There are examples of activist managers engaging with companies on social issues, such as parental controls on devices that restrict usage by children. Quantitative investment strategies are able to respond most readily to specific investor requests by hard-coding restriction lists into their models. However, there is a question mark over machine learning techniques: how can these incorporate RI and ESG-related thinking? This is likely to be an increasingly important question as scrutiny of the industry increases and the role of an investor as an owner necessarily increases with it.
As cheap processing power and increasing amounts of data become available, more and more managers are using Artificial Intelligence, Machine Learning and Big Data to analyse and invest in markets. Although these techniques are still under development, and the amount of available data continues to grow, they need to be understood and harnessed, albeit to varying degrees. The general consensus of the paper is that short-term trading strategies will benefit most from the successful application of these techniques.
Long-term investment strategies will use these techniques as one more tool that helps to inform their decision-making, rather than outsourcing the decision altogether.
- Hedge funds: a central bank perspective.
- Download Hedge Fund industry: Developments and Practices By International Monetary Fund Free Online!
- Short Stories About Tiny Tasks;
- Analysing hedge fund returns and getting value for money.
- A History of the Universe?
- hedge fund industry developments and practices Manual;
In order to assess the incremental value of each dollar spent, investors should focus on understanding where, and how much, budget is being allocated to harnessing these techniques, and what the impact of that investment is. Previously, hedge funds typically hired talent from banks, who in turn tended to hire MBA graduates. While people with these skills continue to have a place, hedge funds increasingly focus on hiring computer scientists and physicists, competing for this talent with the large technology firms.
This new talent works to analyse large amounts of data and build systems to exploit it. Investors should look to hedge fund firms that are adopting similar structures to the large technology companies when they are competing to attract talented employees. These firms tend to have flat structures where ideas can be quickly and easily shared among teams in an open environment.
Some managers will already be working in this way, or will naturally adapt, while others may struggle to adopt this way of working and managing people. Where investors feel that these skills are fundamental to the strategy, they should look for managers that have adopted these structures and have innovated successfully. There may also be nuances among hedge fund firms as larger companies drive better operational economies of scale than smaller ones.
As a result, smaller firms that want to compete will need to differentiate their offering. They might focus on building more creative high-performance teams. In order to be more creative, and to provide a differentiated source of returns, more diversity of thought will be required. In this case, investors might look for managers that are prepared to hire diverse talent with truly different characteristics, experience and investing styles. The investors that the hedge fund community seeks to serve increasingly overlap with those served by traditional asset managers. As hedge funds compete with traditional asset managers for the same investor base, they must increasingly improve their business and distribution models.
One key tenet is longevity and succession planning. If an investor commits capital to any asset manager, they must be sure that there is proper succession planning in place. Many successful hedge fund managers are closer to the end of their careers than to the beginning see right-hand side Chart 3 and capital must be well managed throughout changes in leadership. This confluence of issues resolves itself in different ways for different firms.
Hedge funds’ hopes for 2018 dashed amid closures
To demonstrate a commitment to succession planning, both to their investors and their employees, some hedge fund managers are selling stakes in their business. Others create meaningful partnership structures where they share equity. Investors should focus on what the succession plan is and how these plans are derived in order to make an assessment of the robustness of this aspect of the business model.
Another key to sustainable success is growth. While there are many ways to grow, some hedge fund managers are exploring ways to service retail investors. Best in class digital and mobile technology could enable hedge funds to offer cost-competitive solutions to retail investors. Archived from the original on 14 May Retrieved 16 April Academic Press. Archived from the original on 9 August Retrieved 18 April Handbook of Hedge Funds.
Retrieved 11 March Bloomberg Businessweek. Archived from the original on 25 February Retrieved 9 January Archived from the original on 23 November Retrieved 22 November The Handbook of Alternative Assets. Archived from the original on 28 February Retrieved 16 March The Phrase Finder.
Archived from the original on 29 July Retrieved 25 July Guide to Hedge Funds. London: Profile Books. Archived from the original on 28 July Spring Archived from the original on 17 November Archived from the original on 25 October Retrieved 26 November Dear Mr. International Monetary Fund. Archived from the original on 28 June Retrieved 3 March Absolute Returns: the risks and opportunities of hedge fund investing. Hedge funds of funds investing: an investor's guide.
