INVESTOR
EDUCATION
INVESTOR
EDUCATION
Hedge Funds
What is Hedge Fund?
Ability to short the market, to leverage the portfolio to multiply gains, and to hold high concentrations of positions.
No industry-wide classifications of hedge fund strategies, each major industry group has its own classification system.
Key performance driver is manager skill rather than market returns.
Target consistent returns in the long term rather than outperformance of a benchmark index.
Managers are unrestricted in their choice of investment strategies.
The ability to invest in any asset class or instrument.
Expectation of strong returns (historical data).
Low correlations to traditional asset classes and ability to provide diversification.
Target absolute returns rather than relative return.
Difference Between Mutual Fund and Hedge Fund
Authorization
A mutual fund is usually authorized by authorties, and can be sold to an unlimited number of investors. Most hedge funds are not authorized and can only be sold to carefully defined sophisticated investors. Mutual funds may advertise freely; hedge funds may not.
Flexibility
The hedge fund manager has fewer constraints to deal with; he can sell short, use derivatives, and use leverage. The manager can also make significant changes to the strategy if he thinks it is appropriate. The mutual fund manager cannot be as flexible.
Liquidity
The mutual fund often offers daily liquidity (you can withdraw at any time); the hedge fund usually has some sort of “lockup” provision. You can only get your money periodically
Absolute vs. Relative
The hedge fund aims for absolute return (it wants to produce positive returns regardless of what the market is doing); the mutual fund is usually managed relative to an index benchmark and is judged on its variance from that benchmark.
Self-Investment
The hedge fund manager is expected to put some of his own capital at risk in the strategy. The mutual fund does not face this same expectation.
Fees Paid to Hedge Fund
Hedge fund typically charge both a management fee and a performance fee.
Management fees are calculated as a percentage of the fund’s net asset value and typically range from 1% to 4% per annum, with 2% being standard.
The performance fee is typically 20% of the fund’s return during any year, though they range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits.
Almost all hedge fund performance fees include a “high water mark” (or “loss carryforward provision”), which means that the performance fee only applies to net profits (i.e., profits after losses in previous years have been recovered).
Some performance fees include a “hurdle”, so that a fee is only paid on the fund’s performance in excess of a benchmark rate (e.g. LIBOR) or a fixed percentage. A hurdle is intended to ensure that a manager is only rewarded if the fund generates returns in excess of the returns that the investor would have received if they had invested their money elsewhere.
Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year). The purpose of the fee is to discourage short-term investing, reduce turnover and deter withdrawals after periods of poor performance.
Side Pockets
A side pocket is a mechanism whereby a fund compartmentalizes assets that are relatively illiquid or difficult to value reliably. When an investment is side-pocketed, its value is calculated separately from the value of the fund’s main portfolio.
Because side pockets are used to hold illiquid investments, investors do not have the standard redemption rights with respect to the side pocket investment.
Profits or losses from the investment are allocated on a pro rata basis only to those who are investors at the time the investment is placed into the side pocket and are not shared with new investors.
Funds typically carry side pocket assets “at cost” for purposes of calculating management fees and reporting net asset values. This allows fund managers to avoid attempting a valuation of the underlying investments, which may not always have a readily available market value.
Side pockets allowed fund managers to lay away illiquid securities until market liquidity improved, a move that reduced losses. Despite these benefits, some investors complained that the practice was abused and not always transparent.
Types of Hedge Fund
Market Trend (Directional / Tactical) Strategies Hedge Funds
Event Driven Strategies Hedge Funds
Arbitrage Strategies Hedge Funds
Quant Funds
Hedge Fund Key Risk Factors
A Hedge Fund may employ a distinctive strategy which may not have a readily ascertainable comparative benchmark or index.
Hedge Fund documents are not reviewed or approved by regulators.
Hedge Funds may be leveraged (including highly leveraged) and a Hedge Fund performance may be volatile.
Hedge Funds may use benchmarks or targets for measurement purposes. There is no guarantee that a Hedge Funds’ goals, objectives, benchmarks or targeted returns will be achieved or reached.
Hedge Funds may have little or no operating history or performance and may use hypothetical or pro forma performance which may not reflect actual trading done by the manager or advisor and such history or performance should be reviewed carefully.
A Hedge Fund is not required to provide periodic pricing or valuation information to investors and it may be the Hedge Fund’s practice to not provide such information.
Some Hedge Funds may use a single advisor or employ a single strategy, which could mean a lack of diversification and higher risk.
An investment in a Hedge Fund may be illiquid and there may be significant restrictions on transferring interests in a Hedge Fund. There is no secondary market for an investor’s investment in a Hedge Fund and none is expected to develop.
A Hedge Fund’s fees and expenses, which may be substantial regardless of any positive return, will offset the Fund’s trading profits.
A Hedge Fund may involve a complex tax structure (which should be reviewed carefully) and delays in distributing important tax information.
A Hedge Fund may not provide any transparency regarding its underlying investments (including sub-funds in a Fund of Funds structure) to investors. In such a case, there will be no way for an investor to discover or monitor the specific investments made by the Hedge Fund or, in a Fund of Funds structure, to know whether the sub-fund investments are consistent with the Hedge Fund’s investment strategy or risk parameters.
For the basic knowledge and trading mechanism of Hedge Funds, please refer to the information provided by Investor and Financial Education Council. You should pay careful attention to the Liability Statement section on the homepage of the website of The IFEC at (www.ifec.org.hk) when referring to information using this link.
