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FAQs on Hedge Funds Research Team | Posted On Thursday, April 23,2009, 04:47 PM

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FAQs on Hedge Funds



What is Absolute Return?

Investment returns have conventionally been measured against a market index rather than in terms of whether the investments appreciate in value or not. Absolute Return investments seek to generate positive investment returns at all times.

What is a hedge fund?

Hedge funds can be defined as absolute return oriented investment vehicles which utilize sophisticated investment techniques for the purpose of achieving superior risk adjusted returns. Hedge funds are frequently referred to as alternative investments.

What is the history of hedge fund investing?

The first acknowledged hedge fund was introduced in 1949, even though leverage and short selling had been used long before this time, but not collectively in a low risk hedged model. The original model of long/short equities in the similar sector has evolved into a multitude of strategies.

Portfolios of hedge funds, called as funds of funds, have been one of the most significant ways of accessing hedge funds as they have historically succeeded in reducing overall portfolio instability and diminishing the risk of selecting an inappropriate individual hedge fund.

Aren't hedge funds risky?

Many individuals in the professional investment community believe hedge funds to be speculative investment vehicles which take highly leveraged, directional bets based on broad macroeconomic or market views. This tainted image is partly as a result of articles in the press which refer to Global Macro funds such a Julian Robertson's Tiger Fund or George Soros's Quantum Fund. The Long Term Capital Management (LTCM) debacle opened the public's eyes to other forms of hedge funds and the dangers of leverage, but again distorted people's views of the industry.

The reality is that the hedge fund industry is much more diverse and, for the most part, quite conservative. Most hedge funds are specifically designed to reduce risk and limit volatility. Global Macro funds represent a small part of the hedge fund universe which contains a diverse range of investment strategies. The leverage employed by most hedge funds is modest and some use none at all. This contrasts with the exceptionally high leverage employed at LTCM.

Are there other benefits to hedge fund investing?

As an additional benefit, the timing of entry and exit is considerably diminished as the volatility of many hedge funds is much lower than equivalent traditional investment products.

Are there different sorts of hedge funds?

There are many different styles of hedge funds. Each of these will have different performance characteristics in diverse market environments. A blend of diverse styles of hedge funds has characteristically exhibited good capital preservation and positive investment performance over the two most recent strong and weak equity market cycles. Individual hedge funds exhibit individual performance and risk characteristics and require careful monitoring and evaluation.

Who invests in hedge funds?

Subjective evidence suggests that in the 1980's and early 1990's investments in hedge funds were predominantly made by high net worth private individuals, but that is changing and new capital flowing into this style of investment has also come from institutions ranging from corporate treasuries to pension funds and endowments.

What is the difference between a hedge fund and a fund of hedge funds?

A hedge fund is an absolute return oriented fund which has its own portfolio of investments. A fund of hedge funds invests in a number of individual hedge funds and seeks to create a diversified portfolio of funds which will deliver comparable risk and return characteristics, but with a lower level of volatility.

What are the benefits of investing in a fund of hedge funds?

Improved risk adjusted investment returns in the form of :
  • Acceptable levels of volatility
  • Capital preservation
  • Investing in a pool of top international investment managers through a single fund
  • Portfolio diversification

What are the risks of investing in hedge funds?

Investors reviewing opportunities in hedge fund investing should be aware that there are still risks to consider, and that there are obstacles to creating a sensibly diversified portfolio of hedge funds. Other than normal investment risk, factors to consider include the following :
  • There are a large funds to select from
  • Finding adequate information may not be straightforward
  • There are meaningful differences in risk and return between individual funds
  • These funds may not necessarily be regulated
  • The fund's management team is often small and not institutionalized
  • The vast majority of hedge funds only offer infrequent liquidity, monthly being typical, but six month lock-ups or even annual liquidity is not unusual

Are there other factors to consider?

Many of the best hedge funds are closed to new investors (they are capacity constrained by their investment style) or have high minimum investment thresholds. For most investors, structuring a sensible hedge fund portfolio is not a simple process, and many investors use hedge fund selection specialists to access this sector in a controlled matter. Hedge fund selection specialists would provide ongoing quantitative and qualitative analysis of existing and potential new managers.

What is meant by the term "offshore" fund?

Most hedge funds and funds of hedge funds are Offshore Funds since they are registered or incorporated in "offshore" locations situated outside the main centers for investments.

Are all Hedge Funds hedged?

No. Not all hedge funds are hedged. Many are simply long stocks, and may even use leverage. One must ascertain on a case by case basis, as a result, whether a fund hedges, how, and how much. This is absolutely crucial to understanding a fund's performance. Without this information, one cannot gauge how much risk produced its return.

Are hedge fund returns reported before or after fees?

Most funds report their returns from previous years "net of all fees." This means net of management fees and net of incentive/performance fees. However, don't assume this; look carefully and if you are not sure, ask. Some funds report gross returns or returns net of management fees but gross of incentive /performance fees. Still others will report audited net of all fees returns with estimated/pre-audited net of all fees performance for the current year's performance. But regardless of which method is used, almost all funds state that their pre-audit figures are subject to adjustment by the partnership's auditor after the end of the year. These adjustments are almost always minor. If the adjustments are large, you should look for an awfully good explanation

What Types of Strategies do hedge funds employ?

Every investment strategy in existence is probably used by at least one hedge fund, from the basic buy-and-hold to more esoteric strategies such as currency arbitrage or CMO derivatives. The majority of hedge funds are fairly straightforward, long-bias equity funds. Of these, most fall into the same categories one applies to mutual funds: micro- to large-cap, value, growth, momentum, etc.

Who typically invests in hedge funds?

Qualified clients, institutions, endowments, fund of funds, family offices and pensions invest in hedge funds.

Can a qualified client place IRA or ERISA assets in a hedge fund?

Usually qualified clients may invest IRA or ERISA assets in hedge funds; however, funds are limited in the amount of these assets they may accept. IRA investments in hedge funds make a great deal of sense because of the deferral of taxes on capital gains. The details of this deferral should be discussed with an accountant before making an investment.

What are the tax implications of becoming a limited partner/investor in a hedge fund?

At the end of each year a Hedge Fund as a limited partnership reports in a K-1 form gains or losses for the trades the fund made that year. These gains or loses are treated as are any other capital gain. It is important to note that the return of a fund is separate from the taxable gains and losses the fund has made over the course of the year. For example, it is possible that a fund may have "realized" a loss for tax purposes but have reported positive performance (capital appreciation) through unrealized gains. The opposite is also possible.

What are hurdle rates?

The minimum investment return a fund must exceed before a performance allocation/incentive fee can be taken.

What are lock-up periods?

Lock up periods signifies the time period that you must hold your assets in the fund before they can be removed.

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