Archived from the original on 10 April Retrieved 9 April Archived from the original on 3 June Retrieved 22 April Retrieved 14 August Wall Street Journal. Wall Street Journal Online. Archived from the original on 18 March Retrieved 10 March The Financial Times. Archived from the original on 27 May Retrieved 14 June Archived from the original on 2 June Absolute Return. Archived from the original on 29 August The Wall Street Journal. Archived from the original on 11 June Financial Times. Retrieved 26 April Retrieved 18 September Archived from the original on 2 May Retrieved 4 March Archived from the original on 15 December Retrieved 12 May Archived from the original on 6 November Retrieved 6 November Retrieved 29 August Bloomberg L.
Archived from the original on 12 July Retrieved 3 June Archived from the original on 9 October Retrieved 5 August Institutional Investor, Inc. Archived from the original on 18 April Retrieved 31 December Cooperman Archived 29 July at the Wayback Machine ". Archived from the original on 3 September Retrieved 27 August Archived from the original on 15 October Retrieved 18 October Archived from the original on 9 July Retrieved 4 August Archived from the original on 5 February Retrieved 14 February Archived from the original on 2 March Retrieved 12 June Insider Monkey.
Retrieved 17 June Archived from the original on 16 April Archived from the original on 31 October Retrieved 29 November Archived from the original on 24 April Retrieved 14 March Archived from the original on 16 November Capital Beacon. Archived from the original on 29 September Retrieved 18 March International Asset Management Ltd. Archived from the original PDF on 13 May Retrieved 17 March Fortress Strategy USA. Archived from the original PDF on 6 April Guide to Hedge Funds 2nd ed. The Economist Newspaper Ltd.
Goizueta Business School. Emory University. Archived from the original PDF on 28 November Wave Theory for Alternative Investments. McGraw-Hill Companies. Investment strategies of hedge funds. Evaluating hedge fund performance. Archived from the original on 9 January Retrieved 14 April BarclayHedge LTD.
Archived from the original on 30 December Archived from the original on 15 March Hedge Fund Research Inc. Archived from the original on 20 July Retrieved 20 March Archived from the original on 28 December Retrieved 27 March Retrieved 30 March Financial Analysts Journal. Archived from the original PDF on 27 June Retrieved 29 March Hedge Fund Journal.
Archived from the original on 6 October EFM Symposium. European Financial Management Association. Archived from the original PDF on 15 August Hedge funds: crossing the institutional frontier. Euromoney Books. Partners Group. Archived from the original PDF on 22 November The Business Times Singapore. Singapore Press Holdings. Archived from the original on 29 December Retrieved 8 March Archived from the original on 16 March Retrieved 28 March New York University.
Archived PDF from the original on 26 May Quant Risk Group.
Archived from the original on 19 August Journal of Financial Economics. Archived from the original on 20 March Retrieved 21 March Archived from the original on 20 May Archived from the original on 9 December Archived from the original on 15 August Archived from the original PDF on 10 July Archived from the original on 23 September Archived from the original on 4 October Close Shop".
Hedge Fund industry : Developments and Practices
Archived from the original on 18 January Archived from the original on 15 September Rittereiser, Lawrence E. Archived from the original on 21 October Archived from the original on 19 October Retrieved 26 July Schwartz 31 March New York Times. Archived from the original on 30 June Retrieved 8 August Chasing Alpha. London: Bodley Head. Archived from the original on 10 November Retrieved 28 July Chicago Booth Research Paper No.
Social Science Research Network. Archived from the original on 23 July Retrieved 12 July Archived from the original on 15 June Archived from the original on 16 January March Archived from the original on 22 August Retrieved 9 August HITC Business. Here Is The City. April Essvale Corporation Limited. Strachman The Fundamentals of Hedge Fund Management.
Hoboken, New Jersey: Wiley. Anson Edward Elgar Publishing. Fabozzi Handbook of Finance, Financial Markets and Instruments. Archived PDF from the original on 2 December Retrieved 7 February Archived PDF from the original on 7 February Archived from the original on 7 February Hedge Fund Investment Management.
Financial Risk Manager Handbook. PricewaterhouseCoopers LLP. Archived PDF from the original on 8 June Retrieved 31 October Archived from the original on 10 August Archived from the original on 11 August They received renewed attention in the late s. During the s, the number of hedge funds increased significantly, with the s stock market rise ,  the aligned-interest compensation structure i.
