User:Bryant Park Fifth/Hedge fund

Hedge fund risk
Because investments in hedge funds can add diversification to investment portfolios, investors may use them as a tool to reduce their overall portfolio risk exposures. Managers of hedge funds use particular trading strategies and instruments with the specific aim of reducing market risks to produce risk-adjusted returns, which are consistent with investors' desired level of risk. Hedge funds ideally produce returns relatively uncorrelated with market indices. While "hedging" can be a way of reducing the risk of an investment, hedge funds, like all other investment types, are not immune to risk. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500 between 1993 and 2010.

Risk management
Investors in hedge funds are, in most countries, required to be sophisticated qualified investors who are assumed to be aware of the investment risks, and accept these risks because of the potential returns relative to those risks. Fund managers may employ extensive risk management strategies in order to protect the fund and investors. According to the Financial Times, "big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management." Hedge fund managers may hold a large number of investment positions for short durations and are likely to have a particularly comprehensive risk management system in place. Funds may have "risk officers" who assess and manage risks but are not otherwise involved in trading, and may employ strategies such as formal portfolio risk models. A variety of measuring techniques and models may be used to calculate the risk incurred by a hedge fund's activities; fund managers may use different models depending on their fund's structure and investment strategy. Some factors ,such as normality of return, are not always accounted for by conventional risk measurement methodologies. Funds which use value at risk as a measurement of risk may compensate for this by employing additional models such as drawdown and “time under water” to ensure all risks are captured. In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence, a technique used by hedge funds to assess the risks of an investment paired with financial risks. Operational due diligence is also used by investors in hedge funds to assess the operational risk of investing in a particular fund. This technique involves examining the operations of the fund or investment to identify any risks, in particular identifying whether the investment strategy is likely to produce a risk-adjusted return that is consistent with the investor's objectives, how sustainable the fund's operations are, and the fund's ability to develop as a company.

Transparency and regulatory considerations
Since hedge funds are private entities and have few public disclosure requirements, this is sometimes perceived as a lack of transparency. Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/or registration requirements as other financial investment managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud. New regulations introduced in the U.S. and the EU as of 2010 require hedge fund managers to report more information, leading to greater transparency. In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and external regulatory requirements. The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology, positions and leverage exposure.

Risks shared with other investment types
Hedge funds share many of the same types of risk as other investment classes, including liquidity risk and manager risk. Liquidity refers to the degree to which an asset can be bought and sold or converted to cash; similar to private equity funds, hedge funds employ a lock-up period during which an investor cannot remove money. Manager risk refers to those risks which arise from the management of funds. As well as specific risks such as style drift, which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors include valuation risk, capacity risk, concentration risk and leverage risk. Valuation risk refers to the concern that the net asset value of investments may be inaccurate; capacity risk can arise from placing too much money into one particular strategy, which may lead to fund performance deterioration; and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group of correlated funds. These risks may be managed through defined controls over conflict of interest, restrictions on allocation of funds, and set exposure limits for strategies.

Some types of funds, including hedge funds, are perceived as having a greater appetite for risk, with the intention of maximizing returns, subject to the risk tolerance of investors and the fund manager. Managers will have an additional incentive to increase risk oversight when their own capital is invested in the fund.

Many investment funds use leverage, the practice of borrowing money or trading on margin in addition to capital from investors. Although leverage can increase potential returns, the opportunity for larger gains is weighed against the possibility of greater losses. Hedge funds employing leverage are likely to engage in extensive risk management practices. In comparison with investment banks, hedge fund leverage is relatively low; according to a National Bureau of Economic Research working paper, the average leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.

Systemic risk
Systemic risk refers to the risk of instability across the finance industry, as opposed to within a single company. Such risk may arise following a destabilizing event or events affecting a group of financial institutions linked through investment activity. Compared with investment banks and mutual funds, hedge funds are relatively small, in terms of the assets they manage, and operate generally with low leverage, thereby limiting the potential impact on systemic risk. Financial writer Sebastian Mallaby has described hedge funds as "small enough to fail". Hedge funds fail regularly, and numerous hedge funds failed during the financial crisis. In testimony to the House Financial Services Committee in 2009, Ben Bernanke, the Federal Reserve Board Chairman said he “would not think that any hedge fund or private equity fund would become a systemically-critical firm individually”.

