The Mysterious World of Hedge Funds

Kavaljit Singh


The growing turbulence in the international finance markets in the 1990s has drawn attention to the existence and operations of hedge funds. There is no doubt that hedge funds have grown in popularity in recent years largely because of their outsized returns. But, simultaneously, hedge funds have been blamed for creating the ERM crisis in 1992, causing instability in the international bond market in 1994 and precipitating the Southeast Asian financial crisis in 1997. Due to lack of transparency in their operations very little information is available about them. The entire hedge fund industry is shourded in mystery. In order to understand the intricacies of hedge funds, let us examine their basic characteristics.


What is a Hedge Fund ?


There is no standard legal definition of a hedge fund. In fact, the term ‘hedge funds’ is a misnomer because a large number of hedge funds do not hedge against risk at all. In simple terms, a hedge fund is a private investment partnership wherein investors’ assets are pooled for the purpose of investing in a variety of securities and derivatives. As they are private investement partnership in the US, the Securities and Exchange Commission (SEC) limits these entities to 99 investors, at least 65 of whom must be ‘accredited.’ Accredited investors are defined as investors having a net worth of at least $1 million. The minimum investement in a hedge fund is extremely high, usually not less than $1 million. Hedge funds are open only to rich people who are also referred to as ‘high-net worth client’.


By effectively using the existing loopholes in the regulatory system, many hedge fund managers structure the fund in such a way that they do not come under the purview of regulatory authorities. For instance, in the US, hedge funds are required to have less than 100 ‘high-net-worth clients’ in order to make use of exemptions to regulations under the Securities Act of 1933, the Securities Act of 1934, and the Investment Company Act of 1940.


By and large, hedge funds are illiquid, requiring a commitment of money for a minimum period of one year with exit privileges thereafter on a quarterly basis. Unlike mutual funds hedge funds are not regulated and are not publicy sold and purchased. Beyond a few disclosure and reporting requirements, hedge funds are largely unregulated investment instruments. By accepting investemnt only from institutional investors, companies and ‘high-net-worth investors’, hedge funds are exempted from various regulations. They are not required to publicly disclose data on their financial performance and transactions. There is no limit on the amount of leverage hedge funds can use or the size of any one investment.


While the size and number of hedge funds have increased by leaps and bounds in the 1980s and 1990s, they have existed since the late 1940s when A W Jones, a professor and Fortune magazine editor, founded the first hedge fund called A W Jones Group on January 1, 1949. The name, hedge fund, was derived from the fund’s strategy of taking offsetting long and short positions in the stock of companies in the same industry, thereby hedging macroeconomic factors while benefiting from individual companies’ specific performance. The Jones fund used a private partnership as a vehicle for flexibility, sold-stock short and employed leverage. Jones reasoned that having both short and long  positions in a protfolio could increase returns and reduce risk due to lesser net market exposure. Many haedge funds still follow the structure and strategies of the Jones.


At present, nearly 90 percent of hedge funds are located in the US and several offshore financial centres. According to the estimates of TASS Investments Research, 33.9 percent of hedge funds are located in the US, 18.9 percent in Cayman Islands, 16.5 percent in British Virgin Islands, 11 percent in Bermuda, 7.2 percent in Bahamas and the rest in the UK, Switzerland and several offshore financial centers. Further, 91 percent of hedge fund managers are domiciled in the US. The primary reason behind the offshore location of hedge funds is to gain tax regulatory concessions. The offshore havens allow the formation of hedge funds as long as they are not sold to citizens/taxpayers in the offshore jurisdiction. Offshore hedge funds are usually mutual fund companies that are domiciled in tax havens. They have no legal limits on the number of non-US investors. In the case of US investors, these funds are subject to the same legal guidelines as US-based investment partnerships. There are two types of partners in hedge fund – a general partner and limited partners. The general partner is the individual or entity who starts the hedge fund. The general partner handles all the trading activity and day-to-day operations of running a hedge fund. The limited partners supply most of the capital but do not partcipate in the trading of day-to-day running of the fund. For the services provided, the general partner  recieves an incentive fee that is



