Hedging funds & its impact on capital market

“Hedging Fund & Its Impact On Capital Market”
CONTENTS
Sr.No. Particulars Page No.
1. Introduction 1.
2. Characteristics Of Hedge Funds 7.
3. Growth Of Hedge Funds 9.
4. Hedge Fund Data 12.
5. Benefits Of Hedge Funds 21.
6. Workings Of Hedge Funds 27.
7. Risks Involved In Hedge Funds 32.
8. Impact Of Hedge Funds In Capital Market 45.
9. Role Of Hedge Funds In Capital System 48.
10. Investor Protection 50.
11. The Federal Reserve & Hedge Funds 52.
Hemant Palav / MBA / Semester II 1.

INTRODUCTION
The term 'hedge fund' is used to describe a wide variety of institutional investors
employing a diverse set of investment strategies. Although there is no formal definition of 'hedge
fund,' hedge funds are largely defined by what they are not and by the regulations to which they
are not subject. As a general matter, the term 'hedge fund' refers to unregistered, private
investment partnerships for wealthy sophisticated investors (both natural persons and
institutions) that use some form of leverage to carry out their investment strategies.
The term 'hedge fund' is undefined, including
in the federal securities laws. Indeed, there is no
commonly accepted universal meaning. As hedge
funds have gained stature and prominence, though,
'hedge fund' has developed into a catch-all
classification for many unregistered privately managed
pools of capital. These pools of capital may or may not
utilize the sophisticated hedging and arbitrage strategies
that traditional hedge funds employ, and many appear to
engage in relatively simple equity strategies. Basically, many 'hedge funds' are not actually
hedged, and the term has become a misnomer in many cases.
Hedge funds engage in a variety of investment activities. They cater to sophisticated
investors and are not subject to the regulations that apply to mutual funds geared toward the
general public. Fund managers are compensated on the basis of performance rather than as a
fixed percentage of assets. 'Performance funds' would be a more accurate description.

SeleCTeD DefINITIONS Of "HeDge fUND"
"Hedge fund" is an expression believed to have been first applied in 1949 to a fund managed by
Alfred Winslow Jones.1
Mr. Jones's private investment fund combined both long and short equity
positions to "hedge" the portfolio's exposure to movements in the market. Today, hedge funds
are no longer defined by a particular strategy and often do not "hedge" in the economic sense.
The following is a selection of definitions and descriptions of the term "hedge fund" showing the
diversity of views among commentators.
"The term 'hedge fund' is commonly used to describe a variety of different types of investment
vehicles that share some common characteristics. Although it is not statutorily defined, the term
encompasses any pooled investment vehicle that is privately organized, administered by
professional money managers, and not widely available to the public."
--THe PReSIDeNT'S WORKINg gROUP ON fINANCIAl
MARKeTS, HeDge fUNDS, leVeRAge, AND THe leSSONS
Of lONg-TeRM CAPITAl MANAgeMeNT 1 (1999).
"The term 'hedge fund' refers generally to a privately offered investment vehicle that pools the
contributions of its investors in order to invest in a variety of asset classes, such as securities,
futures contracts, options, bonds, and currencies."
--THe SeCReTARY Of THe TReASURY, THe BOARD Of
gOVeRNORS Of THe feDeRAl ReSeRVe SYSTeM, THe
SeCURITIeS AND eXCHANge COMMISSION, A RePORT TO
CONgReSS IN ACCORDANCe WITH § 356(C) Of THe USA
PATRIOT ACT Of 2001 (2002).

"A hedge fund can be broadly defined as a privately offered fund that is administered by a
professional investment management firm (or 'hedge fund manager'). The word 'hedge' refers to
a hedge fund's ability to hedge the value of the assets it holds (e.g., through the use of options or
the simultaneous use of long positions and short sales). However, some hedge funds engage only
in 'buy and hold' strategies or other strategies that do not involve hedging in the traditional
sense. In fact, the term 'hedge fund' is used to refer to funds engaging in over 25 different types
of investment strategies .…"
--MANAgeD fUNDS ASSOCIATION, HeDge fUND
fAQS 1 (2003).
"There is no universally accepted meaning of the expression 'hedge fund'; indeed, many
competing (and sometimes partially contradicting) definitions exist. The term first came into use
in the 1950s to describe any investment fund that used incentive fees, short-selling, and leverage.
A summary definition frequently used in official sector reports is 'any pooled investment vehicle
that is privately organised, administered by professional investment managers, and not widely
available to the public'. The term can also be defined by considering the characteristics most
commonly associated with hedge funds. Usually, hedge funds:
• are organised as private investment partnerships or offshore investment corporations;
• use a wide variety of trading strategies involving position-taking in a range of markets;
• employ an assortment of trading techniques and instruments, often including short-
selling, derivatives and leverage;
• pay performance fees to their managers; and
• Have an investor base comprising wealthy individuals and institutions and a relatively
high minimum investment limit (set at US$100,000 or higher for most funds)."

--FINANCIAL SERVICES AUTHORITY (UNITED
KINGDOM), HEDGE FUNDS AND THE FSA, DISCUSSION
PAPER 16, at 8 (2002).
"Originally set up to 'hedge bets' or insure against currency or interest rate risks, hedge funds
have since taken on a much wider remit, investing in assets ranging from equities and fixed
interest stocks to derivatives and commodities. Their aim is to make absolute returns, that is to
make performance returns irrespective of which way the markets are going. Rather like
derivative funds, hedge funds use derivative instruments or gearing (borrowing against the
fund's assets) to gain greater exposure to their investments or to protect against losses."
--ROBeRT B. MIlROY, STANDARD & POOR'S gUIDe TO
OffSHORe INVeSTMeNT fUNDS 28 (2000).
"The term 'hedge fund' was in use as early as the 1960s to describe a new speculative investment
vehicle that used sophisticated hedging and arbitrage techniques in the corporate equities
market. In the late 1960s, former Securities and Exchange Commissioner Hugh Owens
described 'hedge funds' as 'private investment partnerships which employ the investment
techniques of leveraging and hedging.' In the 1970s and 1980s, the activities of similar types of
funds broadened into a range of financial instruments and activities .… The term 'hedge fund'
does not have a precise definition, but it has been used to refer generally to a cadre of private
investment partnerships that are engaged in active trading and arbitrage of a range of different
securities and commodities."
--DePARTMeNT Of THe TReASURY, SeCURITIeS AND
eXCHANge COMMISSION, BOARD Of gOVeRNORS Of THe
feDeRAl ReSeRVe SYSTeM, JOINT RePORT ON THe
gOVeRNMeNT SeCURITIeS MARKeT, AT B-64 (1992)

(CITINg HUgH OWeNS, SeCURITIeS AND eXCHANge
COMMISSIONeR, A RegUlATOR lOOKS AT SOMe
UNRegUlATeD INVeSTMeNT COMPANIeS: THe eXOTIC
fUNDS, ReMARKS BefORe THe NORTH AMeRICAN
SeCURITIeS ADMINISTRATORS ASSOCIATION (OCT. 21,
1969)).
A hedge fund is a "private investment partnership (for U.S. investors) or an off-shore investment
corporation (for non-U.S. or tax-exempt investors) in which the general partner has made a
substantial personal investment, and whose offering memorandum allows for the fund to take
both long and short positions, use leverage and derivatives, and investment in many markets.
Hedge funds often take large risks on speculative strategies, including [program trading, selling
short, swap, and arbitrage]. A fund need not employ all of these tools all of the time; it must
merely have them at its disposal."
--JOHN DOWNeS AND JORDAN ellIOTT gOODMAN,
BARRON'S, fINANCe & INVeSTMeNT HANDBOOK 358 (5TH
eD. 1998).
"There is no precise definition of the term 'hedge fund,' and one will not be found in the federal
or state securities laws. The term was first used to describe private investment funds that
combine both long and short equity positions within a single leveraged portfolio. It is generally
believed that the first such fund to employ this approach was an investment partnership
organized in 1949 by Alfred Winslow Jones … Hedge funds are no longer defined by the strategy
they pursue. While a number of today's funds pursue the hedged equity strategy of Jones,
numerous different investment styles are embraced by hedge funds .… Hedge funds are defined

more by their form of organization and manner of operation than by the substance of their
financial strategies."
--SCOTT J. leDeRMAN, HeDge fUNDS, IN fINANCIAl
PRODUCT fUNDAMeNTAlS: A gUIDe fOR lAWYeRS 11-3,
11-4, 11-5 (ClIffORD e. KIRSCH eD., 2000).
"Like mutual funds, hedge funds pool investors' money and invest those funds in financial
instruments in an effort to make a positive return. However, unlike mutual funds, hedge funds
are not registered with the SEC. This means that hedge funds are subject to very few regulatory
controls. In addition, many hedge fund managers are not required to register with the SEC and
therefore are not subject to regular SEC oversight. Because of this lack of regulatory oversight,
hedge funds historically have been available to accredited investors and large institutions, and
have limited their investors through high investment minimums (e.g., $1 million).
Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other
speculative investment practices that may increase the risk of investment loss."
--SeCURITIeS AND eXCHANge COMMISSION, HeDgINg YOUR
BeTS: A HeADS UP ON HeDge fUNDS AND fUNDS Of HeDge
fUNDS, AVAIlABle AT
HTTP://WWW.SeC.gOV/ANSWeRS/HeDge.HTM.
"'Hedge fund' is a general, non-legal term used to describe private, unregistered investment
pools that traditionally have been limited to sophisticated, wealthy investors. Hedge funds are
not mutual funds and, as such, are not subject to the numerous regulations that apply to mutual
funds for the protection of investors - including regulations requiring a certain degree of
liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations
protecting against conflicts of interest, regulations to assure fairness in the pricing of fund
shares, disclosure regulations, regulations limiting the use of leverage, and more."

