“Hedging Fund & Its Impact On Capital Market”

CONTENTS

Sr.No. Particulars Page No.

1. Introduction 1.

2. Characteristics Of Hedge Funds 7.

3. Growth Of Hedge Funds 9.

4. Hedge Fund Data 12.

5. Benefits Of Hedge Funds 21.

6. Workings Of Hedge Funds 27.

7. Risks Involved In Hedge Funds 32.

8. Impact Of Hedge Funds In Capital Market 45.

9. Role Of Hedge Funds In Capital System 48.

10. Investor Protection 50.

11. The Federal Reserve & Hedge Funds 52.

Hemant Palav / MBA / Semester II 1.

“Hedging Fund & Its Impact On Capital Market”

INTRODUCTION

The term 'hedge fund' is used to describe a wide variety of institutional investors

employing a diverse set of investment strategies. Although there is no formal definition of 'hedge

fund,' hedge funds are largely defined by what they are not and by the regulations to which they

are not subject. As a general matter, the term 'hedge fund' refers to unregistered, private

investment partnerships for wealthy sophisticated investors (both natural persons and

institutions) that use some form of leverage to carry out their investment strategies.

The term 'hedge fund' is undefined, including

in the federal securities laws. Indeed, there is no

commonly accepted universal meaning. As hedge

funds have gained stature and prominence, though,

'hedge fund' has developed into a catch-all

classification for many unregistered privately managed

pools of capital. These pools of capital may or may not

utilize the sophisticated hedging and arbitrage strategies

that traditional hedge funds employ, and many appear to

engage in relatively simple equity strategies. Basically, many 'hedge funds' are not actually

hedged, and the term has become a misnomer in many cases.

Hedge funds engage in a variety of investment activities. They cater to sophisticated

investors and are not subject to the regulations that apply to mutual funds geared toward the

general public. Fund managers are compensated on the basis of performance rather than as a

fixed percentage of assets. 'Performance funds' would be a more accurate description.

Hemant Palav / MBA / Semester II 2.

“Hedging Fund & Its Impact On Capital Market”

Selected Definitions of "Hedge Fund"

"Hedge fund" is an expression believed to have been first applied in 1949 to a fund managed by

Alfred Winslow Jones.1 Mr. Jones's private investment fund combined both long and short equity

positions to "hedge" the portfolio's exposure to movements in the market. Today, hedge funds are

no longer defined by a particular strategy and often do not "hedge" in the economic sense. The

following is a selection of definitions and descriptions of the term "hedge fund" showing the

diversity of views among commentators.

 "The term 'hedge fund' is commonly used to describe a variety of different types of investment

vehicles that share some common characteristics. Although it is not statutorily defined, the term

encompasses any pooled investment vehicle that is privately organized, administered by

professional money managers, and not widely available to the public."

--THE PRESIDENT'S WORKING GROUP ON FINANCIAL

MARKETS, HEDGE FUNDS, LEVERAGE, AND THE

LESSONS OF LONG-TERM CAPITAL MANAGEMENT 1

(1999).

 "The term 'hedge fund' refers generally to a privately offered investment vehicle that pools the

contributions of its investors in order to invest in a variety of asset classes, such as securities,

futures contracts, options, bonds, and currencies."

--THE SECRETARY OF THE TREASURY, THE BOARD OF

GOVERNORS OF THE FEDERAL RESERVE SYSTEM,

THE SECURITIES AND EXCHANGE COMMISSION, A

REPORT TO CONGRESS IN ACCORDANCE WITH §

356(c) OF THE USA PATRIOT ACT OF 2001 (2002).

Hemant Palav / MBA / Semester II 3.

“Hedging Fund & Its Impact On Capital Market”

 "A hedge fund can be broadly defined as a privately offered fund that is administered by a

professional investment management firm (or 'hedge fund manager'). The word 'hedge' refers to

a hedge fund's ability to hedge the value of the assets it holds (e.g., through the use of options or

the simultaneous use of long positions and short sales). However, some hedge funds engage only

in 'buy and hold' strategies or other strategies that do not involve hedging in the traditional

sense. In fact, the term 'hedge fund' is used to refer to funds engaging in over 25 different types

of investment strategies .…"

--MANAGED FUNDS ASSOCIATION,

HEDGE FUND FAQs 1 (2003).

  "There is no universally accepted meaning of the expression 'hedge fund'; indeed, many

competing (and sometimes partially contradicting) definitions exist. The term first came into use

in the 1950s to describe any investment fund that used incentive fees, short-selling, and leverage.

A summary definition frequently used in official sector reports is 'any pooled investment vehicle

that is privately organised, administered by professional investment managers, and not widely

available to the public'. The term can also be defined by considering the characteristics most

commonly associated with hedge funds. Usually, hedge funds:

are organised as private investment partnerships or offshore investment corporations;

 

use a wide variety of trading strategies involving position-taking in a range of markets;

 

employ an assortment of trading techniques and instruments, often including short-

selling, derivatives and leverage;

 

pay performance fees to their managers; and

 

Have an investor base comprising wealthy individuals and institutions and a relatively

high minimum investment limit (set at US$100,000 or higher for most funds)."

Hemant Palav / MBA / Semester II 4.

“Hedging Fund & Its Impact On Capital Market”

--FINANCIAL SERVICES AUTHORITY (UNITED

KINGDOM), HEDGE FUNDS AND THE FSA, DISCUSSION

PAPER 16, at 8 (2002).

 

"Originally set up to 'hedge bets' or insure against currency or interest rate risks, hedge funds

have since taken on a much wider remit, investing in assets ranging from equities and fixed

interest stocks to derivatives and commodities. Their aim is to make absolute returns, that is to

make performance returns irrespective of which way the markets are going. Rather like

derivative funds, hedge funds use derivative instruments or gearing (borrowing against the

fund's assets) to gain greater exposure to their investments or to protect against losses."

--ROBERT B. MILROY, STANDARD & POOR'S GUIDE TO

OFFSHORE INVESTMENT FUNDS 28 (2000).

 

"The term 'hedge fund' was in use as early as the 1960s to describe a new speculative investment

vehicle that used sophisticated hedging and arbitrage techniques in the corporate equities

market. In the late 1960s, former Securities and Exchange Commissioner Hugh Owens described

'hedge funds' as 'private investment partnerships which employ the investment techniques of

leveraging and hedging.' In the 1970s and 1980s, the activities of similar types of funds

broadened into a range of financial instruments and activities .… The term 'hedge fund' does not

have a precise definition, but it has been used to refer generally to a cadre of private investment

partnerships that are engaged in active trading and arbitrage of a range of different securities

and commodities."

--DEPARTMENT OF THE TREASURY, SECURITIES AND

EXCHANGE COMMISSION, BOARD OF GOVERNORS OF

THE FEDERAL RESERVE SYSTEM, JOINT REPORT ON

THE GOVERNMENT SECURITIES MARKET, at B-64

(1992) (citing HUGH OWENS, SECURITIES AND

Hemant Palav / MBA / Semester II 5.

“Hedging Fund & Its Impact On Capital Market”

EXCHANGE COMMISSIONER, A REGULATOR LOOKS

AT SOME UNREGULATED INVESTMENT COMPANIES:

THE EXOTIC FUNDS, REMARKS BEFORE THE NORTH

AMERICAN SECURITIES ADMINISTRATORS

ASSOCIATION (Oct. 21, 1969)).

 

A hedge fund is a "private investment partnership (for U.S. investors) or an off-shore investment

corporation (for non-U.S. or tax-exempt investors) in which the general partner has made a

substantial personal investment, and whose offering memorandum allows for the fund to take

both long and short positions, use leverage and derivatives, and investment in many markets.

Hedge funds often take large risks on speculative strategies, including [program trading, selling

short, swap, and arbitrage]. A fund need not employ all of these tools all of the time; it must

merely have them at its disposal."

--JOHN DOWNES AND JORDAN ELLIOTT GOODMAN,

BARRON'S, FINANCE & INVESTMENT HANDBOOK 358

(5th ed. 1998).

 

"There is no precise definition of the term 'hedge fund,' and one will not be found in the federal

or state securities laws. The term was first used to describe private investment funds that

combine both long and short equity positions within a single leveraged portfolio. It is generally

believed that the first such fund to employ this approach was an investment partnership

organized in 1949 by Alfred Winslow Jones … Hedge funds are no longer defined by the strategy

they pursue. While a number of today's funds pursue the hedged equity strategy of Jones,

numerous different investment styles are embraced by hedge funds .… Hedge funds are defined

more by their form of organization and manner of operation than by the substance of their

financial strategies."

Hemant Palav / MBA / Semester II 6.

“Hedging Fund & Its Impact On Capital Market”

--Scott J. Lederman, Hedge Funds, in FINANCIAL

PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS

11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000).

 "Like mutual funds, hedge funds pool investors' money and invest those funds in financial

instruments in an effort to make a positive return. However, unlike mutual funds, hedge funds are

not registered with the SEC. This means that hedge funds are subject to very few regulatory

controls. In addition, many hedge fund managers are not required to register with the SEC and

therefore are not subject to regular SEC oversight. Because of this lack of regulatory oversight,

hedge funds historically have been available to accredited investors and large institutions, and

have limited their investors through high investment minimums (e.g., $1 million).

Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other

speculative investment practices that may increase the risk of investment loss."

--SECURITIES AND EXCHANGE COMMISSION,

HEDGING YOUR BETS: A HEADS UP ON HEDGE

FUNDS AND FUNDS OF HEDGE FUNDS, available at

http://www.sec.gov/answers/hedge.htm.

 "'Hedge fund' is a general, non-legal term used to describe private, unregistered investment

pools that traditionally have been limited to sophisticated, wealthy investors. Hedge funds are

not mutual funds and, as such, are not subject to the numerous regulations that apply to mutual

funds for the protection of investors - including 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, regulations limiting the use of leverage, and more."

--SECURITIES AND EXCHANGE COMMISSION, INVEST

WISELY: AN INTRODUCTION TO MUTUAL FUNDS,

available at

http://www.sec.gov/investor/pubs/inwsmf.htm.

Hemant Palav / MBA / Semester II 7.

“Hedging Fund & Its Impact On Capital Market”

 

 "A hedge fund is an actively managed investment fund that seeks attractive absolute return. In

pursuit of their absolute return objective, hedge funds use a wide variety of investment strategies

and tools. Hedge funds are designed for a small number of large investors, and the manager of

the fund receives a percentage of the profits earned by the fund. Hedge fund managers are active

managers seeking absolute return."

--ROBERT A. JAEGER, ALL ABOUT HEDGE FUNDS, at x

(2003) (Perhaps in a bit of his own hedging, Jaeger

calls his definition "provisional.").

Key Characteristics of Hedge Funds

Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and

minimize the correlation with equity and bond markets. Many hedge funds are flexible in

their investment options (can use short selling, leverage, derivatives such as puts, calls,

options, futures, etc.).

Hedge funds vary enormously in terms of investment returns, volatility and risk. Many,

but not all, hedge fund strategies tend to hedge against downturns in the markets being

traded.

Many hedge funds have the ability to deliver non-market correlated returns.

Many hedge funds have as an objective consistency of returns and capital preservation

rather than magnitude of returns.

Most hedge funds are managed by experienced investment professionals who are

generally disciplined and diligent.

Pension funds, endowments, insurance companies, private banks and high net worth

individuals and families invest in hedge funds to minimize overall portfolio volatility and

enhance returns.

Most hedge fund managers are highly specialized and trade only within their area of

expertise and competitive advantage.

Hemant Palav / MBA / Semester II 8.

“Hedging Fund & Its Impact On Capital Market”

Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards

performance incentives, thus attracting the best brains in the investment business. In

addition, hedge fund managers usually have their own money invested in their fund.

Facts About the Hedge Fund Industry

Estimated to be a $1 trillion industry and growing at about 20% per year with

approximately 8350 active hedge funds.

Includes a variety of investment strategies, some of which use leverage and derivatives

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 through the use

of derivatives.

Most hedge funds are highly specialized, relying on the specific expertise of the manager

or management team.

Performance of many hedge fund strategies, particularly relative value strategies, is not

dependent on the direction of the bond or equity markets -- unlike conventional equity or

mutual funds (unit trusts), which are generally 100% exposed to market risk.

Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much

capital they can successfully employ before returns diminish. As a result, many

successful hedge fund managers limit the amount of capital they will accept.

Hedge fund managers are generally highly professional, disciplined and diligent.

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.

Beyond the averages, there are some truly outstanding performers.

Investing in hedge funds tends to be favored by more sophisticated investors, including

many Swiss and other private banks that have lived through, and understand the

consequences of, major stock market corrections.

An increasing number of endowments and pension funds allocate assets to hedge funds.

Hemant Palav / MBA / Semester II 9.