Over the next decade, hedge fund strategies expanded to include: credit arbitrage, distressed debt , fixed income , quantitative , and multi-strategy. The US equity market correlation became untenable to short sellers. Hedge fund strategies are generally classified among four major categories: global macro , directional, event-driven , and relative value arbitrage. A fund may employ a single strategy or multiple strategies for flexibility, risk management , or diversification. The elements contributing to a hedge fund strategy include: the hedge fund's approach to the market; the particular instrument used; the market sector the fund specializes in e.
There are a variety of market approaches to different asset classes , including equity , fixed income , commodity , and currency. Instruments used include: equities, fixed income, futures , options , and swaps. Sometimes hedge fund strategies are described as " absolute return " and are classified as either " market neutral " or "directional". Market neutral funds have less correlation to overall market performance by "neutralizing" the effect of market swings, whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.
Hedge funds using a global macro investing strategy take sizable positions in share, bond, or currency markets in anticipation of global macroeconomic events in order to generate a risk-adjusted return. While global macro strategies have a large amount of flexibility due to their ability to use leverage to take large positions in diverse investments in multiple markets , the timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns.
Global macro strategies can be divided into discretionary and systematic approaches. Discretionary trading is carried out by investment managers who identify and select investments, whereas systematic trading is based on mathematical models and executed by software with limited human involvement beyond the programming and updating of the software. These strategies can also be divided into trend or counter-trend approaches depending on whether the fund attempts to profit from following market trend long or short-term or attempts to anticipate and profit from reversals in trends.
Within global macro strategies, there are further sub-strategies including "systematic diversified", in which the fund trades in diversified markets, or "systematic currency", in which the fund trades in currency markets. They also take both long and short positions, allowing them to make profit in both market upswings and downswings. Directional investment strategies use market movements, trends, or inconsistencies when picking stocks across a variety of markets. Computer models can be used, or fund managers will identify and select investments. These types of strategies have a greater exposure to the fluctuations of the overall market than do market neutral strategies.
Within directional strategies, there are a number of sub-strategies. Funds using a "fundamental growth" strategy invest in companies with more earnings growth than the overall stock market or relevant sector, while funds using a " fundamental value " strategy invest in undervalued companies. Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event.
Managers employing such a strategy capitalize on valuation inconsistencies in the market before or after such events, and take a position based on the predicted movement of the security or securities in question. Large institutional investors such as hedge funds are more likely to pursue event-driven investing strategies than traditional equity investors because they have the expertise and resources to analyze corporate transactional events for investment opportunities. Corporate transactional events generally fit into three categories: distressed securities , risk arbitrage , and special situations.
Hedge fund managers pursuing the distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds purchasing distressed debt may prevent those companies from going bankrupt, as such an acquisition deters foreclosure by banks. Risk arbitrage or merger arbitrage includes such events as mergers , acquisitions, liquidations, and hostile takeovers. The risk element arises from the possibility that the merger or acquisition will not go ahead as planned; hedge fund managers will use research and analysis to determine if the event will take place.
To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company's equity and equity-related instruments. Other event-driven strategies include: credit arbitrage strategies, which focus on corporate fixed income securities; an activist strategy, where the fund takes large positions in companies and uses the ownership to participate in the management; a strategy based on predicting the final approval of new pharmaceutical drugs ; and legal catalyst strategy, which specializes in companies involved in major lawsuits.
Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, the underlying security or the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical, technical , or fundamental techniques.
In addition to those strategies within the four main categories, there are several strategies that do not fit into these categorizations or can apply across several of them. For an investor who already holds large quantities of equities and bonds, investment in hedge funds may provide diversification and reduce the overall portfolio risk. Investors in hedge funds are, in most countries, required to be qualified investors who are assumed to be aware of the investment risks , and accept these risks because of the potential returns relative to those risks. Fund managers may employ extensive risk management strategies in order to protect the fund and investors.
According to the Financial Times , "big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management. In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence to assess the risk that error or fraud at a hedge fund might result in loss to the investor. Considerations will include the organization and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund's ability to develop as a company.
Since hedge funds are private entities and have few public disclosure requirements, this is sometimes perceived as a lack of transparency. Hedge funds share many of the same types of risk as other investment classes, including liquidity risk and manager risk. As well as specific risks such as style drift, which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors include valuation risk , capacity risk, concentration risk , and leverage risk.
Many investment funds use leverage , the practice of borrowing money, trading on margin , or using derivatives to obtain market exposure in excess of that provided by investors' capital. Although leverage can increase potential returns, the opportunity for larger gains is weighed against the possibility of greater losses.
