterly, half-yearly or yearly exit windows.

Those seeking to invest in hedge funds can approach a wealth manager, securities broker or

investment consultant abroad, who can advise them on the available options and select the

hedge fund they wish to invest in, based on its track record and management style. After

that they can approach their bank in India to arrange for the foreign remittance to the

hedge fund. Whenever they wish to redeem their investment, as permitted by the hedge

fund, they can repatriate the proceeds to India into their bank account.

WHAT INFORMATION SHOULD INVESTOR SEEK

BEFORE INVESTING IN A HEDGE FUND OR A FUND OF

HEDGE FUNDS?

Read a fund's prospectus or offering memorandum and related materials. Make

sure you understand the level of risk involved in the fund's investment strategies and

ensure that they are suitable to your personal investing goals, time horizons, and risk

tolerance. As with any investment, the higher the potential returns, the higher the

risks you must assume.

Understand how a fund's assets are valued. Funds of hedge funds and hedge funds

may invest in highly illiquid securities that may be difficult to value. Moreover, many

hedge funds give themselves significant discretion in valuing securities. You should

understand a fund's valuation process and know the extent to which a fund's

securities are valued by independent sources

Ask questions about fees. Fees impact your return on investment. Hedge funds

typically charge an asset management fee of 1-2% of assets, plus a "performance

fee" of 20% of a hedge fund's profits. A performance fee could motivate a hedge

fund manager to take greater risks in the hope of generating a larger return. Funds

of hedge funds typically charge a fee for managing your assets, and some may also

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include a performance fee based on profits. These fees are charged in addition to

any fees paid to the underlying hedge funds.

Understand any limitations on your right to redeem your shares. Hedge funds

typically limit opportunities to redeem, or cash in, your shares (e.g., to four times a

year), and often impose a "lock-up" period of one year or more, during which you

cannot cash in your shares.

Research the backgrounds of hedge fund managers. Know with whom you are

investing. Make sure hedge fund managers are qualified to manage your money, and

find out whether they have a disciplinary history within the securities industry. You

can get this information (and more) by reviewing the adviser’s Form ADV. You can

search for and view a firm’s Form ADV using the SEC’s Investment Adviser Public

Disclosure (IAPD) website. You also can get copies of Form ADV for individual

advisers and firms from the investment adviser, the SEC’s Public Reference Room, or

(for advisers with less than $25 million in assets under management) the state

securities regulator where the adviser's principal place of business is located. If you

don’t find the investment adviser firm in the SEC’s IAPD database, be sure to call

your state securities regulator or search the NASD's Broker Check database for any

information they may have.

Don't be afraid to ask questions. You are entrusting your money to someone else.

You should know where your money is going, who is managing it, how it is being

invested, how you can get it back, what protections are placed on your investment

and what your rights are as an investor. In addition, you may wish to read NASD’s

investor alert, which describes some of the high costs and risks of investing in funds

of hedge funds.

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Hedge Funds

HEDGING STRATEGIES

Wide ranges of hedging strategies are available to hedge funds. For example:

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 -

for example, can be long convertible bonds and short the underlying issuer’s equity.

Trading options or derivatives - contracts whose values are based on the

performance of any underlying financial asset, index or other investment.

Investing in anticipation of a specific event - merger transaction, hostile takeover,

spin-off, exiting of bankruptcy proceedings, etc.

Investing in deeply discounted securities - of companies about to enter or exit

financial distress or bankruptcy, often below liquidation value.

Many of the strategies used by hedge funds benefit from being non-correlated to the

direction of equity markets

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 Funds

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

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

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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 issuers 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

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

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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

Short Selling: Sells securities short in anticipation of being able to rebuy 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 under followed 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

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ADVANTAGES OF HEDGE FUNDS OVER 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 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 shares 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.

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IMPACT OF HEDGE FUNDS ON CAPITAL MARKET

The hedge fund universe is expanding rapidly, with more than 7,300 funds managing some

$1.7 trillion in assets by mid-2007. The three largest hedge funds each manages at least $30

billion in investors' assets, and have estimated investment positions in financial markets of

up to $100 billion. MGI projects that the value of hedge fund assets under management will

more than double over the next five years to $3.5 trillion.