“Hedging Fund & Its Impact On Capital Market”

The growth of hedge funds

In the entire financial services area, the sector showing the most growth is clearly the area of

hedge funds. While brokerage commissions continue to decline, investment banking fees start to

come under pressure and the entire financial services industry worries about intensified

regulatory scrutiny, the hedge fund industry with its rapid growth stands out from the crowd.

New funds are starting up every week and many are beginning with an excess of a billion dollars

under management from day one. The amount of money under management with hedge funds

has gone up four times between 1996 and 2004 and is expected to further triple between now and

2010 to over $2.7 trillion. Public funds, endowments, and corporate sponsors have all increased

their allocations to hedge funds within the context of an increased allocation towards alternative

investments more generally. This move towards increased investments in real estate/private

equity/hedge funds (alternative investments) is driven by the need for a higher return to

compensate for the expected lower returns from more conventional investment strategies focused

on US bonds and equities. There is also a clear desire among this investor base to be more

focused on absolute-return strategies rather than relative return. Given the current level of

allocations most of these large long-term investors have towards alternative investments, and

their professed long-term target allocation, the flow of funds to these asset classes will remain

strong.

One of the intriguing developments in the hedge fund world is the clear desire and ability

of the newer funds to charge higher fees and impose more stringent terms on investors. No

longer are funds charging a 1 per cent management fee and 20 per cent of profits -- the norm for

the first generation of funds set up in the early to mid 1990s. As per an interesting study done by

Morgan Stanley's prime brokerage unit, about a third of the funds opening in the past six months

are charging a 2 per cent management fee and 20 per cent of profits or higher, while the majority

are charging a 1.5 per cent management fee and 20 per cent of profits. Many of the new funds

have more stringent lock-ups and stiff penalties if you redeem early, as well as modified high-

water marks.

Hemant Palav / MBA / Semester II 10.

“Hedging Fund & Its Impact On Capital Market”

The hedge fund business thus seems to have the unique characteristic of being possibly

the only business that I know of wherein new players (most of whom are unproven) have the

ability to charge more and get better terms than the established operators. This implies a

negative franchise value for the established large fund complexes which have survived and

prospered through the years. Given that most of the best hedge fund complexes are closed to new

investors, the new guys seem to be taking advantage of the huge demand-supply mismatch for

quality money managers. There is a feeding frenzy currently under way in the world of

alternative investments and clients are paying up the higher fees for fear of being locked out

from these funds at a later date, if they actually survive and grow.

One reason why the new boys are focusing more on fees and lock-ups could be the difficulty all

hedge funds are having in generating adequate alpha (excess return) to ensure an adequate

payout for themselves.

In a study done by Morgan Stanley on the excess returns generated by hedge funds over

the last decade, this trend of declining returns was very apparent. In the study they defined

excess returns as the return of the Hedge Fund research composite over one month LIBOR (a

proxy for cash returns).

In the 1995-97 period, excess returns were 14 per cent; these returns have consistently

declined dropping to as low as 5 per cent in 2001-03 and have dropped further since.

The current huge inflows into funds focused on emerging markets make sense if you look

at performance numbers over the past three years.

Hedge funds focused on the emerging markets had the best returns with an 18 per cent

annual return during 2001-04, closely followed by distressed debt focused funds at 17 per cent.

More conventional hedge fund strategies of tech at 0 per cent and risk arbitrage at 3 per cent

annual return lagged far behind. Given the constant inflows into new hedge funds, clients do not

yet seem to be bothered about paying higher and higher fees for lower returns, but this is a

discussion that I am sure will come up at some stage in most investment committees. At some

stage if the hedge fund community continues to show declining alpha (excess returns), clients

Hemant Palav / MBA / Semester II 11.

“Hedging Fund & Its Impact On Capital Market”

will need to question whether the proliferation of hedgies has reduced returns because the field

has become too competitive.

The beauty of the hedge fund business and the reason why the upward drift in fee

structure is even more surprising is the ease of entry of new players into the game. The average

long short hedge fund needs only about six back office staff per billion dollars, while a global

macro fund needs about 11 people for a fund of similar size (Morgan Stanley survey). The

typical long short US equity manager has only nine investment professionals and three in the

back office. These funds are also not really regulated and have very limited disclosure

requirements, if any. The start-up costs of these vehicles are also minimal and most funds will

be able to break even at sub $100 million in assets under management. There is no other industry

that I am aware of where exit and entry are as simple.

Hedge funds till date in 2005 have had a tough year; there have been few strong trends to

capitalise on and most funds are struggling to show a positive return. If the hedge fund industry

ends the year flat or even (god forbid) negative after disappointing relative performance in 2003

and just about average numbers in 2004, some of the more sophisticated clients may migrate

back to more conventional forms of investing with lower fee structures. Hedge funds are clearly

here to stay, and continue to attract the best talent because of their payout structures; however,

their ability to continue to command a premium fee structure will eventually be limited by their

ability to differentiate themselves from their long-only brethren on the performance front.

Hemant Palav / MBA / Semester II 12.

“Hedging Fund & Its Impact On Capital Market”

Hedge fund data

Top performing funds

The top 50 performing hedge funds, based on average annual return over the previous three

years, were ranked by Barron's Online in October 2007 (Hedge Fund 50). The top 10 are as

follows:

1. RAB Special Situations Fund (RAB Capital, London) - 47.69%

2. The Children's Investment Fund (The Children's Investment Fund Management,

London) - 44.27%

3. Highland CDO Opportunity Fund (Highland Capital Management, Dallas) -

43.98%

4. BTR Global Opportunity Fund, Class D (Salida Capital, Toronto) - 43.42%

5. SR Phoenicia Fund (Sloane Robinson, London) - 43.10%

6. Atticus European Fund (Atticus Management, New York) - 40.76%

7. Gradient European Fund A (Gradient Capital Partners, London) - 39.18%

8. Polar Capital Paragon Absolute Return Fund (Polar Capital Partners, London) -

38.00%

9. Paulson Enhanced Partners Fund (Paulson & Co., New York) - 37.97%

10. Firebird Global Fund (Firebird Management, New York) - 37.18%

Because of the unavailability of reliable figures, the top 50 list excludes funds such as

Renaissance Technologies' Renaissance Medallion Fund and ESL Investments' ESL Partners

(each thought to have returned an average of over 35% in the previous 3 years) and funds by

SAC Capital and Appaloosa Management, which might otherwise have made the list.

The list also excludes funds with a net asset value of less than $250 million. The returns are net

of fees.

Hemant Palav / MBA / Semester II 13.

“Hedging Fund & Its Impact On Capital Market”

Top earners

Institutional Investor magazine annually ranks top-earning hedge fund managers. Earnings from

a hedge fund are simply 100% of the capital gains on the manager's own equity stake in the fund

plus the manager's share of the performance fee (usually 20% to 50% (depending on policy) of

the gains on the other investors' capital).

The 2004 top earner was Edward Lampert of ESL Investments Inc. who earned $1.02 billion

during the year (PR Newswire link).

The 2005 top earner was James Harris Simons with an earning of $1.6 billion according to Alpha

magazine.[18] However, Trader Monthly reported that Simons only earned about $1 billion and

that the top earner was instead T. Boone Pickens with an estimated earning of over $1.5 billion

during the year.[19]

The full top 10 list of hedge fund earners according to Trader Monthly Magazine.

includes:

1. T. Boone Pickens - estimated 2005 earnings $1.5bn +

2. Steven A. Cohen, SAC Capital Advisers - $1bn +

3. James H. Simons, Renaissance

Technologies Corp. - $900m - $1bn

4. Paul Tudor Jones, Tudor Investment Corp.

- $800m - $900m

5. Stephen Feinberg, Cerberus Capital

Management - $500 - $600m

6. Bruce Kovner, Caxton Associates -

$500m - $600m

7. Eddie Lampert, ESL Investments - $500m - $600m

8. David E. Shaw, D. E. Shaw & Co. - $400m - $500m

9. Jeffrey Gendell, Tontine Partners - $300m - $400m

10. Louis Bacon, Moore Capital Management - $300m - $350m

Hemant Palav / MBA / Semester II 14.

“Hedging Fund & Its Impact On Capital Market”

The 2006 top earner was John Arnold according to Trader Monthly Magazine. The list

includes:

1. John D. Arnold, Houston, Texas- of Centauras Energy- $1.5-2B

2. James Simons, East Setauket, New York- of Renaissance Technologies Corp.- $1.5-2B

3. Eddie Lampert, Greenwich, Connecticut- of ESL Investments- $1-1.5B

Notable hedge fund management companies

Sometimes also known as alternative investment management companies.

Amaranth Advisors

Bridgewater Associates

Caxton Associates

Centaurus Energy

Citadel Investment Group

D. E. Shaw & Co.

Fortress Investment Group

Goldman Sachs Asset Management

Long Term Capital Management

Man Group

Pirate Capital LLC

Renaissance Technologies

SAC Capital Advisors

Soros Fund Management

Marshall Wace

Hemant Palav / MBA / Semester II 15.

“Hedging Fund & Its Impact On Capital Market”

Why hedge funds are attractive?

There are a large number of investment vehicles that offer you good and stable returns. Products

like diversified mutual funds, blue chip stocks and property are some of them. But for high net

worth individuals (HNIs), there are more routes, especially in the international markets. Here we

look at one such vehicle, namely hedge funds. A hedge fund is a common term used to describe

private unregistered investment partnerships. Since most of them are not registered with financial

regulators in their countries of origin, they do not need to meet the eligibility requirements to

register as institutional investors. This is good in a way but could turn sour as well because there

are no guidelines binding them. At present, there are no hedge funds operating out of India. But

internationally, there are a large number of such funds.

These funds are very manager-centric as the entire onus of their success or failure falls on the

fund manager's ability to exploit existing market conditions. No wonder then that they charge a

fixed fee of around 2 per cent a year of assets under management, along with a very high profit

sharing percentage, which is mostly 20 per cent. Of course, they have to assure returns as well.

Thus, profit sharing may start on the returns over and above say, the first 10 per cent returns. The

fee is also based on a high watermarking concept, which means that the fund manager is entitled

to a share of profits the first time. Thereafter, if the fund incurs losses and then recoups, the fund

manager will not be entitled to any share of the recouped losses. The next time he will be entitled

is when he beats his earlier performance.

However, given the plethora of opportunities worldwide, the fund manager has the luxury of

making investment decisions in stocks, bonds, commodities, currencies etc. The basic idea is to

generate aggressive returns. The most important feature of hedge funds is that they seek to

deliver absolute, rather than benchmarked returns. For example, equity mutual funds are

benchmarked against an index like the Nifty or BSE 200, or a banking sector mutual fund could

benchmark its returns against the banking index on a stock exchange and can show the investors

how much better/worse he has performed. However, hedge funds managers do not have any such

luxuries.

Hemant Palav / MBA / Semester II 16.

“Hedging Fund & Its Impact On Capital Market”

Since they are not regulated, most countries do not allow them to raise money from the general

public through a prospectus or advertisements. A few are registered with the regulators in their

countries because their main investors are universities, pension funds and insurance companies.

Most of the marketing is done through investment advisors or personal contacts, with their main

investors being restricted to sophisticated HNIs.  With the Reserve Bank of India [Get Quote]

(RBI) allowing Indian residents to invest up to $200,000 abroad per head a year, it is another

opportunity for HNIs to tap these funds as the minimum limit of many of them start from

$100,000. But you need to remember that the amount invested is not very liquid and may be

subject to a lock-in period, with quarterly, half-yearly or yearly exit windows.

Those seeking to invest in hedge funds can approach a wealth manager, securities broker or

investment consultant abroad, who can advise them on the available options and select the hedge

fund they wish to invest in, based on its track record and management style. After that they can

approach their bank in India to arrange for the foreign remittance to the hedge fund. Whenever

they wish to redeem their investment, as permitted by the hedge fund, they can repatriate the

proceeds to India into their bank account.

Hemant Palav / MBA / Semester II 17.

“Hedging Fund & Its Impact On Capital Market”

What information should I seek if I am considering investing in a

hedge fund or a fund of hedge funds?

Read a fund's prospectus or offering memorandum and related materials. Make sure

you understand the level of risk involved in the fund's investment strategies and ensure

that they are suitable to your personal investing goals, time horizons, and risk tolerance.

As with any investment, the higher the potential returns, the higher the risks you must

assume.

 

Understand how a fund's assets are valued. Funds of hedge funds and hedge funds

may invest in highly illiquid securities that may be difficult to value. Moreover, many

hedge funds give themselves significant discretion in valuing securities. You should

understand a fund's valuation process and know the extent to which a fund's securities are

valued by independent sources.

 

Ask questions about fees. Fees impact your return on investment. Hedge funds typically

charge an asset management fee of 1-2% of assets, plus a "performance fee" of 20% of a

hedge fund's profits. A performance fee could motivate a hedge fund manager to take

greater risks in the hope of generating a larger return. Funds of hedge funds typically

charge a fee for managing your assets, and some may also include a performance fee

based on profits. These fees are charged in addition to any fees paid to the underlying

hedge funds.