--SeCURITIeS AND eXCHANge COMMISSION, INVeST
WISelY: AN INTRODUCTION TO MUTUAl fUNDS,
AVAIlABle AT
HTTP://WWW.SeC.gOV/INVeSTOR/PUBS/INWSMf.HTM.
"A hedge fund is an actively managed investment fund that seeks attractive absolute return. In
pursuit of their absolute return objective, hedge funds use a wide variety of investment strategies
and tools. Hedge funds are designed for a small number of large investors, and the manager of
the fund receives a percentage of the profits earned by the fund. Hedge fund managers are active
managers seeking absolute return."
--ROBeRT A. JAegeR, All ABOUT HeDge fUNDS, AT X
(2003) (PeRHAPS IN A BIT Of HIS OWN HeDgINg, JAegeR
CAllS HIS DefINITION "PROVISIONAl.").
KeY CHARACTeRISTICS Of HeDge fUNDS
• Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and
minimize the correlation with equity and bond markets. Many hedge funds are flexible in
their investment options (can use short selling, leverage, derivatives such as puts, calls,
options, futures, etc.).
• Hedge funds vary enormously in terms of investment returns, volatility and risk. Many,
but not all, hedge fund strategies tend to hedge against downturns in the markets being
traded.
• Many hedge funds have the ability to deliver non-market correlated returns.
• Many hedge funds have as an objective consistency of returns and capital preservation
rather than magnitude of returns.
• Most hedge funds are managed by experienced investment professionals who are
generally disciplined and diligent.

• Pension funds, endowments, insurance companies, private banks and high net worth
individuals and families invest in hedge funds to minimize overall portfolio volatility and
enhance returns.
• Most hedge fund managers are highly specialized and trade only within their area of
expertise and competitive advantage.
• Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards
performance incentives, thus attracting the best brains in the investment business. In
addition, hedge fund managers usually have their own money invested in their fund.
fACTS ABOUT THe HeDge fUND INDUSTRY
• Estimated to be a $1 trillion industry and growing at about 20% per year with
approximately 8350 active hedge funds.
• Includes a variety of investment strategies, some of which use leverage and derivatives
while others are more conservative and employ little or no leverage. Many hedge fund
strategies seek to reduce market risk specifically by shorting equities or through the use
of derivatives.
• Most hedge funds are highly specialized, relying on the specific expertise of the manager
or management team.
• Performance of many hedge fund strategies, particularly relative value strategies, is not
dependent on the direction of the bond or equity markets -- unlike conventional equity or
mutual funds (unit trusts), which are generally 100% exposed to market risk.
• Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much
capital they can successfully employ before returns diminish. As a result, many
successful hedge fund managers limit the amount of capital they will accept.
• Hedge fund managers are generally highly professional, disciplined and diligent.
• Their returns over a sustained period of time have outperformed standard equity and bond
indexes with less volatility and less risk of loss than equities.
• Beyond the averages, there are some truly outstanding performers.

• Investing in hedge funds tends to be favored by more sophisticated investors, including
many Swiss and other private banks that have lived through, and understand the
consequences of, major stock market corrections.
• An increasing number of endowments and pension funds allocate assets to hedge funds.
THe gROWTH Of HeDge fUNDS
In the entire financial services area, the sector showing the most growth is clearly the area of
hedge funds. While brokerage commissions continue to decline, investment banking fees start to
come under pressure and the entire financial services industry worries about intensified
regulatory scrutiny, the hedge fund industry with its rapid growth stands out from the crowd.
New funds are starting up every week and many are beginning with an excess of a billion dollars
under management from day one. The amount of money under management with hedge funds
has gone up four times between 1996 and 2004 and is expected to further triple between now and
2010 to over $2.7 trillion. Public funds, endowments, and corporate sponsors have all increased
their allocations to hedge funds within the context of an increased allocation towards alternative
investments more generally. This move towards increased investments in real estate/private
equity/hedge funds (alternative investments) is driven by the need for a higher return to
compensate for the expected lower returns from more conventional investment strategies focused
on US bonds and equities. There is also a clear desire among this investor base to be more
focused on absolute-return strategies rather than relative return. Given the current level of
allocations most of these large long-term investors have towards alternative investments, and
their professed long-term target allocation, the flow of funds to these asset classes will remain
strong.
One of the intriguing developments in the hedge fund world is the clear desire and ability
of the newer funds to charge higher fees and impose more stringent terms on investors. No
longer are funds charging a 1 per cent management fee and 20 per cent of profits -- the norm for
the first generation of funds set up in the early to mid 1990s. As per an interesting study done by

Morgan Stanley's prime brokerage unit, about a third of the funds opening in the past six months
are charging a 2 per cent management fee and 20 per cent of profits or higher, while the majority
are charging a 1.5 per cent management fee and 20 per cent of profits. Many of the new funds
have more stringent lock-ups and stiff penalties if you redeem early, as well as modified high-
water marks.
The hedge fund business thus seems to have the unique characteristic of being possibly
the only business that I know of wherein new players (most of whom are unproven) have the
ability to charge more and get better terms than the established operators. This implies a
negative franchise value for the established large fund complexes which have survived and
prospered through the years. Given that most of the best hedge fund complexes are closed to new
investors, the new guys seem to be taking advantage of the huge demand-supply mismatch for
quality money managers. There is a feeding frenzy currently under way in the world of
alternative investments and clients are paying up the higher fees for fear of being locked out
from these funds at a later date, if they actually survive and grow.
One reason why the new boys are focusing more on fees and lock-ups could be the difficulty all
hedge funds are having in generating adequate alpha (excess return) to ensure an adequate
payout for themselves.
In a study done by Morgan Stanley on the excess returns generated by hedge funds over
the last decade, this trend of declining returns was very apparent. In the study they defined
excess returns as the return of the Hedge Fund research composite over one month LIBOR (a
proxy for cash returns).
In the 1995-97 period, excess returns were 14 per cent; these returns have consistently
declined dropping to as low as 5 per cent in 2001-03 and have dropped further since.
The current huge inflows into funds focused on emerging markets make sense if you look
at performance numbers over the past three years.
Hedge funds focused on the emerging markets had the best returns with an 18 per cent
annual return during 2001-04, closely followed by distressed debt focused funds at 17 per cent.

More conventional hedge fund strategies of tech at 0 per cent and risk arbitrage at 3 per cent
annual return lagged far behind. Given the constant inflows into new hedge funds, clients do not
yet seem to be bothered about paying higher and higher fees for lower returns, but this is a
discussion that I am sure will come up at some stage in most investment committees. At some
stage if the hedge fund community continues to show declining alpha (excess returns), clients
will need to question whether the proliferation of hedgies has reduced returns because the field
has become too competitive.
The beauty of the hedge fund business and the reason why the upward drift in fee
structure is even more surprising is the ease of entry of new players into the game. The average
long short hedge fund needs only about six back office staff per billion dollars, while a global
macro fund needs about 11 people for a fund of similar size (Morgan Stanley survey). The
typical long short US equity manager has only nine investment professionals and three in the
back office. These funds are also not really regulated and have very limited disclosure
requirements, if any. The start-up costs of these vehicles are also minimal and most funds will
be able to break even at sub $100 million in assets under management. There is no other industry
that I am aware of where exit and entry are as simple.
Hedge funds till date in 2005 have had a tough year; there have been few strong trends to
capitalise on and most funds are struggling to show a positive return. If the hedge fund industry
ends the year flat or even (god forbid) negative after disappointing relative performance in 2003
and just about average numbers in 2004, some of the more sophisticated clients may migrate
back to more conventional forms of investing with lower fee structures. Hedge funds are clearly
here to stay, and continue to attract the best talent because of their payout structures; however,
their ability to continue to command a premium fee structure will eventually be limited by their
ability to differentiate themselves from their long-only brethren on the performance front.

