hedge fund

 

  • [15] Cumulative hedge fund and other risk asset returns (1997–2012) During the 1990s, the number of hedge funds increased significantly with the 1990s stock market rise,[14]
    the aligned-interest compensation structure (i.e., common financial interests), and the promise of above average returns[18] as likely causes.

  • [88] Valuation risk refers to the concern that the net asset value (NAV) of investments may be inaccurate;[93] capacity risk can arise from placing too much money into one
    particular strategy, which may lead to fund performance deterioration;[94] and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group of correlated funds.

  • To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company’s equity and equity-related
    instruments.

  • “[81] Hedge fund managers that hold a large number of investment positions for short periods are likely to have a particularly comprehensive risk management system in place,
    and it has become usual for funds to have independent risk officers who assess and manage risks but are not otherwise involved in trading.

  • A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk
    management techniques in an attempt to improve performance, such as short selling, leverage, and derivatives.

  • [64] The elements contributing to a hedge fund strategy include the hedge fund’s approach to the market, the particular instrument use, the market sector the fund specializes
    in (e.g., healthcare), the method used to select investments, and the amount of diversification within the fund.

  • [63] The hedge fund’s prospectus, also known as an offering memorandum, offers potential investors information about key aspects of the fund, including the fund’s investment
    strategy, investment type, and leverage limit.

  • Although hedge funds can be considered risky investments, the expected returns of some hedge fund strategies are less volatile than those of retail funds with high exposure
    to stock markets because of the use of hedging techniques.

  • [77] Other event-driven strategies include credit arbitrage strategies, which focus on corporate fixed income securities; an activist strategy, where the fund takes large
    positions in companies and uses the ownership to participate in the management; a strategy based on predicting the final approval of new pharmaceutical drugs; and legal catalyst strategy, which specializes in companies involved in major lawsuits.

  • [95] Many investment funds use leverage, the practice of borrowing money, trading on margin, or using derivatives to obtain market exposure in excess of that provided by investors’
    capital.

  • [91] Risks shared with other investment types[edit] Hedge funds share many of the same types of risk as other investment classes, including liquidity risk and manager risk.

  • [84][88] In comparison with investment banks, hedge fund leverage is relatively low; according to a National Bureau of Economic Research working paper, the average leverage
    for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.

  • [16] Jones referred to his fund as being “hedged”, a term then commonly used on Wall Street to describe the management of investment risk due to changes in the financial markets.

  • [17] In the 1970s, hedge funds specialized in a single strategy with most fund managers following the long/short equity model.

  • [75][76] Special situations are events that impact the value of a company’s stock, including the restructuring of a company or corporate transactions including spin-offs,
    share buy backs, security issuance/repurchase, asset sales, or other catalyst-oriented situations.

  • It is common for hedge fund investment strategies to aim to achieve a positive return on investment regardless of whether markets are rising or falling (“absolute return”).

  • [101][102] Performance fees have been criticized by Warren Buffett, who believes that because hedge funds share only the profits and not the losses, such fees create an incentive
    for high-risk investment management.

  • However, due to economies of scale the management fee from larger funds can generate a significant part of a manager’s profits, and as a result some fees have been criticized
    by some public pension funds, such as CalPERS, for being too high.

  • They are also considered distinct from private equity funds and other similar closed-end funds as hedge funds generally invest in relatively liquid assets and are usually
    open-ended.

  • Risk For an investor who already holds large quantities of equities and bonds, investment in hedge funds may provide diversification and reduce the overall portfolio risk.

  • [61] • Bill Ackman of Pershing Square Capital Management LP Strategies Hedge fund strategies are generally classified among four major categories: global macro, directional,
    event-driven, and relative value (arbitrage).

  • This means they typically allow investors to invest and withdraw capital periodically based on the fund’s net asset value, whereas private-equity funds generally invest in
    illiquid assets and only return capital after a number of years.

  • [4] Although most modern hedge funds are able to employ a wide variety of financial instruments and risk management techniques,[5] they can be very different from each other
    with respect to their strategies, risks, volatility and expected return profile.

  • [66] Global macro fund managers use macroeconomic (“big picture”) analysis based on global market events and trends to identify opportunities for investment that would profit
    from anticipated price movements.

  • According to the Financial Times, “big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management.

  • [86] In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence to assess the risk that error
    or fraud at a hedge fund might result in a loss to the investor.

  • Fund managers may employ extensive risk management strategies in order to protect the fund and investors.

  • [8] Early hedge funds sought to hedge specific investments against general market fluctuations by shorting the market, hence the name.

  • Large institutional investors such as hedge funds are more likely to pursue event-driven investing strategies than traditional equity investors because they have the expertise
    and resources to analyze corporate transactional events for investment opportunities.