Understand any limitations on your right to redeem your shares. Hedge funds

typically limit opportunities to redeem, or cash in, your shares (e.g., to four times a year),

and often impose a "lock-up" period of one year or more, during which you cannot cash

in your shares.

 

Hemant Palav / MBA / Semester II 18.

“Hedging Fund & Its Impact On Capital Market”

Research the backgrounds of hedge fund managers. Know with whom you are

investing. Make sure hedge fund managers are qualified to manage your money, and find

out whether they have a disciplinary history within the securities industry. You can get

this information (and more) by reviewing the adviser’s Form ADV. You can search for

and view a firm’s Form ADV using the SEC’s Investment Adviser Public Disclosure

(IAPD) website. You also can get copies of Form ADV for individual advisers and firms

from the investment adviser, the SEC’s Public Reference Room, or (for advisers with less

than $25 million in assets under management) the state securities regulator where the

adviser's principal place of business is located. If you don’t find the investment adviser

firm in the SEC’s IAPD database, be sure to call your state securities regulator or search

the NASD's BrokerCheck database for any information they may have.

 

Don't be afraid to ask questions. You are entrusting your money to someone else. You

should know where your money is going, who is managing it, how it is being invested,

how you can get it back, what protections are placed on your investment and what your

rights are as an investor. In addition, you may wish to read NASD’s investor alert, which

describes some of the high costs and risks of investing in funds of hedge funds.

Hemant Palav / MBA / Semester II 19.

“Hedging Fund & Its Impact On Capital Market”

What protections do I have if I purchase a hedge fund?

Hedge fund investors do not receive all of the federal and state law protections that commonly

apply to most registered investments. For example, you won't get the same level of disclosures

from a hedge fund that you'll get from registered investments. Without the disclosures that the

securities laws require for most registered investments, it can be quite difficult to verify

representations you may receive from a hedge fund. You should also be aware that, while the

SEC may conduct examinations of any hedge fund manager that is registered as an investment

adviser under the Investment Advisers Act, the SEC and other securities regulators generally

have limited ability to check routinely on hedge fund activities.

The SEC can take action against a hedge fund that defrauds investors, and we have brought a

number of fraud cases involving hedge funds. Commonly in these cases, hedge fund advisers

misrepresented their experience and the fund's track record. Other cases were classic "Ponzi

schemes," where early investors were paid off to make the scheme look legitimate. In some of

the cases we have brought, the hedge funds sent phony account statements to investors to

camouflage the fact that their money had been stolen. That's why it is extremely important to

thoroughly check out every aspect of any hedge fund you might consider as an investment.

Hemant Palav / MBA / Semester II 20.

“Hedging Fund & Its Impact On Capital Market”

Hedging Strategies

Wide ranges of hedging strategies are available to hedge funds. For example:

Selling short - selling shares without owning them, hoping to buy them back at a future

date at a lower price in the expectation that their price will drop.

Using arbitrage - seeking to exploit pricing inefficiencies between related securities - for

example, can be long convertible bonds and short the underlying issuer’s equity.

Trading options or derivatives - contracts whose values are based on the performance of

any underlying financial asset, index or other investment.

Investing in anticipation of a specific event - merger transaction, hostile takeover, spin-

off, exiting of bankruptcy proceedings, etc.

Investing in deeply discounted securities - of companies about to enter or exit financial

distress or bankruptcy, often below liquidation value.

Many of the strategies used by hedge funds benefit from being non-correlated to the

direction of equity markets

Popular Misconception

The popular misconception is that all hedge funds are volatile -- that they all use global macro

strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold,

while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most

hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no

leverage.

Hemant Palav / MBA / Semester II 21.

“Hedging Fund & Its Impact On Capital Market”

Benefits of Hedge Funds

Many hedge fund strategies have the ability to generate positive returns in both rising and

falling equity and bond markets.

Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and

volatility and increases returns.

Huge variety of hedge fund investment styles – many uncorrelated with each other –

provides investors with a wide choice of hedge fund strategies to meet their investment

objectives.

Academic research proves hedge funds have higher returns and lower overall risk than

traditional investment funds.

Hedge funds provide an ideal long-term investment solution, eliminating the need to

correctly time entry and exit from markets.

Adding hedge funds to an investment portfolio provides diversification not otherwise

available in traditional investing.

Hedge Fund Styles

The predictability of future results shows a strong correlation with the volatility of each

strategy. Future performance of strategies with high volatility is far less predictable than

future performance from strategies experiencing low or moderate volatility.

Aggressive Growth: Invests in equities expected to experience acceleration in growth of

earnings per share. Generally high P/E ratios, low or no dividends; often smaller and

micro cap stocks which are expected to experience rapid growth. Includes sector

specialist funds such as technology, banking, or biotechnology. Hedges by shorting

equities where earnings disappointment is expected or by shorting stock indexes. Tends

to be "long-biased." Expected Volatility: High

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

Hemant Palav / MBA / Semester II 22.

“Hedging Fund & Its Impact On Capital Market”

of the true value of the deeply discounted securities and because the majority of

institutional investors cannot own below investment grade securities. (This selling

pressure creates the deep discount.) Results generally not dependent on the direction of

the markets. Expected Volatility: Low - Moderate

Emerging Markets: Invests in equity or debt of emerging (less mature) markets that

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, although

Brady debt can be partially hedged via U.S. Treasury futures and currency markets.

Expected Volatility: Very High

Funds of Hedge Funds: Mix and match 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. Returns, risk, and

volatility can be controlled by the mix of underlying strategies and funds. Capital

preservation is generally an important consideration. Volatility depends on the mix and

ratio of strategies employed. Expected Volatility: Low - Moderate - High

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. Expected Volatility:

Low

Macro: Aims to profit from changes in global economies, typically brought about by

shifts in government policy that 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. Utilizes hedging, but the leveraged directional

investments tend to make the largest impact on performance. Expected Volatility: Very

High

Hemant Palav / MBA / Semester II 23.

“Hedging Fund & Its Impact On Capital Market”

Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking

offsetting positions, often in different securities of the same issuer. For example, can be

long convertible bonds and short the underlying issuers equity. May also use futures to

hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to

both the equity and bond markets. These relative value strategies include fixed income

arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund

arbitrage. Expected Volatility: Low

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. Usually low or no correlation to the market.

Sometimes uses market index futures to hedge out systematic (market) risk. Relative

benchmark index usually T-bills. Expected Volatility: Low

Market Timing: Allocates assets among different asset classes depending on the

manager's view of the economic or market outlook. Portfolio emphasis may swing widely

between asset classes. Unpredictability of market movements and the difficulty of timing

entry and exit from markets add to the volatility of this strategy. Expected Volatility:

High

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. Expected Volatility: Variable

Multi Strategy: Investment approach is diversified by employing various strategies

simultaneously to realize short- and long-term gains. Other strategies may include

systems trading such as trend following and various diversified technical strategies. This

style of investing allows the manager to overweight or underweight different strategies to

best capitalize on current investment opportunities. Expected Volatility: Variable

Hemant Palav / MBA / Semester II 24.

“Hedging Fund & Its Impact On Capital Market”

Short Selling: Sells securities short in anticipation of being able to rebuy 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. Often used as a

hedge to offset long-only portfolios and by those who feel the market is approaching a

bearish cycle. High risk. Expected Volatility: Very High

Special Situations: Invests in event-driven situations such as mergers, hostile takeovers,

reorganizations, or leveraged buyouts. May involve simultaneous purchase of stock in

companies being acquired, and the sale of stock in its acquirer, hoping to profit from the

spread between the current market price and the ultimate purchase price of the company.

May also utilize derivatives to leverage returns and to hedge out interest rate and/or

market risk. Results generally not dependent on direction of market. Expected Volatility:

Moderate

Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or

potential worth. Such securities may be out of favor or under followed by analysts. Long-

term holding, patience, and strong discipline are often required until the ultimate value is

recognized by the market. Expected Volatility: Low - Moderate

Hemant Palav / MBA / Semester II 25.

“Hedging Fund & Its Impact On Capital Market”

Advantages of Hedge Funds over Mutual Funds

        Hedge funds are extremely flexible in their investment options because they use financial

instruments generally beyond the reach of mutual funds, which have SEC regulations and

disclosure requirements that largely prevent them from using short selling, leverage,

concentrated investments, and derivatives.

        This flexibility, which includes use of hedging strategies to protect downside risk, gives

hedge funds the ability to best manage investment risks.

        The strong results can be linked to performance incentives in addition to investment

flexibility. Unlike many mutual fund managers, hedge fund managers are usually heavily

invested in a significant portion of the funds they run and shares the rewards as well as risks with

the investors. "Incentive fees" remunerate hedge fund managers only when returns are positive,

whereas mutual funds pay their financial managers according to the volume of assets managed,

regardless of performance. This incentive fee structure tends to attract many of Wall Street’s best

practitioners and other financial experts to the hedge fund industry.

        In the last nine years, the number of hedge funds has risen by about 20 percent per year and

the rate of growth in hedge fund assets has been even more rapid. Currently, there are estimated

to be approximately 8350 hedge funds managing $1 trillion. While the number and size of hedge

funds are small relative to mutual funds, their growth reflects the importance of this alternative

investment category for institutional investors and wealthy individual investors.

Hemant Palav / MBA / Semester II 26.

“Hedging Fund & Its Impact On Capital Market”

Hedge Funds Outperform Mutual Funds in Falling Equity Markets

  S&P 500VAN U.S. Hedge

Fund Index

Morningstar Average

Equity Mutual Fund

1Q90 -3% 2.20% -2.80%

3Q90 -13.70% -3.70% -15.40%

2Q91 -0.20% 2.30% -0.90%

1Q92 -2.50% 5.00% -0.70%

1Q94 -3.80% -0.80% -3.20%

4Q94 -0.02% -1.20% -2.60%

3Q98 -9.90% -6.10% -15.00%

3Q99 -6.20% 2.10% -3.20%

2Q00 -2.70% 0.30% -3.60%

3Q00 -1.00% 3.00% 0.60%

4Q00 -7.80% -2.40% -7.80%

1Q01 -11.90% -1.10% -12.70%

3Q01 -14.70% -3.80% -17.20%

2Q02 -13.40% -1.40% -10.70%

3Q02 -17.30% -3.60% -16.60%

3Q04 -2.30% 1.40% -1.70%

1Q05 -2.59% .10% -2.20%

Total -113.01% -10.30% -115.70%

Hemant Palav / MBA / Semester II 27.

“Hedging Fund & Its Impact On Capital Market”

During the last 18 years, the S&P 500 Index has had 17 negative quarters, totaling a negative

return of 113.01%. During those negative quarters, the average U.S. equity mutual fund had a

total negative return of 115.7%, while the average hedge fund had a total negative return of only

10.3%, displaying the ability of hedge funds to preserve capital in falling equity markets.

Hemant Palav / MBA / Semester II 28.

“Hedging Fund & Its Impact On Capital Market”

ABOUT WORKINGS OF HEDGE FUNDS

A hedge fund is a private investment fund charging a performance fee and typically open

to only a limited range of qualified investors. In the United States, hedge funds are open to

accredited investors only. Because of this restriction, they are usually exempt from any direct

regulation by regulatory bodies. Alfred Winslow Jones is credited with inventing hedge funds in

1949. [1]

As a hedge fund's investment activities are limited only by the contracts governing the particular

fund, it can make greater use of complex investment strategies such as short selling, entering into

futures, swaps and other derivative contracts and leverage.

As their name implies, hedge funds often seek to offset potential losses in the principal markets

they invest in by hedging via any number of methods. However, the term "hedge fund" has come

in modern parlance to be overused and inappropriately applied to any absolute-return fund –

many of these so-called "hedge funds" do not actually hedge their investments.

Hedge funds have acquired a reputation for secrecy. Unlike open-to-the-public "retail" funds

(e.g., U.S. mutual funds) which market freely to the public, in most countries, hedge funds are

specifically prohibited from marketing to investors who are not professional investors or

individuals with sufficient private wealth. This limits the information a hedge fund can legally

release. Additionally, divulging a hedge fund's methods could unreasonably compromise their

business interests; this limits the information a hedge fund would want to release.

Since hedge fund assets can run into many billions of dollars and will usually be multiplied by

leverage, their sway over markets, whether they succeed or fail, is potentially substantial and

there is a continuing debate over whether they should be more thoroughly regulated.

Industry

In 2005, Absolute Return magazine found there were 196 hedge funds with $1 billion or more in

assets, with a combined $743 billion under management - the vast majority of the industry's

estimated $1 trillion in assets.[2] However, according to hedge fund advisory group Hennessee,

total hedge fund industry assets increased by $215 billion in 2006 to $1.442 trillion, up 17.5% on

Hemant Palav / MBA / Semester II 29.

“Hedging Fund & Its Impact On Capital Market”

a year earlier, an estimate for 2005 seemingly at odds with Absolute Return.

