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What is a Hedge Fund
The term “hedge fund” has no precise legal definition, yet a hedge fund is commonly referred to as an actively managed, open-end, unregistered, pooled investment fund that employs one or more investment strategies. Hedge funds are typically private funds that are open only to a limited number of accredited investors. The general partner and investment manager of the fund generally receive compensation from fees based on the total value of the assets under management and a performance-based fee.
Capital raising strategies of hedge funds vary widely. Some funds raise capital through family and friends while others are formed with the backing of a large investor or marketed primarily to institutional investors, such as pension plans.
In contrast to closed-end, private equity funds, a typical hedge fund makes shorter-term investments in primarily liquid assets. In a limited partnership structure, investors have capital accounts, where the balance reflects each investor’s pro-rata share of the fund’s total investments and liabilities. Each capital account is increased when the investor makes additional capital contributions or profits are allocated to the account and decreased when expenses or losses are allocated to the account or the investor makes withdrawals or redemptions.
Structural Benefits of a Limited Partnership
An efficient, well-designed hedge fund is typically structured to achieve maximum tax efficiencies for its investors. Generally, most domestic, US-based hedge funds are set up as a Delaware limited partnership. The limited partnership will have a general partner, most likely to be set up as a limited liability company and a separate investment manager, also likely to be set up as an additional limited liability company. The general partner typically exercises full control over all of the activities of the fund, including management of the fund’s portfolio and business affairs, while the investment manager is typically responsible for raising capital and making recommendations on which assets to purchase and sell and when the fund ought to take such action. Hence the reason why the management fees and performance fees are split and paid to two separate entities; the performance fees are typically paid to the general partner and the management fees are paid to the investment manager. Hedge fund managers will typically enjoy greater fees and other benefits when the hedge fund outperforms other attractive indices or mutual funds because of their unique strategies or edge.
Common Hedge Fund Strategies
Hedge fund managers may pursue varying strategies to meet their investment objectives. A
distinguishing feature of most hedge funds is that they invest primarily in liquid securities. Some of the most common hedge fund investment strategies include:
Long/short equity—This "classic" strategy involves equity-oriented investing on both long and short sides of the markets. The focus may be regional or sector-specific, such as long/short technology or health care stocks. Long/short equity funds tend to build and hold portfolios that are substantially more concentrated than those of traditional mutual funds.
Global macro—Global macro funds carry long and short positions in the securities, futures, and derivative markets. These positions reflect the manager’s views on overall market direction as influenced by major economic trends and events. Portfolios of these funds can include stocks, bonds, currencies, and commodities in the form of cash or derivative instruments.
Event driven/special situation—Often referred to as “special situations” investing, is a strategy designed to capture price movement generated by a significant pending corporate event, such as a merger, corporate restructuring, liquidation, bankruptcy, or reorganization and often involves investing in distressed or high-yield securities.
Fixed income arbitrage—This strategy is employed by managers seeking to profit from price anomalies between related interest-rate securities. Fixed income arbitrage also includes interest-rate swap arbitrage, U.S. government bond arbitrage, and mortgage-backed securities arbitrage.
Convertible arbitrage—Funds following this strategy typically take long positions in the convertible securities of a company and short positions in the common stock of that same company. Such positions are designed to generate profits from the fixed income security, as well as the short sale of stock, while protecting principal market fluctuations.
Equity market neutral—This strategy is designed to exploit equity market inefficiencies and usually involves investing simultaneously in long- and short- matched equity portfolios. The portfolios of these investments will often control for industry, sector, market capitalization and other exposures.
Managed futures—Managed futures funds invest in listed financial and commodity futures markets and currency markets around the world. Fund managers employing this strategy are usually regulated as "commodity trading advisors" under the Commodity Exchange Act.
Statistical arbitrage/high frequency/quantitative analysis—These strategies focus on using quantitative models to determine the statistical relationships between different securities. Funds employing these strategies may employ automated trading systems, using sophisticated models that analyze a bevy of data, such as pricing, timing, and historical information.