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HEDGE FUNDS-INTRODUCTION

-Jeet R.Shah

M.Com , CFP CM

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What is a Hedge Fund?

Standard definitions of a hedge fund

Jeet R.Shahwww.veerconsultancy.com

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A hedge fund can be defined

as an actively managed, pooled investment vehicle that is open to only a limited group of investors and

whose performance is measured in absolute return

units. However, this simple definition excludes some

hedge funds and includes some funds that are

clearly not hedge funds. There is no simple and all encompassing definition.

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The nomenclature hedge fund provides insight into its originaldefinition.

To hedge is to lower overall risk by taking on an asset positionthat offsets an existing source of risk. For example, an investorholding a large position in foreign equities can hedge the portfolioscurrency risk by going short currency futures.

A trader with a large inventory position in an individual stock canhedge the market component of the stocks risk by going short equityindex futures.

One might define a hedge fund as an information-motivated fundthat hedges away all or most sources of risk not related to the price-

relevant information available for speculation. Note that short positions are intrinsic to hedging and are critical in

the original definition of hedge funds.

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Alternatively, a hedge fund can be defined

theoretically as the purely active component of atraditional actively-managed portfolio whoseperformance is measured against a market benchmark.

Let w denote the portfolio weights of the traditional

actively-managed equity portfolio. Let b denote the market benchmark weights for the

passive index used to gauge the performance of thisfund.

Consider the active weights, h, defined as thedifferences between the portfolio weights and thebenchmark weights: h = w b

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A traditional fund has no short positions, so w has all

nonnegative weights; most market benchmarks alsohave all nonnegative weights.

So w and b are nonnegative in all components but theactive weights portfolio, h, has an equal percentage

of short positions as long positions. Theoretically, one can think of the portfolio h as the

hedge fund implied by the traditional active portfoliow.

The following two strategies are equivalent:1. hold the traditional actively-managed portfolio w

2. hold the passive index b plus invest in the hedge fundh.

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Defined in this way, hedge funds are a device to separate thepurely active investment portfolio h from the purely passive

portfolio b. The traditional active portfolio w combines the two components.

This theoretical hedge fund is not implementable in practice sinceshort positions require margin cash.

Note that the theoretical hedge fund described above has zeronet investment and so no cash available for margin accounts.

If the benchmark includes a positive cash weight, this can be re-allocated to the hedge fund.

Then the hedge fund will have a positive overall weight, consistingof a net-zero investment (long and short) in equities, plus a positiveposition in cash to cover margin.

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Why might strategy 2 above (holding a passive index plus a hedge fund) bemore attractive than strategy 1 (holding a traditional actively-managed

portfolio)? It could be due to specialisation.

The passive fund involves pure capital investment with no information-basedspeculation.

The hedge fund involves pure speculation with no capital investment.

The traditional active manager has to undertake both functions simultaneouslyand so cannot specialise in either.

This theoretical definition of a hedge fund also explains the hedgeterminology.

Suppose that the traditional actively-managed fund has been constructed sothat its exposures to market-wide risks are kept the same as in the benchmark.

Then the implied hedge fund has zero exposures to market-wide risks, sincethe benchmark and active portfolio exposures cancel each other out, i.e.,hedging.

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What we have just described is a classic hedge fund, butthe operational composition of hedge funds has steadilyevolved until it is now difficult to define a hedge fund basedupon investment strategies alone.

Hedge funds now vary widely in investing strategies, size,and other characteristics.

All hedge funds are fundamentally skill-based, relying onthe talents of active investment management to exceed thereturns of passive indexing.

Hedge fund managers are motivated by incentive fees tomaximise absolute returns under any market condition, sohedge funds returns are not compared to benchmarks thatrepresent the overall market.

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Hedge fund managers have flexibility to choose from

a wide range of investment techniques and assets,including long and short positions in stocks, bonds, andcommodities.

Leverage is commonly used (83% of funds) to magnify

the effect of investment decisions [Liang, 1999]. Fund managers may trade in foreign currencies and

derivatives (options or futures), and they mayconcentrate, rather then diversify, their investments in

chosen countries or industry sectors. Managers may switch investment styles, if they perceive

better opportunities in doing so.

