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First Hedge FundFormed by Alfred Winslow Jones in 1949
Started with $100,000Between 1955-1965 had returns of 670%
Primarily long positions, but also short
Hedge Fund a private investment vehicle that
engages in the active trading of various types of securities and commodities, employ sophisticated investment techniques, such as arbitrage, leverage, and hedging and whose structure and operations are designed to promote the goal of absolute returns.
Pooled/Partnerships of Investment advisors registered with the Securities & Exchange Commission Frequently invested in one or more upper
tier partnerships Low turn over of investments Low turn over of partners and partners are
often committed to additional contributions There are usually no distributions until
investment in upper tier is sold
Former Math ProfessorCode Breaker for
Department of DefenseUses computer driven models to
detect pricing anomalies in stocks,commodities, futures, and options
Charges 5 and 44Earns over 20% for his partners over
a multi-year period
Worked in mergers & acquisitions at Bear Stearns
Founded his own hedge fundwith $2 million and 2 employees
Under his direction, Paulson & Co. capitalized on the problem in the foreclosure and mortgage backed
securities market In 2007 alone his firm earned $15 billion! He
personally made $3.7 billion
In 2008, his firm hired former Fed Chairman, Alan Greenspan
Management Fee% of total assets in fund usually 2%
Incentive Fee % of net income – usually 20% High water mark –
Meaning no compensation for manager if he/she has net income in year one but, falls behind in year 2, than no more incentive until he gets back to where he was.
High water mark may only apply for 2 years
Absolute Return Strategy vs. Relative Return Strategy Relative is relative to something else, i.e.,
Standard & Poors You can’t eat relative returns! Absolute returns stand alone Alpha producing returns not tied to an
index
Four Primary Characteristics Organized as partnerships with the General Partner
having a significant investment Managers are compensated based on fund
performance Investors purchase interest in fund for a % of a fund
profit.Interests are significant, restricted transferability and
limited redemption Provide liquidity and capital to the market place• A role that has been vacated by the large brokerage firms
as they have shut down their proprietary trading desks
Limited Partnerships/LLCFees typically are 2 and 20Normally utilize a high water mark or
hurdle rate Claw back provision
No rules Unlimited types of investments Shorts permitted Margins permitted
Limited redemption opportunitiesGoverned by the partnership agreementApproximately 8,000 hedge funds with
more than $2.68 trillion currently
Types of Funds Fund of Funds Master Feeder Funds• Assets are pooled into one account and managed as a single
portfolio• Profits and losses are allocated on where funds come from
(capital contributions/distributions) 3(c)(7) Fund– under 500 investors, limited to only
qualified investors (investors with over $5 million in liquid, investable assets)
3(c)(1) Fund– under 100 investors and limited to 35 non-accredited sophisticated investors (accredited investors have excess of $200,000 of annual income or a minimum of $1 million in net worth exclusive of Primary residence
Except for the exemption under Sec. 3(c)(1) or Sec. (c)(7) above, hedge funds would fall under the regulations for regulated investment companies
Entry normally limited to yearly, quarterly, or monthly per partnership agreement
Sold through a private placement memorandum Partnership Agreement Subscription Agreement
Administration/Operations Prime Broker• Execution of trades done monthly through
trading screens piped through the internet to a broker• Provides portfolio reporting, securities lending,
office space, technology help, leverage, etc. Hedge Fund Hotels• Could be the prime broker or a non-clearing
broker• Provides office space, computer, and the rest
of build out in the office quarters
Administrator Provide general ledger accounting The allocation of income and expenses and
gains and losses to the partners Calculation of management and incentive
fees, high-water-marks and hurdle rates There is an interface between what the
prime broker provides and what the administrator provides• The prime broker often provides a special
trade date run that complies with U.S. GAAP
Accounting Break Period• Occurs as partners ownership percentages
changes through purchases and redemptions Aggregate Method vs. Layering Method• The Aggregate Method does not take into
account each partners individual portion of unrealized gain or loss for each security held by the fundAllocations are based on the unrealized gain or
loss of the partnership’s securities as a whole• The Layering Method accounts for each
partner’s share of unrealized gain or loss generated on each security over a period of time
Rule 206(4), an investment advisor registered with the Sec and acting as general partner to a pooled investment vehicle, such as a hedge fund, and has custody of the client’s assets is subject to this rule. 1
Must maintain client’s funds and securities with a qualified custodian
Must be audited annually Must distribute audited U.S. GAAP financial statements to
all investors within 120 days of the end of the fiscal year or 180 days for Fund-of-Funds
Must have a compliance officer
1 Hedge funds must register with the Securities and ExchangeCommission when they have $100 million in assets.