Organizations such as the National Bureau of Economic Research and the European Central Bank have charged that hedge funds pose systemic risks to the financial sector, a claim disputed by parts of the financial industry, including the Risk and Asset Management Research Centre at EDHEC. The failure or near failure of large hedge funds has been cited by media commentators as an example of the potential for systemic risk, in particular the failure of Long-Term Capital Management (LTCM) in 1998. However, no financial assistance was provided to LTCM by the U.S. Federal Reserve, incurring no cost for U.S. taxpayers.

In October 2009, April 2010, and September 2010, the FSA surveyed 50 hedge fund managers regarding the sector's risks, leverage levels and counterparties. Based on information collected in the 2009 and 2010 surveys, the FSA published reports that affirmed that the European hedge fund industry posed no systemic risk to the financial system. The FSA determined that, based on indicators of risk, there was "no clear evidence to suggest that... any individual fund posed a significant systemic risk to the financial system." In particular, the reports noted that hedge funds have a relatively small "footprint" of securities compared to equity raised from investors, indicating that use of leverage was reasonable.

<!--==Regulation== A range of regulatory methods are used to provide oversight of hedge funds worldwide. According to a report by the International Organization of Securities Commissions, the most common tactic is the direct regulation of financial advisers—including hedge fund managers, which is primarily intended to protect investors against fraud. Specific regulations differ by national, federal and state jurisdiction. Historically, hedge funds have been exempt from certain registration and reporting requirements that apply to other investment companies, because in most jurisdictions regulation permits investments in hedge funds by only "qualified" investors who are able to make an informed decision about investment decisions without relying on regulatory oversight. In 2010, new regulations were passed in the U.S. and European Union, which (among other changes) introduced new hedge fund reporting requirements. The Dodd-Frank Wall Street Reform Act was passed in the U.S. in July 2010, and contains provisions which require hedge fund advisers with $150 million or more in assets to register with the SEC. In November 2010, the EU Parliament passed the Alternative Investment Fund Managers Directive, which seeks to provide greater monitoring and control of alternative investment fund managers operating in the EU.

U.S. regulation
Hedge funds within the U.S. are subject to various regulatory trading reporting and record keeping requirements that also apply to other investors in publicly traded securities. Before the Dodd-Frank Act made registration mandatory for hedge fund advisers with more than US$150 million in assets under management, hedge funds were primarily regulated through their managers or advisers, under the anti-fraud provisions of the Investment Advisers Act of 1940. Hedge funds are privately-owned pools of investment capital with regulatory limits on the number and type of investor that each fund may have. Because of these regulatory restrictions on ownership, hedge funds have been exempt from mandatory registration with the U.S. Securities and Exchange Commission (SEC)  under the Investment Company Act of 1940, which is generally intended to regulate investment funds sold to retail investors. The two primary exemptions in the Investment Company Act of 1940 that hedge funds relied on were (a) Section 3(c)1 which restricts funds to 100 or fewer investors and (b) Section 3(c)7, which requires all investors to meet a "qualified purchaser" criterion. These sections also both prohibit hedge funds from selling their securities through public offerings. Under 3(c)7, a qualified purchaser is defined to include an individual with at least $5,000,000 in investment assets. Companies, including institutional investors, generally qualify as qualified purchasers if they have at least $25,000,000 in investment assets. Although under Section 3(c)7 a fund can have an unlimited number of investors, if a fund has any class of equity securities owned by more than 499 investors, it must register its securities with the SEC under the Securities Exchange Act of 1934.

Because Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940 prohibit hedge funds from making public offerings, funds must sell their securities in accordance with the private offering rules under the Securities Act of 1933. The 1933 Act generally requires companies to file a registration statement with the SEC if they want to sell their securities publicly, or comply with private placement rules under the Act. Though the securities of hedge funds are not registered under the 1933 Act, they remain subject to the anti-fraud provisions of the Act.