Hedge funds have benefited capital markets by increasing liquidity and spurring financial

innovations. Yet worries persist that their growing size and heavy use of borrowing could

destabilize financial markets. When Long Term Capital Management ran into trouble in

1998, the fund's catastrophic losses prompted the Federal Reserve to coordinate a $3.6

billion rescue by a group of large banks.

More recently, several multibillion-dollar hedge funds suffered big losses in mid-2007 as

rising defaults on subprime mortgages caused turmoil in the debt and equity markets. Some

smaller and midsize funds shut down. So the question arises again: could a hedge fund

meltdown trigger a broader financial-market crisis?

MGI's research suggests that several developments over the past decade may have reduced

—but certainly not eliminated—the risks. Hedge funds have adopted more diverse trading

strategies, reducing the likelihood that many would fail simultaneously. The banks that lend

to hedge funds have improved their assessment and monitoring of risk, and they have

reasonable financial cushions—collateral and equity—to protect them in case one or more

of their hedge fund clients were to fail (as we saw last summer). The largest hedge funds

have begun to raise permanent capital in public stock and bond markets, while imposing

more restrictions on investor withdrawals—changes that should improve their ability to

weather market downturns. Once financial-market mavericks, hedge funds are joining the

mainstream.

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ROLE OF HEDGE FUNDS IN THE CAPITAL MARKETS

The role that hedge funds are playing in capital markets cannot be quantified with any

precision. A fundamental problem is that the definition of a hedge fund is imprecise, and

distinctions between hedge funds and other types of funds are increasingly arbitrary. Hedge

funds often are characterized as unregulated private funds that can take on significant

leverage and employ complex trading strategies using derivatives or other new financial

instruments. Private equity funds are usually not considered hedge funds, yet they are

typically unregulated and often leverage significantly the companies in which they invest.

Likewise, traditional asset managers more and more are using derivatives or are investing in

structured securities that allow them to take on leverage or establish short positions.

Although several databases on hedge funds are compiled by private vendors, they cover

only the hedge funds that voluntarily provide data. Consequently, the data are not

comprehensive. Furthermore, because the funds that choose to report may not be

representative of the total population of hedge funds, generalizations based on these

databases may be misleading. Data collected by the Securities and Exchange Commission

(SEC) from registered advisers to hedge funds are not comprehensive either. The primary

purpose of registration is to protect investors by discouraging hedge fund fraud. The SEC

does not require an adviser to a hedge fund, regardless of how large it is, to register if the

fund does not permit investors to redeem their interests within two years of purchasing

them. While registration of advisers of such funds may well be unnecessary to discourage

fraud, the exclusion from the database of funds with long lock-up periods makes the data

less useful for quantifying the role that hedge funds are playing in the capital markets.

Even if a fund is included in a private database or its adviser is registered with the SEC, the

information available is quite limited. The only quantitative information that the SEC

currently collects is total assets under management. Private databases typically provide

assets under management as well as some limited information on how the assets are

allocated among investment strategies, but they do not provide detailed balance sheets.

Some databases provide information on funds’ use of leverage, but their definition of

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leverage is often unclear. As hedge funds and other market participants increasingly use

financial products such as derivatives and securitized assets that embed leverage,

conventional measures of leverage have become much less useful. More meaningful

economic measures of leverage are complex and highly sensitive to assumptions about the

liquidity of the markets in which financial instruments can be sold or hedged.

Although the role of hedge funds in the capital markets cannot be precisely quantified, the

growing importance of that role is clear. Total assets under management are usually

reported to exceed $1 trillion. Furthermore, hedge funds can leverage those assets through

borrowing money and through their use of derivatives, short positions, and structured

securities. Their market impact is further magnified by the extremely active trading of some

hedge funds. The trading volumes of these funds reportedly account for significant shares of

total trading volumes in some segments of fixed income, equity, and derivatives markets.

