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Hedge Funds – It’s really about Investing in the Manager

November 1, 2012 in Hedging and Hedge Funds

Hedge fund manager and Hedge fund investment

This is our concluding article on hedge funds, and a brief recap is in order.

We looked at what hedge funds are, their different kinds, the pros and cons of investing in them, a hedge fund gone wrong (LTCM), one of the most successful hedge funds in history (Bridgewater) and the fees structure of a typical fund.

By definition, hedge funds are higher-risk vehicles, often using large amounts of leverage, but able to deploy funds across a wide variety of assets, some of which may be illiquid, requiring the investor to lock in funds for extended periods of time. Since the hedge fund manager is paying himself first, and as we saw, his fees can be quite a packet, the manager must earn high returns to justify his fees and thereafter also provide a decent return to the investor. Yet, all of this must be achieved with acceptable risk!

All this leads us to an inescapable conclusion: most everything depends upon the abilities of the hedge fund manager – selecting the investment, determining the entry point, nursing the position, keeping risk at bay and finally closing the transaction with a decent profit without leaving too much on the table.

That takes some doing. It means you must be sure that the hedge fund manager has what it takes to achieve all of the above and some more.

An investment in a hedge fund is really an investment in a manager and the specialized talent he possesses to capture profits from a unique strategy.–– Sanford J. Grossman, The Wall Street Journal, September 29, 2005

Clearly, you are investing in the manager’s abilities. And you are duty-bound to your investment to conduct a sort of ‘due diligence’ of the hedge fund manager, as far as possible. How to do that?


Take a look at the educational qualifications of the manager. A good college record, preferably an MBA qualification, is a must for in depth understanding of the complex financial markets of the day. Studies have shown that better qualified managers earn better returns, gain more inflows into their funds and manage risk better.


The manager’s track record of managing funds should give you a picture of his abilities. Adequate experience is a must for managing funds, and to do so efficiently and with risk under control. Returns achieved on previous funds managed by him could provide a pointer to what to expect in the current fund.


Look up the manager’s standing in the market – that should not be too difficult a task in these days of the Internet, Facebook, LinkedIn and what-have-you.

SEC Registration

Check that the manager is registered with the SEC as an investment manager. This means some screening of their background has already been carried out by the government.

Manager’s Own Investment

Hedge funds are very entrepreneurial in nature and most often their own managers also invest alongside outside investors. So, check that whether the hedge fund manager has also put his money where his mouth is! A substantial investment by the manager should be a source of comfort to you.

These actions should at least help to point you in the right direction, and avoid getting into funds that may be frauds or scams, at the very least, and maybe some decent returns otherwise.


Hedge Funds – Where are the Customers’ Yachts?

October 30, 2012 in Hedging and Hedge Funds

Hedge funds Broker commissions and profits

An oft-quoted nugget from financial literature goes as follows:

A young man, about to be recruited into the financial markets, was being shown around New York and was shown some smart yachts anchored at the Battery. “Those are the yachts owned by the bankers, and there, those are the ones owned by the brokers,” said his guide.

“Nice,” said the novice, who then naively asked, “And… where are the customers’ yachts?”

The anecdote above is quoted here, in this chapter on the fees charged by hedge funds.

How do hedge funds charge their investors?

Most commonly, the fees charged by a hedge fund are of two kinds. One is a “management fee,” charged to meet the costs of operating and maintaining the fund. This fee is charged as a percentage of the value of assets under management, and is most often levied on a quarterly basis. The fee varies from fund to fund, but is usually in the range 1 – 2%.

The other fee, known as a “performance fee,” is charged by the fund for generating the returns on the investor’s fund, and is a sort of incentive payment for the deployment of the skills of the hedge fund manager. Calculated as a percentage of the profits achieved, the fee is governed by the terms and conditions specified in the offer documents of the fund. In some cases these fees are only payable if the manager grows the assets (i.e. earns returns) above the previous “high water mark,” i.e. the previous level up to which the manager has been paid the performance fee. Since the manager is not required to refund fees in the case of losses, new fees become payable only when the losses are recouped and the fund value becomes profitable again by crossing the high water mark.

Again, some terms specify that performance fees would be payable only on returns earned in excess of a certain, usually risk-free rate of return, called a “benchmark” rate.

The performance fee also varies from fund to fund, but the most common levy is 20% of the growth achieved.