Some types of funds, including hedge funds, are perceived as having a greater appetite for risk , with the intention of maximizing returns,  subject to the risk tolerance of investors and the fund manager. Managers will have an additional incentive to increase risk oversight when their own capital is invested in the fund.
Hedge fund management firms typically charge their funds both a management fee and a performance fee. Management fees for hedge funds are designed to cover the operating costs of the manager, whereas the performance fee provides the manager's profits. However, due to economies of scale the management fee from larger funds can generate a significant part of a manager's profits, and as a result some fees have been criticized by some public pension funds, such as CalPERS , for being too high.
Performance fees are intended to provide an incentive for a manager to generate profits. Performance fee rates have fallen since the start of the credit crunch. 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. This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather than attempt to recover the losses over a number of years without a performance fee. 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.
A "hard" hurdle is calculated only on returns above the hurdle rate. Some hedge funds charge a redemption fee or withdrawal fee]] for early withdrawals during a specified period of time typically a year , or when withdrawals exceed a predetermined percentage of the original investment. Unlike management fees and performance fees, redemption fees are usually kept by the fund. Hedge fund management firms are usually owned by their portfolio managers , who are therefore entitled to any profits that the business makes.
President's working group on financial markets: best practices for the hedge fund industry
As management fees are intended to cover the firm's operating costs, performance fees and any excess management fees are generally distributed to the firm's owners as profits. Funds do not tend to report compensation and so published lists of the amounts earned by top managers tend to be estimates based on factors such as the fees charged by their funds and the capital they are thought to have invested in them. Of the 1, people on the Forbes World's Billionaires List for ,  36 of the financiers listed "derived significant chunks" of their wealth from hedge fund management.
A hedge fund is an investment vehicle that is most often structured as an offshore corporation , limited partnership , or limited liability company. Prime brokers clear trades , and provide leverage and short-term financing. Hedge fund administrators are typically responsible for valuation services, and often operations and accounting. Calculation of the net asset value "NAV" by the administrator, including the pricing of securities at current market value and calculation of the fund's income and expense accruals, is a core administrator task, because it is the price at which investors buy and sell shares in the fund.
Administrator back office support allows fund managers to concentrate on trades. A distributor is an underwriter , broker , dealer , or other person who participates in the distribution of securities. Many hedge funds do not have distributors, and in such cases the investment manager will be responsible for distribution of securities and marketing, though many funds also use placement agents and broker-dealers for distribution.
Most funds use an independent accounting firm to audit the assets of the fund, provide tax services, and perform a complete audit of the fund's financial statements. The year-end audit is often performed in accordance with the standard accounting practices enforced within the country in which the fund it established, or the International Financial Reporting Standards IFRS.
The legal structure of a specific hedge fund, in particular its domicile and the type of legal entity in use, is usually determined by the tax expectations of the fund's investors. Regulatory considerations will also play a role. Many hedge funds are established in offshore financial centers to avoid adverse tax consequences for its foreign and tax-exempt investors. However, the fund's investors are subject to tax in their own jurisdictions on any increase in the value of their investments.
US tax-exempt investors such as pension plans and endowments invest primarily in offshore hedge funds to preserve their tax exempt status and avoid unrelated business taxable income. The hedge funds would then execute trades — many of them a few seconds in duration — but wait until just after a year had passed to exercise the options, allowing them to report the profits at a lower long-term capital gains tax rate.
The US Senate Permanent Subcommittee on Investigations chaired by Carl Levin issued a report that found that from and , hedge funds avoided billions of dollars in taxes by using basket options. A dozen other hedge funds along with Renaissance Technologies used Deutsche Bank 's and Barclays ' basket options. These basket options will now be labeled as listed transactions that must be declared on tax returns, and a failure to do would result in a penalty. In contrast to the funds themselves, investment managers are primarily located onshore.
London was Europe's leading center for hedge fund managers, but since the Brexit referendum some formerly London-based hedge funds have relocated to other European financial centers such as Frankfurt , Luxembourg , Paris , and Dublin , while some other hedge funds have moved their European head offices back to New York City. Hedge fund legal structures vary depending on location and the investor s.
US hedge funds aimed at US-based, taxable investors are generally structured as limited partnerships or limited liability companies. Limited partnerships and other flow-through taxation structures assure that investors in hedge funds are not subject to both entity-level and personal-level taxation. The general partner may be an individual or a corporation. The general partner serves as the manager of the limited partnership, and has unlimited liability. Their liability is limited to the amount of money they invest for partnership interests.