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Some hedge funds do not hedge at all; they simply

take advantage of the legal and compensatorystructures of hedge funds to pursue desired trading

strategies.

In practice, a legal structure that avoids certainregulatory constraints remains a common thread

that unites all hedge funds.

Hence it is possible to use their legal status as analternative means of defining a hedge fund.

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Practical definition of a hedge fund


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A privately organised , pooled investment vehicle

Investing primarily in publicly traded securities & derivatives on publicly

traded exchanges Using Leverage

Typically organised as LLPs or LL Cos

Often domiciled offshore , for tax or regulatory reasons

Not burdened with regulations analogous to that which limits the activitiesof the entities under Investment Act of 1940 in US , SEBI regulations in Indiaetc

However they pay a penalty : they cannot raise funds from investor viapublic offerings of their securities .

In practice , this has the following implications: Cannot have more than 100 accredited investors or 500 super

accredited investors

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accredited investors = net worth ( incl. principal residence ) in excess ofUSD 1 million ,or income of USD 2,00,000 in each of the past 2 years (USD

3,00,000 for married couples ) superacredited investors = net worth ( incl. principal residence ) in excess

of USD 5 million

No more than 25% of the funds may be attributed to Erisa plans and,

May not advertise broadly or engage in general solicitation of theinvesting public

As they are not limited by regulatory or contractual limits on investmentdiscretion , they enjoy unlimited freedom to invest across vide array ofasset classes and geographies , to use leverage & derivatives and to shortsecurities .

Charge aggressive fees typically 1 or 2% of AUM & 20% of cumulativeprofits

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Often require advance notice for redemptions of as short as

1 month to as long as 3 years ! As a result of the above ,HF investors are predominately

wealthy individuals and to a lesser degree foundations andendowments. State & local pension plans have not

historically been significant investors. HF managers are usually general partner ( Designated

Partners) in their respective funds and often invest a largepart of their personal N/W in their funds.

Staff tend to be small , and organized in a flat reportingstructure to facilitate rapid & decisive responses to marketopportunities.

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The Legal Structures of Hedge Funds- In

USA


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Hedge funds are clearly recognisable by their legal structures.

Many people think that hedge funds are completely unregulated,but it is more accurate to say that hedge funds are structured totake advantage of exemptions in regulations.

Fung and Hsieh (1999) explain the justification for these exemptionsis that the regulations are meant for the general public and that

hedge funds are intended for well-informed and well-financedinvestors.

The legal structure of hedge funds is intrinsic to their nature.

Flexibility, opaqueness, and aggressive incentive compensation arefundamental to the highly speculative, information-motivated trading

strategies of hedge funds. These features are in conflict with a highly regulated legal

environment.

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The Legal Structures of Hedge Funds- In

USA


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Hedge funds are almost always organised as limitedpartnerships or limited liability companies to provide pass-through tax treatment.

The fund itself doesnt pay taxes on investment returns, butreturns are passed through so that investors pay the taxeson their personal tax bills. (If the hedge fund were set up as

a corporation, profits would be taxed twice.) In the U.S.A., hedge funds usually seek exemptions from a

number of SEC regulations.

The Investment Company Act of 1940 contains disclosure

and registration requirements and imposes limits on the useof investment techniques, such as leverage anddiversification [Lhabitant, 2002 ]

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The Legal Structures of Hedge Funds - In

USA


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The Investment Company Act was designed for

mutual funds, and it exempted funds with fewerthan 100 investors.

In 1996, it was amended so that more investors

could participate, so long as each qualifiedpurchaser was either an individual with at least $5

million in assets or an institutional investor with at

least $25 million [Presidents Working Group,1999].

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USA


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Hedge funds usually seek exemption from the

registration and disclosure requirements in the SecuritiesAct of 1933, partly to prevent revealing proprietarytrading strategies to competitors and partly to reducethe costs and effort of reporting.

To obtain the exemption, hedge funds must agree toprivate placement, which restricts a fund from publicsolicitation (such as advertising) and limits the --------.