Hedge funds raise capital via private placement under Regulation D of the Securities Act of 1933,  which means the shares are not registered. To comply with the private placement rules in Regulation D, hedge funds generally offer their securities solely to accredited investors. An accredited investor is an individual person with a minimum net worth of $1,000,000 or, alternatively, a minimum income of $200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. For banks and corporate entities, the minimum net worth is $5,000,000 in invested assets.

For SEC registered hedge fund advisers to charge an incentive or performance fee, the investors in the funds must be "qualified clients" as defined in the Investment Advisers Act of 1940 Rule 205-3. To be a qualified client an individual must have $750,000 in assets invested with the adviser or a net worth in excess of $1.5 million, or be one of certain high-level employees of the investment adviser. Under the Dodd-Frank Act, the SEC is required to periodically adjust the qualified client standard for inflation.

Because hedge funds do not have publicly traded securities, they are not subject to all of the reporting requirements of the Securities Exchange Act of 1934. Hedge funds that have a class of equity securities owned by more than 499 investors do, however, have to register under Section 12(g) of the 1934 Act and are subject the quarterly reporting requirements of the Act. Similar to other institutional investors, hedge fund managers with at least $100,000,000 in assets under management are required to file publicly quarterly reports disclosing ownership of registered equity securities. Also similar to other investors, hedge fund managers are subject to public disclosure if they own more than 5% of the class of any registered equity security. Hedge fund managers are also subject to anti-fraud provisions.

Prior to the requirements of the Dodd-Frank Act, many hedge fund advisers voluntarily registered with the SEC. Advisers who do so are subject to the same requirements as all other registered investment advisers. Registered advisers must provide information about their business practices and disciplinary history to the SEC and investors. They are required to have written compliance policies and have a chief compliance officer to enforce those policies. In addition, they are required to maintain certain books and records and have their practices examined by SEC staff. As a result of the Dodd-Frank Wall Street Reform Act, hedge fund advisers with at least $150,000,000 in assets under management will be required to register with the SEC as of July 21, 2011, while smaller advisers will be subject to state registration.

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 $25,000,000 with over 14 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 new rule was controversial, with two commissioners dissenting, and was later challenged in court by a hedge fund manager. In June 2006, the U.S. Court of Appeals for the District of Columbia overturned the rule and sent it back to the agency to be reviewed. In response to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the earlier challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity.

Many hedge funds also fall under the jurisdiction of the Commodity Futures Trading Commission. Hedge fund advisers registered as Commodity Pool Operators (CPO) or Commodity Trading Advisors (CTA) would fall within this category, as would any manager of a hedge fund investing in markets under the CFTC’s jurisdiction, even if they qualify for an exemption from CPO or CTA registration. Hedge fund managers who meet these criteria are subject to rules and provisions of the Commodity Exchange Act prohibiting fraud and manipulation.

Comparison with other funds
The regulations and restrictions that apply to hedge funds and mutual funds differ in three major ways. First, mutual funds are required to be registered with and regulated by the SEC, while hedge funds historically have not. Investors in hedge funds must be accredited investors, with certain exceptions (employees, etc.), and cannot be marketed to retail investors; mutual funds, however, do not have this restriction. Finally, mutual funds must be liquid on a daily basis. If a mutual fund investor wishes to redeem his or her investment the fund must be able to meet that request immediately. Hedge funds 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.

Mutual funds must also determine the net asset value (NAV) of the fund. While some hedge funds that are based offshore report their NAV to the Financial Times, for the most part there is no method of ascertaining pricing on a regular basis. In addition, mutual funds must have a prospectus available to anyone who requests one (either electronically or via U.S. postal mail), and must disclose their asset allocation quarterly, whereas hedge funds do not have to abide by these terms.

All investment funds are subject to regulations that prohibit charging fees to investors, unless the investment performance of the fund is equivalent to that of an index or other measure of performance. This regulation is set out under Section 205(b) of the Investment Advisers Act of 1940, which limits performance fees to so-called "fulcrum fees". Due to this regulation, hedge funds charging a performance fee are unique compared with other funds.

