The Viability of Hedge Funds as Reliable Retirement Vehicles Essay

Abstract

Hedging practices restricted volatile market trends in supply and prices through pre-planned buying patterns. This could be used as a tool to manipulate risks arising out of price fluctuations and uncertain deliveries. Companies employ strategies different from one another to beat price escalation and uncertainties of supply. Flexibility in contracts between producers and buyers can be viewed as an option. Hedging strategies is another. Time-tested procurement methods are another. We have seen that many companies that ventured into this highly volatile business had to close their operations and declare bankruptcy to avoid further hardships.

With globalization and liberalization, many countries become hotspots for investments. Major conglomerates took advantage of this, and saw it as an opportunity to elicit more profits. Cheap labor and local government subsidies could bring more sales and profits.

They could also use the cheaper production costs to beat global competition. China and India are two developing nations that has benefited from liberalization. China became a major destination for investors in the late 70s, when Communist China opened its skies to attract FDI. India followed much later, as late as the 90s. However, both these countries are giving the developed nations a run for their money with massive developmental schemes and success. China is currently the world’s leading exporter of products and India is not too far behind.

US-based hedge funds are investing in projects the world over. This is particularly so in rapidly developing economies such as China, India and Brazil. What are hedge funds? Hedge funds, like mutual funds, is the accumulation of funds collected from investors, to use in buying stocks and bonds in those countries where the company seems confident of drawing high returns for their investment.

Unlike mutual funds, hedge fund managers take very little risk and invest in long and short positions in assets to lower portfolio risk arising from uncertain market movements due to the countless external factors.

So, how does a hedge fund operate and how do fund managers overcome market unpredictability to maintain financial security on their investments?

Due to its unpredictability, a hedge fund is invested with the vision of drawing attractive returns, be it long term or short term. Investments are made in such a way that the portfolio beta is close to zero. A beta close to zero means that the portfolio will remain relatively unchanged due to the broad unpredictable market movement, and will change only when the stocks move more than the broad market.

For instance, if hedge fund managers found company X and Y to be attractive propositions to invest in, he would hedge long term in X and short term in Y. Assuming that X share moves up 10% and the share of Y goes by 5%, the funds net gain over the two investments is 5 per cent.

This is precisely what hedge managers’ target when they invest funds in projects. Company X expectedly outperformed the market as anticipated by the hedge managers were betting on when it constructed the portfolio.

In short, hedge funds generate security-specific returns, and attempt to lower market risk. To improve their security-specific returns, hedge funds leverage their portfolio (Venkatesh B, 2003).

There have been strong indications that hedge funds are testing the Indian waters. Not since 2000-01, has this presence been seen as a factor influencing price trends significantly. Hedge funds typically adopt a highly aggressive style of investing. They leverage their assets to invest more and trade more in an effort to spike returns to above-normal rates. This is the way hedge fund managers attract huge returns for their investment.

This is way off target to the way traditional foreign institutional investors’ (FII) methods. FII mandate generally dissuades them from leveraging their investment to attract returns as hedge funds resort to. In reality FII has now begun to change their practices to suit their interests. The perception that hedge funds play a role that can have volatile effects on the market is substantiated by the dual roles of traders and speculators in the ongoing bullish market phase. In 2003, FII flows were recorded at about $ 875 million in the Indian market (Vaidya Nathan S, 2003).

1.0    Overview

Hedge funds have never been under the public eye. It has been taken for granted that hedge fund investors are presumably well-versed with the business and are capable of judging risk and bearing the losses (if, and when it arises), that it has never found sympathy in the event of failure. Thus, hedge funds have not been a public policy concern either. Times changed and there came the exception to this rule. An exception to this was the introduction of the Long-Term Capital Management (LICM) hedge fund which, in 1998, was saved from collapse by the intervention of the Federal Reserve of New York (H.R.2924, 2000).

Hedge funds are essentially unregulated mutual funds that invest money for wealthy individuals and financial institutions seeking high returns or diversification of portfolio risk. Since individual or small public investors are not involved directly, Government protection that is normally associated with investment involving collective investment is considered unnecessary.

Hedge is an avenue that allows for low risk in this highly volatile industry. It allows both the buyer and the seller to inter-lock prices and margins in advance of a major transaction in anticipation of future uncertainties. This will mitigate loses to both parties.

This has put the investment of unsuspecting investors at considerable risk in the event of a substantial lose occurring. In order to overcome such anxiety the working group has recommended that hedge funds and their creditors be required to make public basic financial information about the size and risk of their portfolios. H.R. 2924 is a quarterly disclosure that applies to the largest hedge funds. Section 2 of H.R. 2924 contains a finding that market forces are the best protection against possible systemic risk caused by hedge fund losses, but that such forces do require a minimum of reliable information on which to base their judgments (H.R.2924, 2000).

2.0    Hedging

 

To hedge or not to hedge is a continuously debatable topic in multinational financial management circles. The proponents of hedging do it for the following reasons:

Firms with a smoother value position can reduce the probability of business disruption costs. According to Altman study, the average indirect bankruptcy cost is 17.5% (Altman, 1984) of a company’s value, a year prior the bankruptcy.

Hedging stabilize the cost of accounting and price setting. Firms with smoother value position gain more business opportunities and can improve the planning capability so as to gain competitive advantage over other competing companies.

This can be achieved by predicting future cash flows, and investing surplus in R&D for development activities.

They can reduce the amount of taxes they pay since most countries have convex corporate taxation system (Dhanani, A. Mar 2000); the higher the profit the higher the tax percentage applicable. For the periods the company earns a high amount of profit, it will pay higher taxes, although the periods it generate low or even negative profit, no compensation will be given.

Firms with smooth value position can increase their debt capacity; market increases. Financial lenders are more willing to lend to the companies that show stable cash flows and enough funds. When the firm‘s financial position is stable and cash flow predictable, it has the choice of addressing its concerns on its terms and conditions.

Compared to individual stockholders, a company manager has an advantage in accessing different kinds of information to decide on hedging or not to hedge.

Again, compared to individual stockholders, the manager has an advantage in tracing market disequilibria, which could be caused by structural and institutional imperfections, as well as unexpected external shocks.

However, there are those who choose to ignore the above for the following reasons:

The stockholders can diversify currency risk in their portfolio in accordance with their personal risk attitude. Therefore, the manager’s activity on spending the company’s resources for hedging is useless.

Hedging is not a tool with which one can increase a firm’s value. Also one must not forget that hedging doesn’t come free of cost; a firm has to utilize their own resources to undertake hedging activity.

In order to save his/her reputation, a company manager is more risk averse than stockholders and will conduct hedging activity. Therefore, if a company’s target is only stockholder wealth maximization, then part of hedging activity might be not in the stockholders interests.

Market forecasts may not be perfect and market equilibrium with respect to parity conditions could be zero. Therefore it becomes unnecessary to hedge.

(Vika Brucaite & Shanhong Yan, Chapter 2.1, Why Hedge? page 31-34, 2000).