HeDge fUND DATA
Top performing funds
The top 50 performing hedge funds, based on average annual return over the previous three
years, were ranked by Barron's Online in October 2007 (Hedge Fund 50). The top 10 are as
follows:
• 1. RAB Special Situations Fund (RAB Capital, London) - 47.69%
• 2. The Children's Investment Fund (The Children's Investment Fund Management,
London) - 44.27%
• 3. Highland CDO Opportunity Fund (Highland Capital Management, Dallas) -
43.98%
• 4. BTR Global Opportunity Fund, Class D (Salida Capital, Toronto) - 43.42%
• 5. SR Phoenicia Fund (Sloane Robinson, London) - 43.10%
• 6. Atticus European Fund (Atticus Management, New York) - 40.76%
• 7. Gradient European Fund A (Gradient Capital Partners, London) - 39.18%
• 8. Polar Capital Paragon Absolute Return Fund (Polar Capital Partners, London) -
38.00%
• 9. Paulson Enhanced Partners Fund (Paulson & Co., New York) - 37.97%
• 10. Firebird Global Fund (Firebird Management, New York) - 37.18%
Because of the unavailability of reliable figures, the top 50 list excludes funds such as
Renaissance Technologies' Renaissance Medallion Fund and ESL Investments' ESL Partners
(each thought to have returned an average of over 35% in the previous 3 years) and funds by
SAC Capital and Appaloosa Management, which might otherwise have made the list.
The list also excludes funds with a net asset value of less than $250 million. The returns are net
of fees.

TOP eARNeRS
Institutional Investor magazine annually ranks top-earning hedge fund managers. Earnings from
a hedge fund are simply 100% of the capital gains on the manager's own equity stake in the fund
plus the manager's share of the performance fee (usually 20% to 50% (depending on policy) of
the gains on the other investors' capital).
The 2004 top earner was Edward Lampert of ESL Investments Inc. who earned $1.02 billion
during the year (PR Newswire link).
The 2005 top earner was James Harris Simons with an earning of $1.6 billion according to Alpha
magazine.[18]
However, Trader Monthly reported that Simons only earned about $1 billion and
that the top earner was instead T. Boone Pickens with an estimated earning of over $1.5 billion
during the year.[19]
The full top 10 list of hedge fund earners according to Trader Monthly Magazine.
includes:
• 1. T. Boone Pickens - estimated 2005 earnings $1.5bn +
• 2. Steven A. Cohen, SAC Capital Advisers - $1bn +
• 3. James H. Simons, Renaissance
Technologies Corp. - $900m - $1bn
• 4. Paul Tudor Jones, Tudor Investment Corp.
- $800m - $900m
• 5. Stephen Feinberg, Cerberus Capital
Management - $500 - $600m
• 6. Bruce Kovner, Caxton Associates -
$500m - $600m
• 7. Eddie Lampert, ESL Investments - $500m - $600m
• 8. David E. Shaw, D. E. Shaw & Co. - $400m - $500m
• 9. Jeffrey Gendell, Tontine Partners - $300m - $400m
• 10. Louis Bacon, Moore Capital Management - $300m - $350m

The 2006 top earner was John Arnold according to Trader Monthly Magazine.
The list includes:
• 1. John D. Arnold, Houston, Texas- of Centauras Energy- $1.5-2B
• 2. James Simons, East Setauket, New York- of Renaissance Technologies Corp.- $1.5-2B
• 3. Eddie Lampert, Greenwich, Connecticut- of ESL Investments- $1-1.5B
NOTABle HeDge fUND MANAgeMeNT COMPANIeS
Sometimes also known as alternative investment management companies.
• Amaranth Advisors
• Bridgewater Associates
• Caxton Associates
• Centaurus Energy
• Citadel Investment Group
• D. E. Shaw & Co.
• Fortress Investment Group
• Goldman Sachs Asset Management
• Long Term Capital Management
• Man Group
• Pirate Capital LLC
• Renaissance Technologies
• SAC Capital Advisors
• Soros Fund Management
• Marshall Wace

WHY HeDge fUNDS ARe ATTRACTIVe?
There are a large number of investment vehicles that offer you good and stable returns. Products
like diversified mutual funds, blue chip stocks and property are some of them. But for high net
worth individuals (HNIs), there are more routes, especially in the international markets. Here we
look at one such vehicle, namely hedge funds. A hedge fund is a common term used to describe
private unregistered investment partnerships. Since most of them are not registered with financial
regulators in their countries of origin, they do not need to meet the eligibility requirements to
register as institutional investors. This is good in a way but could turn sour as well because there
are no guidelines binding them. At present, there are no hedge funds operating out of India. But
internationally, there are a large number of such funds.
These funds are very manager-centric as the entire onus of their success or failure falls on the
fund manager's ability to exploit existing market conditions. No wonder then that they charge a
fixed fee of around 2 per cent a year of assets under management, along with a very high profit
sharing percentage, which is mostly 20 per cent. Of course, they have to assure returns as well.
Thus, profit sharing may start on the returns over and above say, the first 10 per cent returns. The
fee is also based on a high watermarking concept, which means that the fund manager is entitled
to a share of profits the first time. Thereafter, if the fund incurs losses and then recoups, the fund
manager will not be entitled to any share of the recouped losses. The next time he will be entitled
is when he beats his earlier performance.
However, given the plethora of opportunities worldwide, the fund manager has the luxury of
making investment decisions in stocks, bonds, commodities, currencies etc. The basic idea is to
generate aggressive returns. The most important feature of hedge funds is that they seek to
deliver absolute, rather than benchmarked returns. For example, equity mutual funds are
benchmarked against an index like the Nifty or BSE 200, or a banking sector mutual fund could
benchmark its returns against the banking index on a stock exchange and can show the investors
how much better/worse he has performed. However, hedge funds managers do not have any such
luxuries.

Since they are not regulated, most countries do not allow them to raise money from the general
public through a prospectus or advertisements. A few are registered with the regulators in their
countries because their main investors are universities, pension funds and insurance companies.
Most of the marketing is done through investment advisors or personal contacts, with their main
investors being restricted to sophisticated HNIs. With the Reserve Bank of India [Get Quote]
(RBI) allowing Indian residents to invest up to $200,000 abroad per head a year, it is another
opportunity for HNIs to tap these funds as the minimum limit of many of them start from
$100,000. But you need to remember that the amount invested is not very liquid and may be
subject to a lock-in period, with quarterly, half-yearly or yearly exit windows.
Those seeking to invest in hedge funds can approach a wealth manager, securities broker or
investment consultant abroad, who can advise them on the available options and select the hedge
fund they wish to invest in, based on its track record and management style. After that they can
approach their bank in India to arrange for the foreign remittance to the hedge fund. Whenever
they wish to redeem their investment, as permitted by the hedge fund, they can repatriate the
proceeds to India into their bank account.

WHAT INfORMATION SHOUlD I SeeK If I AM CONSIDeRINg INVeSTINg IN A
HeDge fUND OR A fUND Of HeDge fUNDS?
• Read a fund's prospectus or offering memorandum and related materials. Make sure
you understand the level of risk involved in the fund's investment strategies and ensure
that they are suitable to your personal investing goals, time horizons, and risk tolerance.
As with any investment, the higher the potential returns, the higher the risks you must
assume.
• Understand how a fund's assets are valued. 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. You should
understand a fund's valuation process and know the extent to which a fund's securities are
valued by independent sources.
• Ask questions about fees. Fees impact your return on investment. Hedge funds typically
charge an asset management fee of 1-2% of assets, plus a "performance fee" of 20% of a
hedge fund's profits. A performance fee could motivate a hedge fund manager to take
greater risks in the hope of generating a larger return. Funds of hedge funds typically
charge a fee for managing your assets, and some may also include a performance fee
based on profits. These fees are charged in addition to any fees paid to the underlying
hedge funds.
• Understand any limitations on your right to redeem your shares. Hedge funds
typically limit opportunities to redeem, or cash in, your shares (e.g., to four times a year),
and often impose a "lock-up" period of one year or more, during which you cannot cash
in your shares.

• Research the backgrounds of hedge fund managers. Know with whom you are
investing. Make sure hedge fund managers are qualified to manage your money, and find
out whether they have a disciplinary history within the securities industry. You can get
this information (and more) by reviewing the adviser’s Form ADV. You can search for
and view a firm’s Form ADV using the SEC’s Investment Adviser Public Disclosure
(IAPD) website. You also can 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 where the
adviser's principal place of business is located. If you don’t find the investment adviser
firm in the SEC’s IAPD database, be sure to call your state securities regulator or search
the NASD's BrokerCheck database for any information they may have.
• Don't be afraid to ask questions. You are entrusting your money to someone else. You
should know where your money is going, who is managing it, how it is being invested,
how you can get it back, what protections are placed on your investment and what your
rights are as an investor. In addition, you may wish to read NASD’s investor alert, which
describes some of the high costs and risks of investing in funds of hedge funds.