As large institutional investors have entered the hedge fund industry the total asset levels

continue to rise. The 2008 Hedge Fund Asset Flows & Trends Report [4] published by

HedgeFund.net and Institutional Investor News estimates total industry assets reached $2.68

trillion in Q3 2007.

Fees

Usually the hedge fund manager will receive both a management fee and a performance fee (also

known as an incentive fee). Performance fees are closely associated with hedge funds, and are

intended to incentivize the investment manager to produce the largest returns possible.

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 typically range

from 1% to 4% per annum, with 2% being the standard figure. Therefore, if a fund has $1 billion

of assets at the year end and charges a 2% management fee, the management fee will be $20

million in total. Management fees are usually calculated annually and paid monthly.

Performance fees

Performance fees, which give a share of positive returns to the manager, are one of the defining

characteristics of hedge funds. In contrast to retail investment firms, performance fees are

prohibited in the U.S. for stock brokers.[citation needed] A hedge fund'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 willing to pay managers more

generously when the investors have themselves made money. For managers who perform well

the performance fee is extremely lucrative.

Typically, hedge funds charge 20% of gross returns as a performance fee, but again the range is

wide, with highly regarded managers demanding higher fees. In particular, Steven Cohen's SAC

Hemant Palav / MBA / Semester II 30.

“Hedging Fund & Its Impact On Capital Market”

Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons'

Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its

flagship Medallion Fund before returning all investors' capital and running solely on its

employees' money.[citations needed]

Managers argue that performance fees help to align the interests of manager and investor better

than flat fees that are payable even when performance is poor. However, performance fees have

been criticized by many people, including notable investor Warren Buffett, for giving managers

an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to

control this problem, fees are usually limited by a high water mark and sometimes by a hurdle

rate. Alternatively, the investment manager might be required to return performance fees when

the value of the fund drops. This provision is sometimes called a ‘claw-back.’

High water marks

A "High water mark" is often applied to a performance fee calculation.[5] This means that the

manager does not receive performance fees unless the value of the fund exceeds the highest net

asset value it has previously achieved. For example, if a fund was launched at a net asset value

(NAV) per share of $100, which then rose to $130 in its first year, a performance fee would be

payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If

in the third year the NAV per share rises to $143, a performance fee will be payable only on the

extra $13 return from $130 to $143 rather than on the full return from $120 to $143.

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 trades. 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. However, this mechanism does not provide

complete protection to investors: a manager who has lost money may simply decide to close the

fund and start again with a clean slate -- provided that he can persuade investors to trust him with

their money. A high water mark is sometimes referred to as a "Loss Carryforward Provision."

Hemant Palav / MBA / Semester II 31.

“Hedging Fund & Its Impact On Capital Market”

Poorly performing funds frequently close down rather than work without fees, as would be

required by their high water mark policies. [6]

Hurdle rates

Some funds also specify a hurdle rate, which signifies that the fund will not charge a

performance fee until its annualized performance exceeds a benchmark rate, such as T-bills or a

fixed percentage, over some period. 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.

Funds which specify a soft hurdle rate charge a performance fee based on the entire annualized

return. Funds which use a hard hurdle rate only charge a performance fee on returns above the

hurdle rate.

Though logically appealing, this practice has diminished as demand for hedge funds has

outstripped supply and hurdles are now rare.[citations needed]

Strategies

Hedge funds are no longer a homogeneous class. Under certain circumstances, an investor or

hedge fund can completely hedge the risks of an investment, leaving pure profit.[citation needed] For

example, at one time it was possible for exchange traders to buy shares of, say, IBM on one

exchange and simultaneously sell them on another exchange, leaving pure profit.[citation needed]

Competition among investors has leached away such profits, leaving hedge fund managers with

trades that are partially hedged, at best. These trades still contain residual risks which can be

considerable. Some styles of hedge fund investing, such as global macro investing, may involve

no hedging at all. Strictly speaking, it is not accurate to call such funds hedge funds, but that is

current usage.

The bulk of hedge funds describe themselves as long / short equity, but many different

approaches are used taking different exposures, exploiting different market opportunities, using

different techniques and different instruments:

Hemant Palav / MBA / Semester II 32.

“Hedging Fund & Its Impact On Capital Market”

Global macro – seeking related assets that have deviated from some anticipated

relationship.

Arbitrage – seeking assets that are mispriced relative to related assets.

o Convertible arbitrage – between a convertible bond and the same company's

equity.

o Fixed income arbitrage – between related bonds.

o Risk arbitrage – between securities whose prices appear to imply different

probabilities for one event.

o Statistical arbitrage (or StatArb) – between securities that have deviated from

some statistically estimated relationship.

o Derivative arbitrage – between a derivative and its security.

Long / short equity – generic term covering all hedged investment in equities.

o Short bias – emphasizing or solely using short positions.

o Equity market neutral – maintaining a close balance between long and short

positions.

Event driven – specialized in the analysis of a particular kind of event.

o Distressed securities – companies that are or may become bankrupt.

o Regulation D – distressed companies issuing securities.

o Merger arbitrage - arbitrage between an acquiring public company and a target

public company.

Other – the strategies below are sometimes considered hedge strategies, although in

several cases usage of the term is debatable.

o Emerging markets- this usually means unhedged, long positions in small overseas

markets.

o Fund of hedge funds - unhedged, long only positions in hedge funds (though the

underlying funds, of course, may be hedged). Additional leverage is sometimes

used.[citation needed]

o Quantitative

o 130-30 funds - Through leveraging, 130% of the money invested in the fund is

used to buy stocks. 30% of the money invested in the fund is used to short stock.

Hemant Palav / MBA / Semester II 33.

“Hedging Fund & Its Impact On Capital Market”

Hedge fund risk

Investing in a hedge fund is considered to be a riskier proposition than investing in a regulated

fund, despite the traditional notion of a "hedge" being a means of reducing the risk of a bet or

investment. The following are some of the primary reasons for the increased risk:

Leverage - in addition to putting money into the fund by investors, a hedge fund will

typically borrow money, with certain funds borrowing sums many times greater than the

initial investment. Where a hedge fund has borrowed $9 for every $1 invested, a loss of

only 10% of the value of the investments of the hedge fund will wipe out 100% of the

value of the investor's stake in the fund, once the creditors have called in their loans. At

the beginning of 1998, shortly before its collapse, Long Term Capital Management had

borrowed over $26 for each $1 invested.

Short selling - due to the nature of short selling, the losses that can be incurred on a

losing bet are theoretically 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 collateralised debt obligations based on sub-prime mortgages.

Lack of transparency - hedge funds are secretive entities. 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 from financial

regulators, and therefore some may carry undisclosed structural risks.

Investors in hedge funds are willing to take these risks because of the corresponding rewards.

Leverage amplifies profits as well as losses; short selling opens up new investment opportunities;

riskier investments typically provide higher returns; secrecy helps to prevent imitation by

competitors; and being unregulated reduces costs and allows the investment manager more

freedom to make decisions on a purely commercial basis.

Hemant Palav / MBA / Semester II 34.

“Hedging Fund & Its Impact On Capital Market”

Legal structure

A hedge fund is a vehicle for holding and investing the funds of its investors. The fund itself is

not a genuine business, having no employees and no assets other than its investment portfolio

and a small amount of cash, and its investors being its clients. The portfolio is managed by the

investment manager, which has employees and property and which is the actual business. An

investment manager is commonly termed a “hedge fund” (e.g. a person may be said to “work at a

hedge fund”) but this is not technically correct. An investment manager may have a large number

of hedge funds under its management.

Domicile

The specific legal structure of a hedge fund – in particular its domicile and the type of entity used

– is usually determined by the tax environment of the fund’s expected investors. Regulatory

considerations will also play a role. Many hedge funds are established in offshore tax havens so

that the fund can avoid paying tax on the increase in the value of its portfolio. An investor will

still pay tax on any profit it makes when it realises its investment, and the investment manager,

usually based in a major financial centre, will pay tax on the fees that it receives for managing

the fund.

At the end of 2004 55% of the world’s hedge funds, accounting for nearly two-thirds of total

hedge fund assets, were established offshore. The most popular offshore location was the

Cayman Islands, followed by the British Virgin Islands, Bermuda and the Bahamas. The US was

the most popular onshore location, accounting for 34% of funds and 24% of assets. EU countries

were the next most popular location with 9% of funds and 11% of assets. Asia accounted for the

majority of the remaining assets.[citations needed]

The legal entity

Limited partnerships are principally used for hedge funds aimed at US-based investors who pay

tax, as the investors will receive relatively favorable tax treatment in the US. The general partner

of the limited partnership is typically the investment manager (though is sometimes an offshore

Hemant Palav / MBA / Semester II 35.

“Hedging Fund & Its Impact On Capital Market”

corporation) and the investors are the limited partners. Offshore corporate funds are used for

non-US investors and US entities that do not pay tax (such as pension funds), as such investors

do not receive the same tax benefits from investing in a limited partnership. Unit trusts are

typically marketed to Japanese investors. Other than taxation, the type of entity used does not

have a significant bearing on the nature of the fund.[7]

Many hedge funds are structured as master/feeder funds. In such a structure the investors will

invest into a feeder fund which will in turn invest all of its assets into the master fund. The assets

of the master fund will then be managed by the investment manager in the usual way. This

allows several feeder funds (e.g. an offshore corporate fund, a US limited partnership and a unit

trust) to invest into the same master fund, allowing an investment manager the benefit of

managing the assets of a single entity while giving all investors the best possible tax treatment.

The investment manager, which will have organized the establishment of the hedge fund, may

retain an interest in the hedge fund, either as the general partner of a limited partnership or as the

holder of “founder shares” in a corporate fund. Founder shares typically have no economic

rights, and voting rights over only a limited range of issues, such as selection of the investment

manager – most of the fund’s decisions are taken by the board of directors of the fund, which is

self-appointing and independent but invariably loyal to the investment manager.

Open-ended nature

Hedge funds are typically open-ended, in that the fund will periodically issue additional

partnership interests or shares directly to new investors, the price of each being the net asset

value (“NAV”) per interest/share. To realise the investment, the investor will redeem the

interests or shares at the NAV per interest/share prevailing at that time. Therefore, if the value of

the underlying investments has increased (and the NAV per interest/share has therefore also

increased) then the investor will receive a larger sum on redemption than it paid on investment.

Investors do not typically trade shares between themselves and hedge funds do not typically

Hemant Palav / MBA / Semester II 36.

“Hedging Fund & Its Impact On Capital Market”

distribute profits to investors before redemption. This contrasts with a closed-ended fund, which

has a limited number of shares which are traded between investors, and which distributes its

profits.

Listed funds

Corporate hedge funds often list their shares on smaller stock exchanges, such as the Irish Stock

Exchange, in the hope that the low level of quasi-regulatory oversight will give comfort to

investors and to attract certain funds, such as some pension funds, that have bars or caps on

investing in unlisted shares. Shares in the listed hedge fund are not traded on the exchange, but

the fund’s monthly net asset value and certain other events must be publicly announced there.

A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an

investment manager. Although widely reported as a "hedge-fund IPO"[8], the IPO of Fortress

Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it

managed.

Hedge fund management worldwide

In contrast to the funds themselves, hedge fund managers are primarily located onshore in order

to draw on larger pools of financial talent. The US East coast – principally New York City and

the Gold Coast area of Connecticut (particularly Stamford and Greenwich) – is the world's

leading location for hedge fund managers with approximately double the hedge fund managers

of the next largest centre, London. With the bulk of hedge fund investment coming from the US,

this distribution is natural.

London is Europe’s leading centre for the management of hedge funds. At the end of 2006,

three-quarters of European hedge fund investments, totalling $400bn (£200bn), were managed

from London, having grown from $61bn in 2002. Australia was the most important centre for the

management of Asia-Pacific hedge funds, with managers located there accounting for

Hemant Palav / MBA / Semester II 37.

“Hedging Fund & Its Impact On Capital Market”

approximately a quarter of the $140bn of hedge fund assets managed in the Asia-Pacific region

in 2006.[10]

Regulatory Issues

Part of what gives hedge funds their competitive edge, and their cachet in the public imagination,

is that they straddle multiple definitions and categories; some aspects of their dealings are well-

regulated, others are unregulated or at best quasi-regulated.

US regulation

The typical public investment company in the United States is required to be registered with the

U.S. Securities and Exchange Commission (SEC). Mutual funds are the most common type of

registered investment companies. Aside from registration and reporting requirements, investment

companies are subject to strict limitations on short-selling and the use of leverage. There are

Hemant Palav / MBA / Semester II 38.

“Hedging Fund & Its Impact On Capital Market”

other limitations and restrictions placed on public investment company managers, including the

prohibition on charging incentive or performance fees.