In various capital markets, hedge funds clearly are increasingly consequential as providers of

liquidity and absorbers of risk. For example, a study of the markets in U.S. dollar interest

rate options indicated that participants viewed hedge funds as a significant stabilizing force.

In particular, when the options and other fixed income markets were under stress in the

summer of 2003, the willingness of hedge funds to sell options following a spike in options

prices helped restore market liquidity and limit losses to derivatives dealers and investors in

fixed-rate mortgages and mortgage-backed securities. Hedge funds reportedly are

significant buyers of the riskier equity and subordinated tranches of collateralized debt

obligations (CDOs) and of asset-backed securities, including securities backed by

nonconforming residential mortgages.

At the same time, however, the growing role of hedge funds has given rise to public policy

concerns. These include concerns about whether hedge fund investors can protect

themselves adequately from the risks associated with such investments, whether hedge

fund leverage is being constrained effectively, and what potential risks the funds pose to the

financial system if their leverage becomes excessive.

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INVESTOR PROTECTION

Hedge funds and their investment advisers historically were exempt from most provisions of

the federal securities laws. Those laws effectively allow only institutions and relatively

wealthy individuals to invest in hedge funds. Such investors arguably are in a position to

protect themselves from the risks associated with hedge funds. However, in recent years

hedge funds reportedly have been marketed increasingly to a less wealthy clientele.

Furthermore, pension funds, many of whose beneficiaries are not wealthy, have increased

investments in hedge funds.

Concerns about the potential direct and indirect exposures of less wealthy investors from

hedge fund investments and hedge fund fraud contributed to the SEC’s decision in

December 2004 to require many advisers to hedge funds that are offered to U.S. investors

to register with the commission.

The SEC believes that the examination of registered hedge fund advisers will deter fraud.

But fraud is very difficult to uncover, even through on-site examinations. Therefore, it is

critical that investors do not view the SEC registration of advisers as an effective substitute

for their own due diligence in selecting funds and their own monitoring of hedge fund

performance. Most institutional investors probably understand this well. In a survey several

years ago of U.S. endowments and foundations, 70 percent of the respondents said that a

hedge fund adviser’s registration or lack of registration with the SEC had no effect on their

decision about whether or not to invest because the institutions conducted their own due

diligence.

In the case of pension funds, sponsors and pension fund regulators should ensure that

pension funds conduct appropriate due diligence with respect to all their investments, not

just their investments in hedge funds. Pension funds and other institutional investors seem

to have a growing appetite for a variety of alternatives to holding stocks and bonds,

including real estate, private equity and commodities, and investments in hedge funds are

only one means of gaining exposures to those alternative assets. The registration of hedge

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fund advisers simply cannot protect pension fund beneficiaries from the failures of plan

sponsors to carry out their fiduciary responsibilities.

As for individual investors, the income and wealth criteria that define eligible investors in

hedge funds unavoidably are a crude test for sophistication. If individuals with relatively

little wealth increasingly become the victims of hedge fund fraud, it may become

appropriate to tighten the criteria for an individual to be considered an eligible investor.

THE FEDERAL RESERVE AND HEDGE FUNDS

The President’s Working Group made a series of recommendations for improving market

discipline on hedge funds. These included recommendations for improvements in credit risk

management practices by the banks and securities firms that are hedge funds’

counterparties and creditors and improvements in supervisory oversight of those banks and

securities firms. As a regulator of banks and bank holding companies, the Federal Reserve

has worked with other domestic and international regulators to implement the necessary

improvements in supervisory oversight. Regulatory cooperation is essential in this area

because hedge funds’ principal creditors and counterparties include foreign banks as well as

U.S. banks and securities firms.

In January 1999, the Basel Committee on Banking Supervision (BCBS) published a set of

recommendations for sound practices for managing counterparty credit risks to hedge funds

and other highly leveraged institutions. Around the same time, the Federal Reserve, the SEC,

and the Treasury Department encouraged a group of twelve major banks and securities

firms to form a Counterparty Risk Management Policy Group (CRMPG), which in July 1999

issued its own complementary recommendations for improving counterparty risk

management practices.

