Hedge funds have historically lodged in a dark corner of the investment universe, where investors and regulators were happy to leave them.


There they have rested, mostly in the investment portfolios of the wealthy clients of private banks as tools to preserve wealth.


But institutional investors - the big pension funds, local authorities, charities and university endowment funds - have become more interested in alternative investments. Falling markets have highlighted the benefits of funds that can pay positive returns regardless of what stock markets are doing, apparently with less volatility.


Fund managers, too, are seeking more flexibility in the way they invest, and have migrated in their hundreds to set up and run their own hedge funds.


The number of hedge funds now exceeds 7,500, according to some estimates. And the amount of money invested has more than doubled since 1998 to more than USD 1 trillion.


The most developed market is in the US, where most managers are based. But more funds are being set up across Europe as demand has risen.


Regulators have always worried about the risks attached to these alternatives investments to traditional, onshore equity and bond funds. Hedge fund managers can take huge, unmonitored bets and cause funds to collapse entirely for no other reason than that the manager got his strategy wrong. These funds are unlike the funds that most investors are used to, they say.


But as the demand for alternative investments continues to grow, regulators and tax authorities are being forced to temper their antipathy. The rules governing hedge funds have changed out of all recognition in the last few years, and look set to change even faster over the next few years.


What are Hedge Funds?


Like mutual funds, hedge funds pool investors' money in the hope of paying a positive return. But they do it in a huge variety of ways. No two funds are alike and there is no precise or legal definition of what a hedge fund is. There are a few well-known giants, such as George Soros's Quantum fund. These funds account for a large percentage of the industry's assets - as much as half, by some accounts.


But the majority of hedge funds are designed to be small and nimble, run by a few people who outsource almost everything but the investment management to other banks, brokers and advisers. These funds have limited numbers of investors, who have faith that the manager has the skill to find value in out-of-the way investments that the big, onshore institutions miss.


In an attempt to come up with a blanket definition, hedge funds are often described as funds that use high levels of debt and derivatives to leverage returns, and go short - that is, buy or borrow stock to sell in the expectation that the price will drop and they can buy it back at a lower price. This gives them a unique tool to bet against falling markets. But not all funds go short or are highly leveraged.


A wider definition is that hedge funds are absolute return funds - they aim to pay out returns regardless of how markets have performed. The attraction to investors is that they shouldn't lose money when markets fall. However, not all absolute return funds are hedge funds.


Some authorities say that the best way to describe a hedge fund is to focus on what they are not - that is, regulated in the UK or other European Union jurisdictions, or in the US - other than in the sense that access is restricted.
Unlike mutual funds sold to ordinary investors in these jurisdictions, hedge funds are subject to very few regulatory controls. Of the 6,500 funds thought to exist, few are registered onshore or monitored by the onshore regulatory authorities.


Regulated funds have to have:
* An identifiable investment objective;
* A policy that ensures that changes to policy or objectives must be subject to investor approval;
* An outside board of directors, trustee, auditor or administrator to monitor the fund and its managers frequently
* Timely audited accounts;
* A regular and detailed statement about the portfolio and big sales or purchases.


Regulators subject onshore funds to all kinds of rules barring them from activities such as going short, switching between asset classes or using debt and derivatives to leverage returns or bet against falling markets. Regulators in the UK have also until recently banned onshore funds from charging performance fees.


In contrast, performance fees are one of the characteristics of hedge funds. Typically hedge funds charge high fees of 1 to 2 per cent of assets up front, another 1 to 2 per cent of assets in annual management fees and then performance fees of about 20 per cent or more if assets grow by pre-determined amounts.


Another characteristic of the hedge fund industry is its attitude to risk. Hedge fund managers use techniques to isolate and analyse risk in ways that traditional fund managers are only just beginning to employ. This means that they can minimise risk while targeting double-digit returns.


During the last few years, they have gained a reputation for succeeding, even if not all have paid the high returns investors hoped for.


What are the different Hedge Fund Strategies?