Dodd-Frank
The Dodd-Frank Wall Street Reform Act was passed in the U.S. in July 2010, aiming to increase regulation of financial companies, including hedge funds. The act requires advisers to private pools of capital of $150 million or more in assets to register with the SEC as investment advisers and become subject to all the rules that apply to registered advisers by July 21, 2011. Previous exemptions from registration provided under the Investment Advisers Act of 1940 will no longer apply to most hedge fund advisers. Under Dodd-Frank, hedge fund managers who have less than $100 million in assets under management will be overseen by the state where the manager is domiciled and become subject to state regulation. This will significantly increase the number of hedge funds under state supervision, as the threshold for SEC regulation was previously $30 million. In addition to U.S. hedge funds, many overseas funds with more than 15 U.S. clients and investors, and managing more than $25 million for these clients, will also have to register with the SEC by July 21, 2011. Mandatory registration of hedge fund advisers was supported by the largest hedge fund trade group, the Managed Funds Association (MFA), which announced its support for registration in testimony to a U.S. congressional committee on May 7, 2009.

Additionally, Dodd-Frank requires hedge funds to provide information about their trades and portfolios to help regulators fulfill their obligation to monitor and regulate systemic risk. The aim is for this data to be analyzed and shared among regulators – including the newly created Financial Stability Oversight Council – and for the SEC to report to Congress on how the data is being used to protect both investors and market integrity. Under the so-called "Volcker Rule", regulators are also required to implement regulations for banks, their affiliates and holding companies to limit their relationships with hedge funds and also to prohibit these organizations from proprietary trading, and limit their investment in, and sponsorship of hedge funds.

European regulation
Within the European Union (EU), as with the U.S., hedge funds are primarily regulated through advisers who manage the funds. In the United Kingdom, which is the hedge fund center of the EU, hedge fund advisers are required to be authorized and regulated by the Financial Services Authority (FSA), the national regulator. Historically, there have been different regulatory approaches within each country in the EU. In some countries there are specific restrictions on hedge fund activities, including controls on use of derivatives in Portugal, and limits on leverage in France.

In 2010, the EU approved a law to require hedge funds to register with national regulatory authorities. The EU's Directive on Alternative Investment Fund Managers (AIFMD) was passed by the EU Parliament on November 11, 2010 and is the first EU directive focused on "alternative investment fund managers", including hedge fund managers. According to the EU, the aim of the directive is to provide greater monitoring and control of alternative investment funds. The directive requires managers to disclose more information, on a more frequent basis, to regulators about their investment strategies. The directive also introduces a rule that hedge fund managers should hold larger amounts of capital. All hedge fund managers within the EU will also be subject to potential limitations on the amount of leverage they can use. Since AIFMD covers the entire EU, and individual countries have different rules for hedge fund marketing, the directive introduced a "passport" for hedge funds authorized in one EU country to operate throughout the EU. The scope of the AIFMD is broad and encompasses managers located within the EU as well as non-EU managers that market their funds to European investors. Countries within the EU are required to adopt the directive in national legislation by early 2013.

Offshore and other locations
Offshore centers offer business-friendly regulation, which has encouraged the establishment of hedge funds. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin Islands, and Bermuda. Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centers. 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.

In Asia, Singapore offers fewer licensing requirements and regulations for hedge funds than Hong Kong and other financial capitals in the region. Singapore’s oversight of hedge funds will increase following the introduction of new rules and regulations in 2011, but small funds will be able to continue operating without a license. Hedge funds based in Hong Kong are subject to the same licensing requirements as mutual funds.

Many international hedge fund markets are affected by regulation passed in 2010 within the United States and European Union. Under the EU’s Alternative Investment Fund Managers directive, offshore hedge funds using prime brokers as depositaries will be required to use EU-registered credit institutions before they can be sold in the EU. The AIFMD’s regulatory requirements will essentially mandate equivalent regulations for non-EU investment funds, if they wish to operate in EU markets.