2.1    Hedge funds

As mentioned a little earlier, hedge funds are very much like mutual funds; hedge funds are created by pooling in investors’ money and this is then invested in bonds and shares in an effort to make attractive returns for the investors. Hedge funds are extremely pro-active and hedge fund managers seek attractive returns from all kinds of markets by pursuing leveraging and other speculative investment practices, but in doing so can also jeopardize the investment to a considerable extent.

Hedge funds are very unlike mutual funds, where the investment is secured and not so volatile. They are stable investments and bring marginal profits over a longer period. But unlike hedge funds, mutual funds are required to register with the Securities and Exchange Commission (SEC).

Hedge funds instead offer securities that are ‘private’ in nature instead of being registered with the SEC under the Securities Act of 1933, and so do not have to make period reports under the Securities Exchange Act of 1934. But investors can take heart from the fact that hedge funds are subject to prohibitions against fraud as any other financial market participants, and their managers have the same fiduciary duties as other investment advisers.

2.2    Funds of Hedge Funds

This is a term that an investor comes across when he/she plans to invest their money in hedge funds. A ‘fund of hedge funds’ is simply an investment company that invests in hedge funds. A company that accepts deposits from individual or group investors are pooled together to form the company’s ‘funds’. Once the company has a sizable amount within it through fund mobilization, the company looks to invest this in hedge funds. Not surprising though, some funds of hedge funds do register their securities with the SEC. These funds that are registered with SEC will have to undergo the formalities of periodic reports as well. When a company registers certain funds with SEC, the hedge funds must provide investors with a prospectus.

Many registered funds of hedge funds may take much lower investment than their normal intake; say for example $10,000-$25,000. These investments may require the investor’s complete satisfaction and safety. In such cases, the fund of hedge funds registers these under the SEC and provides these small investors with a prospectus. Small investors may not be able to invest directly into hedge funds directly, and so can purchase shares of registered funds of hedge funds and expect more cover and safety of their investment.

Issues related to fund investment in hedge funds:

Most importantly, understand the nature of business that the fund plans to do with the investment. Read a fund’s prospectus or offering memorandum and related materials in detail and be sure that one has understood the fund policy and risk factors. Understanding the level of risk involved in the fund’s investment strategies is of prime importance and ensuring that they are suited to one’s personal investing goals, time horizons, and risk tolerance is met is mandatory. As with any investment, the higher the potential returns, the higher the risks you must assume.

Understanding how a fund’s assets are valued is equally important. Hedge funds are highly volatile and such investments seek high and quick returns, therefore 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. Therefore, one must have enough understanding of how a fund’s valuation process takes place and the extent to which a fund’s securities are valued by independent sources.

Fees are a key to understanding the gravity of fund activeness. If one has the knowledge of how fees are calculated, it will give a greater insight into the fund activities. As a rule, fees impact one’s return on investment. Hedge funds typically charge an asset management fee of 1-2% on assets, apart from a high 20% as performance fee from the hedge fund’s profits. Performance fee is what actually motivates a hedge fund manager to take greater risks in the hope of generating a larger return. Funds of hedge funds are more stable and seek a fee for managing an individual’s minimum investment or assets, and some may even include a performance fee based on profits. These fees are charged in addition to any fees paid to the underlying hedge funds.

If one were investing in hedge funds through a fund of hedge funds, he/she would end up paying two layers of fees:

Fees of the fund of hedge funds, and

The fees charged by the underlying hedge funds.

Redemption of funds is very important. If by chance the investor wants to recall or redeem his/her investment from the hedge funds, one must understand any limitations on their right to redeem their shares. Hedge funds offer very limited opportunities to redeem, or cash in one’s shares during a year of operation, and can impose a fixed period of one year or more, during which you cannot cash in your shares.

The background of the person to whom one has entrusted their money is also important. Hedge fund managers are the ‘game players’. As indicated, they are the one’s who initiate fund risks to bring attractive returns on the investments. They play the market, to try and influence purchase and sales of products to generate high returns in the shortest period of time. Get to know with the person with whom one will be risking their hard earned money. Find out how qualified they are to manage one’s money, and also whether they have any disciplinary history within the securities industry. Such information can be viewed through reviewing the adviser’s Form ADV. This can be done by searching and viewing a firm’s Form ADV using the SEC’s Investment Adviser Public Disclosure (IAPD) website (provided they are registered with SEC).

One can also 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. Failing this, find the investment adviser firm in the SEC’s IAPD database with one’s state securities regulator or search the NASD BrokerCheck database for any information they may have. This information will be of immense help and save the investor a lot of trouble.

Ask as many questions as possible, until one is doubly sure of his/her investment. One must understand that, it is their hard earned money that is being played with, and so they have every right to know where the money is going or how they are going to profit from it. Questions like, where the money is going, who is managing it, how it is being invested, how one is going to get it back, what protections are placed on the investment and what rights does one have as an investor are within one’s jurisdiction. In addition, NASD investor alert describes some of the high costs and risks of investing in funds of hedge funds.

2.3    Protection and hedge fund

Some hedge fund investors may not receive all of the federal and state law protections that apply to registered investments, such as disclosures. Without disclosures it can be quite difficult to verify representations that one may receive from a hedge fund. One 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 (SEC, 2003).

The SEC can take action against a hedge fund that defrauds investors. In most cases, action was taken against hedge fund advisers for misrepresented experience and fund’s track record. Others, such as ‘Ponzi schemes’, where early investors were paid off to make the scheme look legitimate, and hedge funds sending unrealistic account statements to investors to camouflage the fact that their money had been stolen have also been recorded. This is why, it is always better to question and investigate one’s hedge fund before considering investment (SEC, 2003).

2.4    Hedging with the cash market

How can one hedge financial price risk using derivatives? Hedgers use derivatives to shift unwanted price risk to others willing to assume risk for a price. In some cases, these ‘risk-mongers’ may in turn, lay off some of the risk they have taken on by hedging themselves. This way, risks can be passed onto others for a price. This is quite similar to re-insurance. Just as insurance can be thought of as an option, with pay-offs and features such as excesses or deductibles, hedging too lays stress on pay-offs, excesses, and deductibles.

Hedgers will try to avoid any form of risk that can cause losses due to adverse price movements over a given period of time. Buyers want low price and sellers want their product to be sold at a reasonable price. Most hedges involve the fixing of a current price to be used at a later date. The values are fixed and cannot be improved upon; and there can be no windfall gains due to favorable price movement. Options on the other hand is to fix a price for later use, limit loss as others hedge, and if need be, hedge if prices are unfavorable in the spot market. With options, purchases enjoy no downside risk, but do enjoy upside potential. This does not come free and is reflected in the cost of options.

In most cases, it is possible to devise a way to hedge using the cash market. Take for example the following sample:

A UK importer has to pay a US dollar invoice for $50,000 in three months time. The risk is that when the time arrives to pay the invoice, US dollars will be more expensive relative to sterling than they are now, so that fewer per pound can be obtained in exchange at spot. The UK importer exchanges an equivalent value of pounds for dollars at the spot rate and holds them until needed three months from then. No exchange occurs in three months’ time. The spot rate in three months’ time has no bearing on the pound. The value of sterling against the dollar is fixed. There is neither loss nor gain through hedging.