What protections do i have if i purchase a hedge fund?
Hedge fund investors do not receive all of the federal and state law protections that commonly
apply to most registered investments. For example, you won't get the same level of disclosures
from a hedge fund that you'll get from registered investments. Without the disclosures that the
securities laws require for most registered investments, it can be quite difficult to verify
representations you may receive from a hedge fund. You 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.
The SEC can take action against a hedge fund that defrauds investors, and we have brought a
number of fraud cases involving hedge funds. Commonly in these cases, hedge fund advisers
misrepresented their experience and the fund's track record. Other cases were classic "Ponzi
schemes," where early investors were paid off to make the scheme look legitimate. In some of
the cases we have brought, the hedge funds sent phony account statements to investors to
camouflage the fact that their money had been stolen. That's why it is extremely important to
thoroughly check out every aspect of any hedge fund you might consider as an investment.

hedging strategies
Wide ranges of hedging strategies are available to hedge funds. For example:
• Selling short - selling shares without owning them, hoping to buy them back at a future
date at a lower price in the expectation that their price will drop.
• Using arbitrage - seeking to exploit pricing inefficiencies between related securities - for
example, can be long convertible bonds and short the underlying issuer’s equity.
• Trading options or derivatives - contracts whose values are based on the performance of
any underlying financial asset, index or other investment.
• Investing in anticipation of a specific event - merger transaction, hostile takeover, spin-
off, exiting of bankruptcy proceedings, etc.
• Investing in deeply discounted securities - of companies about to enter or exit financial
distress or bankruptcy, often below liquidation value.
• Many of the strategies used by hedge funds benefit from being non-correlated to the
direction of equity markets
popular Misconception
The popular misconception is that all hedge funds are volatile -- that they all use global macro
strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold,
while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most
hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no
leverage.

Benefits of hedge funds
• Many hedge fund strategies have the ability to generate positive returns in both rising and
falling equity and bond markets.
• Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and
volatility and increases returns.
• Huge variety of hedge fund investment styles – many uncorrelated with each other –
provides investors with a wide choice of hedge fund strategies to meet their investment
objectives.
• Academic research proves hedge funds have higher returns and lower overall risk than
traditional investment funds.
• Hedge funds provide an ideal long-term investment solution, eliminating the need to
correctly time entry and exit from markets.
• Adding hedge funds to an investment portfolio provides diversification not otherwise
available in traditional investing.
hedge fund styles
The predictability of future results shows a strong correlation with the volatility of each
strategy. Future performance of strategies with high volatility is far less predictable than
future performance from strategies experiencing low or moderate volatility.
Aggressive Growth: Invests in equities expected to experience acceleration in growth of
earnings per share. Generally high P/E ratios, low or no dividends; often smaller and
micro cap stocks which are expected to experience rapid growth. Includes sector
specialist funds such as technology, banking, or biotechnology. Hedges by shorting
equities where earnings disappointment is expected or by shorting stock indexes. Tends
to be "long-biased." Expected Volatility: High
Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies
in or facing bankruptcy or reorganization. Profits from the market's lack of understanding

of the true value of the deeply discounted securities and because the majority of
institutional investors cannot own below investment grade securities. (This selling
pressure creates the deep discount.) Results generally not dependent on the direction of
the markets. Expected Volatility: Low - Moderate
Emerging Markets: Invests in equity or debt of emerging (less mature) markets that
tend to have higher inflation and volatile growth. Short selling is not permitted in many
emerging markets, and, therefore, effective hedging is often not available, although
Brady debt can be partially hedged via U.S. Treasury futures and currency markets.
Expected Volatility: Very High
Funds of Hedge Funds: Mix and match hedge funds and other pooled investment
vehicles. This blending of different strategies and asset classes aims to provide a more
stable long-term investment return than any of the individual funds. Returns, risk, and
volatility can be controlled by the mix of underlying strategies and funds. Capital
preservation is generally an important consideration. Volatility depends on the mix and
ratio of strategies employed. Expected Volatility: Low - Moderate - High
Income: Invests with primary focus on yield or current income rather than solely on
capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives
in order to profit from principal appreciation and interest income. Expected Volatility:
Low
Macro: Aims to profit from changes in global economies, typically brought about by
shifts in government policy that impact interest rates, in turn affecting currency, stock,
and bond markets. Participates in all major markets -- equities, bonds, currencies and
commodities -- though not always at the same time. Uses leverage and derivatives to
accentuate the impact of market moves. Utilizes hedging, but the leveraged directional
investments tend to make the largest impact on performance. Expected Volatility: Very
High

Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking
offsetting positions, often in different securities of the same issuer. For example, can be
long convertible bonds and short the underlying issuers equity. May also use futures to
hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to
both the equity and bond markets. These relative value strategies include fixed income
arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund
arbitrage. Expected Volatility: Low
Market Neutral - Securities Hedging: Invests equally in long and short equity
portfolios generally in the same sectors of the market. Market risk is greatly reduced, but
effective stock analysis and stock picking is essential to obtaining meaningful results.
Leverage may be used to enhance returns. Usually low or no correlation to the market.
Sometimes uses market index futures to hedge out systematic (market) risk. Relative
benchmark index usually T-bills. Expected Volatility: Low
Market Timing: Allocates assets among different asset classes depending on the
manager's view of the economic or market outlook. Portfolio emphasis may swing widely
between asset classes. Unpredictability of market movements and the difficulty of timing
entry and exit from markets add to the volatility of this strategy. Expected Volatility:
High
Opportunistic: Investment theme changes from strategy to strategy as opportunities arise
to profit from events such as IPOs, sudden price changes often caused by an interim
earnings disappointment, hostile bids, and other event-driven opportunities. May utilize
several of these investing styles at a given time and is not restricted to any particular
investment approach or asset class. Expected Volatility: Variable
Multi Strategy: Investment approach is diversified by employing various strategies
simultaneously to realize short- and long-term gains. Other strategies may include
systems trading such as trend following and various diversified technical strategies. This
style of investing allows the manager to overweight or underweight different strategies to
best capitalize on current investment opportunities. Expected Volatility: Variable

Short Selling: Sells securities short in anticipation of being able to rebuy them at a future
date at a lower price due to the manager's assessment of the overvaluation of the
securities, or the market, or in anticipation of earnings disappointments often due to
accounting irregularities, new competition, change of management, etc. Often used as a
hedge to offset long-only portfolios and by those who feel the market is approaching a
bearish cycle. High risk. Expected Volatility: Very High
Special Situations: Invests in event-driven situations such as mergers, hostile takeovers,
reorganizations, or leveraged buyouts. May involve simultaneous purchase of stock in
companies being acquired, and the sale of stock in its acquirer, hoping to profit from the
spread between the current market price and the ultimate purchase price of the company.
May also utilize derivatives to leverage returns and to hedge out interest rate and/or
market risk. Results generally not dependent on direction of market. Expected Volatility:
Moderate
Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or
potential worth. Such securities may be out of favor or under followed by analysts. Long-
term holding, patience, and strong discipline are often required until the ultimate value is
recognized by the market. Expected Volatility: Low - Moderate

advantages of hedge funds over Mutual funds
Hedge funds are extremely flexible in their investment options because they use financial
instruments generally beyond the reach of mutual funds, which have SEC regulations and
disclosure requirements that largely prevent them from using short selling, leverage,
concentrated investments, and derivatives.
This flexibility, which includes use of hedging strategies to protect downside risk, gives
hedge funds the ability to best manage investment risks.
The strong results can be linked to performance incentives in addition to investment
flexibility. Unlike many mutual fund managers, hedge fund managers are usually heavily
invested in a significant portion of the funds they run and shares the rewards as well as risks with
the investors. "Incentive fees" remunerate hedge fund managers only when returns are positive,
whereas mutual funds pay their financial managers according to the volume of assets managed,
regardless of performance. This incentive fee structure tends to attract many of Wall Street’s best
practitioners and other financial experts to the hedge fund industry.
In the last nine years, the number of hedge funds has risen by about 20 percent per year and
the rate of growth in hedge fund assets has been even more rapid. Currently, there are estimated
to be approximately 8350 hedge funds managing $1 trillion. While the number and size of hedge
funds are small relative to mutual funds, their growth reflects the importance of this alternative
investment category for institutional investors and wealthy individual investors.

Hedge Funds Outperform Mutual Funds in Falling Equity Markets
S&P 500
VAN U.S. Hedge
Fund Index
Morningstar Average
Equity Mutual Fund
1Q90 -3% 2.20% -2.80%
3Q90 -13.70% -3.70% -15.40%
2Q91 -0.20% 2.30% -0.90%
1Q92 -2.50% 5.00% -0.70%
1Q94 -3.80% -0.80% -3.20%
4Q94 -0.02% -1.20% -2.60%
3Q98 -9.90% -6.10% -15.00%
3Q99 -6.20% 2.10% -3.20%
2Q00 -2.70% 0.30% -3.60%
3Q00 -1.00% 3.00% 0.60%
4Q00 -7.80% -2.40% -7.80%
1Q01 -11.90% -1.10% -12.70%
3Q01 -14.70% -3.80% -17.20%
2Q02 -13.40% -1.40% -10.70%
3Q02 -17.30% -3.60% -16.60%
3Q04 -2.30% 1.40% -1.70%
1Q05 -2.59% .10% -2.20%
Total -113.01% -10.30% -115.70%
During the last 18 years, the S&P 500 Index has had 17 negative quarters, totaling a negative
return of 113.01%. During those negative quarters, the average U.S. equity mutual fund had a
total negative return of 115.7%, while the average hedge fund had a total negative return of only
10.3%, displaying the ability of hedge funds to preserve capital in falling equity markets.