Alfred Winslow Jones is said to have set up the first hedge fund. In 1949 he set up a private partnership that invested in equities, but also used leverage and short selling to "hedge" the portfolio's exposure to the movements of equity markets.


Jones's premise was that it was impossible to forecast the direction of the stock market with any consistency. His idea was to eliminate market risk, shifting the onus of the fund. He used borrowing to enhance returns, but took pains to hedge out the effect of market movements. Instead, he picked undervalued stocks, which he would buy, and overvalued stocks, which he would sell short. Shorting was a form or insurance, or hedge, against a drop in the market. Hence the term hedge fund.


Since Jones came up with the idea many more strategies have developed. These can be broadly classified as:


Market trend strategies


These exploit broad trends in, for example, currencies, commodities equities, interest rates.They include macro funds, which can take huge bets on currency movements based on the manager's view of a country's economic position. If, for example, the manager believes a country will have to devalue its currency, the fund will short the currency. These funds are notorious for being highly leveraged and high risk. Some macro funds are also called global asset allocators, because they take positions in any security. The most famous was George Soros's fund, which bet against sterling and the UK government and is credited with having forced the UK out of the European Exchange Rate Mechanism in 1992.
Long/short funds, which try to exploit anomalies in the value of securities, are also market trend strategies. Equity market neutral funds fall into this category. These funds will, for example, buy shares in one company that they think is under-priced, while matching their exposure by selling shares in another company in the same sector that they think are over-priced. The largest group of funds follows this strategy. Sometimes equity market neutral funds are called relative value funds.Market trend strategies also include other sectors, such as emerging market funds.



Event-driven funds


These try to exploit specific events, such as bankruptcies, mergers or takeovers. Into this class fall distressed securities funds. These take bets on companies going through reorganisation or bankruptcy. Risk/merger arbitrage funds are also event-driven, betting on pending takeover activity. They might buy stock in a company being bought, and short stock in the purchaser.


Arbitrage strategies


These exploit pricing inefficiencies and discrepancies between closely related securities that may be mis-priced, if only temporarily. These strategies are generally designed to be very low risk. Arbitrage is also an important feature, though, in event driven and long/short funds. Convertible arbitrage funds invest in convertible bonds, warrants and preference stock while shorting the ordinary shares. Fixed income arbitrage exploit small price inefficiencies in bonds. Similarly statistical arbitrage funds try to exploit pricing inefficiencies revealed through mathematical models.


Funds of Funds


Although the first fund of hedge funds is thought to have emerged in the late 1960s, this product has taken off recently. Recent estimates suggest that the 6,500 hedge funds now include 1,700 funds of hedge funds. Around 250 were launched in 2003 alone.


Funds of funds work on the basis that they spread risk. Rather than investing in individual securities a fund of hedge funds invests in several hedge funds. These funds are taking off in Europe. France, Ireland, Italy, Luxembourg and Sweden all now have domestically domiciled fund of hedge funds products with low (or no) investment threshold.
The attraction for private investors is that the manager of the fund bears a significant responsibility for due diligence, while the broader spread of investments and strategies reduces the potential impact of the failure of a single fund.
For this reason, these are seen as more appropriate vehicles than single manager funds. Many jurisdictions, including the US and UK, allow funds of hedge funds to be sold to private investors more freely than single manager funds and many funds have much lower investment minimums than individual funds.


The investment case for investing in a fund of funds is that the managers are supposed to specialise in assessing hedge funds and have access to better information and to funds that are closed to private investors. The downside is that they charge a fee for this service, in addition to the fees charged by the underlying funds. This structure has given rise to criticisms that these funds add risk in order to raise returns to cover fees. Alternatively, they are criticised for diversifying returns so much that they become "cash minus fees" funds.


How can I buy a Hedge Fund?