The easiest way for hedge funds to meet thisrequirement is to restrict the offering to wealthyinvestors.

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USA


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Some hedge fund managers also seek an exemptionfrom the Investment Advisers Act of 1940, whichrequires hedge fund managers to register as investmentadvisers.

For registered managers, a fund may only charge a

performance-based incentive fee (which is typically themanagers main remuneration) if the fund is limited tohigh net-worth individuals.

Some managers elect to register as investment advisers,

because some investors may feel greater reassurance,and the additional restrictions are not especiallyonerous [Lhabitant, 2002].

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USA


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Hedge funds are usually more secretive than otherpooled investment vehicles, such as mutual funds.

A hedge fund manager may want to acquire hispositions quietly, so as not to tip off other investors ofhis intentions.

Or a fund manager may use proprietary tradingmodels without wanting to reveal clues to his systematicapproach.

With so much flexibility and privacy conferred to

managers, investors must heavily rely upon managersjudgement in investment selection, asset allocation, andrisk management.

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USA


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There is a fundamental conflict between the needs ofhedge funds and the needs of regulators overseeingconsumer investment products.

Hedge funds need flexibility, secrecy, and strongperformance incentives.

Regulators of consumer financial products need toensure reliability, full disclosure, and managerialconservatism.

Removing hedge funds from the set of regulated

consumer investment products, and then barring orrestricting general consumer access to them, reconcilesthese conflicting objectives.

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Legal Structures for Non-U.S. Hedge

Funds


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The United States has been the centre of hedge fund

activity, but about twothirds of all hedge funds aredomiciled outside the U.S.A.

Often these offshore hedge funds are established intax-sheltering locales, such as the Cayman Islands, the

British Virgin Islands, Bermuda, the Bahamas,Luxembourg, and Ireland, specifically to minimise taxesfor non-US investors.

US hedge funds often set up a complementary offshorefund to attract additional capital without exceedingSEC limits on US investors.

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Legal Structures for Non-U.S. Hedge

Funds


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Outside the U.S., U.K., and tax-haven countries, the situationfor hedge funds is wide-ranging.

In Switzerland, hedge funds need to be authorised by theFederal Banking Commission, but once authorised, hedgefunds have few restrictions.

Swiss hedge funds may be advertised and sold to investorswithout minimum wealth thresholds.

In Ireland and Luxembourg, hedge funds and offshoreinvestment funds are even allowed listings on the stockexchange.

On the other extreme, France has greatly restricted theestablishment of French hedge funds, and French taxauthorities frown upon offshore investing.

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REGULATORY ISSUE FOR ALLOWING FOREIGN

HEDGE FUNDS IN

INDIA

CAC

FEMA

Regulated as FII

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HEDGE FUNDS IN

INDIA

Though hedge funds are not an excluded category of foreigninstitutional investors under the SEBI (FII) Regulations, 1995 they are ,

however, by virtue of not being regulated by securities regulators intheir place of incorporation or operations, cannot come as FII under thepresent provisions of SEBI (FII) Regulations. Regulation 6 (i) (b) of the FIIRegulations requires an FII applicant to be a regulated entity in itsplace of incorporation or operations.

The FII Regulations allow sub-accounts sponsored by registered FIIs toinvest in India. Regulation 2 (k) defines sub-account which includesforeign corporates or foreign individuals and those institutions,established or incorporated outside India and those funds, or portfolios,

established outside India, whether incorporated or not, on whosebehalf investments are proposed to be made in India by a foreigninstitutional investor.

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HEDGE FUNDS IN

INDIA

Further, provisions of the regulation 13 lay down the conditions andprocedure for granting registration to a sub-account of an FII.

Hedge Funds of almost all variations can meet the requirements of sub-accounts if they are fit and proper persons.

However, based on (an internal administrative decision) if an applicantindicates in the application that it is a hedge fund, the consideration ofthe application is withheld.

Since granting of registration to FII/sub-accounts is based on thedisclosure of details and on the undertaking given by the applicant inthe application form, it could be possible that a few entities whodescribed their activities in the application form in terms other thanhedge funds could have already got registration as sub- accounts.