However, using the cash market, the exchange of currency at spot and then retaining them for three months has its drawbacks. One, it blocks precious foreign exchange which could otherwise be used as working capital in the importer’s business. Two, there may be no surplus cash to exchange leading to further borrowing of sterling, using up the importer’s credit line that could be utilized for other purposes.

Three, these backlogs could even lead the importer to face insufficient credit lines to support the borrowing. What is required is device that can achieve similar results, the same pay-off, but with a difference, so that the disadvantages of using the cash market are removed. Here, the outcome is almost the same, as it was achieved using a forward exchange contract. The forward rate used in the contract derives interest rate differential, due to the sterling to US dollar three month maturities.

Identification of the need to hedge is important as in identification of risk. A view to hedge selectively, by hedging only on the belief that spot rates will move against you is necessary. Cost of hedges can also be reduced when spot rates move in one’s favor and he/she decides to lift the hedge before maturity.

3.0    What are the benefits of a Hedge Fund?

Hedge funds can be categorized by three distinct features:

Performance

Non-Correlation

Diversification

Performance:

The performance of alternative investments has generally exceeded that of more traditional investments in stocks and bonds, even though they carry a larger risk. The alternative investments, hedge funds included, have consistently out-performed U.S Stocks, and the following chart is a good indication of where alternative investments are heading. The chart is an indicator to how hedge funds performed in relation to U.S. Stocks during the period 1990-2001. The graph shows that from 1990to 1992, things were even Stevens.

The trend changed from then on till 1998, when the U.S. Bonds began to recover lost grounds and came within striking distance to level the difference. However, since then, hedge funds have just rocketed into the distance. This goes to show how the investors are finding hedge funds much more rewarding and attractive in terms of mutual funds and bonds. At times, hedge funds have moved steadily upward while U.S. stocks declined. As is the case, hedge funds have outperformed U.S Stocks incredibly.

Figure No.1 shows the performance graph of Hedge Funds vs. U.S. Stocks. Graph courtesy: Benchmark Funds Inc.

Non-Correlation:

What remains an important aspect of hedge funds as an alternative investment strategy to traditional investments in stocks is the non-correlation of their returns. Stocks follow a steady path and reacts in accordance to market trends. This means that should the market crash, stock markets will tumble causing millions of investors in the doldrums. In the case of alternative investments (read hedge funds), rather than being caught in the flow of market fluctuations, they can take their own course and remain level if not positive during periods of even dramatic stock market declines.

A case for consideration, no doubt! The following chart just about sums it all. Even as the average returns of U.S. stocks fell by -4.91% during the down periods of the market, alternative investment funds (all Hedge funds, Long/Short Hedge funds, Market Neutral Hedge funds, Funds of funds Hedge funds, and ITR P-40 Index) all recorded positive returns. This just goes to say that hedge funds were indeed seen as the more profitable proposition for investors than the standard U.S. Bonds.

Figure No.2 shows the chart displaying average returns during 1st Quarter 1990 and 2nd Quarter 2001. Chart courtesy: Benchmark Funds Inc.

Diversification:

Investors who seek quick and huge returns on their investment do so by diversification of their investment in accordance to market trends. Portfolio diversification is the key to stability over the long term. Bonds can fluctuate with the market and at times leave the investor fighting to stay afloat. Hedge funds don’t remain in the same domain. While diversification includes bonds and domestic and international stocks, the other option is to include as much as a third of one’s portfolio in alternative investments, hedge funds and other alternative investments included. In order to simplify this argument, the following pie charts are sound indicators of what typical stock and bonds portfolio looks like in comparison to the suggested diversified portfolio.

There is a positive return of +86% and a gain of 2.45% on annual returns. We also see that in the worst of unpredictability the drawdown is much better in the suggested diversified portfolio than the traditional stock and bonds portfolio. The diversified portfolio with an alternative investment component indicates a substantially higher rate of return over time, and a significantly lower decline during drawdown, than the portfolio without an alternative investment component. These projections are indicators of where investors could invest to gain better returns.

Figure No.3 shows the pie chart representation of stock and bond portfolio returns annually. Pie Chart courtesy: Benchmark Funds Inc.

           Typical Stock and Bond Portfolio

              Total Rate of Return      200.87%

Annual Rate of Return     10.05%

            Worst Drawdown                  -17.12%

Figure No.4 shows the pie chart representation of suggested diversified portfolio. Pie Chart courtesy: Benchmark Funds Inc.

Read also  Theories of Capital Structure

Suggested Diversified Portfolio

            Total Rate of Return              287.29%

Annual Rate of Return           12.50%

Worst Drawdown                  -10.73%

4.0    How do Hedge Funds compare to the top retirement vehicle competition?

We have seen that hedge funds have shown remarkable investor benefits in comparison to standard government bonds and shares. The hype of late in investing in hedge funds has just about made other investments look pale. As institutions and high net-worth investors continue pouring money in at record rates and the media increases coverage of this investment vehicle, one needs to know how and what hedge funds do with one’s investment. After all, investors need to know about where their hard earned money is and why. In order to understand how hedge funds compare to other top retirement vehicles, Greg Frith, hedge fund veteran, had the following to say:

The basic difference between mutual funds and hedge funds is the investment freedom offered by hedge funds. Hedge funds can invest in just about anything, whereas mutual funds are highly regulated and have very specific investment guidelines. A large-cap stock mutual fund will invest in large-cap stocks, appreciate when the market appreciates, and depreciate when the market depreciates. With mutual funds one is sure what he/she is exactly getting into. They are in more than one way, one dimensional. However the same cannot be said about hedge funds. Multi-dimensional, hedge funds can invest in just about anywhere, be it in strategies, ideas, or assets. Hedge funds can leverage to produce positive returns in any investment climate.

Equity markets, including mutual funds have gone through some serious downturns over the past five years, yet hedge funds performed comparatively better. Relative to mutual funds, hedge fund performance has been quite good over the last couple of years, which was to be expected. As a rule of thumb, when equity market moves up, hedge funds should performance below par, but they produce positive returns.

Similarly, when equities move up, hedge funds outperform mutual funds. So it is but natural for hedge funds to outshine others during bearish times. The bottom line is that good hedge funds should be able to produce absolute positive returns in any market condition.  It is still unclear whether rigorous marketing and advertising regulations have an impact on investors vs. mutual funds. Frith was of the opinion that the marketing of mutual fund and the concurrent media frenzy surrounding it confused investors more than anything else.

Very few investors understand the relationship between interest rates and bond prices, despite the fact that there is so much money is in mutual funds. Hedge fund investors are better placed as they have a better understanding of how the system works. This is because most of them are high net-worth individuals who can afford to have dedicated, quality advisors around them. Another point of contention is that while some may go through bad financial times due to poor decisions, they can usually bounce back, whereas middle income mutual fund investors cannot always do so. But having said this, hedge fund investors must be careful when it comes to doing business and ensure that they know what they are looking for when it comes to their investments.

Another difference between hedge funds and mutual funds is their fee structure. While mutual funds are highly regulated vehicles and so have fee limits on what they can charge clients. Hedge funds on the other hand have no fee limit on what they charge clients. A change can come about only if some form of regulation is imposed on such practices in future.