From the above it is clear that the standard hedge fund fees structure is usually a 2% management fee plus a 20% performance fee – in hedge fund parlance this is known as a “two-and-twenty” structure.

It is imperative that you understand the implications of the fee plan. Get this: As an investor in a two-and-twenty fund, you will only earn returns after the hedge fund fees are paid. That means the hedge fund has to earn very high returns. That’s a tall order when world-wide interest rates are ruling at near-zero rates. This means that the manager will have to take very high risks with your money.

This also means that the manager has to be very good at reading and trading the markets.

This also means that you have to be doubly careful about the selection of your hedge fund.

Let us illustrate the two-and-twenty structure with an example below, which shows a fund starting with an investment of $1 billion and its performance for six years:

Starting AUM (Assets Under Management):







Return %







Gross Aum





















*Fees Calculation
Growth Amount







Perf fee (On Growth Amt)







Mgt Fee (On Opg. AUM)








Total Fee







Net Result After 6 Years
Client Earnings


Hedge Fund Mgr Earnings



See the point? After six years, the client had a loss of $189 million to show for the money invested and risks assumed. On the other hand, the hedge fund managers romped home with $279 million in fees.

No surprises then that there were no customers’ yachts in the harbor!

The Story of Bridgewater Associates – Hedge Funds

October 28, 2012 in Hedging and Hedge Funds

Hedge funds - the story of Bridgewater Associates

From a January, 2008, newsletter by Bridgewater Associates cited in The New Yorker:

“If the economy goes down, it will not be a typical recession.” Rather, it would be a disaster in which “the financial deleveraging causes a financial crisis that causes an economic crisis. . . . This continues until there is reflation, currency devaluation and government guarantees of the efficacy of key financial intermediaries.”

That is prophetic as shown by subsequent events.

Bridgewater Associates, run by legendary hedge fund manager, Ray Dalio, is one of the most successful hedge funds ever. A ‘global macro’ firm, the firm manages about $130 billion in assets, primarily for institutional clients such as pension funds, endowments, charities and sovereign funds.

Ray Dalio founded the firm in 1975, commencing business from a two-bedroom apartment. The son of a jazz musician, he earned a side income as a golf caddy and often received stock tips from wealthy golfers. By age 12 he had made his first stock investment, and grew that to an investment worth a few thousand dollars by the time he entered college. He obtained a BA degree from Long Island University and an MBA from Harvard. He then served a short stint as a futures trader, and thereafter set up Bridgewater at age 25.

The firm currently operates out of a wooded, secluded and waterside headquarters located in Westport, CT, and has about 1200 employees. Bridgewater was ranked in 2010 and in 2011 as the biggest and best-performing hedge fund manager in the world.

Bridgewater Associates



The firm is known for its adept understanding of economic trends and events globally, and takes advantage of these macro moves by making trades in a huge variety of assets and markets around the world.  Dalio abhors risk, and its natural cousin, excessive leveraging. Key to his investing strategy is the dilution of risk by the means of innovative and varying distribution of assets (allocation), and a strict avoidance of excessive leverage. Where other hedge funds go for big-hit, ‘home-run’ returns, Bridgewater is known to take the route of smaller, but less riskier returns, generated over and over again.

The firm became a pioneer in its field by introducing strategies such as inflation-linked bonds, currency overlay and was the first to segregate its funds between and alpha (actively managed, higher returns) and beta (passively managed, standard market returns) investments. Its flagship funds were the Pure Alpha Fund and the All Weather Fund.

Starting from about $5 million in the nineties, assets under management (AUM) reached $33 billion by year 2000 and then onto $50 billion by 2007. The launch of the Pure Alpha Major Markets Fund catapulted AUM past the $100 billion mark in 2010.

The firm is reputed for its slightly off-beat (sometimes described as cult-like in the media)  management policies that demand complete transparency and adherence to a set of ‘Principles’ authored by Dalio that effectively dominates its culture, and methods of operation. Reportedly, these Principles are also linked into the computer system and used for investment analysis. All meetings are recorded electronically and are available to be viewed for training and analysis.

The firm’s Pure Alpha Fund earned over $13.8 billion during 2011. This brought the fund’s total earnings since its inception in 1975 to $35.8 billion, taking it past the $31.2 billion that was earned by Soros’ Quantum Fund between 1973 and 2011.