Although hedge funds fall within the statutory definition of an investment company, the limited-

access, private nature of hedge funds permits them to operate pursuant to exemptions from the

registration requirements. The two major exemptions are set forth in Sections 3(c)1 and 3(c)7 of

the Investment Company Act of 1940. Those exemptions are for funds with 100 or fewer

investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7

Fund"). [6] A qualified purchaser is an individual with over US$5,000,000 in investment assets.

(Some institutional investors also qualify as accredited investors or qualified purchasers.) [7] A

3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited

number of investors. Both types of funds can charge performance or incentive fees.

In order to comply with 3(c)(1) or 3(c)(7), hedge funds are sold via private placement under the

Securities Act of 1933. Thus interests in a hedge fund cannot be offered or advertised to the

general public, and are normally offered under Regulation D. Although it is possible to have

non-accredited investors in a hedge fund, the exemptions under the Investment Company Act,

combined with the restrictions contained in Regulation D, effectively require hedge funds to be

offered solely to accredited investors. An accredited investor is an individual with a minimum

net worth of US $5,000,000 or, alternatively, a minimum income of US$200,000 in each of the

last two years and a reasonable expectation of reaching the same income level in the current

year.

The regulatory landscape for Investment Advisors is changing, and there have been attempts to

register hedge fund investment managers. There are numerous issues surrounding these proposed

requirements. One issue of importance to hedge fund managers is the requirement that a client

who is charged an incentive fee must be a "qualified client" under Advisers Act Rule 205-3. To

be a qualified client, an individual must have US$750,000 in assets invested with the adviser or a

net worth in excess of US$1.5 million, or be one of certain high-level employees of the

investment adviser.

Hemant Palav / MBA / Semester II 39.

“Hedging Fund & Its Impact On Capital Market”

For the funds, the tradeoff of operating under these exemptions is that they have fewer investors

to sell to, but they have few government-imposed restrictions on their investment strategies. The

presumption is that hedge funds are pursuing more risky strategies, which may or may not be

true depending on the fund, and that the ability to invest in these funds should be restricted to

wealthier investors who are presumed to be more sophisticated and who have the financial

reserves to absorb a possible loss.

In December 2004, the SEC issued a rule change that required most hedge fund advisers to

register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers

Act. The requirement, with minor exceptions, applied to firms managing in excess of

US$25,000,000 with over 15 investors. The SEC stated that it was adopting a "risk-based

approach" to monitoring hedge funds as part of its evolving regulatory regimen for the

burgeoning industry. The rule change was challenged in court by a hedge fund manager, and in

June 2006, the U.S. Court of Appeals for the District of Columbia overturned it and sent it back

to the agency to be reviewed. See Goldstein v. SEC.

Although the SEC is currently examining how it can address the Goldstein decision,

commentators have stated that the SEC currently has neither the staff nor expertise to

comprehensively monitor the estimated 8,000 U.S. and international hedge funds. See New

Hedge Fund Advisor Rule. One of the Commissioners, Roel Campos, has said that the SEC is

forming internal teams that will identify and evaluate irregular trading patterns or other

phenomena that may threaten individual investors, the stability of the industry, or the financial

world. "It's pretty clear that we will not be knocking on [hedge fund] doors very often," Campos

told several hundred hedge fund managers, industry lawyers and others. And even if it did, "the

SEC will never have the degree of knowledge or background that you do.

In February 2007, the President's Working Group on Financial Markets rejected further

regulation of hedge funds and said that the industry should instead follow voluntary guidelines.

Hemant Palav / MBA / Semester II 40.

“Hedging Fund & Its Impact On Capital Market”

Comparison to private equity funds

Hedge funds are similar to private equity funds in many respects. Both are lightly regulated,

private pools of capital that invest in securities and compensate their managers with a share of

the fund's profits. Most 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

primarily in very illiquid assets such as early-stage companies and so investors are "locked in"

for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition

funds.

Between 2004 and February 2006 some hedge funds adopted 25 month lock-up rules expressly

to exempt themselves from the SEC's new registration requirements and cause them to fall under

the registration exemption that had been intended to exempt private equity funds.

Comparison to U.S. mutual funds

Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to

invest). However, there are many differences between the two, including:

Mutual funds are regulated by the SEC, while hedge funds are not

A hedge fund investor must be an accredited investor with certain exceptions (employees,

etc.)

Mutual funds must price and be liquid on a daily basis

Hemant Palav / MBA / Semester II 41.

“Hedging Fund & Its Impact On Capital Market”

Some hedge funds that are based offshore report their prices to the Financial Times, but for most

there is no method of ascertaining pricing on a regular basis. Additionally, mutual funds must

have a prospectus available to anyone that requests them (either electronically or via US postal

mail), and must disclose their asset allocation quarterly, while hedge funds do not have to abide

by these terms.

Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time

where the total returns are generated (net of fees) for their investors and then returned when the

term ends, through a passthrough requiring CPAs and US Tax W-forms. Hedge fund investors

tolerate these policies because hedge funds are expected to generate higher total returns for their

investors versus mutual funds.

Recently, however, the mutual fund industry has created products with features that have

traditionally only been found in hedge funds.

Mutual funds have appeared which utilize some of the trading strategies noted above. Grizzly

Short Fund (GRZZX), for example, is always net short, while Arbitrage Fund (ARBFX)

specializes in merger arbitrage. Such funds are SEC regulated, but they offer hedge fund

strategies and protection for mutual fund investors.

Also, a few mutual funds have introduced performance-based fees, where the compensation to

the manager is based on the performance of the fund. However, under Section 205(b) of the

Investment Advisers Act of 1940, such compensation is limited to so-called "fulcrum fees".[15]

Under these arrangements, fees can be performance-based so long as they increase and decrease

symmetrically.

For example, the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves,

within limits and symmetrically, similarly to a hedge fund "0 and 50" fee: A 0% management fee

coupled with a 50% performance fee if the fund outperforms its benchmark index. However, the

125 bp base fee is reduced (but not below zero) by 50% of underperformance and increased (but

not to more than 250 bp) by 50% of outperformance.

Hemant Palav / MBA / Semester II 42.

“Hedging Fund & Its Impact On Capital Market”

Offshore regulation

Many offshore centers are keen to encourage the establishment of hedge funds. To do this they

offer some combination of professional services, a favorable tax environment, and business-

friendly regulation. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin

Islands and Bermuda. The Cayman Islands have been estimated to be home to about 75% of

world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM[11].

Hedge funds have to file accounts and conduct their business in compliance with the

requirements of these offshore centres. Typical rules concern restrictions on the availability of

funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the

requirement for the fund to be independent of the fund manager.

Many offshore hedge funds, such as the Soros funds, are structured as mutual funds rather than

as limited partnerships.

Hedge Fund Indices

There are a number of indices that track the hedge fund industry. These indices come in two

types, Investable and Non-investable, both with substantial problems. There are also new types

of tracking product launched by Goldman Sachs and Merrill Lynch, "clone indices" that aim to

replicate the returns of hedge fund indices without actually holding hedge funds at all.

Investable indices are created from funds that can be bought and sold, and only Hedge Funds that

agree to accept investments on terms acceptable to the constructor of the index are included.

Investability is an attractive property for an index because it makes the index more relevant to

the choices available to investors in practice, and is taken for granted in traditional equity indices

such as the S&P500 or FTSE100. However, such indices do not represent the total universe of

hedge funds and may under-represent the more successful managers, who may not find the index

terms attractive. Fund indexes include BarclayHedge, Hedge Fund Research, Eurekahedge

Indices, Credit Suisse Tremont and FTSE Hedge.

Hemant Palav / MBA / Semester II 43.

“Hedging Fund & Its Impact On Capital Market”

The index provider selects funds and develops structured products or derivative instruments that

deliver the performance of the index, making investable indices similar in some ways to fund of

hedge funds portfolios.

Non-investable benchmarks are indicative in nature, and aim to represent the performance of the

universe of hedgefunds using some measure such as mean, median or weighted mean from a

hedge fund database. There are diverse selection criteria and methods of construction, and no

single database captures all funds. This leads to significant differences in reported performance

between different databases.

Non-investable indices inherit the databases' shortcomings, or strengths, in terms of scope and

quality of data. Funds’ participation in a database is voluntary, leading to “self reporting bias”

because those funds that choose to report may not be typical of funds as a whole. For example,

some do not report because of poor results or because they have already reached their target size

and do not wish to raise further money. This tends to lead to a clustering of returns around the

mean rather than representing the full diversity existing in the hedge fund universe. Examples of

non-investable indices include an equal weighted benchmark series known as the HFN Averages,

and a revolutionary rules based set known as the Lehman Brothers/HFN Global Index Series

which leverages an Enhanced Strategy Classification System.

The short lifetimes of many hedge funds means that there are many new entrants and many

departures each year, which raises the problem of “survivorship bias”. If we examine only funds

that have survived to the present, we will overestimate past returns because many of the worst-

performing funds have not survived, and the observed association between fund youth and fund

performance suggests that this bias may be substantial. As the HFR and CISDM databases began

in 1994, it is likely that they will be more accurate over the period 1994/2000 than the Credit

Suisse database, which only began in 2000.

When a fund is added to a database for the first time, all or part of its historical data is recorded

ex-post in the database. It is likely that funds only publish their results when they are favourable,

so that the average performances displayed by the funds during their incubation period are

inflated. This is known as "instant history bias” or “backfill bias”.

Hemant Palav / MBA / Semester II 44.

“Hedging Fund & Its Impact On Capital Market”

In traditional equity investment, indices play a central and unambiguous role. They are widely

accepted as representative, and products such as futures and ETFs provide liquid access to them

in most developed markets. However, among hedge funds no index combines these

characteristics. Investable indices achieve liquidity at the expense of representativeness. Non-

investable indices are representative, but their quoted returns may not be available in practice.

Neither is wholly satisfactory.

Debates and controversies

Privacy issues

As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to

third parties. This is in contrast to a fully regulated mutual fund (or unit trust) which will

typically have to meet regulatory requirements for disclosure. An investor in a hedge fund

usually has direct access to the investment advisor of the fund, and may enjoy more personalised

reporting than investors in retail investment funds. This may include detailed discussions of risks

assumed and significant positions. However, 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.

Restrictions on marketing and the lack of regulation is that there are no official hedge fund

statistics. An industry consulting group, HFR (hfr.com), reported at the end of the second quarter

2003 that there are 5,660 hedge funds world wide managing $665 billion. For comparison, at the

same time the US mutual fund sector held assets of $7.818 trillion (according to the Investment

Company Institute).

Market capacity

Analysis of the rather disappointing hedge fund performance in 2004 and 2005 called into

question the alternative investment industry's value proposition. Alpha may have been becoming

rarer for two related reasons. First, the increase in traded volume may have been reducing the

market anomalies that are a source of hedge fund performance. Second, the remuneration model

is attracting more and more managers, which may dilute the talent available in the industry.

Hemant Palav / MBA / Semester II 45.

“Hedging Fund & Its Impact On Capital Market”

However, the market capacity effect has been questioned by the EDHEC Risk and Asset

Management Research Centre through a decomposition of hedge fund returns between pure

alpha, dynamic betas, and static betas.

While pure alpha is generated by exploiting market opportunities, the dynamic betas depend on

the manager’s skill in adapting the exposures to different factors, and these authors claim that

these two sources of return do not exhibit any erosion. This suggests that the market environment

(static betas) explains a large part of the poor performance of hedge funds in 2004 and 2005.

Systematic risk

Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital

Management (LTCM) in 1998, which necessitated a bailout coordinated by the U.S. Federal

Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM

disaster. The excessive leverage (through derivatives) that can be used by hedge funds to achieve

their return is outlined as one of the main factors of the hedge funds contribution to systematic

risk.

The ECB (European Central Bank) has issued a warning on hedge fund risk for financial stability

and systemic risk: "... the increasingly similar positioning of individual hedge funds within broad

hedge fund investment strategies is another major risk for financial stability which warrants close

monitoring despite the essential lack of any possible remedies. This risk is further magnified by

evidence that broad hedge fund investment strategies have also become increasingly correlated,

thereby further increasing the potential adverse effects of disorderly exits from crowded trades."

The Times wrote about this review: "In one of the starkest warnings yet from an official

institution over the role of the burgeoning but secretive industry, the ECB sounded a note of

alarm over the possible repercussions from any collapse of a hedge fund, or group of funds."

However, the ECB statement itself has been criticized by a part of the financial research

community. These arguments are developed by the EDHEC Risk and Asset Management

Research Centre: The main conclusions of the study are that “the ECB article’s conclusion of a

risk of “disorderly exits from crowded trades” is based on mere speculation. While the question

of systemic risk is of importance, we do not dispose of enough data to reliably address this

Hemant Palav / MBA / Semester II 46.

“Hedging Fund & Its Impact On Capital Market”

question at this stage”, “ it would be worthwhile for financial regulators to work towards

obtaining data on hedge fund leverage and counterparty credit risk. Such data would allow a

reliable assessment of the question of systemic risk”, and “besides evaluating potential systemic

risk, it should be recognised that hedge funds play an important role as “providers of liquidity

and diversification”.