In comparison to the money or assets going into hedge funds and other similar retirement vehicles, one sees an unprecedented rate of movement of assets into hedge funds, especially from large institutions like pension funds. That’s right! The trend seems to be tilting in favour of investments in hedge funds. Fortunately, there is a limit to the amount of assets that a hedge fund can handle; otherwise, performance will most likely suffer, leaving investors fuming.

All said and done, there is still no comparison regarding the quantity of money flowing into hedge funds and the money that continually flows into mutual funds. Mutual fund inflows in fact dwarf hedge fund money inflows by a long distance. Mutual funds get a constant inflow from 401k and IRA retirement contributions that hedge funds simply do not see. This is because of the long time-tested mutual funds are more easily accessible and can suit most investors, big and small. The fact that hedge funds have just now become conspicuous also gives credence to this theory.

In retail, hedge fund investors need to assess his/her current asset allocation. There are considerable financial improprieties when it comes to retail investment advice. The mid to late 90s was witnessed by unprecedented investment by retail investors, especially in the U.S. equity markets. Investing in hedge fund, one must understand what their asset choices are and how these choices may react to one another. Hedge funds are assets which include equities, fixed income, cash, real estate, and hard assets like gold.

The media hype built up to project hedge funds as being risky business is quite contradictory. Hedge funds, as a group, are less risky than mutual funds. There is of course the element of risk in any business, but in hedge funds, those funds that take the Long-term Capital Management route are considered most risky.

FBS is a U.S. equity long / short dollar neutral hedge fund that does not use leverage nor attempts to time markets. It works on the simple principle of, for every dollar of equity that is invested on long, an equal number of dollars is invested in short term. This way, one can be assured that despite market fluctuations, the returns are not affected. This ensures that investors get through market turbulence without running any risk.  There have been comparisons drawn on the nature of returns expected from stock markets in the next ten years, to those of hedge funds.

One can be assured that market trends are on an upscale with returns expected to go well into the better half of +5% per annum margin. Hedge funds too will not lack behind and will be hard pressed to perform better. However, there is a strong indication that a good hedge fund will do much better and produce low double digit returns on a consistent basis. Whatever the forecast or the designs, an investor is adviced to study hedge funds before attempting to invest in them.

On the contrary, there is the availability of Morningstar and Kiplinger’s to help investors evaluate mutual funds before they invest in them. Retail investors sadly lack such tools to evaluate hedge funds. They have to rely on financial advisors, brokers, and on hedge fund marketers for advice. But as noted a little earlier, those who invest in hedge funds are relatively financially well of and can take the personal opinion of financial advisors before investing n hedge funds.

There is a piece of advice though for those investment seekers; be prepared to ask as many questions as possible to clear all doubts before placing their valued investment in a hedge fund. There is the question of the reliability of the tools available to evaluate mutual funds. Most analytical stats are based on historical records. Though the figures make funds look good and its competitors bad, most these stats are a creation of statisticians. A lot of importance is paid to individual mutual fund performance. Instead, one should focus their attention on asset selection. Asset allocation accounts for 90% of overall investor return. Therefore, it is paramount that retail investors understand their business well before investing.

There are some basic questions that one can ask from their advisors before investing in hedge funds. Remember, not all hedge funds are the same. Every hedge fund is unique and different from the other. We see that there are long and short hedge funds, Market Neutral hedge funds, Fund of funds hedge funds and so on. Hedge fund investing is very different from mutual fund investing and does require more time and effort. There fore before taking the plunge, ask the concerned hedge fund manager a few questions and see how well he/she answers them. If the manager is unconvincing or finds it difficult to answer your queries, don’t invest in the fund.

Try using the following set of questions:

As a hedge fund manager, what is your investment strategy?

As a serious investor, would you be able to produce a few examples of past trades?

As a serious hedge contender, what is a current trade that your group has invested in?

What are your best and worst monthly returns on record and what influenced these returns?

Are there certain types of market or economic conditions that influence your returns for the better or worse?

Does your fund employ leverage? And if you do, by how much, and how do these affect the investors’ assets?

Tell me more about derivatives, and how does your fund utilize derivatives?

And risk managers, does your group employ a risk manager?

Excuse me for asking, but can I have access to your auditor to obtain an audited performance record for the last three years?

Who is your auditor?

Does the auditor have independent access to all of your records (current and historical)?

Finally, can I receive a copy of your prospectus?

Remember, it is one’s hard earned money that is at stake, and every investor has the right to answers to these questions. Hedge funds no doubt, in the right hands, can bring good returns on investments (Bull & Bear Financial Report, 2007).

Figure No.5 shows how the various bonds, including hedge bonds returned in extreme market environments.

Table Courtesy: Partners Group, Empirical Return and Risk Properties of Hedge Funds and Their Benefits in the Global Investment Portfolio, p.27, http://www.partnersgroup.net/docs/library/HF_EmpiricalFacts_10_04.pdf

The following tables give a relatively clear idea as to how hedge funds differ from mutual funds. To participate in hedge funds, an investor must be accredited, whereas for mutual funds, no basic qualification is required. This is perhaps the biggest drawback in terms of participation. Hedge fund managers tie up with big financial institutions and pension portfolios to generate the required investment to hedge and invest. They also borrow large sum of money to leverage, in case of high risk.

Table shows the comparison between hedge funds and mutual funds.

Table Courtesy: Benchmark Funds Inc, http://www.benchmarkfundsinc.com/hedge_vs_mutual.html

 

 

 Hedge Funds

 Mutual Funds

 Investors

 Must be Accredited

 No minimum qualifications

 Objectives

 Positive return in all market

conditions

 Obtain higher return than other

funds with same strategy

 Investment Strategies

 Need not be limited

 Limitations on short selling,

leverage, etc.

 Reporting

 Monthly

 Daily

 Primary Sources of Risk

 Manager skills and strategies

 Normal trading risks

 Liquidity

 Monthly or quarterly

 Daily

 Marketing

 No public advertising

 Open to all retail investors

 Fees

 Includes performance-based fees

 Percentage of assets under

management

 Flexibility

 Can enter or leave markets at will

 Must weather market downturns

 

 

Hedge Fund Analysis Factors

 Advantage

 Disadvantage

 Objective

 May excel in down market

 May under perform in bear

markets

 Manager

 Fund may benefit from

manager’s relative freedom

 Increased amount of risk with

choice of manager

 Performance Fees

 Provides incentive to achieve

short-term results at possible

expense of asset growth

 May create incentive to take

unwarranted risks

 Liquidity

 Less liquidity provides easier

fund administration

 Investor cannot access money

very easily

 Style

 Smaller organizations can be more

aggressive in finding opportunities

 Increased dependence on small

number of key persons

 

4.1    Hedge Fund Advisers and the Investment Advisers Act of 1940

“Virtually all hedge fund advisers meet the definition of investment adviser under the U.S Advisers Act. Under this act, investment advisers must register with the Commission and comply with the provisions of that Act and Commission rules. Registered investment advisers must keep current a Form ADV that is filed with the Commission and provide a disclosure statement that includes the information disclosed on Part II of Form ADV to clients. These disclosures provide both the Commission and investors with current information about the adviser’s business practices and disciplinary history, among other things.