However, it must be remembered that all sub-accounts have to besponsored by registered FIIs who are required to be regulated entitiesby the relevant regulators in their home countries.

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Identifying Hedge Funds

i) borrowing and leverage restrictions, which are typicallyincluded in Mutual Fund Regulation are not applied, and

many (but not all) hedge funds use high levels of leverage.ii) significant performance fees (often in the form or

percentage of profits) are paid to the manager in additionto an annual management fees.

iii) investors are typically permitted to redeem their interestsperiodically, e.g. quarterly, semi-annually or annually;

iv) often significant own funds are invested by manager;

v) derivatives are used, often for speculative purposes, andthere is an ability to short sell securities;

vi) More diverse risks or complex underlying products areinvolved.

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Investment limits applicable to FIIs:

Chapter II of the SEBI (Foreign Institutional Investors) Regulations, 1995interalia list out the instruments in which an FII/sub-account can invest.

The regulation does not include currency or commodities as eligibleinstruments for investment for the FIIs.

Therefore, currency trading or investment in commodity relatedfinancial products will not be an option for any hedge funds under the

present FII Regulations. The SEBI (Foreign Institutional Investors) Regulations, 1995 also lays

down scrip-wise and fund wise maximum limits a fund can invest.

Further, through circular No. SMD/DC/CIR-11/02 dated February 12,

2002 and SEBI/DNAD/CIR-21/2004/03/09 dated March 9, 2004issued by Secondary Market Department, position limits for investmentby FIIs in derivatives have been advised.

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Investment limits applicable to FIIs:

These limits will help diversify the foreign hedge fundinvestments and will help in jettisoning concentration in anyspecific scrip.

The provisions of Chapter III (Regulation 15 (3) (a)) disallowsshort selling by FIIs and stipulates that all trades by FIIs are

delivery based. The provision will clearly keep the hedge funds if allowed to

invest as FIIs out of short selling at least in the cash segment.

It is therefore, clear that existing provisions in the FII

Regulations include several checks and balances which cankeep our market safe from potential market abuse andmanipulation.

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Additional Regulatory Concerns:

In view of the increasing popularity among the institutions as well astheir increasing interest in the Indian market, it might be time to provide

a limited window to this growing segment of asset management industrywithin the existing framework of the SEBI (Foreign Institutional Investors)Regulations.

While opening up our market one cannot be oblivious to the specialconcerns associated with the creative fund management strategies used

by these funds. Thus, the approach adopted in formulating the followingpolicy suggestions has been that of transparent and regulated accesswith abundant caution.

Para 4.4 of this section has already outlined the existing provisions inthe SEBI (Foreign Institutional Investors) Regulations, 1995 and the

Guidelines issued by SEBI which an address the concerns related tocurrency speculations, short selling, scrip wise concentration in the cashmarket and excessive positions in the derivative segment of our market.

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1. The investment adviser to the hedge funds should be a regulatedinvestment advisor under the relevant Investor Advisor Act or the fund is

registered under Collective Investment Fund Regulations or InvestmentCompanies Act .

2. At least 20% of the corpus of the fund should be contributed by theinvestors such as pension funds, university funds, charitable trusts orsocieties, endowments, banks and insurance companies.

The presence of institutional investors in the fund is expected to ensurebetter governance on the part of the fund manager and fundadministrators.

Further, institutional investors may help fund managers to take a longterm perspective of the market.

3. The fund should be a broad based fund in terms of the SEBI (ForeignInstitutional Investors) Regulations, particularly in terms of theexplanation to Regulation 6 (1) (d).

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4. The fund manager or investment adviser must have

experience of at least 3 years of managing fundswith similar investment strategy that the applicant

fund has adopted.

This provision is expected to allow well managedfunds to access our market and at the same time,

keep our markets insulated from the possible

adverse effects of trial and errors by uninitiatedrookies.

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THE HISTORY OF HEDGEFUNDS

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The First Hedge Fund


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In 1949, Alfred Winslow Jones started an investment partnershipthat is regarded as the first hedge fund.