Hedge Funds – The Story of Long Term Capital Management

October 26, 2012 in Hedging and Hedge Funds

Hedge fund and long term capital management







This chapter is all about how a seemingly ‘can’t-do-wrong’ hedge fund went bust, and whose sheer size sent tremors down Wall Street and the financial markets, so much so that the government had to step in and take matters in hand to avoid a financial meltdown.

Long Term Capital Management, a hedge fund manager, was started in 1994 by John W Meriwether, who was at one time the head of bond trading at Salomon Brothers.

Meriwether included top bond traders from Salomon Brothers in the management of LTCM as well as cutting edge economists such as Myron S Scholes and Robert C Merton, who later went on to win the Nobel Prize. The investable funds were held in a Cayman Island registered partnership called Long-Term Capital Portfolio LP. With the help of Merrill Lynch the firm was able to raise capital of about $1 billion by February 1994.

Starting out with fixed income arbitration deals, LTCM gradually branched out to other trades such as merger arbitrage, interest rate swaps and options, because the firm soon exhausted available opportunities in fixed income. Meanwhile funds continued to pour in and the pressure to turn out market beating profits grew. Ultimately the firm had to take recourse to deals in which the spread was small but which required substantial funds for implementation. LTCM soon had a huge amount of debt on its books and by 1998 this figure had grown to $124.5 billion. Apart from this, LTCM also had over $1 trillion worth of open positions in interest rate derivatives and swaps. But so far, the fund had managed to keep a good record with investors getting returns of about 40% per annum.

In September 1998, the Russian government defaulted on their bonds causing international turmoil in the bond markets. Investors bailed out of bonds such as those issued by Japan and Europe, and piled into safe haven bonds issued by the United States. This turmoil caused huge variances in the prices of bonds and inflicted massive losses on LTCM – which lost about $1.85 billion of its capital.

In a domino effect, the fund had to bail out of other positions, many at a substantial loss because it was no longer possible to hold those trades for the time required to make a profit. Panicked investors headed for the exits, and this resulted in LTCM’s equity crashing from $2.3 billion to about $400 million in that same month.

It was a sobering example of how market realities could crush number-crunching and “just-can’t-fail” trades supported by the best financial brains and executed by star traders.

Unfortunately, the ramifications of the LTCM debacle stretched far beyond the firm itself and its investors. The huge debts, as well as the portfolio losses, could now unhinge Wall Street itself because of their sheer size and the chain reaction that could be set up in the form of end to end defaults.

After a rescue attempt organized by Goldman Sachs, Warren Buffett and AIG fizzled out, the Federal Reserve Bank of New York had to step in and organize a bailout of LTCM through various banks. Sounds familiar?

The bailout enabled the fund to continue its operations until 2000 by which time the money invested by the rescuers was repaid and the fund liquidated.

Why did we tell you this story? It’s because we want to tell it as it really is – in the financial markets, as also hedge funds, risk lurks around the corner, and you should be well aware of it.

We will continue with the good, bad and ugly of the hedge fund industry. Coming up next is the story of Bridgewater Associates, one of the most successful hedge funds in history.

You may also check:

1) Types of Hedge Funds

2) Hedge Funds – Pros & Cons


Hedge Funds – Pros and Cons

October 24, 2012 in Hedging and Hedge Funds

Pros and Cons of Hedge Funds








Before you start looking at hedge funds as your ticket to financial nirvana, it would be useful to understand the arguments both for, and against investing in hedge funds. As they say, buyers beware!

Hedge Funds – The Arguments “Against”

One of the most common grounds for criticising hedge funds is their high cost to the investor. Apart from a basic account fee, investors also have to shell out performance fee. Taken together, these charges could be very high, sometimes as high as 50%! In the case of a Fund of Funds, another layer of fees is added to the charges incurred on the underlying funds.

Hedge funds are not easily accessible to the average retail investor, and their doors are only open usually to well-heeled, “accredited” investors who are financially savvy and able to weather the risks of investing in a hedge fund. These investors are able to meet the criteria of a minimum size of investment (which can be very high) and agree to lock-in periods for extended lengths of time.

Hedge funds are usually cagey about publicly disclosing their trading strategies and portfolios. So the average investor, used to a far greater transparency such as in mutual funds, may find it difficult to get as much information as he may desire. Often these strategies are highly complex and proprietary, and very difficult to understand.