aBout WorKings of hedge funds
A hedge fund is a private investment fund charging a performance fee and typically open
to only a limited range of qualified investors. In the United States, hedge funds are open to
accredited investors only. Because of this restriction, they are usually exempt from any direct
regulation by regulatory bodies. Alfred Winslow Jones is credited with inventing hedge funds in
1949. [1]

As a hedge fund's investment activities are limited only by the contracts governing the particular
fund, it can make greater use of complex investment strategies such as short selling, entering into
futures, swaps and other derivative contracts and leverage.
As their name implies, hedge funds often seek to offset potential losses in the principal markets
they invest in by hedging via any number of methods. However, the term "hedge fund" has come
in modern parlance to be overused and inappropriately applied to any absolute-return fund –
many of these so-called "hedge funds" do not actually hedge their investments.
Hedge funds have acquired a reputation for secrecy. Unlike open-to-the-public "retail" funds
(e.g., U.S. mutual funds) which market freely to the public, in most countries, hedge funds are
specifically prohibited from marketing to investors who are not professional investors or
individuals with sufficient private wealth. This limits the information a hedge fund can legally
release. Additionally, divulging a hedge fund's methods could unreasonably compromise their
business interests; this limits the information a hedge fund would want to release.
Since hedge fund assets can run into many billions of dollars and will usually be multiplied by
leverage, their sway over markets, whether they succeed or fail, is potentially substantial and
there is a continuing debate over whether they should be more thoroughly regulated.
Industry
In 2005, Absolute Return magazine found there were 196 hedge funds with $1 billion or more in
assets, with a combined $743 billion under management - the vast majority of the industry's
estimated $1 trillion in assets.[2]
However, according to hedge fund advisory group Hennessee,
total hedge fund industry assets increased by $215 billion in 2006 to $1.442 trillion, up 17.5% on
a year earlier, an estimate for 2005 seemingly at odds with Absolute Return.
As large institutional investors have entered the hedge fund industry the total asset levels
continue to rise. The 2008 Hedge Fund Asset Flows & Trends Report [4]
published by
HedgeFund.net and Institutional Investor News estimates total industry assets reached $2.68
trillion in Q3 2007.

Fees
Usually the hedge fund manager will receive both a management fee and a performance fee (also
known as an incentive fee). Performance fees are closely associated with hedge funds, and are
intended to incentivize the investment manager to produce the largest returns possible.
Management fees
As with other investment funds, the management fee is calculated as a percentage of the net asset
value of the fund at the time when the fee becomes payable. Management fees typically range
from 1% to 4% per annum, with 2% being the standard figure. Therefore, if a fund has $1 billion
of assets at the year end and charges a 2% management fee, the management fee will be $20
million in total. Management fees are usually calculated annually and paid monthly.
Performance fees
Performance fees, which give a share of positive returns to the manager, are one of the defining
characteristics of hedge funds. In contrast to retail investment firms, performance fees are
prohibited in the U.S. for stock brokers.[citation needed]
A hedge fund's performance fee is calculated
as a percentage of the fund's profits, counting both unrealized profits and actual realized trading
profits. Performance fees exist because investors are usually willing to pay managers more
generously when the investors have themselves made money. For managers who perform well
the performance fee is extremely lucrative.
Typically, hedge funds charge 20% of gross returns as a performance fee, but again the range is
wide, with highly regarded managers demanding higher fees. In particular, Steven Cohen's SAC
Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons'
Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its
flagship Medallion Fund before returning all investors' capital and running solely on its
employees' money.[citations needed]
Managers argue that performance fees help to align the interests of manager and investor better
than flat fees that are payable even when performance is poor. However, performance fees have
been criticized by many people, including notable investor Warren Buffett, for giving managers

an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to
control this problem, fees are usually limited by a high water mark and sometimes by a hurdle
rate. Alternatively, the investment manager might be required to return performance fees when
the value of the fund drops. This provision is sometimes called a ‘claw-back.’
High water marks
A "High water mark" is often applied to a performance fee calculation.[5]
This means that the
manager does not receive performance fees unless the value of the fund exceeds the highest net
asset value it has previously achieved. For example, if a fund was launched at a net asset value
(NAV) per share of $100, which then rose to $130 in its first year, a performance fee would be
payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If
in the third year the NAV per share rises to $143, a performance fee will be payable only on the
extra $13 return from $130 to $143 rather than on the full return from $120 to $143.
This measure is intended to link the manager's interests more closely to those of investors and to
reduce the incentive for managers to seek volatile trades. If a high water mark is not used, a fund
that ends alternate years at $100 and $110 would generate performance fee every other year,
enriching the manager but not the investors. However, this mechanism does not provide
complete protection to investors: a manager who has lost money may simply decide to close the
fund and start again with a clean slate -- provided that he can persuade investors to trust him with
their money. A high water mark is sometimes referred to as a "Loss Carryforward Provision."
Poorly performing funds frequently close down rather than work without fees, as would be
required by their high water mark policies. [6]
Hurdle rates
Some funds also specify a hurdle rate, which signifies that the fund will not charge a
performance fee until its annualized performance exceeds a benchmark rate, such as T-bills or a

fixed percentage, over some period. This links performance fees to the ability of the manager to
do better than the investor would have done if he had put the money elsewhere.
Funds which specify a soft hurdle rate charge a performance fee based on the entire annualized
return. Funds which use a hard hurdle rate only charge a performance fee on returns above the
hurdle rate.
Though logically appealing, this practice has diminished as demand for hedge funds has
outstripped supply and hurdles are now rare.[citations needed]
Strategies
Hedge funds are no longer a homogeneous class. Under certain circumstances, an investor or
hedge fund can completely hedge the risks of an investment, leaving pure profit.[citation needed]
For
example, at one time it was possible for exchange traders to buy shares of, say, IBM on one
exchange and simultaneously sell them on another exchange, leaving pure profit.[citation needed]
Competition among investors has leached away such profits, leaving hedge fund managers with
trades that are partially hedged, at best. These trades still contain residual risks which can be
considerable. Some styles of hedge fund investing, such as global macro investing, may involve
no hedging at all. Strictly speaking, it is not accurate to call such funds hedge funds, but that is
current usage.
The bulk of hedge funds describe themselves as long / short equity, but many different
approaches are used taking different exposures, exploiting different market opportunities, using
different techniques and different instruments:
• Global macro – seeking related assets that have deviated from some anticipated
relationship.
• Arbitrage – seeking assets that are mispriced relative to related assets.
o Convertible arbitrage – between a convertible bond and the same company's
equity.
o Fixed income arbitrage – between related bonds.

o Risk arbitrage – between securities whose prices appear to imply different
probabilities for one event.
o Statistical arbitrage (or StatArb) – between securities that have deviated from
some statistically estimated relationship.
o Derivative arbitrage – between a derivative and its security.
• Long / short equity – generic term covering all hedged investment in equities.
o Short bias – emphasizing or solely using short positions.
o Equity market neutral – maintaining a close balance between long and short
positions.
• Event driven – specialized in the analysis of a particular kind of event.
o Distressed securities – companies that are or may become bankrupt.
o Regulation D – distressed companies issuing securities.
o Merger arbitrage - arbitrage between an acquiring public company and a target
public company.
• Other – the strategies below are sometimes considered hedge strategies, although in
several cases usage of the term is debatable.
o Emerging markets- this usually means unhedged, long positions in small overseas
markets.
o Fund of hedge funds - unhedged, long only positions in hedge funds (though the
underlying funds, of course, may be hedged). Additional leverage is sometimes
used.[citation needed]
o Quantitative
o 130-30 funds - Through leveraging, 130% of the money invested in the fund is
used to buy stocks. 30% of the money invested in the fund is used to short stock.
hedge fund risK
Investing in a hedge fund is considered to be a riskier proposition than investing in a regulated
fund, despite the traditional notion of a "hedge" being a means of reducing the risk of a bet or
investment. The following are some of the primary reasons for the increased risk:

Leverage - in addition to putting money into the fund by investors, a hedge fund will
typically borrow money, with certain funds borrowing sums many times greater than the
initial investment. Where a hedge fund has borrowed $9 for every $1 invested, a loss of
only 10% of the value of the investments of the hedge fund will wipe out 100% of the
value of the investor's stake in the fund, once the creditors have called in their loans. At
the beginning of 1998, shortly before its collapse, Long Term Capital Management had
borrowed over $26 for each $1 invested.
Short selling - due to the nature of short selling, the losses that can be incurred on a
losing bet are theoretically limitless, unless the short position directly hedges a
corresponding long position. Therefore, where a hedge fund uses short selling as an
investment strategy rather than as a hedging strategy it can suffer very high losses if the
market turns against it.
Appetite for risk - hedge funds are culturally more likely than other types of funds to take
on underlying investments that carry high degrees of risk, such as high yield bonds,
distressed securities and collateralised debt obligations based on sub-prime mortgages.
Lack of transparency - hedge funds are secretive entities. It can therefore be difficult for
an investor to assess trading strategies, diversification of the portfolio and other factors
relevant to an investment decision.
Lack of regulation - hedge funds are not subject to as much oversight from financial
regulators, and therefore some may carry undisclosed structural risks.
Investors in hedge funds are willing to take these risks because of the corresponding rewards.
Leverage amplifies profits as well as losses; short selling opens up new investment opportunities;
riskier investments typically provide higher returns; secrecy helps to prevent imitation by
competitors; and being unregulated reduces costs and allows the investment manager more
freedom to make decisions on a purely commercial basis.

