If you are not sure what a hedge fund does, you have lots of company. Hedge funds raise a pool of money privately from a limited number of investors. Then they use it to make investments that are consistent with the fund manager’s strategy.

The investors, who must be accredited or qualified purchasers, include high net-worth individuals and a variety of institutional investors. It includes pension funds and the endowments of nonprofit entities including colleges, universities, and foundations.

Most hedge funds are organized as limited partnerships, with a managing partner and multiple limited partners. Each investor commits at least the required minimum, receives a pro-rata share of a fund’s income, and owes income tax on that amount.

The fund’s operating, administrative, and investment expenses are subtracted, again on a pro-rata basis, before distributions are made. However, the investors, who are limited partners, aren’t liable for fund debts. Their losses are limited to the amount they invest.

hedge-fund-share

The fund manager, who is the general partner, is also an investor, and his or her income depends on fund performance, providing an incentive to succeed. Hedge funds also employ administrators, auditors, analysts, traders, legal counsel, and other professionals. Also, they generally work with external broker-dealers to execute their trades.

Hedge funds history

The first hedge fund was introduced in 1949, the creation of Alfred W Jones. He took a relatively conservative approach to providing a positive return whether the stock market as a whole went up or down.

His market-neutral strategy was to create an equity portfolio in which he took opposite positions: purchasing, or going long, some stocks and selling others short. The idea was to capitalize on the fact that whether the market as a whole was moving up or down. In other words, some investments would gain value and others would lose. The key was to identify the companies with the potential for increased value as well as those whose value he considered at risk.

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The goal of a market-neutral, or long/short strategy, is to realize more on your profitable positions than you lose on the unprofitable ones. If the market as a whole increased in value, the fund would make more money on the stocks it held long than it would lose on the ones it had sold short. If the opposite occurred, and the market faltered, the fund might lose money on the stocks it owned but could profit from the short sales.

Certainly, any two-sided trade means sacrificing some of the potential gains that come with correctly anticipating the way the market as a whole will move. Also, it protects against steep losses if your assessment is wrong and the market moves in the opposite direction. That’s what hedging is all about. Despite Jones’ success, it took 20 years for hedge funds to become popular and nearly 50 — well into the 1990s – for them to be a major force in the economy.

Hedge fund anatomy

When a hedge fund is established, it’s generally designed to pursue a particular strategy that governs the investments the manager makes and how the fund is structured. For example, an event-driven strategy will concentrate its investments in companies that are involved in a corporate action, such as a merger, tender offer, or restructuring, among others.

In the case of a merger, the fund will typically buy shares in a target company and sell short shares in the acquiring company. If the deal is done, the fund ends up with the opposite positions in the acquiring company. Thus, it may realize a profit on the spread, or difference in prices.

Other major strategic approaches that hedge funds employ are categorized as global macro, directional, and relative value. Though these are actually umbrella terms that encompass a wide variety of approaches — by some counts 25 or more.

  1. Global macro strategies focus on anticipated changes in geopolitical or economic variables, such as oil prices or interest rates, and the effect they will have on traditional securities markets, commodity markets, and currency markets.
  2. Directional, sometimes called tactical, strategies, include traditional long/short and market-neutral approaches to succeeding whichever way the market moves as well as approaches that pursue substantial profits in identifying overvalued securities or markets.
  3. A relative value strategy focuses on finding discrepancies in securities prices or in some cases on implied and actual volatility.

In addition, there are a number of multi-strategy funds that use a combination of approaches to achieve their objectives.

CONSTRUCTING A HEDGE
The hedge in hedge fund refers to the funds tactic of offsetting one investment risk using other investments, including derivatives, such as options or futures contracts, a market-neutral or long/short strategy, arbitrage, or other approaches to realizing greater gains than losses.

Regulation rules

Hedge funds are exempt from registering with the SEC under Regulation D. Though they must report their securities transactions, provide a list of their equity holdings every quarter, in what is known as 13F filings. Moreover, they must meet record-keeping requirements. They are also subject to the same anti-fraud provisions that apply to all investments. But they aren’t required to provide a prospectus or the same level of financial disclosures that are required of registered securities.

Hedge fund managers with more than $150 million under management, however, must register as investment advisers (RIAS). It is a major regulatory change resulting from provisions in the Dodd-Frank Act. In that capacity, they must complete Form ADV and are subject to SEC oversight. Form PF, in 2011, requires most advisers to report how their fund uses leverage, what its exposure to risk is, and what its trading practices are, among other things.

The bigger the fund, the more it must reveal. In addition, funds that invest in markets that the CFTC regulates, including currencies, commodities, and swaps, are subject to that agency’s oversight as well as to SEC oversight. Some fund managers may also have to register as broker-dealers. In other words, they have to become members of FINRA and subject to its rules. It depends on the way the fund operates. Provisions of the JOBS Act of 2012 allow hedge funds to advertise but still require that all their investors be accredited.

What Are Hedge Funds And How Do They Work? by Inna Rosputnia

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