  • [81] The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology,
    positions, and leverage exposure.

  • Funds using a “fundamental growth” strategy invest in companies with more earnings growth than the overall stock market or relevant sector, while funds using a “fundamental
    value” strategy invest in undervalued companies.

  • Over the next decade, hedge fund strategies expanded to include credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy.

  • [88] Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/or registration requirements as other financial investment
    managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud.

  • [68]: 345  Funds using a “short bias” strategy take advantage of declining equity prices using short positions.

  • [80] Managers of hedge funds often aim to produce returns that are relatively uncorrelated with market indices and are consistent with investors’ desired level of risk.

  • [63][66] Global macro[edit] Main article: Global macro Hedge funds using a global macro investing strategy take large positions in share, bond, or currency markets in anticipation
    of global macroeconomic events in order to generate a risk-adjusted return.

  • Considerations will include the organization and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund’s
    ability to develop as a company.

  • [96] Some types of funds, including hedge funds, are perceived as having a greater appetite for risk, with the intention of maximizing returns,[92] subject to the risk tolerance
    of investors and the fund manager.

  • While global macro strategies have a large amount of flexibility (due to their ability to use leverage to take large positions in diverse investments in multiple markets),
    the timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns.

  • Their ability to use leverage and more complex investment techniques distinguishes them from regulated investment funds available to the retail market, commonly known as mutual
    funds and ETFs.

  • [89] Liquidity refers to the degree to which an asset can be bought and sold or converted to cash; similar to private-equity funds, hedge funds employ a lock-up period during
    which an investor cannot remove money.

  • There are a variety of market approaches to different asset classes, including equity, fixed income, commodity, and currency.

  • [1] Financial regulators generally restrict hedge fund marketing to institutional investors, high net worth individuals, and accredited investors.

  • Funds do not tend to report compensation, and so published lists of the amounts earned by top managers tend to be estimates based on factors such as the fees charged by their
    funds and the capital they are thought to have invested in them.

  • • Multi-manager: a hedge fund wherein the investment is spread along separate sub-managers investing in their own strategy.

  • [90] In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and
    external regulatory requirements.

  • Managers employing such a strategy capitalize on valuation inconsistencies in the market before or after such events, and take a position based on the predicted movement of
    the security or securities in question.

  • [84] A variety of different measurement techniques and models are used to estimate risk according to the fund’s leverage, liquidity, and investment strategy.

  • This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather
    than attempt to recover the losses over a number of years without a performance fee.

  • [63][66] Directional hedge fund strategies include US and international long/short equity hedge funds, where long equity positions are hedged with short sales of equities
    or equity index options.

  • [109] Many managers have accumulated large stakes in their own funds and so top hedge fund managers can earn extraordinary amounts of money, perhaps up to $4 billion in a
    good year.

  • Sometimes hedge fund strategies are described as “absolute return” and are classified as either “market neutral” or “directional”.

  • [89] New regulations introduced in the US and the EU as of 2010 required hedge fund managers to report more information, leading to greater transparency.

  • [113] Most hedge fund managers are remunerated much less, however, and if performance fees are not earned then small managers at least are unlikely to be paid significant
    amounts.

  • The risk element arises from the possibility that the merger or acquisition will not go ahead as planned; hedge fund managers will use research and analysis to determine if
    the event will take place.

  • • Equity market neutral: exploit differences in stock prices by being long and short in stocks within the same sector, industry, market capitalization, country, which also
    creates a hedge against broader market factors.

  • [24][25] As of February 2011, 61% of worldwide investment in hedge funds came from institutional sources.

  • “[65] The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager, or a combination.

  • [95] These risks may be managed through defined controls over conflict of interest,[93] restrictions on allocation of funds,[94] and set exposure limits for strategies.

  • [103] Almost all hedge fund performance fees include a “high water mark” (or “loss carryforward provision”), which means that the performance fee only applies to net profits
    (i.e., profits after losses in previous years have been recovered).

  • Although hedge funds are not subject to the many restrictions applicable to regulated funds, regulations were passed in the United States and Europe following the financial
    crisis of 2007–2008 with the intention of increasing government oversight of hedge funds and eliminating certain regulatory gaps.

  • [2][3] However, other than a fund’s regulatory status, there are no formal or fixed definitions of fund types, and so there are different views of what can constitute a “hedge
    fund.”

  • Remuneration of portfolio managers[edit] Hedge fund management firms are often owned by their portfolio managers, who are therefore entitled to any profits that the business
    makes.

  • • 130-30 funds: equity funds with 130% long and 30% short positions, leaving a net long position of 100%.

  • [67] Risk arbitrage typically involves buying and selling the stocks of two or more merging companies to take advantage of market discrepancies between acquisition price and
    stock price.

 

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