legal structure
A hedge fund is a vehicle for holding and investing the funds of its investors. The fund itself is
not a genuine business, having no employees and no assets other than its investment portfolio
and a small amount of cash, and its investors being its clients. The portfolio is managed by the
investment manager, which has employees and property and which is the actual business. An
investment manager is commonly termed a “hedge fund” (e.g. a person may be said to “work at a
hedge fund”) but this is not technically correct. An investment manager may have a large number
of hedge funds under its management.
Domicile
The specific legal structure of a hedge fund – in particular its domicile and the type of entity used
– is usually determined by the tax environment of the fund’s expected investors. Regulatory
considerations will also play a role. Many hedge funds are established in offshore tax havens so
that the fund can avoid paying tax on the increase in the value of its portfolio. An investor will
still pay tax on any profit it makes when it realises its investment, and the investment manager,
usually based in a major financial centre, will pay tax on the fees that it receives for managing
the fund.
At the end of 2004 55% of the world’s hedge funds, accounting for nearly two-thirds of total
hedge fund assets, were established offshore. The most popular offshore location was the
Cayman Islands, followed by the British Virgin Islands, Bermuda and the Bahamas. The US was
the most popular onshore location, accounting for 34% of funds and 24% of assets. EU countries
were the next most popular location with 9% of funds and 11% of assets. Asia accounted for the
majority of the remaining assets.[citations needed]
the legal entity
Limited partnerships are principally used for hedge funds aimed at US-based investors who pay
tax, as the investors will receive relatively favorable tax treatment in the US. The general partner
of the limited partnership is typically the investment manager (though is sometimes an offshore

corporation) and the investors are the limited partners. Offshore corporate funds are used for
non-US investors and US entities that do not pay tax (such as pension funds), as such investors
do not receive the same tax benefits from investing in a limited partnership. Unit trusts are
typically marketed to Japanese investors. Other than taxation, the type of entity used does not
have a significant bearing on the nature of the fund.[7]
Many hedge funds are structured as master/feeder funds. In such a structure the investors will
invest into a feeder fund which will in turn invest all of its assets into the master fund. The assets
of the master fund will then be managed by the investment manager in the usual way. This
allows several feeder funds (e.g. an offshore corporate fund, a US limited partnership and a unit
trust) to invest into the same master fund, allowing an investment manager the benefit of
managing the assets of a single entity while giving all investors the best possible tax treatment.
The investment manager, which will have organized the establishment of the hedge fund, may
retain an interest in the hedge fund, either as the general partner of a limited partnership or as the
holder of “founder shares” in a corporate fund. Founder shares typically have no economic
rights, and voting rights over only a limited range of issues, such as selection of the investment
manager – most of the fund’s decisions are taken by the board of directors of the fund, which is
self-appointing and independent but invariably loyal to the investment manager.
Open-ended nature
Hedge funds are typically open-ended, in that the fund will periodically issue additional
partnership interests or shares directly to new investors, the price of each being the net asset
value (“NAV”) per interest/share. To realise the investment, the investor will redeem the
interests or shares at the NAV per interest/share prevailing at that time. Therefore, if the value of
the underlying investments has increased (and the NAV per interest/share has therefore also
increased) then the investor will receive a larger sum on redemption than it paid on investment.
Investors do not typically trade shares between themselves and hedge funds do not typically

distribute profits to investors before redemption. This contrasts with a closed-ended fund, which
has a limited number of shares which are traded between investors, and which distributes its
profits.
Listed funds
Corporate hedge funds often list their shares on smaller stock exchanges, such as the Irish Stock
Exchange, in the hope that the low level of quasi-regulatory oversight will give comfort to
investors and to attract certain funds, such as some pension funds, that have bars or caps on
investing in unlisted shares. Shares in the listed hedge fund are not traded on the exchange, but
the fund’s monthly net asset value and certain other events must be publicly announced there.
A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an
investment manager. Although widely reported as a "hedge-fund IPO"[8]
, the IPO of Fortress
Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it
managed.
Hedge fund management worldwide
In contrast to the funds themselves, hedge fund managers are primarily located onshore in order
to draw on larger pools of financial talent. The US East coast – principally New York City and
the Gold Coast area of Connecticut (particularly Stamford and Greenwich) – is the world's
leading location for hedge fund managers with approximately double the hedge fund managers
of the next largest centre, London. With the bulk of hedge fund investment coming from the US,
this distribution is natural.
London is Europe’s leading centre for the management of hedge funds. At the end of 2006,
three-quarters of European hedge fund investments, totalling $400bn (£200bn), were managed
from London, having grown from $61bn in 2002. Australia was the most important centre for the
management of Asia-Pacific hedge funds, with managers located there accounting for

approximately a quarter of the $140bn of hedge fund assets managed in the Asia-Pacific region
in 2006.[10]
regulatory issues
Part of what gives hedge funds their competitive edge, and their cachet in the public imagination,
is that they straddle multiple definitions and categories; some aspects of their dealings are well-
regulated, others are unregulated or at best quasi-regulated.
US regulation
The typical public investment company in the United States is required to be registered with the
U.S. Securities and Exchange Commission (SEC). Mutual funds are the most common type of
registered investment companies. Aside from registration and reporting requirements, investment
companies are subject to strict limitations on short-selling and the use of leverage. There are

other limitations and restrictions placed on public investment company managers, including the
prohibition on charging incentive or performance fees.
Although hedge funds fall within the statutory definition of an investment company, the limited-
access, private nature of hedge funds permits them to operate pursuant to exemptions from the
registration requirements. The two major exemptions are set forth in Sections 3(c)1 and 3(c)7 of
the Investment Company Act of 1940. Those exemptions are for funds with 100 or fewer
investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7
Fund"). [6] A qualified purchaser is an individual with over US$5,000,000 in investment assets.
(Some institutional investors also qualify as accredited investors or qualified purchasers.) [7] A
3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited
number of investors. Both types of funds can charge performance or incentive fees.
In order to comply with 3(c)(1) or 3(c)(7), hedge funds are sold via private placement under the
Securities Act of 1933. Thus interests in a hedge fund cannot be offered or advertised to the
general public, and are normally offered under Regulation D. Although it is possible to have
non-accredited investors in a hedge fund, the exemptions under the Investment Company Act,
combined with the restrictions contained in Regulation D, effectively require hedge funds to be
offered solely to accredited investors. An accredited investor is an individual with a minimum
net worth of US $5,000,000 or, alternatively, a minimum income of US$200,000 in each of the
last two years and a reasonable expectation of reaching the same income level in the current
year.
The regulatory landscape for Investment Advisors is changing, and there have been attempts to
register hedge fund investment managers. There are numerous issues surrounding these proposed
requirements. One issue of importance to hedge fund managers is the requirement that a client
who is charged an incentive fee must be a "qualified client" under Advisers Act Rule 205-3. To
be a qualified client, an individual must have US$750,000 in assets invested with the adviser or a
net worth in excess of US$1.5 million, or be one of certain high-level employees of the
investment adviser.

For the funds, the tradeoff of operating under these exemptions is that they have fewer investors
to sell to, but they have few government-imposed restrictions on their investment strategies. The
presumption is that hedge funds are pursuing more risky strategies, which may or may not be
true depending on the fund, and that the ability to invest in these funds should be restricted to
wealthier investors who are presumed to be more sophisticated and who have the financial
reserves to absorb a possible loss.
In December 2004, the SEC issued a rule change that required most hedge fund advisers to
register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers
Act. The requirement, with minor exceptions, applied to firms managing in excess of
US$25,000,000 with over 15 investors. The SEC stated that it was adopting a "risk-based
approach" to monitoring hedge funds as part of its evolving regulatory regimen for the
burgeoning industry. The rule change was challenged in court by a hedge fund manager, and in
June 2006, the U.S. Court of Appeals for the District of Columbia overturned it and sent it back
to the agency to be reviewed. See Goldstein v. SEC.
Although the SEC is currently examining how it can address the Goldstein decision,
commentators have stated that the SEC currently has neither the staff nor expertise to
comprehensively monitor the estimated 8,000 U.S. and international hedge funds. See New
Hedge Fund Advisor Rule. One of the Commissioners, Roel Campos, has said that the SEC is
forming internal teams that will identify and evaluate irregular trading patterns or other
phenomena that may threaten individual investors, the stability of the industry, or the financial
world. "It's pretty clear that we will not be knocking on [hedge fund] doors very often," Campos
told several hundred hedge fund managers, industry lawyers and others. And even if it did, "the
SEC will never have the degree of knowledge or background that you do.
In February 2007, the President's Working Group on Financial Markets rejected further
regulation of hedge funds and said that the industry should instead follow voluntary guidelines.