The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge

funds in June 2007. The funds invested in mortgage-backed securities. The funds' financial

problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside

assistance. It was the largest fund bailout since Long Term Capital Management's collapse in

1998. The U.S. Securities and Exchange commission is investigating.

Performance measurement

The issue of performance measurement in the hedge fund industry has led to literature that is

both abundant and controversial. Traditional indicators (Sharpe, Treynor, Jensen) work best

when returns follow a symmetrical distribution. In that case, risk is represented by the standard

deviation. Unfortunately, hedge fund returns are not normally distributed, and hedge fund return

series are autocorrelated. Consequently, traditional performance measures suffer from theoretical

problems when they are applied to hedge funds, making them even less reliable than is suggested

by the shortness of the available return series.

Innovative performance measures have been introduced in an attempt to deal with this problem:

Modified Sharpe ratio by Gregoriou and Gueyie (2003), Omega by Keating and Shadwick

(2002), Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004), and

Kappa by Kaplan and Knowles (2004). An overview of these performance measures is available

in Géhin, W., 2006, The Challenge of Hedge Fund Performance Measurement: a Toolbox rather

than a Pandora’s Box, EDHEC Risk and Asset Management Research Center, Position Paper,

December. However, there is no consensus on the most appropriate absolute performance

measure, and traditional performance measures are still widely used in the industry.

Relationships with analysts

Hemant Palav / MBA / Semester II 47.

“Hedging Fund & Its Impact On Capital Market”

In June 2006. the U.S. Senate Judiciary Committee began an investigation into the links between

hedge funds and independent analysts, and other issues related to the funds. Connecticut

Attorney General Richard Blumenthal testified that an appeals court ruling striking down

oversight of the funds by federal regulators left investors "in a regulatory void, without any

disclosure or accountability." The hearings heard testimony from, among others, Gary Aguirre, a

staff attorney who was recently fired by the SEC.

Transparency

Some hedge funds, mainly American, do not use third parties either as the custodian of their

assets or as their administrator (who will calculate the NAV of the fund). This can lead to

conflicts of interest, and in extreme cases can assist fraud. In a recent example, Kirk Wright of

International Management Associates has been accused of mail fraud and other securities

violations which allegedly defrauded clients of close to $180 million.

IMPACT OF HEDGE FUNDS ON CAPITAL MARKET

The hedge fund universe is expanding rapidly, with more than 7,300 funds managing some $1.7

trillion in assets by mid-2007. The three largest hedge funds each manages at least $30 billion in

investors' assets, and have estimated investment positions in financial markets of up to $100

billion. MGI projects that the value of hedge fund assets under management will more than

double over the next five years to $3.5 trillion.

Hemant Palav / MBA / Semester II 48.

“Hedging Fund & Its Impact On Capital Market”

Hedge funds have benefited capital markets by increasing liquidity and spurring financial

innovations. Yet worries persist that their growing size and heavy use of borrowing could

destabilize financial markets. When Long Term Capital Management ran into trouble in 1998,

the fund's catastrophic losses prompted the Federal Reserve to coordinate a $3.6 billion rescue by

a group of large banks.

More recently, several multibillion-dollar hedge funds suffered big losses in mid-2007 as rising

defaults on subprime mortgages caused turmoil in the debt and equity markets. Some smaller and

midsize funds shut down. So the question arises again: could a hedge fund meltdown trigger a

broader financial-market crisis?

MGI's research suggests that several developments over the past decade may have reduced—but

certainly not eliminated—the risks. Hedge funds have adopted more diverse trading strategies,

reducing the likelihood that many would fail simultaneously. The banks that lend to hedge funds

have improved their assessment and monitoring of risk, and they have reasonable financial

cushions—collateral and equity—to protect them in case one or more of their hedge fund clients

were to fail (as we saw last summer). The largest hedge funds have begun to raise permanent

capital in public stock and bond markets, while imposing more restrictions on investor

withdrawals—changes that should improve their ability to weather market downturns. Once

financial-market mavericks, hedge funds are joining the mainstream.

Private Equity

Private equity is a relatively small industry, but one that has had a disproportionately large

impact on the corporate world. The value of private-equity-owned companies is only 5 percent of

the value of companies listed in the U.S. stock markets (and just 3 percent in Europe). However,

private-equity firms now account for nearly one in three mergers or acquisitions. These firms

have grabbed public attention with a series of huge deals, including the buyouts of energy giant

TXU Corp. for $45 billion and health-care company HCA, Inc., for $33 billion.

Hemant Palav / MBA / Semester II 49.

“Hedging Fund & Its Impact On Capital Market”

Private-equity firms are ushering in a new model of corporate governance, and the best funds

improve the performance of many of the companies they buy. For instance, one study of 60

leveraged-buyout deals found that two-thirds of them improved company performance and

posted risk-adjusted returns of twice the industry average. Seeing superior returns in companies

taken private, shareholders of publicly listed companies are inclined to scrutinize the

performance of their respective managements more closely and demand improvements.

Although private-equity funds are sometimes accused of seeking short-term profits, most private-

equity funds invest on a three- to five-year horizon, giving them leeway to engage in root-and-

branch corporate restructuring. By adding debt to an acquired company's balance sheet, they

force managers to hit tough financial targets. As the pace of buyouts quickened earlier in 2007,

private-equity firms caused many public companies to rethink their attitudes toward debt and

equity—in the United States, for instance, companies have increasingly been choosing to buy

back shares, often purchasing them partly by raising levels of debt.

The recent tightening of credit markets has complicated the financing of some recent buyout

deals and may dampen the flow of investor money into private-equity firms. But even if growth

slows in the short term, MGI projects that the industry's assets will increase to $1.4 trillion by

2012. As the industry expands, private-equity firms will mature, consolidate, and diversify their

investments, amplifying their influence on the broader corporate and financial landscape.

These new power brokers are here to stay, and they are increasingly venturing into each other's

territory. Hedge funds are buying up companies. Asian central banks are starting to replicate the

sovereign wealth funds of oil exporters. Oil exporters are creating more-sophisticated investment

vehicles such as private-equity funds.

The concerns about the new power brokers are genuine—and may well be justified. But we

should make judgments based on the facts—not out of an emotional response to power's passing

to a new set of actors on the financial stage. There is cause for qualified optimism that the

benefits of liquidity, innovation, and diversification brought by the new players will outweigh

the risks.

Hemant Palav / MBA / Semester II 50.

“Hedging Fund & Its Impact On Capital Market”

Role of Hedge Funds in the Capital Markets

The role that hedge funds are playing in capital markets cannot be quantified with any precision.

A fundamental problem is that the definition of a hedge fund is imprecise, and distinctions

between hedge funds and other types of funds are increasingly arbitrary. Hedge funds often are

characterized as unregulated private funds that can take on significant leverage and employ

complex trading strategies using derivatives or other new financial instruments. Private equity

Hemant Palav / MBA / Semester II 51.

“Hedging Fund & Its Impact On Capital Market”

funds are usually not considered hedge funds, yet they are typically unregulated and often

leverage significantly the companies in which they invest. Likewise, traditional asset managers

more and more are using derivatives or are investing in structured securities that allow them to

take on leverage or establish short positions.

Although several databases on hedge funds are compiled by private vendors, they cover only the

hedge funds that voluntarily provide data. Consequently, the data are not comprehensive.

Furthermore, because the funds that choose to report may not be representative of the total

population of hedge funds, generalizations based on these databases may be misleading. Data

collected by the Securities and Exchange Commission (SEC) from registered advisers to hedge

funds are not comprehensive either. The primary purpose of registration is to protect investors by

discouraging hedge fund fraud. The SEC does not require an adviser to a hedge fund, regardless

of how large it is, to register if the fund does not permit investors to redeem their interests within

two years of purchasing them. While registration of advisers of such funds may well be

unnecessary to discourage fraud, the exclusion from the database of funds with long lock-up

periods makes the data less useful for quantifying the role that hedge funds are playing in the

capital markets.

Even if a fund is included in a private database or its adviser is registered with the SEC, the

information available is quite limited. The only quantitative information that the SEC currently

collects is total assets under management. Private databases typically provide assets under

management as well as some limited information on how the assets are allocated among

investment strategies, but they do not provide detailed balance sheets. Some databases provide

information on funds’ use of leverage, but their definition of leverage is often unclear. As hedge

funds and other market participants increasingly use financial products such as derivatives and

securitized assets that embed leverage, conventional measures of leverage have become much

less useful. More meaningful economic measures of leverage are complex and highly sensitive to

assumptions about the liquidity of the markets in which financial instruments can be sold or

hedged.

Although the role of hedge funds in the capital markets cannot be precisely quantified, the

growing importance of that role is clear. Total assets under management are usually reported to

Hemant Palav / MBA / Semester II 52.

“Hedging Fund & Its Impact On Capital Market”

exceed $1 trillion. Furthermore, hedge funds can leverage those assets through borrowing money

and through their use of derivatives, short positions, and structured securities. Their market

impact is further magnified by the extremely active trading of some hedge funds. The trading

volumes of these funds reportedly account for significant shares of total trading volumes in some

segments of fixed income, equity, and derivatives markets.

In various capital markets, hedge funds clearly are increasingly consequential as providers of

liquidity and absorbers of risk. For example, a study of the markets in U.S. dollar interest rate

options indicated that participants viewed hedge funds as a significant stabilizing force. In

particular, when the options and other fixed income markets were under stress in the summer of

2003, the willingness of hedge funds to sell options following a spike in options prices helped

restore market liquidity and limit losses to derivatives dealers and investors in fixed-rate

mortgages and mortgage-backed securities. Hedge funds reportedly are significant buyers of the

riskier equity and subordinated tranches of collateralized debt obligations (CDOs) and of asset-

backed securities, including securities backed by nonconforming residential mortgages.

At the same time, however, the growing role of hedge funds has given rise to public policy

concerns. These include concerns about whether hedge fund investors can protect themselves

adequately from the risks associated with such investments, whether hedge fund leverage is

being constrained effectively, and what potential risks the funds pose to the financial system if

their leverage becomes excessive.

Investor Protection

Hedge funds and their investment advisers historically were exempt from most provisions of the

federal securities laws. Those laws effectively allow only institutions and relatively wealthy

individuals to invest in hedge funds. Such investors arguably are in a position to protect

themselves from the risks associated with hedge funds. However, in recent years hedge funds

Hemant Palav / MBA / Semester II 53.

“Hedging Fund & Its Impact On Capital Market”

reportedly have been marketed increasingly to a less wealthy clientele. Furthermore, pension

funds, many of whose beneficiaries are not wealthy, have increased investments in hedge funds.

Concerns about the potential direct and indirect exposures of less wealthy investors from hedge

fund investments and hedge fund fraud contributed to the SEC’s decision in December 2004 to

require many advisers to hedge funds that are offered to U.S. investors to register with the

commission.

The SEC believes that the examination of registered hedge fund advisers will deter fraud. But

fraud is very difficult to uncover, even through on-site examinations. Therefore, it is critical that

investors do not view the SEC registration of advisers as an effective substitute for their own due

diligence in selecting funds and their own monitoring of hedge fund performance. Most

institutional investors probably understand this well. In a survey several years ago of U.S.

endowments and foundations, 70 percent of the respondents said that a hedge fund adviser’s

registration or lack of registration with the SEC had no effect on their decision about whether or

not to invest because the institutions conducted their own due diligence.

In the case of pension funds, sponsors and pension fund regulators should ensure that pension

funds conduct appropriate due diligence with respect to all their investments, not just their

investments in hedge funds. Pension funds and other institutional investors seem to have a

growing appetite for a variety of alternatives to holding stocks and bonds, including real estate,

private equity and commodities, and investments in hedge funds are only one means of gaining

exposures to those alternative assets. The registration of hedge fund advisers simply cannot

protect pension fund beneficiaries from the failures of plan sponsors to carry out their fiduciary

responsibilities.

As for individual investors, the income and wealth criteria that define eligible investors in hedge

funds unavoidably are a crude test for sophistication. If individuals with relatively little wealth

increasingly become the victims of hedge fund fraud, it may become appropriate to tighten the

criteria for an individual to be considered an eligible investor.

Excessive Leverage and Systemic Risk

Hemant Palav / MBA / Semester II 54.

“Hedging Fund & Its Impact On Capital Market”

The near failure of the hedge fund Long-Term Capital Management (LTCM) in September 1998

illustrated the potential for a large hedge fund to become excessively leveraged and raised

concerns that a forced liquidation of large positions held by a highly leveraged institution would

create systemic risk by exacerbating market volatility and illiquidity. In our market-based

economy, the primary mechanism that regulates firms’ leverage is the market discipline imposed

by creditors and counterparties. Even when the government has oversight of leverage, as in the

case of banks and broker-dealers, such oversight is intended to supplement market discipline

rather than to replace it. In the case of LTCM, however, market discipline broke down.

