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By Emily Marriott, Isaac Ruiz-Carus & Varun Bhat
I. 1.0 Useful Terms
[derived from Black's Law Dictionary, 7th ed.]
II. A Short History and the Definition of a Hedge Fund
The first hedge fund was set up by Alfred W. Jones in 1949. Jones was the first to use short sales and leverage techniques in combination. In 1952, he converted his general partnership fund into a limited partnership investing with several independent portfolio managers and created the first multi-manager hedge fund. In the mid 1950's other funds started using the short-selling of shares, although for the majority of these funds the hedging of market risk was not central to their investment strategy.
In 1966, an article in Fortune magazine about a "hedge fund" run by a certain A. W. Jones shocked the investment community. Apparently, the fund had outperformed all the mutual funds of its time, even after accounting for a hefty 20% incentive fee. This is because the rate of return was higher on the hedge fund versus all other mutual funds.
"Hedge fund" is a general, non-legal term that was originally used to describe a type of private and unregistered investment pool that employed sophisticated hedging and arbitrage techniques to trade in the corporate equity markets. Hedge funds have traditionally been limited to sophisticated, wealthy investors. Over time, the activities of hedge funds broadened into other financial instruments and activities. Today, the term "hedge fund" refers not so much to hedging techniques, which hedge funds may or may not employ, as it does to their status as private and unregistered investment pools.
Hedge funds are similar to mutual funds in that they both are pooled investment vehicles that accept investors' money and generally invest it on a collective basis. However, they are regulated in significantly different ways. Up until 2005, hedge funds in the United States often relied on Section 4(2) and Rule 506 of Regulation D of the Securities Act of 1933 to avoid having to register their securities with the Securities and Exchange Commission of the United States (SEC). Further, to avoid regulation regarding mutual funds (a type of "investment company"), hedge funds relied on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940. In short, hedge funds escaped most U.S. regulation directed at other investment vehicles such as mutual funds.
European nations regulate hedge funds by either regulating the type of investor who can invest in a hedge fund or by regulating the minimum subscription level required to invest in a hedge fund. In the years to come, experts are predicting the rise of an alternative regulatory framework that will be tiered yet flexible.
III. The "Hedge Fund Rule" and the Effect on Hedge Fund Clients
The increasing incidence of hedge fund fraud (which exceeded $1 billion in recent years) prompted the SEC to introduce regulations aimed at protecting the security markets. In addition to fraud, the SEC was also concerned with the increasing growth of hedge funds and wanted to find a way to police the $870 billion wrapped up in the hedge fund business. During the 1990s and the early 2000s, hedge funds experienced a five-fold increase in size. Additionally, wealthy individuals were no longer the only investors in hedge funds; instead, pensions, universities, charities, and endowments began to place their money in hedge funds. In order to protect these investors, the SEC revised the Investment Advisors Act of 1940 to create the "hedge fund rule."
The hedge fund rule, effective February 2005, adopted the interpretation of "client" to mean shareholders, limited partners, members, or beneficiaries of the funds. (Sec. 203(b)(3) of the Investment Advisors Act of 1940). This interpretation required hedge fund advisers previously exempt from registration, since they had less than 15 "clients" under the previous interpretation, to register with the SEC. According to the SEC, mandatory registration was expected to have a number of benefits such as serving as a deterrent to fraud, providing it with examination authority, fostering strong compliance practices and raising standards for investments in hedge funds. However, in June 2006, a D.C. Circuit Court case ruled that the SEC's interpretation of "client" was incorrect and that clients of hedge fund managers only include the funds they manage, not the individual investors of the funds. Therefore, hedge fund managers who manage fewer than 15 funds are once again exempt from SEC registration. (Goldstein v. SEC)
Hedge funds are also exempt from other requirements that apply to mutual funds for the protection of investors, such as regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, and regulations limiting the use of leverage. These exemptions permit hedge funds to engage in leveraging and other sophisticated investment techniques to a much greater extent, which typically allows them to generate higher returns than other investment vehicles. Of course, like mutual funds, hedge funds are subject to the anti-fraud provisions of U.S. federal securities laws.
IV. Facts about Hedge Funds
V. A Classification of Hedge Funds:
It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same -- investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds.
This is a classification of hedge funds:
The preceding classification of hedge funds can be graphed according to volatility.
Graph 1. Hedge Fund Performance as a function of Risk Characteristics