Remarkably many of the ideas that he introduced over fifty yearsago remain fundamental to todays hedge fund industry.

Jones structured his fund to be exempt from the SEC regulationsdescribed in the Investment Company Act of 1940.

This enabled Jones fund to use a wider variety of investmenttechniques, including short selling, leverage, and concentration(rather than diversification) of his portfolio.

Jones committed his own money in the partnership and based hisremuneration as a performance incentive fee, 20% of profits.

Both practices encourage interest alignment between manager andoutside investor and continue to be used today by most hedge funds.

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The First Hedge Fund


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Jones pioneered combining shorting and leverage, techniques thatgenerally increase risk, and used them to hedge against market

movements and reduce his risk exposure. He considered himself to be an excellent stock picker, but a poor

market timer, so he used a market-neutral strategy of having equallong and short positions.

Jones long/short strategy rewarded exceptional stock selection andcreated a portfolio that reacted less to the vagaries of the overallmarket.

He also used the capital made available from short selling asleverage to make additional investments.

Jones also hired other managers, delegated authority for portionsof the fund, and thus initiated the multi-manager hedge fund. Themulti-manager approach later evolved into the first fund of hedgefunds [Tremont, 2002].

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Hedge Funds from the 1960s to the

1990s


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By the mid-1960s, Jones fund was still active and began to inspire imitations, somefrom investment managers who once worked for Jones.

An SEC report documented 140 live hedge funds in 1968 [Presidents WorkingGroup, 1999]. A stock market boom began in the late 60s, led by a group ofstocks dubbed the Nifty Fifty, and hedge funds that followed the Jones long/shortstyle appeared to underperform the overall market. To capture the rising market,hedge fund managers altered their investing strategy.

Their funds became directional, abandoned the long/short hedging aspect, and

opted for portfolios favouring leveraged long-bias exposure. During the subsequent bear market of 1972-1974, the S&P 500 declined by a

third (adjusted for dividends and splits), and hedge funds with leveraged long-biasstrategies were battered.

As a result, many hedge funds went out of business, and hedge funds were out-of-favour for the next 10 years.

A 1984 survey by Tremont Partners identified only 68 live hedge funds, less thanhalf the number of live funds in 1968 [Lhabitant, 2002].

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1990s


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A mid-80s revival of hedge funds is generally ascribed to thepublicity surrounding Julian Robertsons Tiger Fund (and its offshore

sibling, the Jaguar Fund). The Tiger Fund was one of several so-called global macro funds that

made leveragedinvestments in securities and currencies, based uponassessments of global macroeconomic and political conditions.

In 1985, Robertson correctly anticipated the end of the 4-year trendof the appreciation of the US dollar against European andJapanese currencies and speculated in non-US currency call options.

A May 1986 article in Institutional Investor noted that since itsinception in 1980, Tiger Fund had a 43% average annual return,

spawning a slew of imitators [Eichengreen, 1999].

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1990s


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Hedge funds became admired for their profitability, and reviled fortheir seeming destabilising influence on world financial markets.

In 1992 during the European ERM (Exchange Rate Mechanism) crisis,George Soros Quantum Fund, another global macro hedge fund,made over a billion dollars from shorting the British pound.

During the Asian Contagion currency crisis, the Thai Baht fell 23%in July 1997.

Quantum Fund had shorted the Baht and gained 11.4% that month[Fung and Hsieh, 2000].

Spectacular success stories like these increased the allure andglamour associated with hedge funds,but also established a

reputation for benefiting from and contributing to financial marketchaos.

d d f h 9 0 h

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1990s


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In the late 90s, hedge funds made the headlines once more, but forstaggeringly large losses.

In 1998, Soros Quantum Fund lost $2 billion during the Russian debt crisis. Robertsons Tiger Fund incorrectly bet upon the depreciation of the yen

versus the dollar and lost more than $2 billion.

During the dot-com boom, Quantum lost almost $3 billion more from firstshorting high-tech stocks and then reversing its strategy and purchasing

stocks near the market top [Deutschman, 2001]. Robertson kept his Tiger Fund long on Old Economy and short on New

Economy shares.