Comparison to private equity funds
Hedge funds are similar to private equity funds in many respects. Both are lightly regulated,
private pools of capital that invest in securities and compensate their managers with a share of
the fund's profits. Most hedge funds invest in relatively liquid assets, and permit investors to
enter or leave the fund, perhaps requiring some months notice. Private equity funds invest
primarily in very illiquid assets such as early-stage companies and so investors are "locked in"
for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition
funds.
Between 2004 and February 2006 some hedge funds adopted 25 month lock-up rules expressly
to exempt themselves from the SEC's new registration requirements and cause them to fall under
the registration exemption that had been intended to exempt private equity funds.
Comparison to u.s. mutual funds
Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to
invest). However, there are many differences between the two, including:
• Mutual funds are regulated by the SEC, while hedge funds are not
• A hedge fund investor must be an accredited investor with certain exceptions (employees,
etc.)

• Mutual funds must price and be liquid on a daily basis
Some hedge funds that are based offshore report their prices to the Financial Times, but for most
there is no method of ascertaining pricing on a regular basis. Additionally, mutual funds must
have a prospectus available to anyone that requests them (either electronically or via US postal
mail), and must disclose their asset allocation quarterly, while hedge funds do not have to abide
by these terms.
Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time
where the total returns are generated (net of fees) for their investors and then returned when the
term ends, through a passthrough requiring CPAs and US Tax W-forms. Hedge fund investors
tolerate these policies because hedge funds are expected to generate higher total returns for their
investors versus mutual funds.
Recently, however, the mutual fund industry has created products with features that have
traditionally only been found in hedge funds.
Mutual funds have appeared which utilize some of the trading strategies noted above. Grizzly
Short Fund (GRZZX), for example, is always net short, while Arbitrage Fund (ARBFX)
specializes in merger arbitrage. Such funds are SEC regulated, but they offer hedge fund
strategies and protection for mutual fund investors.
Also, a few mutual funds have introduced performance-based fees, where the compensation to
the manager is based on the performance of the fund. However, under Section 205(b) of the
Investment Advisers Act of 1940, such compensation is limited to so-called "fulcrum fees".[15]
Under these arrangements, fees can be performance-based so long as they increase and decrease
symmetrically.
For example, the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves,
within limits and symmetrically, similarly to a hedge fund "0 and 50" fee: A 0% management fee
coupled with a 50% performance fee if the fund outperforms its benchmark index. However, the
125 bp base fee is reduced (but not below zero) by 50% of underperformance and increased (but
not to more than 250 bp) by 50% of outperformance.

Offshore regulation
Many offshore centers are keen to encourage the establishment of hedge funds. To do this they
offer some combination of professional services, a favorable tax environment, and business-
friendly regulation. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin
Islands and Bermuda. The Cayman Islands have been estimated to be home to about 75% of
world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM[11]
.
Hedge funds have to file accounts and conduct their business in compliance with the
requirements of these offshore centres. Typical rules concern restrictions on the availability of
funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the
requirement for the fund to be independent of the fund manager.
Many offshore hedge funds, such as the Soros funds, are structured as mutual funds rather than
as limited partnerships.
Hedge Fund Indices
There are a number of indices that track the hedge fund industry. These indices come in two
types, Investable and Non-investable, both with substantial problems. There are also new types
of tracking product launched by Goldman Sachs and Merrill Lynch, "clone indices" that aim to
replicate the returns of hedge fund indices without actually holding hedge funds at all.
Investable indices are created from funds that can be bought and sold, and only Hedge Funds that
agree to accept investments on terms acceptable to the constructor of the index are included.
Investability is an attractive property for an index because it makes the index more relevant to
the choices available to investors in practice, and is taken for granted in traditional equity indices
such as the S&P500 or FTSE100. However, such indices do not represent the total universe of
hedge funds and may under-represent the more successful managers, who may not find the index
terms attractive. Fund indexes include BarclayHedge, Hedge Fund Research, Eurekahedge
Indices, Credit Suisse Tremont and FTSE Hedge.

The index provider selects funds and develops structured products or derivative instruments that
deliver the performance of the index, making investable indices similar in some ways to fund of
hedge funds portfolios.
Non-investable benchmarks are indicative in nature, and aim to represent the performance of the
universe of hedgefunds using some measure such as mean, median or weighted mean from a
hedge fund database. There are diverse selection criteria and methods of construction, and no
single database captures all funds. This leads to significant differences in reported performance
between different databases.
Non-investable indices inherit the databases' shortcomings, or strengths, in terms of scope and
quality of data. Funds’ participation in a database is voluntary, leading to “self reporting 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. This tends to lead to a clustering of returns around the
mean rather than representing the full diversity existing in the hedge fund universe. Examples of
non-investable indices include an equal weighted benchmark series known as the HFN Averages,
and a revolutionary rules based set known as the Lehman Brothers/HFN Global Index Series
which leverages an Enhanced Strategy Classification System.
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. As the HFR and CISDM databases began
in 1994, it is likely that they will be more accurate over the period 1994/2000 than the Credit
Suisse database, which only began in 2000.
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 favourable,
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”.

In traditional equity investment, indices play a central and unambiguous role. They are widely
accepted as representative, and products such as futures and ETFs provide liquid access to them
in most developed markets. However, among hedge funds no index combines these
characteristics. Investable indices achieve liquidity at the expense of representativeness. Non-
investable indices are representative, but their quoted returns may not be available in practice.
Neither is wholly satisfactory.
debates and Controversies
Privacy issues
As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to
third parties. This is in contrast to a fully regulated mutual fund (or unit trust) which will
typically have to meet regulatory requirements for disclosure. An investor in a hedge fund
usually has direct access to the investment advisor of the fund, and may enjoy more personalised
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. Several hedge funds are
completely "black box", meaning that their returns are uncertain to the investor.
Restrictions on marketing and the lack of regulation is that there are no official hedge fund
statistics. An industry consulting group, HFR (hfr.com), reported at the end of the second quarter
2003 that there are 5,660 hedge funds world wide managing $665 billion. For comparison, at the
same time the US mutual fund sector held assets of $7.818 trillion (according to the Investment
Company Institute).
Market capacity
Analysis of the rather disappointing hedge fund performance in 2004 and 2005 called into
question the alternative investment industry's value proposition. Alpha may have been becoming
rarer for two related reasons. 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 and more managers, which may dilute the talent available in the industry.

However, the market capacity effect has been questioned by the EDHEC Risk and Asset
Management Research Centre through a decomposition of hedge fund returns between pure
alpha, dynamic betas, and static betas.
While pure alpha is generated by exploiting market opportunities, the dynamic betas depend on
the manager’s skill in adapting the exposures to different factors, and these authors claim that
these two sources of return do not exhibit any erosion. This suggests that the market environment
(static betas) explains a large part of the poor performance of hedge funds in 2004 and 2005.
Systematic risk
Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital
Management (LTCM) in 1998, which necessitated a bailout coordinated by the U.S. Federal
Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM
disaster. The excessive leverage (through derivatives) that can be used by hedge funds to achieve
their return is outlined as one of the main factors of the hedge funds contribution to systematic
risk.
The ECB (European Central Bank) has issued a warning on hedge fund risk for financial stability
and systemic risk: "... the increasingly similar positioning of individual hedge funds within broad
hedge fund investment strategies is another major risk for financial stability which warrants close
monitoring despite the essential lack of any possible remedies. This risk is further magnified by
evidence that broad hedge fund investment strategies have also become increasingly correlated,
thereby further increasing the potential adverse effects of disorderly exits from crowded trades."
The Times wrote about this review: "In one of the starkest warnings yet from an official
institution over the role of the burgeoning but secretive industry, the ECB sounded a note of
alarm over the possible repercussions from any collapse of a hedge fund, or group of funds."
However, the ECB statement itself has been criticized by a part of the financial research
community. These arguments are developed by the EDHEC Risk and Asset Management
Research Centre: The main conclusions of the study are that “the ECB article’s conclusion of a
risk of “disorderly exits from crowded trades” is based on mere speculation. While the question
of systemic risk is of importance, we do not dispose of enough data to reliably address this

question at this stage”, “ it would be worthwhile for financial regulators to work towards
obtaining data on hedge fund leverage and counterparty credit risk. Such data would allow a
reliable assessment of the question of systemic risk”, and “besides evaluating potential systemic
risk, it should be recognised that hedge funds play an important role as “providers of liquidity
and diversification”.
The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge
funds in June 2007. The funds invested in mortgage-backed securities. The funds' financial
problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside
assistance. It was the largest fund bailout since Long Term Capital Management's collapse in
1998. The U.S. Securities and Exchange commission is investigating.
Performance measurement
The issue of performance measurement in the hedge fund industry has led to literature that is
both abundant and controversial. Traditional indicators (Sharpe, Treynor, Jensen) work best
when returns follow a symmetrical distribution. In that case, risk is represented by the standard
deviation. Unfortunately, hedge fund returns are not normally distributed, and hedge fund return
series are autocorrelated. Consequently, traditional performance measures suffer from theoretical
problems when they are applied to hedge funds, making them even less reliable than is suggested
by the shortness of the available return series.
Innovative performance measures have been introduced in an attempt to deal with this problem:
Modified Sharpe ratio by Gregoriou and Gueyie (2003), Omega by Keating and Shadwick
(2002), Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004), and
Kappa by Kaplan and Knowles (2004). An overview of these performance measures is available
in Géhin, W., 2006, The Challenge of Hedge Fund Performance Measurement: a Toolbox rather
than a Pandora’s Box, EDHEC Risk and Asset Management Research Center, Position Paper,
December. However, there is no consensus on the most appropriate absolute performance
measure, and traditional performance measures are still widely used in the industry.
Relationships with analysts