In the wake of the LTCM episode, the President’s Working Group on Financial Markets

considered how best to constrain excessive leverage by hedge funds. The Working Group

concluded that hedge funds’ leverage could be constrained most effectively by promoting

measures that enhance market discipline by improving credit risk management by hedge funds’

counterparties and creditors, nearly all of which are regulated banks and securities firms. The

Working Group termed this approach “indirect regulation” of hedge funds. The Working Group

considered the alternative of direct government regulation of hedge funds, but it concluded that

developing a regulatory regime for hedge funds would present formidable challenges in terms of

cost and effectiveness. It believed that indirect regulation would address concerns about systemic

risks from hedge funds most effectively and would avoid the potential attendant costs of direct

regulation.

The Federal Reserve and Hedge Funds

The President’s Working Group made a series of recommendations for improving market

discipline on hedge funds. These included recommendations for improvements in credit risk

management practices by the banks and securities firms that are hedge funds’ counterparties and

creditors and improvements in supervisory oversight of those banks and securities firms. As a

Hemant Palav / MBA / Semester II 55.

“Hedging Fund & Its Impact On Capital Market”

regulator of banks and bank holding companies, the Federal Reserve has worked with other

domestic and international regulators to implement the necessary improvements in supervisory

oversight. Regulatory cooperation is essential in this area because hedge funds’ principal

creditors and counterparties include foreign banks as well as U.S. banks and securities firms.

In January 1999, the Basel Committee on Banking Supervision (BCBS) published a set of

recommendations for sound practices for managing counterparty credit risks to hedge funds and

other highly leveraged institutions. Around the same time, the Federal Reserve, the SEC, and the

Treasury Department encouraged a group of twelve major banks and securities firms to form a

Counterparty Risk Management Policy Group (CRMPG), which in July 1999 issued its own

complementary recommendations for improving counterparty risk management practices.

The BCBS sound practices have been incorporated into Federal Reserve supervisory guidance

and examination procedures applicable to banks’ capital market activities. In general terms,

routine supervisory reviews of counterparty risk management practices with respect to hedge

funds and other counterparties seek to ensure that banks (1) perform appropriate due diligence in

assessing the business, risk exposures, and credit standing of their counterparties; (2) establish,

monitor, and enforce appropriate quantitative risk exposure limits for each of their

counterparties; (3) use appropriate systems to measure and manage counterparty credit risk; and

(4) deploy appropriate internal controls to ensure the integrity of their processes for managing

counterparty credit risk. Besides conducting routine reviews and continually monitoring

counterparty credit exposures, the Federal Reserve periodically performs targeted reviews of the

credit risk management practices of banks that are major hedge fund counterparties. These

targeted reviews examine in depth the banks’ practices against the BCBS and Federal Reserve

sound practices guidance and the CRMPG recommendations.

According to supervisors and most market participants, counterparty risk management has

improved significantly since the LTCM episode in 1998. However, since that time, hedge funds

have greatly expanded their activities and strategies in an environment of intense competition for

hedge fund business among banks and securities firms. Furthermore, some hedge funds are

among the most active investors in new, more-complex structured financial products, for which

valuation and risk measurement are challenging both to the funds themselves and to their

Hemant Palav / MBA / Semester II 56.

“Hedging Fund & Its Impact On Capital Market”

counterparties. Counterparties and supervisors need to ensure that competitive pressures do not

result in any significant weakening of counterparty risk management and that risk management

practices are evolving as necessary to address the increasing complexity of the financial

instruments used by hedge funds.

The Federal Reserve has also sought to limit hedge funds’ potential to be a source of systemic

risk by ensuring that the clearing and settlement infrastructure that supports the markets in which

the funds trade is robust. Very active trading by hedge funds has contributed significantly to the

extraordinary growth in the past several years of the markets for credit derivatives. A July 2005

report by a new Counterparty Risk Management Policy Group (CRMPG II) called attention to

the fact that the clearing and settlement infrastructure for credit derivatives (and over-the-counter

derivatives generally) had not kept pace with the volume of trading. In particular, a backlog of

unsigned trade confirmations was growing, and the acceptance by dealers of assignments of

trades by one counterparty without the prior consent of the other, despite trade documentation

requirements for such consent, was becoming widespread.

To address these and other concerns about the clearing and settlement of credit derivatives, in

September 2005 the Federal Reserve Bank of New York brought together fourteen major U.S.

and foreign derivatives dealers and their supervisors. The supervisors collectively made clear

their concerns about the risks created by the infrastructure weaknesses and asked the dealers to

develop plans to address those concerns. With supervisors providing common incentives for the

collective actions that were necessary, the dealers have made remarkable progress since last

September. The practice of unauthorized assignments has almost ceased, and dealers are now

expeditiously responding to requests for the authorization of assignments. For the fourteen

dealers as a group, total credit derivative confirmations outstanding for more than thirty days fell

70 percent between September 2005 and March 2006. The reduction in outstanding

confirmations was made possible in part by more widespread and intensive use of an electronic

confirmation-processing system operated by the Depository Trust and Clearing Corporation

(DTCC). The dealers have worked with their largest and most active clients, most of which are

hedge funds, to ensure that they can electronically confirm trades in credit derivatives. By March

2006, 69 percent of the fourteen dealers’ credit derivatives trades were being confirmed

electronically, up from 47 percent last September.

Hemant Palav / MBA / Semester II 57.

“Hedging Fund & Its Impact On Capital Market”

Supervisors and market participants agree that further progress is needed, and in March the

fourteen dealers committed themselves to achieving by October 31, 2006, a “steady state”

position for the industry. The steady state will involve (1) the creation of a largely electronic

marketplace in which all trades that can be processed electronically will be; (2) the creation by

DTCC of an industry trade information warehouse and support infrastructure to standardize and

automate processing of events throughout each contract’s life; (3) new processing standards for

those trades that cannot be confirmed electronically; and (4) the creation of an automated

platform to support notifications and consents with respect to trade assignments. The principal

trade association for the hedge fund industry has stated its support for plans embodied in the

dealers’ commitments.

Hedge funds clearly are becoming more important in the capital markets as sources of liquidity

and holders and managers of risk. But as their importance has grown, so too have concerns about

investor protection and systemic risk. The SEC believes that the examination of registered hedge

advisers will deter fraud. But investors must not view SEC regulation of advisers as an effective

substitute for their own due diligence in selecting funds and their own monitoring of hedge fund

performance.

After the LTCM episode, the President’s Working Group on Financial Markets considered how

best to address concerns about potential systemic risks from excessive hedge fund leverage. The

Working Group concluded that hedge funds’ leverage could be constrained most effectively by

promoting measures that enhance market discipline by improving credit risk management by

funds’ counterparties and creditors, nearly all of which are regulated banks and securities firms.

The Working Group considered the alternative of direct government regulation of hedge funds

but concluded that it would be more costly and would be less effective than an approach focused

on strengthening market discipline.

The Federal Reserve has been seeking to ensure appropriate market discipline on hedge funds by

working with other regulators to promote effective counterparty risk management by hedge

funds’ counterparties and creditors. It has also sought to limit the potential for hedge funds to be

a source of systemic risk by ensuring that the clearing and settlement infrastructure that supports

the markets in which they trade is robust.

Hemant Palav / MBA / Semester II 58.

“Hedging Fund & Its Impact On Capital Market”

1.  Examples of hedge fund databases include Trading Advisors Selection System (TASS),

Centre for International Securities and Derivatives Markets (CISDM) Hedge Fund Database, and

Hedge Fund Research Database.  

2.  The commission decided not to require such funds to register because it had not encountered

significant problems with fraud at private equity or venture capital funds, which are similar in

some respects to hedge funds but usually require investors to make long-term commitments of

capital.  

3.  For a discussion of the definition and construction of economically meaningful measures of

leverage, see appendix A in Counterparty Risk Management Policy Group (1999), Improving

Counterparty Risk Management Practices (New York: CRMPG, June).  

4.  Some of these estimates may double count investments in funds of funds. At the end of last

year, and excluding fund of funds, the TASS database included funds that had $979.3 billion in

assets. Of course, not all funds are included in this database.  

5.  Greenwich Associates estimates that hedge funds in 2004 accounted for 20 to 30 percent of

trading volumes in markets for below-investment-grade debt, credit derivatives, collateralized

debt obligations, emerging-market bonds, and leveraged loans, and 80 percent of trading in

distressed debt. See Greenwich Associates (2004), Hedge Funds: The End of the Beginning?

(Greenwich Associates, December). These estimates were based on interviews with hedge funds

and other institutional investors that Greenwich Associates conducted from February through

April 2004.

The last few years have been good to investors, investment funds, and the M&A market. Now, in

another indication that the party may be over, capital investors are showing signs of retreating

from hedge funds. In response, hedge funds are making new offers and improved terms in order

to woo the investors that support them.

Hemant Palav / MBA / Semester II 59.

“Hedging Fund & Its Impact On Capital Market”

After two prominent Bear Sterns funds specializing in subprime mortgages collapsed, other

hedge funds in the same market began seeing requests from investors seeking to redeem their

investment. The crunch in the subprime mortgage market was followed by a decline in the

overall availability of credit and by falling share prices on the stock market. Since credit and

share values are important factors in the M&A marketplace, the recent high pace of merger and

acquisition deal activity is expected to slow, creating a challenge for funds that invest in stocks

and acquisitions.

Some of the hedge fund sector's prominent players, including AQR Capital Management,

Highbridge Capital Management, DE Shaw, and Goldman Sachs, have recently seen heavy

losses. Investors, ranging from wealthy individuals to chief investment officers for endowments

and trusts, are becoming more cautious about risk.

Investment funds are preparing for the possibility that new investors may be difficult to find and

current investors may ask for their money back. KKR Financial Holdings, an affiliate of

Kohlberg Kravis Roberts & Co., stated that it could lose up to $290 billion in its investments

because investor faith in mortgages has been shaken.

Advertisement

Large-scale redemptions could drive hedge funds to sell off assets below value in order to create

the liquidity necessary to return capital to investors. The greatest demand for redemptions will

likely be seen by hedge funds focused on subprime mortgage investments and quantitative funds.

Quantitative hedge funds, which select investments based on computer-based models and

quantitative analysis, began posting steep losses in late July and early August, when the

subprime mortgage crash triggered a crisis of confidence in credit markets.

Hedge funds are not sitting quietly, waiting for their investors to pull out. Sentinel Management

Group Inc., stating that it cannot meet its investors' requests to withdraw their money without

selling investments at a steep discount, has frozen a $1.5 billion fund. Funds at Bear Sterns,

Braddock Financial, and United Capital Markets have also taken actions to suspend redemptions.

Sentinel Management has reportedly asked regulators for permission to suspend redemptions as

well.

Hemant Palav / MBA / Semester II 60.

“Hedging Fund & Its Impact On Capital Market”

Many hedge funds impose "gates," rule structures that limit the amount of assets withdrawn in a

given quarter. These strictures help limit the impact that sudden investment withdrawals can

have on markets as the funds would otherwise have to sell of assets at discount rates in order to

meet the withdrawal requests.

In the midst of all the concern, investment banking giant Goldman Sachs is making efforts to

draw investors to its Global Equity Opportunities hedge fund, after stock market losses wiped

out about $1.4 billion of its assets. Goldman is offering surprising terms to new participants in

the fund - Goldman is waiving the fund's management fee and cutting its performance fees in

half. Previously, Global Equity investors paid two percent of assets per year as a management

fee and 20 percent of profits as an incentive fee. The new deal doesn't impose any incentive fees

until the fund appreciates by ten percent. Goldman will then keep ten percent of the fund's profits

above that threshold.

There is a catch, however. Global Equity's existing investors can withdraw their money monthly

with 15 days notice. New investors may not withdraw for six months. The deal is clear- ly

structured to draw investors with the resources and confidence to commit for a longer investment

period.

The banking giant has an interest in keeping the fund going. Goldman has invested about $2

billion of its own money in the fund. After its recent market losses, the fund has about $3.6

billion in assets. The fund's value has declined since July 2006, so exisiting investors are not

currently being charged the 20 percent performance fee. The fee will be applied when the funds

performance surpasses its highest level from last year.

It is too early to tell whether new strategies will save hedge funds. It is equally difficult to predict

just how great the investor withdrawal will be. But the easy ride is definitely over, and the road

ahead is likely to get rough.

THREE MAIN ISSUE DISCUSS

Hemant Palav / MBA / Semester II 61.

“Hedging Fund & Its Impact On Capital Market”

A. From a regulatory point of view, what are the key risks posed

by hedge funds?

B. What is the appropriate regulatory response to these risks?

C. What is the approach being taken by the International

Organisation of Securities Commissions to hedge funds,

focusing in particular on its work on valuation policies and

pricing procedures for hedge fund portfolios?

From a regulatory perspective, what are the key risks posed by hedge funds?