Robertson would eventually be proved to be right, but not soon enough.Tiger Fund sustained losses from trading as well as mass investor

redemptions and was closed down in March 2000, ironically, just beforethe dot-com bust which could have validated the funds strategy.

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Development of Funds of Funds


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The explosive growth in hedge funds led to a marketfor professionally managed portfolios of hedge funds,commonly called funds of funds.

Funds of funds provide benefits that are similar tohedge funds, but with lower minimum investment levels,

greater diversification, and an additional layer ofprofessional management.

Some funds of funds are publicly listed on the stock

exchanges in London, Dublin, and Luxembourg,theoldest of which, Alternative Investment Strategies, datesback to 1996.

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Development of Funds of Funds


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In the context of funds of funds, diversification usuallymeans investing across hedge funds using several

different strategies, but may also mean investing acrossseveral funds using the same basic strategy.

Given the secrecy in hedge funds, a professional fundsof funds manager may have greater expertise toconduct the necessary due diligence than an individualinvestor.

Funds of funds may offer access to hedge funds thatare closed to new investors.

Of course, additional professional management comesat the price of an additional layer of fees.

Si d G th f th H d F d

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Size and Growth of the Hedge Fund

Industry


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Since hedge funds are structured to avoid regulation, evendisclosure of the existence of a hedge fund is not mandatory.

There is no regulatory agency that maintains official hedge funddata.

There are private firms that gather data that are voluntarilyreported by the hedge funds themselves.

This gives an obvious source of self-selection bias, since onlysuccessful funds may choose to report.

Some databases combine hedge funds with commodity tradingadvisers (CTAs) and some separate them into two categories.

Also, different hedge funds define leverage inconsistently, which

affects the determination of AUM, so aggregate hedge fund dataare best viewed as estimates.

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HEDGE FUND FEE

STRUCTURES

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Performance-based Fees


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Hedge fund managers are compensated by two types offees:

1. a management fee, usually a percentage of the size of thefund (measured by AUM), and

2. a performance based incentive fee, similar to the 20% ofprofit that Alfred Winslow Jones collected on the very first

hedge fund. Fung and Hsieh (1999) determine that the median

management fee is between 1-2% of AUM and the medianincentive fee is 15-20% of profits.

Ackermann et al. (1999) cite similar median figures: amanagement fee of 1% of assets and an incentive fee of20% (a so-called 1 and 20 fund).

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The incentive fee is a crucial feature for the success ofhedge funds.

A pay-for profits compensation causes the managersaim to be absolute returns, not merely beating abenchmark.

To achieve absolute returns regularly, the hedge fundmanager must pursue investment strategies thatgenerate returns regardless of market conditions; thatis, strategies with low correlation to the market.

However, a hedge fund incentive fee is asymmetric; itrewards positive absolute returns without a correspondingpenalty for negative returns.

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Empirical studies provide evidence for the effectiveness of incentivefees.

Liang (1999) reports that a 1% increase in incentive fee is coupledwith an average 1.3% increase in monthly return.

Ackermann et al. (1999) determine that the presence of a 20%incentive fee results in an average 66% increase in the Sharpe ratio,as opposed to having no incentive fee.

The performance fee enables a hedge fund manager to earn thesame money as running a mutual fund 10 times larger [Tremont,2002].

There is the possibility that managers will be tempted to take

excessive risk, in pursuit of (asymmetric) incentive fees. This is one reason why, in many jurisdictions, asymmetric incentive

fees are not permitted for consumer-regulated investment products.

Determining Incentive Fees: High Water

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Marks and Hurdle Rates


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To ensure profits are determined fairly, high water marksand hurdle rates are sometimes included in the calculation of

incentive fees. A high water mark is an absolute minimum level of

performance over the life of an investment that must bereached before incentive fees are paid.

A high water mark ensures that a fund manager does notreceive incentive fees for gains that merely recover losses inprevious time periods.

A hurdle rate is another minimum level of performance

(typically the return of a risk-free investment, such as ashort-term government bond) that must be achieved beforeprofits are determined.