In June 2006. the U.S. Senate Judiciary Committee began an investigation into the links between
hedge funds and independent analysts, and other issues related to the funds. Connecticut
Attorney General Richard Blumenthal testified that an appeals court ruling striking down
oversight of the funds by federal regulators left investors "in a regulatory void, without any
disclosure or accountability." The hearings heard testimony from, among others, Gary Aguirre, a
staff attorney who was recently fired by the SEC.
Transparency
Some hedge funds, mainly American, do not use third parties either as the custodian of their
assets or as their administrator (who will calculate the NAV of the fund). This can lead to
conflicts of interest, and in extreme cases can assist fraud. In a recent example, Kirk Wright of
International Management Associates has been accused of mail fraud and other securities
violations which allegedly defrauded clients of close to $180 million.
impaCt of Hedge funds on Capital marKet
The hedge fund universe is expanding rapidly, with more than 7,300 funds managing some $1.7
trillion in assets by mid-2007. The three largest hedge funds each manages at least $30 billion in
investors' assets, and have estimated investment positions in financial markets of up to $100
billion. MGI projects that the value of hedge fund assets under management will more than
double over the next five years to $3.5 trillion.

Hedge funds have benefited capital markets by increasing liquidity and spurring financial
innovations. Yet worries persist that their growing size and heavy use of borrowing could
destabilize financial markets. When Long Term Capital Management ran into trouble in 1998,
the fund's catastrophic losses prompted the Federal Reserve to coordinate a $3.6 billion rescue by
a group of large banks.
More recently, several multibillion-dollar hedge funds suffered big losses in mid-2007 as rising
defaults on subprime mortgages caused turmoil in the debt and equity markets. Some smaller and
midsize funds shut down. So the question arises again: could a hedge fund meltdown trigger a
broader financial-market crisis?
MGI's research suggests that several developments over the past decade may have reduced—but
certainly not eliminated—the risks. Hedge funds have adopted more diverse trading strategies,
reducing the likelihood that many would fail simultaneously. The banks that lend to hedge funds
have improved their assessment and monitoring of risk, and they have reasonable financial
cushions—collateral and equity—to protect them in case one or more of their hedge fund clients
were to fail (as we saw last summer). The largest hedge funds have begun to raise permanent
capital in public stock and bond markets, while imposing more restrictions on investor
withdrawals—changes that should improve their ability to weather market downturns. Once
financial-market mavericks, hedge funds are joining the mainstream.
Private Equity
Private equity is a relatively small industry, but one that has had a disproportionately large
impact on the corporate world. The value of private-equity-owned companies is only 5 percent of
the value of companies listed in the U.S. stock markets (and just 3 percent in Europe). However,
private-equity firms now account for nearly one in three mergers or acquisitions. These firms
have grabbed public attention with a series of huge deals, including the buyouts of energy giant
TXU Corp. for $45 billion and health-care company HCA, Inc., for $33 billion.

Private-equity firms are ushering in a new model of corporate governance, and the best funds
improve the performance of many of the companies they buy. For instance, one study of 60
leveraged-buyout deals found that two-thirds of them improved company performance and
posted risk-adjusted returns of twice the industry average. Seeing superior returns in companies
taken private, shareholders of publicly listed companies are inclined to scrutinize the
performance of their respective managements more closely and demand improvements.
Although private-equity funds are sometimes accused of seeking short-term profits, most private-
equity funds invest on a three- to five-year horizon, giving them leeway to engage in root-and-
branch corporate restructuring. By adding debt to an acquired company's balance sheet, they
force managers to hit tough financial targets. As the pace of buyouts quickened earlier in 2007,
private-equity firms caused many public companies to rethink their attitudes toward debt and
equity—in the United States, for instance, companies have increasingly been choosing to buy
back shares, often purchasing them partly by raising levels of debt.
The recent tightening of credit markets has complicated the financing of some recent buyout
deals and may dampen the flow of investor money into private-equity firms. But even if growth
slows in the short term, MGI projects that the industry's assets will increase to $1.4 trillion by
2012. As the industry expands, private-equity firms will mature, consolidate, and diversify their
investments, amplifying their influence on the broader corporate and financial landscape.
These new power brokers are here to stay, and they are increasingly venturing into each other's
territory. Hedge funds are buying up companies. Asian central banks are starting to replicate the
sovereign wealth funds of oil exporters. Oil exporters are creating more-sophisticated investment
vehicles such as private-equity funds.
The concerns about the new power brokers are genuine—and may well be justified. But we
should make judgments based on the facts—not out of an emotional response to power's passing
to a new set of actors on the financial stage. There is cause for qualified optimism that the
benefits of liquidity, innovation, and diversification brought by the new players will outweigh
the risks.

role of Hedge funds in tHe Capital marKets
The role that hedge funds are playing in capital markets cannot be quantified with any precision.
A fundamental problem is that the definition of a hedge fund is imprecise, and distinctions
between hedge funds and other types of funds are increasingly arbitrary. Hedge funds often are
characterized as unregulated private funds that can take on significant leverage and employ
complex trading strategies using derivatives or other new financial instruments. Private equity

funds are usually not considered hedge funds, yet they are typically unregulated and often
leverage significantly the companies in which they invest. Likewise, traditional asset managers
more and more are using derivatives or are investing in structured securities that allow them to
take on leverage or establish short positions.
Although several databases on hedge funds are compiled by private vendors, they cover only the
hedge funds that voluntarily provide data. Consequently, the data are not comprehensive.
Furthermore, because the funds that choose to report may not be representative of the total
population of hedge funds, generalizations based on these databases may be misleading. Data
collected by the Securities and Exchange Commission (SEC) from registered advisers to hedge
funds are not comprehensive either. The primary purpose of registration is to protect investors by
discouraging hedge fund fraud. The SEC does not require an adviser to a hedge fund, regardless
of how large it is, to register if the fund does not permit investors to redeem their interests within
two years of purchasing them. While registration of advisers of such funds may well be
unnecessary to discourage fraud, the exclusion from the database of funds with long lock-up
periods makes the data less useful for quantifying the role that hedge funds are playing in the
capital markets.
Even if a fund is included in a private database or its adviser is registered with the SEC, the
information available is quite limited. The only quantitative information that the SEC currently
collects is total assets under management. Private databases typically provide assets under
management as well as some limited information on how the assets are allocated among
investment strategies, but they do not provide detailed balance sheets. Some databases provide
information on funds’ use of leverage, but their definition of leverage is often unclear. As hedge
funds and other market participants increasingly use financial products such as derivatives and
securitized assets that embed leverage, conventional measures of leverage have become much
less useful. More meaningful economic measures of leverage are complex and highly sensitive to
assumptions about the liquidity of the markets in which financial instruments can be sold or
hedged.
Although the role of hedge funds in the capital markets cannot be precisely quantified, the
growing importance of that role is clear. Total assets under management are usually reported to

exceed $1 trillion. Furthermore, hedge funds can leverage those assets through borrowing money
and through their use of derivatives, short positions, and structured securities. Their market
impact is further magnified by the extremely active trading of some hedge funds. The trading
volumes of these funds reportedly account for significant shares of total trading volumes in some
segments of fixed income, equity, and derivatives markets.
In various capital markets, hedge funds clearly are increasingly consequential as providers of
liquidity and absorbers of risk. For example, a study of the markets in U.S. dollar interest rate
options indicated that participants viewed hedge funds as a significant stabilizing force. In
particular, when the options and other fixed income markets were under stress in the summer of
2003, the willingness of hedge funds to sell options following a spike in options prices helped
restore market liquidity and limit losses to derivatives dealers and investors in fixed-rate
mortgages and mortgage-backed securities. Hedge funds reportedly are significant buyers of the
riskier equity and subordinated tranches of collateralized debt obligations (CDOs) and of asset-
backed securities, including securities backed by nonconforming residential mortgages.
At the same time, however, the growing role of hedge funds has given rise to public policy
concerns. These include concerns about whether hedge fund investors can protect themselves
adequately from the risks associated with such investments, whether hedge fund leverage is
being constrained effectively, and what potential risks the funds pose to the financial system if
their leverage becomes excessive.
Investor Protection
Hedge funds and their investment advisers historically were exempt from most provisions of the
federal securities laws. Those laws effectively allow only institutions and relatively wealthy
individuals to invest in hedge funds. Such investors arguably are in a position to protect
themselves from the risks associated with hedge funds. However, in recent years hedge funds

Hedging funds & its impact on capital market

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