Wealthy private investors have historically been the biggest holders of hedge funds, gaining access through their private banks.Many regulators are wary of giving ordinary private investors access to hedge funds and prohibit the way hedge funds are sold and distributed. In the US, for example, the Securities and Exchange Commission allows only "accredited" investors can invest in hedge funds. Eligible investors are often defined by the amount of money they can put in. Many regulators stipulate minimum investment thresholds. Italy, for example, has imposed an EUR 500,000 minimum investment.


Increasingly, providers have avoided the rules by developing derivative products that invest in hedge funds. In Europe, particularly in Germany, banks have issued certificates where the interest rate or amount repayable depended on the value of a portfolio of hedge funds.


In other jurisdictions, such as Ireland, firms offer funds of hedge funds packaged up as investment trust companies with listings on stock exchanges.  The US also allows investors to buy shares in some SEC-registered funds of hedge funds as long as the funds subject themselves to the full regulatory scrutiny of the SEC.


In the UK, only funds authorised by the Financial Services Authority can be marketed publicly to investors, which bars single-manager funds from public offers. There is nothing to stop a UK investor choosing to invest in an offshore fund, but he or she will lose some of the protection offered by the financial services regulations, and may find it hard to get information because of the marketing prohibition.


UK investors can also buy funds through authorised intermediaries. Alternatively, a number of funds of hedge funds (which do not go short) are eligible to list on the London Stock Exchange as investment trusts. Investors can buy as little as one share in these trusts.


Changing Regulations


Each regime in Europe has developed its own regulation and tax laws reflecting its own culture. Most try to bar all but the wealthiest and most sophisticated private investors from buying shares or units in hedge funds, or limit investments to funds of hedge funds.


This is because regulators are concerned about the risks that hedge funds present to investors who are ignorant of their methods, and also because hedge funds are usually opaque. Regulators find it hard to tolerate the lack of disclosure prevalent among hedge funds.


Some jurisdictions, such as Finland, have established a more disclosure-based regime, setting a higher priority on managers telling investors exactly what they are doing rather than trying to regulate sales and protect investors.
The UK's Financial Services Authority, which has a statutory duty to protect consumers while also aiding the UK's financial services industry to innovate and to compete globally, has developed a different approach.


The FSA has put in place strong rules to protect private investors from buying unsuitable high-risk products. At the same time, the UK has applied a lighter-touch regulatory regime to hedge fund managers themselves, allowing them to operate from the UK as long as they don't try to sell their products to the public.


Partly because of this lighter regulation and partly as a reflection of London's dominance of the asset management industry generally, almost 70 per cent of European single-manager hedge funds are managed from London, even though neither single-manager funds nor funds of hedge funds can be domiciled in the UK.


A recent rush of regulatory changes around the world has prompted the FSA to consider more changes to its rules in order to maintain the UK's competitive position. It has proposed to introduce regulations allowing the establishment of a new class of onshore fund that would be allowed to use hedge fund techniques, such as gearing and derivatives. These funds would be, in effect, authorised hedge funds, but would be only available to institutional investors and sophisticated private investors.


Parallel tax changes are required before any such funds are likely to be established, and such changes have not yet been approved by the Treasury or the Inland Revenue (at Feb 9). Even before that happens, however, pressure is mounting on the FSA to consider whether the UK should introduce a form of onshore hedge fund that could be sold to ordinary investors.


This is a reflection of how quickly the industry is changing. In 2003, the FSA sounded out the fund management industry and concluded that there was no pressure and little need to change the rules on investors' access to hedge funds. It continues to worry about consumer protection.


But the Investment Management Association, which represents the UK's fund management institutions, recently admitted that it has reversed its thinking on retail access to hedge funds. Its members were concerned that they would lose out to other regimes if they could not offer hedge funds to UK investors.


Germany, which has historically been antipathetic to hedge fund structures, this year dismantled laws prohibiting foreign hedge funds distributing in Germany to retail and institutional clients.