The BCBS sound practices have been incorporated into Federal Reserve supervisory

guidance and examination procedures applicable to banks’ capital market activities. In

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general terms, routine supervisory reviews of counterparty risk management practices with

respect to hedge funds and other counterparties seek to ensure that banks

(1) perform appropriate due diligence in assessing the business, risk exposures, and credit

standing of their counterparties; (2) establish, monitor, and enforce appropriate

quantitative risk exposure limits for each of their counterparties; (3) use appropriate

systems to measure and manage counterparty credit risk; and (4) deploy appropriate

internal controls to ensure the integrity of their processes for managing counterparty credit

risk. Besides conducting routine reviews and continually monitoring counterparty credit

exposures, the Federal Reserve periodically performs targeted reviews of the credit risk

management practices of banks that are major hedge fund counterparties. These targeted

reviews examine in depth the banks’ practices against the BCBS and Federal Reserve sound

practices guidance and the CRMPG recommendations.

According to supervisors and most market participants, counterparty risk management has

improved significantly since the LTCM episode in 1998. However, since that time, hedge

funds have greatly expanded their activities and strategies in an environment of intense

competition for hedge fund business among banks and securities firms. Furthermore, some

hedge funds are among the most active investors in new, more-complex structured financial

products, for which valuation and risk measurement are challenging both to the funds

themselves and to their counterparties. Counterparties and supervisors need to ensure that

competitive pressures do not result in any significant weakening of counterparty risk

management and that risk management practices are evolving as necessary to address the

increasing complexity of the financial instruments used by hedge funds.

The Federal Reserve has also sought to limit hedge funds’ potential to be a source of

systemic risk by ensuring that the clearing and settlement infrastructure that supports the

markets in which the funds trade is robust. Very active trading by hedge funds has

contributed significantly to the extraordinary growth in the past several years of the

markets for credit derivatives. A July 2005 report by a new Counterparty Risk Management

Policy Group (CRMPG II) called attention to the fact that the clearing and settlement

infrastructure for credit derivatives (and over-the-counter derivatives generally) had not

kept pace with the volume of trading. In particular, a backlog of unsigned trade

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Hedge Funds

confirmations was growing, and the acceptance by dealers of assignments of trades by one

counterparty without the prior consent of the other, despite trade documentation

requirements for such consent, was becoming widespread.

To address these and other concerns about the clearing and settlement of credit derivatives,

in September 2005 the Federal Reserve Bank of New York brought together fourteen major

U.S. and foreign derivatives dealers and their supervisors. The supervisors collectively made

clear their concerns about the risks created by the infrastructure weaknesses and asked the

dealers to develop plans to address those concerns. With supervisors providing common

incentives for the collective actions that were necessary, the dealers have made remarkable

progress since last September. The practice of unauthorized assignments has almost ceased,

and dealers are now expeditiously responding to requests for the authorization of

assignments. For the fourteen dealers as a group, total credit derivative confirmations

outstanding for more than thirty days fell 70 percent between September 2005 and March

2006. The reduction in outstanding confirmations was made possible in part by more

widespread and intensive use of an electronic confirmation-processing system operated by

the Depository Trust and Clearing Corporation (DTCC). The dealers have worked with their

largest and most active clients, most of which are hedge funds, to ensure that they can

electronically confirm trades in credit derivatives. By March 2006, 69 percent of the

fourteen dealers’ credit derivatives trades were being confirmed electronically, up from 47

percent last September.

Supervisors and market participants agree that further progress is needed, and in March the

fourteen dealers committed themselves to achieving by October 31, 2006, a “steady state”

position for the industry. The steady state will involve (1) the creation of a largely electronic

marketplace in which all trades that can be processed electronically will be; (2) the creation

by DTCC of an industry trade information warehouse and support infrastructure to

standardize and automate processing of events throughout each contract’s life; (3) new

processing standards for those trades that cannot be confirmed electronically; and (4) the

creation of an automated platform to support notifications and consents with respect to

trade assignments. The principal trade association for the hedge fund industry has stated its

support for plans embodied in the dealers’ commitments.

