Introduction:

A hedge fund is a private, largely unregulated pool of capital whose managers can buy or sell any assets, bet on falling as well as rising assets and participate substantially in profits from money invested. It charges both a performance fee and a management fee. An investment fund must be open to a limited number of accredited investors in order to be exempt from direct regulation. There is no legal definition for “hedge fund” under Indian securities law and regulations.

Because of an exemption from certain regulation that otherwise apply to mutual funds, brokerage firms and investment advisors, can invest in more complex and risky investments than a public fund might. Since a hedge fund’s investment activities are limited only by the contracts governing the particular fund, it can maker greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.

As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term “hedge fund” has come in modern parlance to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and trading methods and positions would compromise the business interests of many types of hedge fund, tending to limit the information they want to release.

The assets under the management of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Their sway over markets, whether they succeed or fail, is therefore potentially substantial and there is a continuous debate over whether should be thoroughly regulated.

Fees:

A hedge fund manager will receive both a Management fee and a Performance fee. Performance fees are closely associated with hedge funds and are intended to be an incentive for the investment manager to produce the largest returns he can. A typical manager will charge fees of “2 and 20”, which refers to a management fee of 2% of the fund’s net asset value per annum and a performance fee of 20% of the fund’s profit (being the increase in its NAV)

Management fees:

As with other investment funds, the management fee is calculated as a percentage of the net asset value of the fund at the time when the fee becomes payable. Management fees are usually calculated annually and paid monthly, but can also be paid weekly.

Performance fees:

One of the defining characteristics of hedge funds is performance fees which give a share of positive returns to the manager. The manager’s performance fee is calculated as a percentage of the fund’s profits, counting both unrealized profits and actual realized trading profits. Performance fees exist because investors are usually ready to pay managers more generously when the investors have made themselves made money. Thus, the performance fee is extremely lucrative for managers who perform well.

Calculation of performance fee:

High water marks

A high water mark (also known as a loss carry forward provision) is often applied to a performance fee calculation. This means that the manager only receives performance fees on the value of the fund that exceeds the highest net asset value it has previously achieved.

This measure is intended to link the manager’s interests more closely to those of investors and to reduce the incentive for managers to seek volatile traders. If a high water mark is not used, a fund that ends alternate years at $100 and #110 would generate performance fee every other year, enriching the manager but not the investors.

The mechanism does not provide complete protection to investors: a manager who has lost a significant percentage of the fund’s value will often close the fund and start again with a clean slate, rather than continue working for no performance fee until the loss has been made good. This depends on the manager’s ability to persuade to trust him or her with their money in the new fund.

Hurdle rates:

Some managers specify a hurdle rate, signifying that they will not charge a performance fee until the fund’s annualized performance exceeds a benchmark rate, such as T-bill yield, LIBOR or a fixed percentage. This links performance fees to the ability of the manager to do better than the investor would have done if he had put the money elsewhere.

Because demand for hedge funds has outstripped supply, most managers do not now need hurdle rates in order to attract investors. For this reason, hurdle rates are now rare.

Withdrawal/Redemption fees:

Some managers charge the investors a withdrawal/redemption fee (also known as a surrender charge) if they withdraw money from the fund before a certain period of time has elapsed since the money was invested.

Hedge fund risk:

The following are some of the primary reasons for the increased risk in hedge funds as an industry:

Leverage– in addition to money invested into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing, sums many times greater than the initial investment.

Short selling– due to the nature of short selling, the losses that can be incurred on a losing bet are limitless, unless the short position directly hedges a corresponding long position. Therefore, where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns against it.

Appetite for risk- hedge funds are culturally more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities and collateralized debt obligations based on sub-prime mortgages.

Lack of transparency– hedge funds are secretive entities with a few public disclosure requirements. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision.

Lack of regulation– hedge funds are not subject to as much oversight or from financial regulators a regulated funds, and therefore some may carry undisclosed structural risks.

Legal structure:

The fund itself is not genuine business, having no employees and no assets other than its investment portfolio and a small amount of cash, and its investors being clients. The portfolio is managed by the investment manager, which has employees and property and which actual business. An investor manager may have many hedge funds under its management. In particular it’s domicile and the type of legal entity used is determined by the tax environment of the fund’s expected investors.

Regulatory issues (Indian regulations):

Many offshore centers like Cayman Islands, Dublin, Luxembourg, British Virgin Islands and Bermuda encourage the establishments of hedge funds. Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centers.

Comparison to private equity funds:

Hedge funds invest in relatively liquid assets and permit investors to enter or leave the fund, perhaps requiring some months notice. Private equity funds invest in very illiquid assets and so investors are “locked-in” for the entire term of the fund. Hedge funds often invest in private equity companies’ acquisition funds.

Transparency:

Hedge funds do not have to disclose their activities to third parties unlike mutual funds. It includes detailed discussions of risks assumed and significant positions. This high level of disclosure is not available to non-investors, contributing to hedge funds’ reputation for secrecy. Several hedge funds are completely black-box, meaning that their returns are uncertain to the investor.

 Prepared By

Harshavardhan Bhandari

KPIT Cummins Infosystems LTD

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