Registered advisers must maintain required books and records and submit to periodic examinations by the Commission’s staff. Advisers registered with the Commission also must comply with other requirements, including those relating to safeguarding client assets that are in the adviser’s custody and requiring that clients be told of an adviser’s adverse financial condition. Registered investment advisers must also inform clients of the adviser’s proxy voting practices. The Advisers Act also prohibits them from defrauding their clients.

Many hedge fund advisers, however, avoid registering with the Commission by relying on the Advisers Act’s de minimis exemption under Section 203(b) of that Act. That section excludes from registration investment advisers that have had fewer than 15 clients during the preceding 12 months, do not hold themselves out generally to the public as an investment adviser and are not an investment adviser to a registered investment company.

For purposes of Section 203(b), current Commission rules provide that investment advisers may count a “legal organization,” such as a hedge fund, as a single client. Thus, an adviser may manage up to 14 hedge funds before being required to register with the Commission as an investment adviser, so long as it satisfies the “no holding out” condition. Investment advisers that are exempt from registration nevertheless are subject to the antifraud provisions of the Advisers Act.

Registered investment advisers are not required to indicate whether they manage hedge funds. They are also not required to state the amount of hedge fund assets under their management. A recent survey identifying the largest hedge fund firms accounts for slightly under half of the estimated $600 billion in U.S. hedge fund assets. Approximately 52 percent of the domestic advisers in this survey, managing some $158 billion of hedge fund assets, are not registered with the Commission as investment advisers.

There is no comprehensive database or survey of the smaller firms managing the other half of U.S. hedge fund assets – approximately another $300 billion. We expect that relatively fewer of these smaller advisers would be registered with the Commission, and that the proportion of hedge fund advisers not registered with us industry-wide may be approximately two-thirds.

A number of hedge fund advisers, however, do register as investment advisers under the Advisers Act. Some are required to register because they have 15 or more advisory clients, or they advise one or more registered investment companies, and therefore are ineligible for the de minimis exemption. Others have registered with the Commission voluntarily because their investors demand it or for competitive reasons” (U.S Securities and Exchange Commission, p.20-21, 2003).

4.2    Data on top hedge funds over the last 5 years

 

James Simons, 69, is a man to be envied. As one of the leading hedge fund managers, James Simons took home a whopping $1.7 billion last year alone! This figure dwarfs all the major top chiefs on Wall Street. Mr. Lloyd C. Blankfein of Goldman Sachs, a name to be reckoned with on the Wall in comparison made just $54.3 million in salary, cash, restricted stock and stock options last year, said Anderson and Creswell (2007). Mr. Blankfein’s reported compensation does not include gains on investments.

There is more to the hedge fund billion-dollars-a-year club. Kenneth C. Griffin and Edward S. Lampert took home well over a $1 billion last year, with George Soros missing the bus by a hair, according to an annual ranking of the top 25 hedge fund earners by Institutional Investor’s Alpha magazine (Anderson and Creswell, 2007).

The rewards for managing hedge funds is more than appealing, provided the hedge fund manager knows his business well. These managers have profited immensely from helping wealthy individuals through regulation of private investment pools. A reliable source was quoted as saying that for the hedge fund elite, the rich were getting richer by the minute (Anderson & Creswell, 2007).

Brave new world: Pensions and Investments

 

When the Risk Standards Working Group issued 20 new standards in 1996 to address risk for pension executives and money managers, nobody had thought about “Spitzer risk”(Calio, 2005).

Attorney General Eliot Spitzer’s pursuit of illegal trading practices became synonymous of things to come in the pension investment portfolios. The so-called illegal trading practices on mutual funds and bid-rigging by insurance brokers are now high on the list of potential pitfalls for financial executives. The growth of hedge funds is affecting the pension market behavior, with heavy use of leverage and complex investment strategies to overcome unpredictability and market fluctuations. Much of the pension funds are now being used in use of derivatives, such as interest rate swaps and futures, raising concerns that pension funds are being diverted without understanding the risks and costs involved with these instruments. This has led to many pension executives to:

Dwell on accounting issues, such as how to fairly price securities.

Articulate carefully defined investment policies and documents (Calio, 2005).

Since the prominence of the hedge funds took place, some of the biggest money managers and pension funds have created risk management positions focused on portfolio management and operational risk. People like, Illinois State Board of Investments, Chicago; the New York City Employees Retirement System; the defined benefit plan of International Paper, Inc., Stamford, Conn.; and the Ohio Police & Fire Pension Fund, Columbus have increased their risk management capabilities.

Robert Hunkeler, vice president of investments at International Paper, said the company was hiring a director of alternative investments to oversee its hedge fund and derivatives portfolio, with a specific focus on portfolio risk management. This goes to show that pensioners’ priorities have begun to turn in the direction of hedge funds (Calio, 2005).

Table Courtesy: Corporate Governance and Social Responsibility: A comparative analysis of the U.K and U.S, p.150, http://www.ilir.uiuc.edu/rupp-papers/AguileraWilliamsConleyRupp2006.pdf

The above table is an indicator of the trend within the U.S on institutional investors. We see that the number of insurance companies, banks and trusts have declined considerably, whereas the number if independent investment advisors have gone up substantially.

Hedgers, speculators and arbitrageurs

Hedgers use derivatives with a cash market position. Speculating upon price movements in the derivative as a proxy for speculation is much easier in futures and options. If one were to buy and sell a commodity, he/she would have to take delivery of the commodity on purchase, hold it, before selling it. Speculation in the futures market is different. There is neither any delivery on purchase, nor is there anything on sales.

Futures need very little capital outlay due to the initial margin deposit and because the holding of a futures position requires very little investment, losses and gains are much larger in percentage than in the cash market. These magnified gains or losses are due to leverage. A futures position which controls the value of $500,000 would require an initial deposit of about $15,000. If the price changed to $510,000 this is said to have gained 2%. The futures price will be $10,000, gaining 66.6% on the investment of $15,000.

In finance a speculator is an individual who can identify and quantify risk and is prepared to take it. Speculators use derivatives to avoid risk (Winstone, 1997).

Hedging and Speculating with Commodity Futures

A short position profits whenever futures price falls, and a long position profits when the futures price rises. If one intends to hedge the price of a commodity, opposite positions have to be taken in the future and spot markets.

This is illustrated in the following:

An individual with a stock of wheat (long) fears that the spot price of wheat will fall. If a short position is taken in the futures market, it will automatically profit should the price of wheat crash. This profit can be adjusted and used to set against the loss made in the cash market where the wheat is sold at spot. A perfect hedge is achieved where profit quells the market loss. An alternative is to buy the future and sell the commodity on expiration in futures price. Closing out would be more usual.

If spot prices had in fact risen, then a gain would have been made in the cash market, but off-set by the loss in the futures market. In either event a certain net price is achieved by using both markets. This is how hedge funds are played in the market to derive the maximum benefit in the shortest possible time (Winstone, 1997).

Although there is no universal definition, hedge funds are generally private investment funds or pools that trade and invest in various asset classes such as securities, commodities, currency, and derivatives on behalf of clients. A hedge fund can engage in quite a few investment strategies other than hedging, such as taking both long and short positions, using arbitrage, buying and selling undervalued securities, or being invested in projects across and within the country’s borders.