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Hedge Funds

Hedge funds clearly are becoming more important in the capital markets as sources of

liquidity and holders and managers of risk. But as their importance has grown, so too have

concerns about investor protection and systemic risk. The SEC believes that the examination

of registered hedge advisers will deter fraud. But investors must not view SEC regulation of

advisers as an effective substitute for their own due diligence in selecting funds and their

own monitoring of hedge fund performance.

After the LTCM episode, the President’s Working Group on Financial Markets considered

how best to address concerns about potential systemic risks from excessive hedge fund

leverage. The Working Group concluded that hedge funds’ leverage could be constrained

most effectively by promoting measures that enhance market discipline by improving credit

risk management by funds’ counterparties and creditors, nearly all of which are regulated

banks and securities firms. The Working Group considered the alternative of direct

government regulation of hedge funds but concluded that it would be more costly and

would be less effective than an approach focused on strengthening market discipline.

The Federal Reserve has been seeking to ensure appropriate market discipline on hedge

funds by working with other regulators to promote effective counterparty risk management

by hedge funds’ counterparties and creditors. It has also sought to limit the potential for

hedge funds to be a source of systemic risk by ensuring that the clearing and settlement

infrastructure that supports the markets in which they trade is robust.

1. Examples of hedge fund databases include Trading Advisors Selection System (TASS),

Centre for International Securities and Derivatives Markets (CISDM) Hedge Fund Database,

and Hedge Fund Research Database.

2. The commission decided not to require such funds to register because it had not

encountered significant problems with fraud at private equity or venture capital funds,

which are similar in some respects to hedge funds but usually require investors to make

long-term commitments of capital.

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Hedge Funds

3. For a discussion of the definition and construction of economically meaningful measures

of leverage, see appendix A in Counterparty Risk Management Policy Group (1999),

Improving Counterparty Risk Management Practices (New York: CRMPG, June).

4. Some of these estimates may double count investments in funds of funds. At the end of

last year, and excluding fund of funds, the TASS database included funds that had $979.3

billion in assets. Of course, not all funds are included in this database.

5. Greenwich Associates estimates that hedge funds in 2004 accounted for 20 to 30 percent

of trading volumes in markets for below-investment-grade debt, credit derivatives,

collateralized debt obligations, emerging-market bonds, and leveraged loans, and 80

percent of trading in distressed debt. See Greenwich Associates (2004), Hedge Funds: The

End of the Beginning? (Greenwich Associates, December). These estimates were based on

interviews with hedge funds and other institutional investors that Greenwich Associates

conducted from February through April 2004.

The last few years have been good to investors, investment funds, and the M&A market.

Now, in another indication that the party may be over, capital investors are showing signs of

retreating from hedge funds. In response, hedge funds are making new offers and improved

terms in order to woo the investors that support them.

After two prominent Bear Sterns funds specializing in subprime mortgages collapsed, other

hedge funds in the same market began seeing requests from investors seeking to redeem

their investment. The crunch in the subprime mortgage market was followed by a decline in

the overall availability of credit and by falling share prices on the stock market. Since credit

and share values are important factors in the M&A marketplace, the recent high pace of

merger and acquisition deal activity is expected to slow, creating a challenge for funds that

invest in stocks and acquisitions.

Some of the hedge fund sector's prominent players, including AQR Capital Management,

Highbridge Capital Management, DE Shaw, and Goldman Sachs, have recently seen heavy

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Hedge Funds

losses. Investors, ranging from wealthy individuals to chief investment officers for

endowments and trusts, are becoming more cautious about risk.

Investment funds are preparing for the possibility that new investors may be difficult to find

and current investors may ask for their money back. KKR Financial Holdings, an affiliate of

Kohlberg Kravis Roberts & Co., stated that it could lose up to $290 billion in its investments

because investor faith in mortgages has been shaken.

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Hedge Funds

BIBLIOGRAPHY www.wikipedia.org

www.investopedia.com

www.moneycontrol.com

money.livemint.com

http://www.technofunc.com/

www.finance-glossary.com

(For definition of certain financial terms)

Financial Management -by I. M. Pandey

Financial Management- by Ravi Kishor

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