Hedge Funds
What is Hedge Fund?
Ability to short the market, to leverage the portfolio to multiply gains, and to hold high concentrations of positions.
No industry-wide classifications of hedge fund strategies, each major industry group has its own classification system.
Key performance driver is manager skill rather than market returns.
Target consistent returns in the long term rather than outperformance of a benchmark index.
Managers are unrestricted in their choice of investment strategies.
The ability to invest in any asset class or instrument.
Expectation of strong returns (historical data).
Low correlations to traditional asset classes and ability to provide diversification.
Target absolute returns rather than relative return.
Difference Between Mutual Fund and Hedge Fund
Authorization
A mutual fund is usually authorized by authorties, and can be sold to an unlimited number of investors. Most hedge funds are not authorized and can only be sold to carefully defined sophisticated investors. Mutual funds may advertise freely; hedge funds may not.
Flexibility
The hedge fund manager has fewer constraints to deal with; he can sell short, use derivatives, and use leverage. The manager can also make significant changes to the strategy if he thinks it is appropriate. The mutual fund manager cannot be as flexible.
Liquidity
The mutual fund often offers daily liquidity (you can withdraw at any time); the hedge fund usually has some sort of “lockup” provision. You can only get your money periodically
Absolute vs. Relative
The hedge fund aims for absolute return (it wants to produce positive returns regardless of what the market is doing); the mutual fund is usually managed relative to an index benchmark and is judged on its variance from that benchmark.
Self-Investment
The hedge fund manager is expected to put some of his own capital at risk in the strategy. The mutual fund does not face this same expectation.
Fees Paid to Hedge Fund
Hedge fund typically charge both a management fee and a performance fee.
Management fees are calculated as a percentage of the fund’s net asset value and typically range from 1% to 4% per annum, with 2% being standard.
The performance fee is typically 20% of the fund’s return during any year, though they range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits.
Almost all hedge fund performance fees include a “high water mark” (or “loss carryforward provision”), which means that the performance fee only applies to net profits (i.e., profits after losses in previous years have been recovered).
Some performance fees include a “hurdle”, so that a fee is only paid on the fund’s performance in excess of a benchmark rate (e.g. LIBOR) or a fixed percentage. A hurdle is intended to ensure that a manager is only rewarded if the fund generates returns in excess of the returns that the investor would have received if they had invested their money elsewhere.
Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year). The purpose of the fee is to discourage short-term investing, reduce turnover and deter withdrawals after periods of poor performance.
Side Pockets
A side pocket is a mechanism whereby a fund compartmentalizes assets that are relatively illiquid or difficult to value reliably. When an investment is side-pocketed, its value is calculated separately from the value of the fund’s main portfolio.
Because side pockets are used to hold illiquid investments, investors do not have the standard redemption rights with respect to the side pocket investment.
Profits or losses from the investment are allocated on a pro rata basis only to those who are investors at the time the investment is placed into the side pocket and are not shared with new investors.
Funds typically carry side pocket assets “at cost” for purposes of calculating management fees and reporting net asset values. This allows fund managers to avoid attempting a valuation of the underlying investments, which may not always have a readily available market value.
Side pockets allowed fund managers to lay away illiquid securities until market liquidity improved, a move that reduced losses. Despite these benefits, some investors complained that the practice was abused and not always transparent.
Types of Hedge Fund
Market Trend (Directional / Tactical) Strategies Hedge Funds
Event Driven Strategies Hedge Funds
Arbitrage Strategies Hedge Funds
Quant Funds
Hedge Fund Key Risk Factors
A Hedge Fund may employ a distinctive strategy which may not have a readily ascertainable comparative benchmark or index.
Hedge Fund documents are not reviewed or approved by regulators.
Hedge Funds may be leveraged (including highly leveraged) and a Hedge Fund performance may be volatile.
Hedge Funds may use benchmarks or targets for measurement purposes. There is no guarantee that a Hedge Funds’ goals, objectives, benchmarks or targeted returns will be achieved or reached.
Hedge Funds may have little or no operating history or performance and may use hypothetical or pro forma performance which may not reflect actual trading done by the manager or advisor and such history or performance should be reviewed carefully.
A Hedge Fund is not required to provide periodic pricing or valuation information to investors and it may be the Hedge Fund’s practice to not provide such information.
Some Hedge Funds may use a single advisor or employ a single strategy, which could mean a lack of diversification and higher risk.
An investment in a Hedge Fund may be illiquid and there may be significant restrictions on transferring interests in a Hedge Fund. There is no secondary market for an investor’s investment in a Hedge Fund and none is expected to develop.
A Hedge Fund’s fees and expenses, which may be substantial regardless of any positive return, will offset the Fund’s trading profits.
A Hedge Fund may involve a complex tax structure (which should be reviewed carefully) and delays in distributing important tax information.
A Hedge Fund may not provide any transparency regarding its underlying investments (including sub-funds in a Fund of Funds structure) to investors. In such a case, there will be no way for an investor to discover or monitor the specific investments made by the Hedge Fund or, in a Fund of Funds structure, to know whether the sub-fund investments are consistent with the Hedge Fund’s investment strategy or risk parameters.
For the basic knowledge and trading mechanism of Hedge Funds, please refer to the information provided by Investor and Financial Education Council. You should pay careful attention to the Liability Statement section on the homepage of the website of The IFEC at (www.ifec.org.hk) when referring to information using this link.