usually 20 percent of the profits. The general partner also gets a fixed management fee amounting usually to 1 percent of the assets under management. The earnings of hedge fund managers are many times higher than those earned by mutual fund managers and investemnt managers. A typical hedge fund manager with modest funds under management can reasonably earn over a million dollars in a good year. Many hedge fund managers too put their own capital into the funds. Thrity hedge funds managers were on the list of top paid Wall Streeters prepared by the Financial World in 1995. According to industry estimates, George Soros, Julian Robertson and Stanley Druckenmiller earned $1.1 billion, $300 million and $200 million respectively in 1996.


According to a recent estimate, there are over 6 million millionaires in the world, holding nearly $17 trillion in assets. Over 75 percent of hedge funds investors are high-net-worth clients whose numbers have grown sharply in recent years. The rest include endowments Universities and foundations. Investors in many hedge funds have profited handsomely during the 1990s. There are hedge funds that have given returns of more than 40 percent annually. According to MAR/Hedge 1997 Hedge Fund Profile, the median returns of global macro managers have generated average returns of 19.4 percent during 1992-96 against the Standard & Poor’s return of 15.2 percent and the US Treasury Bill rate of 4.4 percent for the same period. While another industry source, TASS Management Inc., calculated the average hedge fund returns at 17 percent annually between January 1990 and August 1998.


A $300 Billion Industry


Given the lack of transparency in the operations of hedge funds, there is no exact figure on their numbers. As hedge funds are under no regulatory obligation to disclose their activities and trading strategies, much of the information available is through commercial data providers. Accroding to a reliable industry source, VAN Hedge Fund Advisors International the total number of hedge funds operating worlwide is at least 5500 with $300 billion of funds under management, as of mid-1998. Further there are approximately 3800 US-based hedge funds managing $159 billion, while offshore hedge funds number approximately 1700 with $136 billion under management. The largest and most famous funds, run by Soros Fund Management and Tiger Management, both of the US, approximate $11 billion each. There are another two dozen funds with assests exceeding one billion dollars.


In spite of the fact that investments in hedge funds are speculative and extremely risky, the hedge fund industry continues to grow. Even the pension funds which are considered to be the most cautious have investment substantially in hedge funds in recent years. Hedge funds currently represent one of the fastest growing segments of global finance capital in the 1980s and  the 1990s. All new and existing hedge funds are benefiting substantially from the free-flow of capital facilitated through the rapid deregulation and globalizations of financial markets. Over the past 10 years, the number of funds has increased at an average annual rate of 25.74 percent, showing a total growth of 6.48 percent. In 1998 alone, the industry witnessed an increase of 17 percent in numbers with no sign of letting up despite the near collapse of a promiment US-based hedge fund, Long-Term Capital Management (LTCM), in late 1998. Earlier, hedge funds were primarily restricted to offshore financial havens and the US, nowadays hedge funds also originate in Europe, Latin America and Asia. A number of banks and brokerage firms have also started hedge funds in recent years. The list includes institutions like Alliance Capital Management, Swiss Bank Corporation, Daiwa Securities, State Street Global Advisors, among others.


Hedge funds use a host of strategies. There are hedge funds for every category of equity debt and money instruments. The strategies vary in terms of investment returns, volatility and risk. There are funds that specialize in currencies, futures, arbitrage, securities of distressed and bankrupt companies and funds that trade securities using computer models. Many hedge funds bet on foreign currencies, mergers, acquisitions and covertible securities. Others use short selling or bets, assuming that prices will fall to offset their securities holdings. They frequently use leverage in effort to boost returns.


The basic problem with these strategies is the enhancement of risk factor because they are extremely volatile and unpredictable. Strategies such as short selling, programme trading and arbitrage are highly speculative in nature and therefore pose very high risks. This problem is compounded by the fact that most hedge fund managers do not hedge their risks. As hedge funds move billions of dollars in and out of the markets quickly and potentially gain whether markets risk or fall, they have a significant impact on the daily trading developments in the global stock bonds and futures markets.