By contrast, offshore corporate funds are usually used for non-US investors, and when they are domiciled in an applicable offshore tax haven , no entity-level tax is imposed. The investment manager who organizes the hedge fund may retain an interest in the fund, either as the general partner of a limited partnership or as the holder of "founder shares" in a corporate fund. The board's primary role is to provide a layer of oversight while representing the interests of the shareholders. The board may include both affiliated directors who are employees of the fund and independent directors whose relationship to the fund is limited.
A side pocket is a mechanism whereby a fund compartmentalizes assets that are relatively illiquid or difficult to value reliably. 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 were widely used by hedge funds during the financial crisis amidst a flood of withdrawal requests.
Side pockets allowed fund managers to lay away illiquid securities until market liquidity improved, a move that could reduce losses. However, as the practice restricts investors' ability to redeem their investments it is often unpopular and many have alleged that it has been abused or applied unfairly. Hedge funds must abide by the national, federal, and state regulatory laws in their respective locations. The U. On the other hand, U.
These included the U. In in an effort to engage in self-regulation , 14 leading hedge fund managers developed a voluntary set of international standards in best practice and known as the Hedge Fund Standards they were designed to create a "framework of transparency, integrity and good governance" in the hedge fund industry. Hedge funds within the US are subject to regulatory, reporting, and record-keeping requirements.
In June , the U. Court of Appeals for the District of Columbia overturned the rule and sent it back to the agency to be reviewed. They are required to have written compliance policies, a chief compliance officer , and their records and practices may be examined by the SEC. Within the European Union EU , hedge funds are primarily regulated through their managers. According to the EU, the aim of the directive is to provide greater monitoring and control of alternative investment funds.
It also directs hedge fund managers to hold larger amounts of capital. Some hedge funds are established in offshore centres such as the Cayman Islands , Dublin , Luxembourg , the British Virgin Islands , and Bermuda , which have different regulations  concerning non-accredited investors, client confidentiality, and fund manager independence. Performance statistics for individual hedge funds are difficult to obtain, as the funds have historically not been required to report their performance to a central repository, and restrictions against public offerings and advertisement have led many managers to refuse to provide performance information publicly.
However, summaries of individual hedge fund performance are occasionally available in industry journals   and databases. One estimate is that the average hedge fund returned Hedge funds performance is measured by comparing their returns to an estimate of their risk. New performance measures have been introduced that attempt to address some of theoretical concerns with traditional indicators, including: modified Sharpe ratios ;   the Omega ratio introduced by Keating and Shadwick in ;  Alternative Investments Risk Adjusted Performance AIRAP published by Sharma in ;  and Kappa developed by Kaplan and Knowles in There is a debate over whether alpha the manager's skill element in performance has been diluted by the expansion of the hedge fund industry.
Two reasons are given. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more managers, which may dilute the talent available in the industry. Indices that track hedge fund returns are, in order of development, called Non-investable, Investable, and Clone. They play a central and unambiguous role in traditional asset markets, where they are widely accepted as representative of their underlying portfolios.
Hedge Fund industry : Developments and Practices
Equity and debt index fund products provide investable access to most developed markets in these asset classes. Hedge funds, however, are actively managed, so that tracking is impossible.
Non-investable hedge fund indices on the other hand may be more or less representative, but returns data on many of the reference group of funds is non-public. This may result in biased estimates of their returns. In an attempt to address this problem, clone indices have been created in an attempt to replicate the statistical properties of hedge funds without being directly based on their returns data. None of these approaches achieves the accuracy of indices in other asset classes for which there is more complete published data concerning the underlying returns.
Non-investable indices are indicative in nature, and aim to represent the performance of some database of hedge funds using some measure such as mean, median, or weighted mean from a hedge fund database. The databases have diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different indices. Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list of biases.
Funds' participation in a database is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money.. The short lifetimes of many hedge funds means that there are many new entrants and many departures each year, which raises the problem of survivorship bias. If we examine only funds that have survived to the present, we will overestimate past returns because many of the worst-performing funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial.
When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favorable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias" or "backfill bias". Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. To create an investable index, the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index.
When investors buy these products the index provider makes the investments in the underlying funds, making an investable index similar in some ways to a fund of hedge funds portfolio. To make the index investable, hedge funds must agree to accept investments on the terms given by the constructor. To make the index liquid, these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. This means that investable indices do not represent the total universe of hedge funds.