What ultimately matters is for the investor to gain considerable financial gain. Hedge fund managers too find the offer of percentage on profits most attractive and will go all the way to benefit the investor. Hedge fund managers will invest in almost anything where opportunity beckons and with the minimum risk. Once a rich man’s business, hedging has changed to accommodate even smaller investments. It was thought to provide the rich with above-market returns in exchange for greater risk, but this thought has given way to strong incidental faith.

A point of argument remains with regards hedge fund investments not subject to most regulatory oversight than traditional investments.

Returns on hedge fund investments are often uncorrelated. Therefore, pension funds can reduce their overall risk exposure through the purchase of hedge funds. However, as mentioned earlier, if pension funds lack the expertise to evaluate the complex investment strategies that hedge funds employ, greater risks and losses could result. Sponsors will then be forced to cover these losses through higher contributions.

Until recently, hedge funds were limited in how much pension plan equity they could receive, but the Pension Protection Act (PPA) effectively eliminated such restrictions with regard to governmental pension assets, raising the prospect of even greater pension asset investment in such funds, truly music to the ears of hedge fund managers (Baucus & Grassley, 2007).

The growth in hedge funds has been fueled primarily by the increased interest of institutional investors such as pension plans, endowments and foundations seeking to diversify their portfolios with investments in vehicles that feature absolute return strategies with minimal risk, and the elimination of restrictions of use of governmental pension assets by the PPA.

There are also the flexible investment strategies which hedge fund advisers use to pursue positive returns in both declining and rising securities markets, while protecting the investment principals. Funds of hedge funds which normally invest all of their assets in other hedge funds have also fueled this growth (U.S Securities and Exchange Commission, p.11, 2003).

The investment goals of hedge funds vary, but they mainly seek to achieve a positive, absolute return rather than measuring their performance against a securities index or other benchmark. Hedge funds utilize a number of different investment styles and strategies and invest in financial instruments. Hedge funds as we know, invest in equity and fixed income securities, currencies, over-the-counter derivatives, futures contracts and other assets. Some hedge funds may take on substantial leverage, sell securities short and employ certain hedging and arbitrage strategies, to provide markets and investors with substantial benefits.

To avoid registration and substantive regulation under the Investment Company Act, hedge funds rely on one of two exclusions from the definition of Investment Company. First exclusion refers to hedge funds having fewer than 100 investors. The second exclusion applies to hedge funds that sell their interests only to highly sophisticated investors. To rely on either exclusion, hedge funds restrict their offerings so that they meet the requirements for non-public offerings (U.S Securities and Exchange Commission, p.ix, 2003).

Read also  Article Summary_ _the Bottom Line_ Marketing & Firm Performance_

Hedge funds do not register the offer and sale of their interests under the Securities Act. They may not even offer their securities publicly or engage in a public solicitation, instead, sell their interests in private offerings. For conducting their business, hedge funds sell their interests to an unlimited number of accredited investors who could include individuals with a minimum annual income of $200,000 ($300,000 with spouse) or $1 million in net worth, and institutions with $5 million in assets.

Hedge funds that seek the investor exclusion from Investment Company Act Registration, may just sell their interests to qualified purchasers, a standard with significantly higher financial requirements than those necessary for accredited investors. In practice, we understand that most hedge funds sell only to investors whose wealth exceeds that required to meet the standard established for accredited investor status. Although some hedge fund advisers choose to register voluntarily, or do so for some other reason, most advisers to hedge funds do not register under the Investment Advisers Act of 1940. They rely on the “de minimis” exemption from registration for investment advisers with 14 or fewer clients. Under Commission rules, each hedge fund counts as one client (U.S Securities and Exchange Commission, p.x, 2003).

Knowing your Hedge Funds

 

It is of late that people have begun to understand the nature of hedge funds. In the last 9 years hedge funds have grown in numbers by approximately 20% every year. This is a clear indication that the general awareness of hedge funds among the common man was quite negligible. With the growth of hedge funds raising at approximately 20% per annum, the number of people investing in the funds is also growing.

Currently there are an estimated 9000 hedge funds in the world managing over 1.1 trillion USD. The assets within each hedge fund are also growing every year, with performance said to account for a third of this increase.

Hedge funds are said to account for around 50 billion USD of fees on Wall Street and City investment banks. They make up more than 50% of US bonds trading, 40% of equity trades and over three quarters of distressed debt trading (Aaron Nematnejad, 2006).

What are the various educational outlets to inform people about hedge funds?

There are many tools that can be used to educate people on the various financial investment packages available in the market today, including the highly leverage hedge funds. When a person went to a school and raised this question, the response was shocking to say the least.

While a large majority of teens appreciated the importance of safer investment vehicles for short-term savings, they struggled when faced with questions about long-term investment. 80% of the kids understood that for money they would need within a few months or years, a bank savings account. They also felt that a savings bank account was far superior to stocks, corporate bonds, or locking cash in the closet, an encouraging result. When asked about which investment vehicle tends to have the highest growth over a period of 18 years, and given the choice of a US Savings Bond, a checking account, a savings account, or stocks, only 14% knew that the correct answer was in stocks (Christopher Cox, 2006).

Media powers such as the internet, newspapers, television, radio and advertisements would be the ideal tools to spread the word of hedge funds. Hedge funds could turn out to be the right financial solution to the future. Therefore, internet, newspapers, magazines, television and radio should be employed to create more awareness about funds and savings.

Hedge funds have been conspicuous by its absence from public glare for long. Not many people knew about hedge funds or how they functioned till recently. Even hedge fund managers maintain a deafening silence on hedging activities and instead have access to institutions and wealthy individual’s through whose support they trade.

With no restrictions from the government and the further liberalization of pension portfolios to hedging, the chances of the common man getting to know about hedge funds have been suppressed. Pension funds have been investing in hedge funds for long, but this too remain obscure from public domain. With more and more direct participation from individuals and financial institutions, the awareness of hedge funds has become more prominent.

 

 

Social Security Systems and Funds

Social Security Trust Funds contains special bonds issued by the U.S. Treasury Department. They carry competitive interest rates and are redeemable at par at any point of time. It is by far the largest federal government spending program in the country. Most retired and elderly depend on the program for their income, while many working classes pay more in Social Security payroll taxes than in personal income taxes. The program has accomplishments in reducing the poverty rate among the elders.

Despite this, the ever reliable Social Security system in the United States faces a very uncertain economic and political future. Its Trust Fund nearly ran out of money in 1977 and again in the early 1980s. This required serious fixes; and the last round of fixes were designed by the 1983 Greenspan Commission1 which included raising the payroll tax rate, advancing the normal retirement age, and partially taxing the receipt of Social Security benefits. The claim was that the Social Security Trust Fund would remain solvent until 2063 when the youngest baby-boomer would be ninety-nine years old. However, things have not changed and Social Security faces another crisis. The following graph reflects the magnitude of trouble faced by Social Security:

The graph reflects the uneasiness that is about to explode within the next couple of years, if some strong measures are not inculcated. The earlier forecast of funds drying out by 2063 is now expected to run dry by 2037. This means that the earlier calculation of the youngest baby-boomer leaning onto retirement money till 99 has gone up in smoke and will have to plan for years beyond 73.