It is allowing single manager funds to set up onshore. These funds cannot be sold publicly but there will be no minimum investment threshold.  Germany is also permitting funds of hedge funds to be sold to ordinary private investors.
France, meanwhile, has begun to open the doors to hedge funds, making them eligible for investment for the first time.
European jurisdictions are competing to draw the lucrative and fast-growing hedge fund industry into the EU.
John Purvis, a member of the European parliament and vice president of its Economic and Monetary Affairs Committee, has pointed out that in 2001 the number of hedge funds managed in Europe was just 446, representing only 15 per cent of the global total of hedge fund assets. Purvis is pushing the European Commission to introduce a single EU-wide regulatory regime to accommodate sophisticated alternative vehicles, which will include hedge funds as well as property, currencies and commodities to be sold to sophisticated investors. His aim is to coax investors back onshore and into a more supervised environment.


Part and parcel of all these changes are changes to the rules on tax. Some EU states, including Germany, have begun to relax the prescriptive tax laws around which the industry is structured. But the quid pro quo for loosening the prohibitions is more information from these funds. Those funds that don't want to or can't improve disclosure, and don't want to market themselves to a wider investor base, are likely to remain offshore.


Hedge Fund Performance and Investment Risk


How do you judge whether a hedge fund is successful?


Unit trust managers and onshore fund managers, who largely invest in one asset class, such as shares, can be relatively easily measured against a weighted index of shares, such as the FTSE All Share.


In contrast, many hedge funds and "absolute return funds", which aim to make a positive return regardless of indices, claim they diversify portfolio risk away from the returns of a particular index by trading between asset classes, such as commodities, cash, bonds and equities - and use sophisticated instruments, such as derivatives and debt, to do it.
The hard line approach to judging success or failure of an absolute fund is that if it makes money it is succeeding, if it isn't it has failed.


But as the hedge fund industry develops, it is clear that there is a market component in most, if not all, hedge fund strategies.


As a general rule, the greater the expected returns, the greater the fund's exposure to share and bond markets. Some strategies have a greater correlation to these markets than others. Returns on funds investing in distressed debt can be compared with fixed interest markets; long/short equity funds, which tend to show a bias to being long of shares over time, can be compared with the fortunes of stock markets.


In general hedge funds do seem to have performed better than stock markets and shown less volatility - the CSFB Tremont index, for example, shows that over the five years to the end of 2003 hedge funds returned nearly 10 per cent to investors against 4.6 per cent from the Dow Jones and -0.6 per cent from the S&P 500. At the same time the volatility - the extent to which returns deviate from the average - was half that of the S&P and Dow Jones.


But there are wide disparities in the returns and many strategies have moved more in line with markets than investors would have expected. What is more, observers fear that as more money flows into hedge funds, it will become more difficult for managers to gain an edge over their competitors and generate extraordinary returns. Some pension and fund performance consultants believe this may already be happening.


Figures from CSFB Tremont show that the average return from hedge funds was 3 per cent in 2002, when stock markets plummeted. This was still a positive return, but it will well below the 12 per cent or more absolute annual payout that most hedge funds aim for. Average returns including income in 2003 were markedly better - up 15 per cent. But stock markets also recovered. Total returns from the Dow Jones and S&P 500 both rose by more than 28 per cent. Returns from the FTSE 100 rose by just under 14 per cent.


Some studies have concluded that far from diversifying investors' exposures to stock markets, the correlation between hedge funds and stocks can increase during market declines.


Others argue that hedge fund returns have different risk-return characteristics from share-based funds and are more akin to derivatives. They do reduce the volatility of portfolio returns, and there is a body of evidence that suggests that if investors add a limited proportion of hedge funds - around 10 to 20 per cent - to their overall portfolios, they lower risk while enhancing returns.


However, investors should be prepared for more periods of negative or low returns than they may expect.
Hedge Fund Indices


A number of benchmarks have been developed over the past decade by organizations such as Hedge Fund Research (available on www.hedgeweek.com). These are useful as ways for investors and fund of hedge fund managers to assess current and historical market trends and relative performance.