The low level of accountability results in frequent cases of fraud, such as the alleged activities of Bernie Madoff. The investor may find it difficult to conduct a suitable due diligence, and hence may lose money to con artists and fraudsters.

Hedge funds are loosely regulated and do not need to register themselves with the SEC, and hence are not required to submit periodic returns which may highlight problems in advance, and allow an investor to bail out in time. Protection available to investors such as for bank deposits is not available on hedge fund investors.

Typically, a hedge fund uses borrowed capital or utilises derivatives to magnify the possible gains on its strategies. Called “leveraging,” this also inflicts huge losses if the bets go wrong. Hedge funds are therefore not suitable for investors who do not have the stomach for such gut-wrenching losses.

Hedge Funds – The Arguments “For”

Hedge funds are able to operate much more flexibly compared to other vehicles, and can therefore generate returns higher than the market and other more conservative avenues such as mutual funds and ETFs. A competent hedge fund manager may generate returns that would be above average even after the higher fee component.

The high fees may be looked at from another angle – the performance fees/bonus is actually an incentive to the manager to earn greater returns, with the investor being the resultant beneficiary.

Hedge funds, as their name suggests, can effectively ‘hedge’ risks and volatility, and therefore may manage competently the higher leverage in their control. In such a situation the investor is in a situation where risk is controlled but the door to higher returns is nevertheless open.

A hedge fund can offer a diversity of investment strategies that an individual investor would not be able to implement by himself. As the hedge fund may deploy a specialist manager for each such strategy or investment pool, the investor has access to a cross-section of expertise.

There, now you have both sides of the coin for Pros and Cons of Hedge Funds!

You may also check:

1) What are Hedge Funds?
2) Types of Hedge Funds
3) Hedge Fund and Long-term Capital Management


Types of Hedge Funds

October 23, 2012 in Hedging and Hedge Funds

Various types of hedge funds










Now that you have an understanding of what hedge funds are, let’s look at their different kinds.

Hedge fund categories and types

Hedge funds may be broadly categorised as follows:

Equity – directional hedge funds are focused on stocks and maybe long– or short– oriented. On a net basis, these funds are either long or short in their exposure to stocks. Typically, these could also have a regional or country focus – e.g. ‘Asia/Pacific,’ ‘China,’ ‘US’ etc. or ‘Emerging Markets.’

Debt – directional hedge funds focus on fixed income and debt products, and maybe long or short, but usually are seen to be net long. So you could have hedge funds here that could be long or short or long only. Here too there could be a focus on regional or country-specific debt.

Event-based hedge funds look to generate returns by taking positions in specific situations or events, e.g. mergers and acquisitions, bankruptcy proceedings, distressed asset sales, distressed securities, corporate events such as stock repurchase, dividends and other types.

Global derivative hedge funds, as the name suggests, have a global arena, and use derivatives and other financial instruments to profit from currency movements and macro developments. Another kind is a fund that uses technical analysis and computer-system driven trades to profit from changing trends. These funds may trade a huge variety of assets such as commodities, bonds, interest rate instruments and various types of indices.

Multi-strategy hedge funds are hedge funds that employ various strategies to take advantage of emerging developments in the markets, and do not restrict themselves to a particular strategy or focus. Hence a single fund may be practicing many different investment techniques, each overseen by a specialist manager. Fund of Funds (a fund that invests in other funds) may effect multi-strategy through investing in a variety of specialized hedge funds, each with a different strategy.

Relative value hedge funds seek to profit from miss-pricing or other market inefficiencies that result in a pricing imbalance between pairs of related securities – the fund will buy the under-priced security and short the over-priced one. For example a Convertible Arbitrage fund would look to make a return from a pricing anomaly between a company’s stock and its convertible bond or debenture. Similarly, debt- and diversified arbitrage funds look for such opportunities in global debt markets or across different, but linked asset classes.

Type-wise Fund Assets Under Management

Here’s a graphic illustration of the distribution of the hedge fund AUM across different types as at the end of the Second Quarter of 2012 using data sourced from BarclayHedge.

These categories may change as global sentiments change. It can be seen, for instance, that AUM (Asset Under Management) in the hedge fund category of Fixed Income is the highest at $229.2 billion – this shows investors’ preference for a safer asset category in these troubled times of debt crisis and a global slowdown.

In a ‘risk-on’ environment you would find that funds would flow in greater measure to the equity oriented funds.