Graph Courtesy:  Proposals for a Two-Tier Social Security System in the United States, John B. Shoven, p2, http://www.bsos.umd.edu/econ/sabelhaus/conf001215b.pdf

Could this be a strong indication of what is to come? Hedge funds, perhaps?

The payments from the Old Age Survivors and Disability Trust Funds will exceed the payroll tax receipts by 2015, and not 2037. After this, OASDI will have to rely on government interest payments or bond redemptions to meet its expenditure needs. But, for this, interest payments and bond redemption proceeds will require higher tax generation or government borrowing on public markets. The bonds and interest payments won’t make much of an impact after 2015. The government bonds in the trust funds will simply be a claim of one part of the government on another part, as it will not represent real assets to the government or the public as a whole. The 2000 intermediate-cost projection for OASDI in 2036, the year before the Trust Fund exhausts is:

Payroll tax income:     $2.744 Trillion

Benefit Payments:      $3.744 Trillion.

The system will have a cash-flow shortfall of $1 Trillion and income would have to be increased by 36.4 percent just to match expenditures (Shoven, 2000).

5.1    Hedge Funds and the Securities Exchange Act of 1934

Definition of “Broker” and “Dealer”

Some hedge funds may need to register with the Commission as dealers. Section 3(a) (5) of the Exchange Act generally defines a dealer as a person engaged in the business of buying and selling of securities. The Commission has technically distinguished dealers from traders. A trader is a person who buys and sells securities, either individually or as a trustee, but never on a regular business. Entities that buy and sell securities for investment generally are considered traders, but not dealers. Dealers must register with the Commission in accordance with Section 15(b) of the Exchange Act while there is no such provision for traders.

Exchange Act Registration under Section 12

“The Exchange Act contains registration and reporting provisions that may apply to hedge funds. Section 12 of the Exchange Act and the rules promulgated thereunder govern the registration of classes of equity securities traded on an exchange or meeting the holder of record and asset tests of Section 12(g) and related rules. Section 12(g) and Rule 12g-1 thereunder require that an issuer having 500 holders of record of a class of equity security (other than an exempted security) and assets in excess of $10 million at the end of its most recently ended fiscal year, register the equity security under the Exchange Act.

Registration of a class of equity security subjects domestic registrants to the periodic reporting requirements of Section 13, proxy requirements of Section 14 and insider reporting and short swing profit provisions of Section 16 of the Exchange Act. Although hedge fund interests fall within the definition of equity security under the Exchange Act, most hedge funds seek to avoid Exchange Act registration by having fewer than 500 holders of record”(U.S. Securities and Exchange Commission, 2003).

Beneficial Ownership Reporting under Sections 13 and 16 of the Exchange Act

“The beneficial ownership reporting rules under Sections 13(d) and 13(g) of the Exchange Act generally require that any person who, after acquiring beneficial ownership of any equity securities registered under Section 12 of the Exchange Act, beneficially owns greater than five percent of the class of equity securities, file a beneficial ownership statement containing the information required by Schedule 13D or Schedule 13G.

Beneficial ownership is broadly defined by Rule 13d-3 under the Exchange Act to include the power to vote or dispose of any equity securities, or the power to direct the voting or disposition of those securities. Due to the power a hedge fund’s adviser may exercise over the equity securities held by the fund, both the hedge fund and its adviser generally will be deemed to beneficially own any equity securities owned by the hedge fund. In certain specified circumstances, the hedge fund and its advisers may file a short form Schedule 13G in lieu of filing a Schedule 13D”(U.S. Securities and Exchange Commission, 2003) .

“In addition to the amount of equity securities beneficially owned by the reporting person and the percentage of the subject class of equity securities this amount represents, Schedule 13D requires disclosure of certain other material information regarding the reporting person (identity and background) and the acquisition of the securities (source and amount of funds or other consideration used or to be used in making the purchase; the purpose of the acquisition;

contracts, arrangements, understandings or other relationships between the reporting persons with respect to any securities of the issuer, and so on). The information required to be disclosed by Schedule 13G is more limited than the information required to be disclosed by Schedule 13D. Once a hedge fund and its advisers are subject to the reporting obligations of Sections 13(d) or 13(g), previously filed beneficial ownership statements must be amended as a result of certain changes in the information disclosed.

In addition, hedge fund advisers also may be subject to the quarterly reporting obligations of Section 13(f) of the Exchange Act, which apply to any “institutional investment manager” exercising investment discretion with respect to accounts having an aggregate fair market value of at least $100 million in equity securities. An “institutional investment manager” includes any person (other than a natural person) investing in or buying and selling securities for its own account, and any person exercising investment discretion with respect to the account of any other person” (U.S. Securities and Exchange Commission, 2003).

“Section 16 applies to all people who are the beneficial owners of more than ten percent of any class of equity security registered under Section 12 of the Exchange Act, and each officer and director of the issuer of the security. Upon becoming a reporting person, a person is required by Section 16(a) to file an initial report with the Commission disclosing the amount of his or her beneficial ownership of all equity securities of the issuer. Section 16(a) also requires reporting persons to keep this information current by reporting to the Commission changes in ownership of these equity securities, or the purchase or sale of security-based swap agreements involving these securities” (U.S. Securities and Exchange Commission, 2003).

6.0    Pension Plan and Other Institutional Investment in Hedge Funds

The greatest challenge in terms of indirect exposure of individual investments in hedge funds has been the frequency with which pension plans, universities, endowments, foundations and other charitable organizations have begun investing in hedge funds. Not surprisingly, pension plans were among the earliest hedge fund investors. Quite oblivious to the masses, money was pumped into hedge funds to churn out sizable returns through pension plans for a very long time. The pace of these investments, however, has increased over the past few years with awareness among more and more people becoming evident.

The staffs of these institutions have voiced their concern on the recent infusions of funds from public and private pension plans, universities, endowments, foundations and charitable organizations into hedge funds. These concerns do not relate to the ability or propriety of pension plan sponsors or trustees making investment decisions to place plan assets into hedge funds. Indeed, many trustees have now come to believe that hedge fund investments are a critical component of a prudent investment strategy.

However, there is another concern, a concern of the increasing presence of such investors in hedge funds over which neither the Commission nor any other regulatory authority can exercise a meaningful oversight. Although these institutions typically qualify as accredited investors or qualified purchasers, these institutions, by investing in hedge funds, expose their participants and other beneficiaries to hedge funds.

If a pension plan that experiences substantial losses as a result of hedge fund fraud is unable to meet its obligations to pensioners, it will find itself in a most unforgiving situation. The collective indirect investment of the assets of less sophisticated individuals into vehicles that are managed by entities that are not examined by the Commission leaves open the possibility that the Commission will be unable to anticipate problems involving hedge funds that may invest on behalf of these institutions (U.S. Securities and Exchange Commission, 2003).