Most seriously, they under-represent more successful managers, who typically refuse to accept such investment protocols. The most recent addition to the field approach the problem in a different manner. Instead of reflecting the performance of actual hedge funds they take a statistical approach to the analysis of historic hedge fund returns, and use this to construct a model of how hedge fund returns respond to the movements of various investable financial assets.
This model is then used to construct an investable portfolio of those assets. This makes the index investable, and in principle they can be as representative as the hedge fund database from which they were constructed. However, these clone indices rely on a statistical modelling process. Such indices have too short a history to state whether this approach will be considered successful. In March , HFR — a hedge fund research data and service provider — reported that there were more hedge-fund closures in than during the recession. There were hedge fund launches in , fewer than the opened in , and dramatically fewer than the launches in Systemic risk refers to the risk of instability across the entire financial system , as opposed to within a single company.
Such risk may arise following a destabilizing event or events affecting a group of financial institutions linked through investment activity. As it happens, no financial assistance was provided to LTCM by the US Federal Reserve , so there was no direct cost to US taxpayers,  but a large bailout had to be mounted by a number of financial institutions. However, these claims are widely disputed by the financial industry,  who typically regard hedge funds as " small enough to fail ", since most are relatively small in terms of the assets they manage and operate with low leverage, thereby limiting the potential harm to the economic system should one of them fail.
Nevertheless, although hedge funds go to great lengths to reduce the ratio of risk to reward, inevitably a number of risks remain. In addition, while most hedge funds make only modest use of leverage, hedge funds differ from many other market participants, such as banks and mutual funds, in that there are no regulatory constraints on their use of leverage, and some hedge funds seek large amounts of leverage as part of their market strategy. The extensive use of leverage can lead to forced liquidations in a crisis, particularly for hedge funds that invest at least in part in illiquid investments.
The close interconnectedness of the hedge funds with their prime brokers, typically investment banks, can lead to domino effects in a crisis, and indeed failing counterparty banks can freeze hedge funds. These systemic risk concerns are exacerbated by the prominent role of hedge funds in the financial markets. An August survey by the Financial Services Authority concluded that risks were limited and had reduced as a result, inter alia , of larger margins being required by counterparty banks, but might change rapidly according to market conditions.
In stressed market conditions, investors might suddenly withdraw large sums, resulting in forced asset sales. This might cause liquidity and pricing problems if it occurred across a number of funds or in one large highly leveraged fund. Hedge funds are structured to avoid most direct regulation although their managers may be regulated , and are not required to publicly disclose their investment activities, except to the extent that investors generally are subject to disclosure requirements. This is in contrast to a regulated mutual fund or exchange-traded fund , which will typically have to meet regulatory requirements for disclosure.
An investor in a hedge fund usually has direct access to the investment adviser of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, while some hedge funds have very limited transparency even to investors.
Funds may choose to report some information in the interest of recruiting additional investors. Much of the data available in consolidated databases is self-reported and unverified. The study noted that common funds had significant differences in reported information e. A lack of verification of financial documents by investors or by independent auditors has, in some cases, assisted in fraud. Following the Madoff case, the SEC adopted reforms in December that subjected hedge funds to an audit requirement.
The process of matching hedge funds to investors has traditionally been fairly opaque, with investments often driven by personal connections or recommendations of portfolio managers. The complexity and fees associated with hedge funds are causing some to exit the market — Calpers , the largest pension fund in the US, announced plans to completely divest from hedge funds in In June , prompted by a letter from Gary J. Aguirre , the U. Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. Aguirre was fired from his job with the SEC when, as lead investigator of insider trading allegations against Pequot Capital Management , he tried to interview John Mack , then being considered for chief executive officer at Morgan Stanley.
Samberg , chief investment officer of Pequot, was barred from working as an investment advisor. The systemic practice of hedge funds submitting periodic electronic questionnaires to stock analysts as a part of market research was reported by The New York Times in July According to the report, one motivation for the questionnaires was to obtain subjective information not available to the public and possible early notice of trading recommendations that could produce short-term market movements.
One of the attractive features of hedge funds in particular market neutral and similar funds is that they sometimes have a modest correlation with traditional assets such as equities. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers, reducing overall portfolio risk.
However, there are three reasons why one might not wish to allocate a high proportion of assets into hedge funds.