Only by comparing management styles and returns against some kind of broad market or sector benchmark can investors begin to understand whether returns are due to a manager's particular skill - as most hedge fund manager will claim - or to the market. Indices help investors to pinpoint what some of the key drivers behind performance might be.
However, these indices do not provide investors with a foolproof method of gauging funds.


There are problems with the way some indices are set up - most only cover a sliver of the 6,500 hedge fund universe. Many funds don't give data and the information from those that do is often incomplete. In some cases, funds decide themselves which sector they should fit into.


Indices also show a bias to better performing funds that survive. This bias, which tends to raise the apparent rate of return, is true of any index. However, the rate of attrition in the hedge fund industry is high and rising. Just 60 per cent of the funds that were in business in 1996 were still trading in 2001. In 2002, 800 funds are thought to have closed.
During 2003, anecdotal evidence suggests that more funds fell out of the index. Some fall out voluntarily. In recent years some of the biggest and most successful funds have closed down and returned money to investors because the manager has retired or given up.


But most funds stop reporting because they have failed, and they have failed because they are too small and have performed badly.


The danger, according to some academics, is that by concentrating on surviving funds, indices are in danger of overstating returns by as much as 6 per cent a year, leading investors to overestimate the benefits of hedge funds.
Some hedge fund managers argue that it is pointless to categorise funds and compare them against an index. The essence of hedge funds is that they tap into the unusual flair of a few individuals in picking money-making opportunities.
Every fund does it differently, even funds in the same sector. Not only will the managers' styles vary, but there are also big differences in reported returns and fees.


Some say it is unrealistic to expect funds of funds to track indices, because indices suggest a flexibility that investors don't have in real life. Investors are unlikely to be able to access half the funds that make up an index because many are closed to new investors. Nor can they divest themselves of funds as quickly as private investors problems arise and funds fall out of an index.


Even so, indices remain the best tool that investors have to monitor and assess fund performance.


Risk


Much is made of the risks in hedge funds. Investor awareness was heightened by the spectacular failure of Long-term Capital Management, the $7bn fund set up in the US, which had to be rescued when a bet on bond markets backfired in 1998.


Since LTCM, the industry says gearing levels have been cut, that the risks in funds have declined, and that hedge funds have brought to the investment world a new awareness of risk. Indeed, the goal of many funds is to minimise risk by using sophisticated new techniques of mathematical modeling.


Investment Risk


Much effort is spent on defining where the risks to portfolio performance are, and how it affects returns. For example, how do stock market moves affect returns? Has the manager taken on too much debt? And has the manager factored in a global drop in interest rates or a worldwide event that triggers a flight to safer assets, such as US bonds?
Most investors concentrate on this kind of investment risk. But there are other forms of risk inherent in the way that funds are set up and run.


Manager Risk


The US regulator's big concern is that investors are trusting their money to unknown managers. Hedge funds have become a byword for making big returns, which has proved irresistible to both honourable and dishonourable managers.
The SEC has brought a number of fraud cases against hedge fund managers in recent years where the hedge funds lied to investors about the experience of managers and the fund's track record. Many gave the appearance of probity by paying good returns to early investors to make schemes look legitimate.


These cases have prompted the SEC to look hard at ways of making sure all hedge funds managers are registered with it. In the meantime it urges would-be investors to check schemes with it. If the managers have previous records for conning investors it may show up in its records. Investors can also check managers in the UK through the FSA.


Structural Risk


Other risks associated with fund structures are less likely to make the headlines than manager fraud, but can be more widespread.


Many hedge funds are small, focused operations that outsource many functions. Typically, in the case of a European hedge fund, investors' money is fed through an offshore vehicle - to minimise the tax liabilities for both the fund and the investor - to an investment adviser who sponsors or organises the fund. These advisers are often based in low-tax jurisdictions, such as the Cayman Islands. Many will then sub-contract management of the assets to a UK-based investment manager.


The fund will also employ a prime broker - a big investment house that may trade on the fund's behalf, lend stock enabling funds to go short, help to value the fund's trades and provide clearance and settlement services. The fund will also employ administrators who provide support services such as valuing assets and may be based in another EU jurisdiction, such as Dublin or Luxembourg.


