By Emily Marriott, Isaac Ruiz-Carus & Varun Bhat

I. 1.0 Useful Terms

[derived from Black's Law Dictionary, 7^th ed.]

Arbitrage

The simultaneous buying and selling of securities in different markets with the purpose of profiting from the price difference in the markets.

Derivative

A volatile financial instrument whose value depends on or is derived from the performance of a secondary source such as an underlying bond or currency.

Hedge

Making arrangements to safeguard against loss on an investment (can involve various techniques)

Leverage

The use of credit (such as margin) to improve one's speculative ability and to increase the rate of return on an investment

Short Sale

a sale of a security that the seller doesn't own (if the seller does own the security she is said to be in a "long position"), and that the seller must borrow. Usually, the technique is employed when prices drop. If the price of the security does drop, the seller can make a profit on the price of the shares sold versus the price of the shares bought to pay back the borrowed shares.

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

• Estimated to be a $1 trillion worldwide industry and growing at about 20% per year, with approximately 8350 active hedge funds in the world.

• Includes a variety of investment strategies, some of which use leverage while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or derivatives.

• Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities.

• The popular misconception is that all hedge funds are volatile -- that they all use risky techniques and strategies and place large "bets" on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are of this sort. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no leverage.

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:

Aggressive Growth

Invests in equities expected to experience acceleration in growth of earnings per share. This type of fund hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes.

Distressed Securities

Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the market's lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities.

Emerging Markets

Invests in equity or debt of emerging (less mature) markets which tend to have higher inflation and volatile growth. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available

Fund of Funds

Mixes and matches hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Volatility depends on the mix and ratio of strategies employed.

Income

Invests with primary focus on yield or current income rather than solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income.

Macro

Aims to profit from changes in global economies, typically brought about by shifts in government policy which impact interest rates, in turn affecting currency, stock, and bond markets. Participates in all major markets -- equities, bonds, currencies and commodities -- though not always at the same time. Uses leverage and derivatives to accentuate the impact of market moves.

Market Neutral - Arbitrage

Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer.
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Market Neutral - Securities Hedging

Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns.

Market Timing

Allocates assets among different asset classes depending on the manager's view of the economic or market outlook.

Opportunistic

Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class.

Short Selling

Sells securities short in anticipation of being able to re-buy them at a future date at a lower price due to the manager's assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. http://www.magnum.com/offshore/hedgefunds/reducingmarketrisk.asp

Value

Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favor with analysts. Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market.

The preceding classification of hedge funds can be graphed according to volatility.

Graph 1. Hedge Fund Performance as a function of Risk Characteristics