7.0    Conclusion

 

Investors should carefully consider the investment objectives, risks, charges and expenses of each fund. However, there is something waiting to be unleashed. By 2008, institutions will have $300 billion available for hedge-fund investments, up from $60 billion, said the Bank of New York, in consultation with consultants Casey, Quirk & Acito. Pension plans will be the ones to increase their hedge-fund investments, the study concluded.

As already seen, the crash of the stock markets in 2000, 2001 and 2002 left many pension funds with deficits, and this has initiated moves to diversify equity-heavy investments. Calpers, the largest U.S. pension fund, and ABP, the biggest Dutch pension fund, are forerunners in hedge funds investments, and this has encouraged the pension funds to act with immediate effect to protect itself from uncertainties. Hedge funds, the $870 billion industry, deals with a small number of very wealthy individuals rather than large institutions, but the fund is hoping that additional investment from them will generate quick returns.

The increasing influence of institutional investors in alternative investments, especially those of hedge funds, will dramatically change the way firms operate and define success, was what Brian Ruane, executive vice president at The Bank of New York, had to say. The competition to grab this opportunity rests with hedge fund managers, as they make presentations to lure the big fish into their net.

The pension fund on its part will lower their expectations to around 8 percent, as they would rather play it safe initially. They would rather opt for the Long-term investments, rather than the riskier short-term methods. Funds of hedge funds, which place their clients’ money with different hedge fund managers, will maintain 50 percent share of the institutional hedge-fund investments (Barr, 2004).

This, I guess, should put to rest the question of the viability of hedge funds being a reliable retirement vehicle.

 

End Notes to Page 24-26

 

Section 202(a) (11) of the Advisers Act generally defines an investment adviser as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.” The Advisers Act contains certain limited exceptions from this definition for banks, certain professionals, including lawyers and accountants, broker-dealers, publishers and persons giving advice only about U.S. government securities.

Section 206(1) of the Advisers Act prohibits investment advisers from employing “any device, scheme or artifice to defraud any client or prospective client.” Section 206(2) of the Advisers Act prohibits and investment adviser from engaging “in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.”

71 Section 203(b) (3) of the Advisers Act.

72 Rule 203(b)(3)-1 under the Advisers Act provides that an adviser may count a legal organization as a single client if the legal organization receives investment advice based on its investment objectives rather than on the individual investment objectives of its owners.

73 See Institutional Investor, The Hedge Fund 100 (June 2002) (“The Hedge Fund 100”) (The survey lists 86 U.S.-based and U.S.-registered firms managing $298 billion in hedge fund assets. It also covered 14 internationally based firms managing approximately $42 billion in hedge fund assets.).

74 Forty-eight percent of the domestic hedge fund advisers listed in The Hedge Fund 100 are registered with the Commission and manage a total of $140 billion in hedge funds.

75 This expectation is based on our assumption that smaller hedge fund advisers who are not named in The Hedge Fund 100 are more likely to operate without registering with the Commission than larger hedge fund advisers. Larger hedge fund advisers are more likely to serve investors who demand registration, such as pension plans and many endowments, or to engage in other advisory activities such that the adviser is no longer eligible for the exception under Section 203(b)(3).

76 Hennessee Group Comment Letter, supra note 4, at 14 (“Due to market forces predominantly driven by trust and ERISA fiduciaries, hedge funds are finding it necessary to become Registered Investment Advisers in order to attract capital from that market.”); Roundtable Transcript, May 15 (statement of Sandra Manzke) (institutional investors are requiring that hedge fund advisers register). See also U.S. Hedge Fund Regulations Might Help Industry in Long Run, Reuters English News Service (May 24, 2002) (“We registered with the SEC because it was simply easier to say that we were registered. A few fraud cases have gotten attention and when someone writes a $10 million check, they want some assurances.” (Jerry Paul, Quixote Capital Management LLC).

 

 

8.0    References

1.0       B. Venkatesh (2003), What are Hedge Funds? Retrieved from http://www.blonnet.com/iw/2003/07/06/stories/2003070600211300.htm

2.0       S. Vaidya Nathan (2003), Fund flows into stocks: Disclosures need a boost, Retrieved from http://www.blonnet.com/iw/2003/07/06/stories/2003070600170800.htm

3.0       H.R.2924-The Hedge Fund Disclosure Act, (n.d), retrieved on May 25, 2007 from http://commdocs.house.gov/committees/bank/hba63382.000/hba63382_0.HTM

4.0       Vika Brucaite, Shanhong Yan (2000), Financial Risk Management, Case Studies with SKF and Elof Hansson, retrieved from http://www.handels.gu.se/epc/archive/00001538/01/Brucaite_2000_14.pdf.

5.0       Dhanani A. (March, 2000), To hedge or not to hedge. Management

Accounting, London, retrieved from article in management journal

6.0       Implications of the Growth of Hedge Funds (2003), (n.d), Staff Report to the United States Securities and Exchange Commission, retrieved from http://www.sec.gov/news/studies/hedgefunds0903.pdf

7.0       Max Baucus and Chuck Grassley (2007), Committee on Finance, by Baucus, and Grassley Question Hedge Fund Investments for American Workers’ Pension Plan, Retrieved from http://www.finance.senate.gov/press/Bpress/2007press/prb030107c.pdf

8.0       Benchmark Funds, Inc. (2007), (n.d), Hedge Fund Benefits, retrieved from http://www.benchmarkfundsinc.com/hedge_benefits.html

9.0       Bull & Bear Financial Report (2007), (n.d), Mutual Funds vs. Hedge Funds: What’s the Difference? Retrieved from http://www.thebullandbear.com/articles/2005/0405-hedge.html

10.0     Jenny Anderson and Julie Creswell (April 2007), Business, Top Hedge Fund Managers Earn Over $240 Million, New York Times, retrieved from http://www.nytimes.com/2007/04/24/business/24hedge.html?ei=5088&en=22f49c09d1ef88eb&ex=1335067200

11.0     Vince Calio (July 11, 2005 – ), Brave new world: Pensions and Investments, retrieved on May 25, 2007, from http://www.pensionsatwork.ca/english/pdfs/whats_new/0503/brave.pdf

12.0     David Winstone (1997), Retrieved from Financial Derivatives: Hedging with Futures, Forwards, Options & Swaps, on May 24, 2007, Book, ITB Press, London.

13.0     Aaron Nematnejad (2006), An Introduction to Hedge Funds, Growth of Hedge Funds, retrieved on May 25 from http://www.bestwaytoinvest.com/hedge-funds?gclid=CPXz5-GeqowCFQmZbgodohdRSA

14.0     Christopher Cox (2006), U.S. Securities and Exchange Commission, Improving Financial Literary in the United States, retrieved on 26 May, 2007, from http://ftp.sec.gov/news/testimony/ts052306cc.htm

15.0     John B. Shoven (2000), Proposals for a Two-Tier Social Security System in the United States, retrieved on 26 May 2007, from http://www.bsos.umd.edu/econ/sabelhaus/conf001215b.pdf

16.0     Alistair Barr (2004), CBS MarketWatch.com, Global Action on Aging, Pension-Fund Billions for Hedge Funds Institutions to Invest $300B in Hedge Funds, retrieved on May 26, 2007, from http://www.globalaging.org/pension/us/private/2004/hedge.htm

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