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Marks and Hurdle Rates


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Unlike a high water mark, a hurdle rate is only for

a single time period. Liang (1999) determined that funds with high water

marks have significantly better performance (0.2%

monthly) and are widespread (79% of funds). Hurdle rates are only used by 16% of funds and

have a statistically insignificant effect on

performance.

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Equalisation


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The presence of incentive fees and high water marks maycomplicate the calculations of the value of investors shares. If

investors purchase shares at different times with different net assetvalues (NAV), nave calculations of incentive fees may treat theinvestors differently.

For example, presume shares in a hypothetical hedge fund areoriginally worth INR100 when investor A purchases them.

Subsequently the shares fall to INR90, which is when investor Binvests, and then shares return to INR100.

If there is a high water mark at INR100, then investor B theoreticallycan liquidate her shares without incurring a performance fee,because the high water mark has not been passed. Since B hasmade a gross profit of INR10 per share, this is obviously unfair, soan adjustment is required.

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Equalisation


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To treat both earlier and new investors fairly, theadjustment of profit calculations is an accountingprocess called equalisation.

Since new investments are usually limited to certainperiods (sometimes monthly or quarterly), a very simple

form of equalisation is to issue a different series ofshares for each subscription period, each with adifferent high water mark and different accruals ofincentive fees.

However, this form of equalisation leads to anunwieldy number of series of shares, so it is rarely used.

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Equalisation


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A more common equalisation method involves splitting newpurchases into an investment amount and an equalisation

amount that matches the incentive fee of earlier investors. The equalisation amount is used to put earlier investors and

the new investor in the same position.

If the hedge fund shares go up in value, the equalisation

amount is refunded. If the hedge fund shares lose value, the equalisation amount

is reduced or eliminated [Lhabitant, 2002].

Many U.S. hedge funds do not require equalisation,

becausethey are either closed, so they do not allow newinvestments, or they are structured as partnerships that usecapital accounting methods

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Minimum Investment Levels


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Minimum investment levels for hedge funds are usually high,implicitly dictated by legal limits on the number of investors who

are not high net worth individuals (qualified purchasers oraccredited investors), and restrictions on promotion andadvertising.

The SEC & FSA requirement of private placement for hedge fundsmeans that hedge funds tend to be exclusive clubs with a

comparatively small number of wellheeled investors. $250,000 is acommon minimum initial investment, and $100,000 is common forsubsequent investments [Ackermann et al., 1999; Liang, 1999].

From the perspective of the fund manager, having a small number ofclients with relatively large investments keeps client servicing costs

low. This allows the hedge fund manager to concentrate more on trading

and less on client servicing and fund promotion.

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Fees for Funds of Funds


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Funds of funds (portfolios of hedge funds) are an

increasingly popular way to invest in hedge fundswith a much lower minimum investment.

Funds of hedge funds usually impose a 1-2%

management fee and 10-20% performance fee, inaddition to existing hedge fund fees.

However funds of funds often negotiate with hedge

funds for lower fees than individual clients and thislowers their pass-through costs.

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Surrender Fee


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A surrender fee is assessed as a percentage ofredemption amount for exiting investors.

Sometimes this fee is paid back into the fund tocompensate the remaining investors for thetransaction costs caused by the need to liquidate

assets for the redemption. When the fee is paid to the management company,

it serves as a source of additional revenue for the

manager and acts as a deterrent to investorsconsidering leaving the fund.

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Lookback


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Although not a typical structure, some management

companies rebate an incentive fee if a subsequentloss erases a gain shortly after an incentive fee is

charged.

One type of lookback refunds the incentive feewhen losses occur within 3 months of the high-water

mark.

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Miscellaneous Fees


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The management company is free to charge a varietyof fees if they are adequately disclosed to theinvestors.

The fund may be assessed a ticket charge for purchasesand sales handled by the management company.

For leveraged positions, a financing fee is sometimescharged for handling levered long and short financingtransactions.

Sometimes the manager charges the fund a commissionthat is higher than the commission actually charged bythe futures commission merchant.

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Dhanyawaad

Jeet R.Shah

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www.veerconsultancy.com

Documents

1.Intro to HF