Hedge Funds

Hedge Funds generally:

• Use leverage.
• Take both long and short positions.
• Use derivatives for speculation or hedging portfolio risk.

In addition to the structures for limited partnerships and types of fees paid to the general partner we have covered, hedge funds typically have restrictions on limited partner redemptions. A lockup period is the time after initial investment over which limited partners either cannot request redemptions or incur significant fees for redemptions (a soft lockup). A notice period (typically between 30 and 90 days) is the amount of time a fund has to fulfill a redemption request made after the lockup period has passed.

Hedge fund managers often incur significant transactions costs when they redeem shares. Redemption fees can offset these costs. Notice periods allow time for managers to reduce positions in an orderly manner. Redemptions often increase when hedge fund performance is poor over a period, and the costs of honoring redemptions may further decrease the value of the remaining partnership interests. This is an additional source of risk for hedge fund investors.

A fund-of-funds ⇒ is an investment company that invests in hedge funds. Fund-of-funds investing can give investors diversification among hedge fund strategies, can provide expertise in selecting individual hedge funds, and can provide smaller investors with access to hedge funds in which they may not be able to invest directly.

Fund-of-funds managers charge an additional layer of fees beyond the fees charged by the individual hedge funds in the portfolio. Historically, these additional fees have been a 1% management fee and a 10% incentive fee. Because these fees to the fund-of-funds manager are on top of fees charged by the individual funds, they can significantly reduce investor net returns.

Recently, there has been market pressure to reduce hedge fund fees. Rather than the previous standard of 2 and 20, average hedge fund fees have fallen closer to 1.3% in management fees and 15% in incentive fees. Fund-of-funds fees have also fallen from 1 and 10 and some may charge only a management fee or a lower management fee combined with a reduced incentive fee.

Hedge Fund Potential Benefits and Risks

Hedge fund returns have tended to be better than those of global equities in down equity markets and to lag the returns of global equities in up markets. Different hedge fund strategies have the best returns during different time periods. Statements about the performance and diversification benefits of hedge funds are problematic because of the great variety of strategies used. Less-than-perfect correlation with global equity returns may offer some diversification benefits, but correlations tend to increase during periods of financial crisis.

Characteristics of hedge fund indexes may bias returns and correlations with traditional investment returns. Because hedge funds might not be included in an index until they have been in existence for a given time period or until they reach a given size, index returns may exhibit survivorship bias. Funds that have been successful, so that they have stayed in business for multiple years or reached a specific level of assets under management, tend to be overrepresented in a hedge fund index, which biases returns upward. Backfill bias refers to the effect on historical index returns of adding fund returns for prior years to index returns when a fund is added to an index.

Model values and appraisal values are typically less volatile than market values. To the extent that funds use models or appraisals for asset valuation and return calculations, both standard deviations of fund returns and correlations of fund returns with those of traditional investments will be biased downward. Investors must understand these potential biases when using index returns to evaluate the risk and return characteristics of hedge funds.