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Generally, a hedge fund is a lightly regulated private investment fund sometimes characterized by unconventional strategies (e.g., strategies other than investing long only in bonds, equities or money markets). They are primarily organized as limited partnerships, and previously were often simply called "limited partnerships" and were grouped with other similar partnerships such as those that invested in oil development.

The term hedge fund dates back to the first such fund founded by Alfred Winslow Jones in 1949. Jones' innovation was to sell short some stocks while buying others, thus some of the market risk was hedged. While most of today's hedge funds still trade stocks both long and short, many do not trade stocks at all.

For U.S.-based managers and investors, hedge funds are simply structured as limited partnerships or limited liability companies. The hedge fund manager is the general partner or manager and the investors are the limited partners or members respectively. The funds are pooled together in the partnership or company and the general partner or manager makes all the investment decisions based on the strategy it outlined in the offering documents.

In return for managing the investors' funds, the hedge fund manager will receive a management fee and a performance or incentive fee. The management fee is computed as a percentage of assets under management, and the incentive fee is computed as a percentage of the fund's profits.

A "high water mark" may be specified, under which the manager does not receive incentive fees unless the value of the fund exceeds the highest value it has achieved. The "high water mark" is intended to encourage fund managers to recoup losses, but is viewed by critics as encouraging laggard funds to close, to the detriment of investors.

The fee structures of hedge funds vary, but the annual management fee is typically 20% of the profits of the fund plus 2% of assets under management. Certain highly regarded managers demand higher fees. In particular, Steven Cohen's SAC Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons' Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its flagship Medallion Fund before returning all investors' capital and running solely on its employees' money.

Fund of Funds provide easier managed, access to the world of hedge funds.

The typical hedge fund management firm includes both the domestic U.S. hedge fund and the offshore hedge fund. This allows hedge fund managers to attract capital from all over the world. Both funds will trade 'Pari passu' based on the strategy outlined in the offering documents

Hedge Fund Facts:

  • Estimated to be a $1.1 trillion industry and growing every year, with approximately 9000 active hedge funds.
  • Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or derivatives.
  • Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team.
  • Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets -- unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk.
  • Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept.
  • Hedge Fund returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities.
  • Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks, who have lived through, and understand the consequences of, major stock market corrections. Many endowments and pension funds allocate assets to hedge funds.

Copyright 2001, Dion Friedland, Chairman, Magnum Funds. Permission is granted to reprint information in this article provided credit for the information is given to Dion Friedland and Magnum Funds.

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