How and when did hedge funds originate?
Alfred Winslow Jones is usually credited with forming the
first modern hedge fund in 1949. He opened an equity fund that was organized as a
private partnership (and therefore exempt from SEC regulations) to provide maximum
latitude and flexibility in constructing a portfolio. In his original hedge fund model,
Jones merged two speculative tools--short sales and leverage--into a conservative form of
investing. Jones' model was based on the premise that performance depends more on
superior stock selection than on market direction. For example, he believed that during
a rising market, good stock selection will identify stocks that rise more than the market,
while good short stock selection will identify stocks that rise less than the market.
Jones' model outperformed the market. He converted his general partnership to a limited
partnership in 1952, used performance-based fee compensation, and operated his fund in
complete secrecy for seventeen years.
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What are some defining characteristics of hedge funds?
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Structure: US and Offshore
US-domiciled hedge funds are
almost always structured as Limited Partnerships (LPs). Offshore funds are usually
structured as corporations, and therefore, are not limited to a certain number of investors.
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Open- versus closed-end
Most hedge funds are structured as open-end funds, issuing new shares to investors on an
ongoing basis. Existing investors may redeem shares to the fund at the then-current net
asset value, subject to the fund's redemption policies as specified in its offering
memorandum and organizational documents.
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Lack of Transparency
The hedge fund industry has traditionally been characterized by a lack of transparency.
That is, if it conforms to specific SEC exemptions, the hedge fund does not even have to
be registered with the SEC. In addition, hedge fund managers are not required to
publicize performance information, asset allocations, or earnings.
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Performance based fee structure
Hedge fund managers are rewarded primarily in proportion to the profitability of the fund's
investments (typically 20% of profits). Many times a "hurdle" rate of return must be
achieved or any previous losses recouped before the performance fee is paid. This
performance based fee structure gives the manager great incentive to achieve maximum
returns. Most hedge funds also include a management fee based on a percentage of assets
under management (typically 1 to 2%).
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Fund manager is general partner and limited partner
As the fund manager, he or she is a general partner. But the fund manager is also a limited
partner because he or she commits a large portion of his or her own wealth to the fund.
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High minimum investment
Because of the limited number of investors that a US-domiciled fund can have, minimum
investments in hedge funds are relatively high. Having a sufficient amount of capital
(resulting from high minimum investments) ensures that the fund manager will be able to
properly implement his/her strategy.
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Absolute return
Hedge funds are investment vehicles that usually aim for a risk-adjusted absolute return,
as opposed to traditional investment vehicles, which aim to outperform a standard market
benchmark (such as the S&P 500 or Russell Index).
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Flexibility in Investment Tools
Hedge funds have a higher degree of flexibility in the instruments that the fund can invest
in. For example, a hedge fund can invest in nearly any and every investment instrument that
exists. Many but not all hedge funds invest in derivatives-instruments that derive from an
underlying security. Some of these instruments include options, futures, convertibles and
warrants. There are four main reasons hedge funds use derivatives: to reduce risk, to capture
a manager's opinion in a cost effective way, to exploit inefficiencies in the pricing of
derivatives arising from intrinsic pricing complexities, and to increase exposure without
excessively expanding the fund's balance sheet.
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Flexibility in Investment Strategies
Hedge funds have a high degree of flexibility in the investment strategies they employ.
A hedge fund manager can use leverage, short selling, arbitrage, or a focus in a specific
industry or kind of security. Managers can be active on the long and short side of the market.
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Low market correlation
The diversity of strategies and instruments utilized by hedge funds result in the low correlation
to typical equity market benchmarks. This relates to Jones' belief that performance has more to
do with superior stock selection than market direction.
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Liquidity
Hedge funds are generally less liquid than traditional investment vehicles. Most allow redemptions
on a quarterly basis, but very few allow redemptions more frequently than that. Some hedge funds have
longer (e.g. one year) lock up periods, so that they can properly implement their trading strategy
without concern for fluctuations in assets. Some funds charge a redemption fee; this dissuades early
redemption.
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Active management
Most funds seek to add value through active management. There are several overarching techniques
by which hedge fund managers seek to gain a competitive advantage. These include superior
information collection; superior access to opportunities; superior analysis of opportunities;
and superior trade or portfolio structuring.
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Who invests in hedge funds?
Hedge Fund investors include:
Swiss private banks
High net worth families & Family Offices
Japanese proprietary capital
US endowments, foundations, pension funds
Middle East investors
Structured notes for Japanese institutions and German investors
Insurance companies
Accredited individual investors
Institutional investors
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The hedge fund industry has grown considerably in the
last decade.
In 1990, there were about 600 hedge funds worldwide with assets of approximately $38 billion.
According to industry publications, at the end of 1998, despite even the much publicized collapse
of Long Term Capital Management, there were some 3,300 hedge funds with assets of approximately $375
billion. KPMG Peat Marwick and RR Capital Management Corp., in a March 1998 report, projected an
approximate 26% annual growth rate of hedge fund assets, likely resulting in a $500 billion market
in 2001, and growing to $1.7 trillion market within the next ten years.
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