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An Introduction to Hedge Funds
Version 3.0
Connor and Woo (2003)
An Introduction to Hedge Funds
By Gregory Connor and Mason Woo
*
London School of Economics
September 2003
This article gives a nontechnical overview of hedge funds and is intended for students or
practitioners seeking a general introduction. It is not a survey of the research literature,
and citations are kept to a minimum. Section 1 discusses the definition of a hedge fund;
section 2 gives a short history of the hedge fund industry; section 3 describes hedge fund
fees; section 4 categorises hedge fund investment strategies; section 5 briefly analyses
hedge fund risk, and section 6 discusses hedge fund performance measurement. Section
7 offers some concluding comments. A bibliography and glossary of terms appear at the
end of the article.
1. What is a Hedge Fund?
1.1 Standard definitions of a hedge fund
A hedge fund can be defined as an actively managed, pooled investment vehicle
that is open to only a limited group of investors and whose performance is measured in
absolute return units. However, this simple definition excludes some hedge funds and
includes some funds that are clearly not hedge funds. There is no simple and all-
encompassing definition.
*
Gregory Connor is a professor of finance and director of the IAM/FMG hedge fund research
programme, and Mason Woo is a graduate student in the risk and regulation programme at London School
of Economics . We would like to thank Morten Spenner of IAM for helpful comments.
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The nomenclature “hedge fund” provides insight into its original definition. To
“hedge” is to lower overall risk by taking on an asset position that offsets an existing
source of risk. For example, an investor holding a large position in foreign equities can
hedge the portfolio’s currency risk by going short currency futures. A trader with a large
inventory position in an individual stock can hedge the market component of the stock’s
risk by going short equity index futures. One might define a hedge fund as an
information-motivated fund that hedges away all or most sources of risk not related to
the price-relevant information available for speculation. Note that short positions are
intrinsic to hedging and are critical in the original definition of hedge funds.
Alternatively, a hedge fund can be defined theoretically as the “purely active”
component of a traditional actively-managed portfolio whose performance is measured
against a market benchmark. Let w denote the portfolio weights of the traditional
actively-managed equity portfolio. Let b denote the market benchmark weights for the
passive index used to gauge the performance of this fund. Consider the
active weights
, h,
defined as the differences between the portfolio weights and the benchmark weights:
h = w – b
A traditional fund has no short positions, so w has all nonnegative weights; most market
benchmarks also have all nonnegative weights. So w and b are nonnegative in all
components but the “active weights portfolio,” h, has an equal percentage of short
positions as long positions. Theoretically, one can think of the portfolio h as the hedge
fund implied by the traditional active portfolio w. The following two strategies are
equivalent:
1. hold the traditional actively-managed portfolio w
2. hold the passive index b plus invest in the hedge fund h.
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Defined in this way, hedge funds are a device to separate the “purely active” investment
portfolio h from the “purely passive” portfolio b. The traditional active portfolio w
combines the two components.
This “theoretical” hedge fund is not implementable in practice since short
positions require margin cash. Note that the “theoretical hedge fund” described above
has zero net investment and so no cash available for margin accounts. If the benchmark
includes a positive cash weight, this can be re-allocated to the hedge fund. Then the
hedge fund will have a positive overall weight, consisting of a net-zero investment (long
and short) in equities, plus a positive position in cash to cover margin.
Why might strategy 2 above (holding a passive index plus a hedge fund) be more
attractive than strategy 1 (holding a traditional actively-managed portfolio)? It could be
due to specialisation. The passive fund involves pure capital investment with no
information-based speculation. The hedge fund involves pure speculation with no
capital investment. The traditional active manager has to undertake both functions
simultaneously and so cannot specialise in either.
This theoretical definition of a hedge fund also explains the “hedge” terminology.
Suppose that the traditional actively-managed fund has been constructed so that its
exposures to market-wide risks are kept the same as in the benchmark. Then the implied
hedge fund has zero exposures to market-wide risks, since the benchmark and active
portfolio exposures cancel each other out, i.e., hedging.
What we have just described is a “classic” hedge fund, but the operational
composition of hedge funds has steadily evolved until it is now difficult to define a hedge
fund based upon investment strategies alone. Hedge funds now vary widely in investing
strategies, size, and other characteristics. All hedge funds are fundamentally skill-based,
relying on the talents of active investment management to exceed the returns of passive
indexing. Hedge fund managers are motivated by incentive fees to maximise absolute
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returns under any market condition, so hedge funds returns are not compared to
benchmarks that represent the overall market. Hedge fund managers have flexibility to
choose from a wide range of investment techniques and assets, including long and short
positions in stocks, bonds, and commodities. Leverage is commonly used (83% of funds)
to magnify the effect of investment decisions [Liang, 1999]. Fund managers may trade in
foreign currencies and derivatives (options or futures), and they may concentrate, rather
then diversify, their investments in chosen countries or industry sectors. Managers may
switch investment styles, if they perceive better opportunities in doing so.
Some hedge funds do not hedge at all; they simply take advantage of the legal and
compensatory structures of hedge funds to pursue desired trading strategies. In practice,
a legal structure that avoids certain regulatory constraints remains a common thread that
unites all hedge funds. Hence it is possible to use their legal status as an alternative
means of defining a hedge fund.
1.2 The Legal Structures of Hedge Funds
Hedge funds are clearly recognisable by their legal structures. Many people think
that hedge funds are completely unregulated, but it is more accurate to say that hedge
funds are structured to take advantage of exemptions in regulations. Fung and Hsieh
(1999) explain the justification for these exemptions is that the regulations are meant for
the general public and that hedge funds are intended for well-informed and well-financed
investors. The legal structure of hedge funds is intrinsic to their nature. Flexibility,
opaqueness, and aggressive incentive compensation are fundamental to the highly
speculative, information-motivated trading strategies of hedge funds. These features are
in conflict with a highly regulated legal environment.
Hedge funds are almost always organised as limited partnerships or limited
liability companies to provide pass-through tax treatment. The fund itself doesn’t pay
taxes on investment returns, but returns are passed through so that investors pay the
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taxes on their personal tax bills. (If the hedge fund were set up as a corporation, profits
would be taxed twice.)
In the U.S.A., hedge funds usually seek exemptions from a number of SEC
regulations. The Investment Company Act of 1940 contains disclosure and registration
requirements and imposes limits on the use of investment techniques, such as leverage
and diversification [Lhabitant, 2002]. The Investment Company Act was designed for
mutual funds, and it exempted funds with fewer than 100 investors. In 1996, it was
amended so that more investors could participate, so long as each “qualified purchaser”
was either an individual with at least $5 million in assets or an institutional investor with
at least $25 million [President’s Working Group, 1999].
Hedge funds usually seek exemption from the registration and disclosure
requirements in the Securities Act of 1933, partly to prevent revealing proprietary trading
strategies to competitors and partly to reduce the costs and effort of reporting. To obtain
the exemption, hedge funds must agree to
private placement
, which restricts a fund from
public solicitation (such as advertising) and limits the offer to 35 investors who do not
meet minimum wealth requirements (such as a net worth of over $1 million, an annual
income of over $200,000). The easiest way for hedge funds to meet this requirement is to
restrict the offering to wealthy investors.
Some hedge fund managers also seek an exemption from the Investment
Advisers Act of 1940, which requires hedge fund managers to register as investment
advisers. For registered managers, a fund may only charge a performance-based incentive
fee (which is typically the manager’s main remuneration) if the fund is limited to high
net-worth individuals. Some managers elect to register as investment advisers, because
some investors may feel greater reassurance, and the additional restrictions are not
especially onerous [Lhabitant, 2002].
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