The Dodd-Frank Act, passed in the U.S. in 2010, will have several key implications for overseas hedge funds. Funds with more than 15 U.S. clients and investors managing $25 million or more will have to register with the SEC by July 21, 2011. Registered managers must file and maintain information including the assets under management and trading positions. Prior to the Dodd-Frank act, some Asian hedge funds had registered with the SEC.

A hedge fund is a private investment fund that may invest in a diverse range of assets and may employ a variety of investment strategies to maintain a “hedged” portfolio intended to protect the fund's investors from downturns in the market while maximizing returns on market upswings.

Hedge funds are distinct from mutual funds, individual retirement and investment accounts, and other types of traditional investment portfolios in a number of ways. As a class, hedge funds undertake a wider range of investment and trading activities than traditional long-only investment funds, and invest in a broader range of assets, including equities, bonds and commodities. By taking a long position on a particular asset the manager is asserting that this position is likely to increase in value. When the manager takes a short position in another asset they would be asserting that the asset is likely to decrease in value. Most hedge fund investment strategies aim to secure positive return on investment regardless of overall market performance. Hedge fund managers typically invest their own money in the fund they manage, which serves to align their interests with investors in the fund. Investors in hedge funds typically pay a management fee that goes toward the operational costs of the fund, and a performance fee when the fund’s annual return is higher than that of the previous year. The net asset value of a hedge fund can be billions of dollars, due to investments from large institutional investors including pension funds, university endowments and foundations. Worldwide, 61% of investment in hedge funds is from institutional sources. , hedge funds represent 1.1 percent of the total funds and assets held by financial institutions. The estimated size of the global hedge fund industry is $1.9 trillion.

Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. Because hedge funds are not sold to the public or retail investors its advisers have historically not been subject to the same restrictions that govern other investment fund advisers, with regard to how the fund may be structured and how strategies are employed. However, hedge funds must comply with many of the same statutory and regulatory restrictions as other institutional market participants. Regulations passed in the United States and Europe after the 2008 credit crisis are intended to increase government oversight of hedge funds and eliminate any regulatory gaps. <!--

History
Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949. Jones believed that changes in asset prices can be attributed partly to factors specific to the asset in question and partly to trends in the market as a whole. To neutralize the effect of overall market movement, he balanced his portfolio by buying assets whose price he expected to increase in the future, relative to the overall performance of the market, and selling short assets whose price he expected to decrease. He saw that price movements due to the overall market would balance out because, if the overall market rose, the loss on shorted assets would be cancelled by the additional gain on longed assets and vice-versa. By taking this approach his investment strategy was market neutral, as returns depended only on him picking the right stock, not on whether the stock market went up or down. Jones referred to his fund as being "hedged" to describe how the fund managed risk exposure from overall market movement. This type of portfolio became known as a hedge fund.

Jones added a 20% performance fee in 1952 and converted his fund to a limited partnership, and thereby became the first money manager to combine a hedged investment strategy, leverage and shared risk, with compensation based on investment performance. At this time, only a few investors had adopted Jones' investment structure as it was not well known in the financial community. Attention was drawn to the fund and Jones' strategies in 1966 when Carol Loomis, a writer for Fortune magazine, wrote an article about Jones called "The Jones Nobody Keeps Up With". The article noted that Jones’ fund outperformed the best mutual funds even after the 20% performance fee and this news led to great interest within the financial community.

By 1968 there were around 200 hedge funds, and the first fund of hedge funds was created in 1969 in Geneva. Many of the early funds ceased trading due to the market downturns in 1969-70 and 1973-74 as they did not manage their risk. In the 1970s hedge funds typically specialized only in one strategy, and most fund managers followed the long/short equity model created by Jones. Hedge funds lost their popularity during the downturn of the 1970s but received renewed attention in the late 1980s, following the success of several funds profiled in the media. During the 1990s the number of hedge funds increased significantly, with investments provided by the new wealth that was generated in the 1990s stock market rise. The increase in the number hedge funds resulted from traders and investors being attracted to the aligned-interest compensation structure and the freedom of participating in an investment vehicle that was not benchmark-driven. Over the next decade there was also a marked diversification in the strategies funds utilized, including: credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy, among others. This industry expansion led to hedge funds becoming more heterogeneous than they had before. -->