Before turning to the risks that are particular to hedge funds and hedge fund managers, it is worth

stressing that the FSA believes firmly that a regulator should only intervene in markets where the

market is failing to deliver acceptable outcomes, and where the costs of intervention are justified

by the benefits to be delivered by regulation. Moreover, we are not a regulator who considers it

sensible or desirable to deliver a regulatory regime that guarantees that failures will never occur.

A non-zero failure regime of the sort we operate accepts that firms will from time to time fail.

While we aim to minimise the impact of failures which arise from regulatory breaches, we must

Hemant Palav / MBA / Semester II 62.

“Hedging Fund & Its Impact On Capital Market”

accept that firms will make errors of business judgement, timing, or strategy or simply fail to

measure up to the competition. In any vibrant and successful marketplace some businesses must

fail, and this reality helps drive standards higher for those who succeed.

The Amaranth case is in some respects an interesting example of what I mean, and I digress for

just a moment longer. There are inquiries underway and it is not possible to comment

definitively, but there are aspects of this collapse that suggest that the overall regulatory

framework did operate in an effective manner. The losses were catastrophic for the firm and

sudden, but the overall impact on the market relatively insignificant. The prime brokers involved

appear all to have had more than adequate collateral, and the positions of Amarath appear to

have been liquidated or transferred without undue disruption to trading in the sector or its

underlying physical markets. Judging from the information available to investors before the

collapse, there may be interesting questions for fund of hedge fund managers and other investors

in the fund to ask themselves about whether the collapse could have been foreseen, so there may

be lessons to be learned about due diligence performed by hedge fund investors.

But no one should expect that hedge funds will never lose money or forget that they indeed may

from time to time disappear. This is part of the risk/reward framework that underlies all financial

markets.

Let me return then to the question of what the FSA considers are the key regulatory risks arising

in respect of hedge funds and those who manage and provide services to them. I am speaking

therefore of risks that arise to our regulatory objectives of proportionate investor protection and

maintenance of market confidence. Once we have identified the key risks, we must determine the

likelihood of them crystallising, in order to decide whether there are any proportionate mitigating

actions that we or indeed others might be best placed to take.

If these are the principal risks, what then is the appropriate response for a regulator to

them?

Firstly, I must emphasise the FSA is not seeking to authorise and regulate the funds themselves,

which at present are located outside our jurisdiction. Our approach is to mitigate the risks

through our existing authority over hedge fund managers and the broker/dealers who provide

Hemant Palav / MBA / Semester II 63.

“Hedging Fund & Its Impact On Capital Market”

prime brokerage services to the funds. We do not consider that the assertion of extra-territorial

jurisdiction is a necessary or desirable regulatory intervention in this market.

With this in mind, the FSA set up a centre of hedge fund expertise in October 2005. A priority of

this team has been to enhance our oversight of 31 of the largest hedge fund managers in the UK

(accounting for 50% of assets managed). These managers have a dedicated supervisor in regular

contact with the firms and undertaking periodic risk assessments to develop individual risk

mitigation plans with them. Lower impact firms are subject to baseline monitoring through

regulatory returns and other types of alerts and market intelligence. The centre of expertise

advises and where relevant takes the lead on the FSA response to any hedge fund cases.

Furthermore, it undertakes thematic supervision, covering a wide range of entities that have

hedge fund mandates irrespective of where within the FSA that group or firm is primarily

supervised – the approach is designed to address the risks posed to our objectives by the industry

as a whole.

That's how we have organised our resources, but now let me deal with our response to the

specific risks to our objectives I outlined earlier.

1) Market disruption/systemic issues

In 2004, we established a regular six monthly survey on the exposures to hedge funds of the

main London based banks that provide prime brokerage services. The aim of this survey is to

enhance our understanding of prime brokerage and to gather data on the exposures of the firms to

major hedge funds, either via prime brokerage or via the trading of OTC derivatives. The survey

targets the largest Prime Brokers (currently 15 firms) with 2 main data requests; the first looks at

their credit exposures to hedge funds, the second focuses on the prime broker business. The

Hemant Palav / MBA / Semester II 64.

“Hedging Fund & Its Impact On Capital Market”

quantitative benefits of the survey have worked in tandem with qualitative support; it has

advanced supervisory discourse with firms, particularly those with large risk exposures, and

encouraged the improvement of risk management systems in the prime brokers themselves.

We are conscious of the importance to hedge fund managers of a small number of very large

prime brokers, who provide both financial gearing and operational support to the hedge fund

managers. These prime brokers are institutions with which we at the FSA already have a close

regulatory relationship, and we have used this to develop a much improved understanding of the

position of these banks vis-à-vis hedge funds. So what are the headline findings thus far? Our

April 2006 survey showed:

Assets under management had grown, on an equity basis, by 29% per cent to

$494 billion;

Aggregate average leverage had grown slightly from to 2.25 to 2.39;

Two prime brokers continued to account for just over half the sector's total

exposure to hedge funds;

Average excess collateral remains unchanged at 100 per cent;

No fund with major exposures comparable to LTCM has been identified.

Generally, the funds' gearing was significantly lower than LTCM, which was

leveraged at 25:1 until early 1998, and 50:1 by the time of its collapse. Present

leverage on average as revealed by our survey is 2.4:1. The highest gearing of

any fund was 15:1

We found that exposures of the prime brokers to the hedge funds were both

limited in absolute amount and relative to capital, and were in general fully

collateralised, as was evident as noted in the Amaranth collapse.

A word about the limitations of this survey. With two exceptions, our information covers only

exposures booked in London, so we do not have and do not purport to have the total global

picture in respect of these prime brokers or indeed of any underlying hedge fund. Nonetheless,

we consider that this information, which does cover a substantial percentage of the global

market, is a good indicator of the present position. We are also discussing with the prime brokers

Hemant Palav / MBA / Semester II 65.

“Hedging Fund & Its Impact On Capital Market”

and other regulators whether, and if so how, this voluntary survey might be extended

internationally.

2) Market Integrity

Our focus on market integrity has two strands. Firstly, seeking to deter abuse. Credible

deterrence has four key components – pro-active surveillance of likely 'hot spots,' a modern

transaction analysis system, industry cooperation to ensure a steady flow of information, and an

effective enforcement programme. It is worth mentioning that we have been devoting significant

supervisory efforts to enhancing managers' systems and procedures for dealing with price

sensitive information. We have been active in encouraging an improvement of the hedge fund

managers’ procedures in this area. We have also not hesitated to take enforcement action where

warranted and have identified market abuse as an enforcement priority for the organisation going

forward.

3) A co-ordinated global approach to reducing credit derivatives backlogs

We, together with regulators in other major financial centres - notably the US Federal Reserve

and the SEC - became very concerned about significant trade confirmation backlogs in the credit

derivative markets last year. In assessing this risk, we became aware that the assignment of

trades by hedge funds, without prior approval or even notification of their counterparty, was

significantly contributing to this backlog. Our response has been to work as a group to set targets

and encourage the banks to improve. This approach has proved effective, with very significant

reductions in backlogs already achieved, and more still on the way.

4) Transparency/ side letters

We made clear in our policy statement on hedge fund issues that a failure by a UK based hedge

fund manager to make adequate disclosures of material side letters would amount to a breach of

Principle 1 of our Principles for Businesses. This is one of our core principles, and states that a

firm must conduct its business with integrity. As a minimum, we would expect acceptable

market practice to be for managers to ensure that all investors are informed when a material side

letter is granted. AIMA has recently published industry guidance on the disclosure of side letters.

Hemant Palav / MBA / Semester II 66.

“Hedging Fund & Its Impact On Capital Market”

We have reviewed the guidance and confirmed that we will take it into account when exercising

our regulatory functions, although this cannot affect the rights of third parties. In summary, firms

will be required to disclose the existence of side letters which contain “material terms”, and the

nature of such terms, where the firm is a party to the side letters. Material Terms focus

essentially on granting more favourable treatment than other holders of the same class of share or

interest and thereby conferring an advantage in respect of redemption or the right to redeem. We

will be conducting some thematic work to test the market’s response to these standards in the

near future.

5) Retailisation

We published a discussion paper last year on the possibility of opening the UK retail market to a

wider range of alternative investment products. We have decided to consult on the creation of an

on-shore fund of hedge funds and other unauthorised funds regime. Given the increasing

penetration of the UK retail market by alternative investment vehicles, it seemed anomalous that

there was no similar on-shore vehicle that was more widely available to the retail market, and

which would benefit from some of the structural and investment protections that characterised

regulated investment funds on shore. We will be publishing our consultation paper in the first

quarter of the New Year.

6) Mis-valuation of complex illiquid instruments/fraud

Internationally, we have been at the forefront of work among regulators on the issue of

valuations. I am chairing a sub-committee of the International Organisation of Securities

Commissions, which is looking to develop a set of good practice principles for the valuation

policies and pricing procedures of hedge fund portfolios. We have been given a mandate from

the IOSCO Technical Committee and expect to publish our report at the annual meeting in

Mumbai in April of 2007.

This is a risk that I think deserves a fuller treatment, and I turn to that now as my third major

point in today’s remarks.

Hemant Palav / MBA / Semester II 67.

“Hedging Fund & Its Impact On Capital Market”

What is IOSCO's approach to hedge fund valuation risks?

Valuation of the portfolio of assets of an investment fund is not a topic of unique interest to

hedge funds. Regulators around the world have long sought to ensure that the net asset value of

public traded funds such as mutual funds and UCITS in Europe is rigorously controlled to ensure

that fair value is achieved for the underlying investors dealing in the funds.

But IOSCO decided to focus on hedge funds in particular because of a number of factors and

risks that are particularly heightened in hedge funds.

First, as widely recognised, hedge funds have grown at an astonishing rate in recent years and

have emerged as a very important component of global capital markets. They make a major

contribution to the innovation, liquidity and efficiency of the capital markets and as such have a

central place in the health and soundness of financial markets internationally.

Second, hedge funds often deal in asset classes that can be hard to price making their strategies

and portfolios difficult to value. AIMA estimated that in 2004 some 20% of Hedge Fund

strategies were in hard to value securities (for example distressed debt, emerging markets, fixed

income arbitrage). Moreover, an investor in a fund which focuses on just one of these strategies

may have a 100% exposure to hard-to-value assets.

Third, hedge funds often utilize substantial leverage in their trading, potentially magnifying the

impact of a pricing mis-mark.

Fourth, the performance based remuneration of hedge fund managers, coupled with difficult-to-

value assets and in some cases self-administration of the funds, can create very substantial

conflicts of interest in the pricing of assets.

Fifth, in the case of some highly illiquid assets, it is virtually impossible to find a completely

objective pricing source, forcing reliance upon models or observed or implied prices based upon

the judgment of market participants, none of whom may be disinterested in the transaction.

Last, but by no means least, it is estimated that in 2005, valuation-related losses in hedge funds

globally totalled some $1.6 billion dollars. Poor valuation controls in combination with weak

internal procedures were exploited to misrepresent hedge fund values and commit fraud. This

Hemant Palav / MBA / Semester II 68.

“Hedging Fund & Its Impact On Capital Market”

was a wake up call to industry and the regulators to the real dangers of slipshod valuation

policies and pricing practices.

What is IOSCO doing about this?

As I mentioned, I am chairing an IOSCO sub-committee that is looking to develop good practice

valuation policies and pricing procedures for hedge fund managers. Unusually for IOSCO, the

sub-committee includes industry representatives as contributing members of the sub-committee,

working with us hand-in-hand throughout the process. They include a small number of

representatives from hedge fund managers, fund of hedge fund managers, prime brokers,

auditors, administrators and third party pricing providers.

The group is mandated to develop a single set of valuation principles with a reasonable level of

granularity. Without giving too much away at this stage of our work, you should expect us to be

focusing on the existence of robust, written policies and procedures, the effective day-to-day

operation of them, the role of the hedge fund manager, the role of independent parties in

producing and/or verifying prices, and adequacy of disclosure to investors, among other key

issues.

Let me stress that we are not seeking to reinvent the wheel here. There is a good deal of excellent

practice out in the market already. As you would expect, many institutional investors and funds

of hedge funds undertake quite demanding due diligence in respect of their investments in hedge

funds. We want to encourage the spread of that good practice.

In addition, international trade associations like AIMA and the Managed Funds Association in

the US have already undertaken substantial work in this area and continue to do so. Moreover,

academics and industry experts have published a good deal about valuation issues for illiquid

assets, and we have taken that work on board as well.

Our aim is to produce a set of principles that are practical, and can be used by investors as a

guide in real-life interactions with hedge fund managers, and have the added benefit of

endorsement by the international regulatory community. We hope that will make a meaningful

contribution to an evolving global standard for sound valuation policies and pricing procedures

in the hedge fund sector.

Hemant Palav / MBA / Semester II 69.

“Hedging Fund & Its Impact On Capital Market”

BIBLIOGRAPHY

Hemant Palav / MBA / Semester II 70.