Maybe the above discussion would help you find your own fund type – one that meets your investing and risk preferences. Stay tuned as we delve more into hedge funds in later chapters.

You may also check:

1) What are Hedge Funds?
2) Hedge Funds – Pros & Cons
3) Hedge Fund and Long-term Capital Management

What are Hedge Funds?

October 20, 2012 in Hedging and Hedge Funds

Hedge fund deninition







That’s not a hedge fund! A real hedge fund has little to do with plants and vegetation, and plenty to do with the other green stuff – your investment dollars, a.k.a, greenbacks.

Hedge Fund Definition and Description

A hedge fund is in fact a specialized investment vehicle, but strangely, a regulatory definition of the term ‘hedge fund’ is hard to find. But here is one from the SEC:

“Form PF defines “hedge fund” generally to include any private fund having any one of the three common characteristics of a hedge fund: (a) a performance fee that takes into account market value (instead of only realized gains); (b) high leverage; or (c) short selling.”

Thus a hedge fund may pay its advisers a remuneration (performance fee) that is calculated regardless of the gains actually realized, and based on the market value of the assets under management. Again, the hedge fund may be heavily borrowed, or have very high exposure in the markets through the use of derivatives or other instruments. Lastly the fund indulges in short-selling (selling a security or asset it does not possess – yes, that is possible!).

But let us not stay within the confines of this definition and look at some more characteristics of this investing vehicle.

Hedge funds are usually privately held and raise their funds directly from investors (often called “accredited” investors who may be wealthy individuals or institutions) and are not listed on an exchange. Retail investors generally do not get access because of their relative financial unsophistication and limited resources.

Investors are usually bound by the rules of the hedge fund, which may be specific and unique to the fund, and this may result in a reduction in the liquidity of the investment – often there are restrictions on redemption, such as ‘lock-up’ periods.

So far, hedge funds have been lightly regulated and taxed, but after the financial crisis of 2008, there have been persistent demands for more comprehensive regulation of hedge funds and this may happen in the not too distant future.

Hedge funds have acquired immense financial power in recent years, as their free-wheeling investing and speculative style along with nimble-footed trading in various asset classes, which is substantially unfettered by geographic or regional boundaries, allows them to generate super-normal returns. That is not to say that they are infallible – investors have burnt their fingers with hedge funds too – the famous case of Long Term Capital Management and its spectacular implosion springs immediately to mind. No matter that it was run by Nobel Prize winners and elite traders!

Talking of elite traders, hedge funds are known to employ the best financial and trading brains in the management of their investments, which is why the performance fees in many cases are very high, sometimes as much as 20-25%, almost like a partnership. Hedge funds are also able to invest in cutting edge equipment, technology and software that give them an edge in evaluating, trading and monitoring off-the-beaten-track assets and investments.

Hedge Funds Market Size

According to data from research firm BarclayHedge, hedge fund assets under management (AUM) grew from $118.23 billion in 1997 to $1.7089 trillion by the end of the second quarter of 2012.

Hedge funds assets under management (Hedge fund AUM)

More recent data for the third quarter of 2012 according to a Press Release from Hedge Fund Research says that total hedge fund assets as at the end of the third quarter 2012 stood at a record $2.19 trillion!

These figures look like an astonishing growth story, but experts estimate that this is still a small percentage of the total non-hedge fund assets under management out there.

Returns on Hedge Funds

For all their high profile and size, what did hedge funds earn for their investors?

The chart below shows returns have been fairly good though somewhat erratic and decidedly bad during the 2008 financial crisis and in 2011, when the European debt crisis took center-stage.

Return on Hedge funds

Hedge Funds – Me?

O.K. so you may not yet be ready to entrust your hard-earned dollars to a hedge fund manager, but yet, even as an ordinary retail investor, it pays to understand hedge funds and their often market-moving strategies. A wealth of information is available on their investments through statutory filings and also reports in the press – these could help to sharpen your own investment focus and make you a better market player. You could study and read about legendary hedge fund managers and how they made their billions.

And take heart: No less a person than David Rubenstein, co-founder of buy-out firm Carlyle Group LP feels it is only a matter of time before the ordinary investor would gain access to firms such as his, hedge funds and alternative investment vehicles.

So, keep reading, and stick with us as we bring you more on hedge funds in this series.

You may also check:

1) Types of Hedge Funds
2) Hedge Funds – Pros & Cons
3) Hedge Fund and Long-term Capital Management