In addition, hedge funds employ outside professional consultants, lawyers, accountants and systems managers.
These structures are complex, can add layers of costs, are hard to control and put investors at a considerable distance from the manager of their assets.


Valuation Risk


A growing concern is that outsourcing introduces uncertainties about the way that hedge funds value their assets. One of the biggest risks that any investor in a hedge fund faces is how to value what the manager is doing. Hedge funds are notoriously reluctant - and are under little regulatory obligation - to publish their holdings. LTCM, for example, did not disclose the details of its trades to outsiders because it had developed a highly-specialised proprietory strategy. Investors were also unaware of the level of gearing in the fund - as much as 100 times assets by the time it failed.
Yet valuation methods are integral to the success of any hedge fund. Strategies often revolve around backing small discrepancies in asset valuations with large amounts of money. If managers get the value wrong, the strategy fails.
Difficulties arise because valuing funds is by no means as straightforward as valuing assets in long-only onshore funds that buy shares in regulated stock exchanges at prices listed on an index. 


Hedge fund managers deal frequently in thin and illiquid markets, where there is no public price for the assets and it is hard to buy or sell stock. They may add to the complexity by borrowing against these assets and shorting them. Others create synthetic instruments that are made up of a combination of inter-related trades.


Managers often give themselves significant discretion in valuing assets. Some value securities in non-publicly traded companies at cost, some at a suggested market value. Others will rely on administrators or their prime brokers to value trades on the fund's behalf. This can, in itself, create potential conflicts of interests among the brokers, say regulators.
For investors who are unprotected if something goes wrong, and who are unlikely to be able to sell their holdings in a fund quickly or easily, poor disclosure and uncertain valuations pose big risks.


It is important, says the SEC, to find out and understand how a fund's assets are valued, and to ensure that there is some kind of independent check.


Taxation of Hedge Funds


The success or failure of hedge funds rests on the way they are taxed. Many of the big  jurisdictions in the EU tax the funds in ways that make it uneconomic to set up in Europe, which is why hedge funds go "offshore" to low-tax states where the tax rules are less onerous.


But this has implications for investors in these funds, depending on where they buy the funds and where they are taxed. Every state has a different set of rules governing the taxation of hedge funds and the investors who put their money in them.


The UK authorities currently categorise offshore funds as distributor and non-distributor funds or roll-up funds. Distributor funds must pay out 85 per cent of their annual income to investors to qualify, rather than allowing it to roll up. Roll-up funds, in contrast, don't pay an income but allow all gains to accumulate in the fund.


Distributor funds are taxed in the same way as UK unit trusts, with income tax due each year on income payments and capital gains tax on profits above the annual CGT allowance (£7,900 in 2003/4). With roll-up funds, there is no tax to pay until you cash in all or part of your holding, but any money you make is then liable to income tax.


Investor Protection


As one regulator describes it: "Investors aren't likely to make a fortune in a unit trust, but they are also unlikely to lose all their money. In contrast, the risks of investing in one hedge fund can veer from zero to infinity".


And, because these funds are not subject to onshore regulation, if it all goes wrong there is little chance that the authorities in your home schemes or compensation schemes set up to look after investors will be able to help.
It is vital, says the SEC, that investors do their homework - and they need to do more than they might for onshore investments. Investors should read the prospectus and any documents to do with a hedge fund carefully to ensure that the goals, time horizons and risks in the fund match their needs and risk-tolerance.


Investing in hedge funds requires a lot more effort from sensible investors than buying into an onshore regulated fund. Make sure you understand the way that the manager works and what strategies are being used.


Note that you may not be able to sell your investments when you want.  Most funds set fixed times - say every three or even six months - when investors can buy or sell units in the fund. Some lock investors in for much longer.


Ask questions about fees, too. Fees make an impact on your returns and performance fees can motivate managers to take greater risks to achieve greater returns.


Above all, check out the manager, and don't put all your money in one fund.


 


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