HEDGE FUNDS:

AN INTRODUCTION
UNDERSTANDING A CRITICAL TOOL IN THE GLOBAL
ECONOMY

What is a hedge fund?

Its a tool that delivers reliable returns for pensions,

university endowments, and others

What is a hedge fund?

Its a tool that creates value to help fund pensions,

universities and non-profits

What is a hedge fund?

Its a tool that institutions and investors

use to manage risk

What is a hedge fund?

Its a tool that helps

diversify investments
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Simply put:

Its a tool that helps millions meet

their financial goals and obligations

The term hedge fund has been used

to describe private, professionally
managed investment funds since 1949.

Sociologist Alfred Winslow Jones, writing on

assignment for Fortune, bought undervalued
securities and shorted other stocks as a
market neutral approach to investing.
By combining short selling, leverage, and
incentive fees in combination, Jones was
able to deliver solid returns while minimizing
risk. His innovative approach created the first
hedge fund.

While hedge funds have grown in popularity,

their size is relatively small compared to the
markets where they invest.
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Assets Under
Management
(in trillions)

10,018

9,810

9,575

9,237

9,045

9,284

10,096

9,462

8,661

Total Number of Funds

14.4

3,873

Q3 2013

2012

2011

2010

2009

2008

2007

2006

2005

2000

2.51

1995

1990

610

2,383

13.0

Sources: (1) Hedge Fund Research, Inc., Q3 2013;

(2) Hedge Fund Research, Inc., Q3 2013; (3) FDIC, 3/13, (4) ICI, 12/12

Hedge
U.S.
U.S.
2
Funds Banking Mutual
Industry 3 Fund
Industry 4

Most hedge funds are established as

limited partnerships.
Investors share in the partnerships income, expenses, gains
and losses; each partner is taxed on its respective share
Key Players:
Portfolio
Manager(s)

Determines strategy and is invested in the fund

(compensated based on funds annual performance)

Prime
Broker

Funds must secure their loans with collateral to

gain margin and secure trades. In turn, each broker
(usually a large securities firm) uses its own risk
matrix to determine how much to lend to each of
its clients, acting as a stand-in regulator.

Auditors

Ensure fund compliance; verify financial statements

as required by federal law
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Typical U.S. Hedge Fund Structure

Auditors and
Administrators
Portfolio Manager
Investors
Prime Broker

Investors

Hedge Fund
Executing Broker

Investors
Investors

Legal Advisors,
Registrar and
Transfer Agent

Source: Hedge Funds and Other Private Funds: Regulation and Compliance Thomson West, 2010

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Who can invest in hedge funds?

U.S. regulations limit hedge fund
participants to accredited investors
or qualified purchasers.
Individuals with investments in excess of $5
million; or net worth of at least $1 million; or
income of at least $200,000 in last two years
Institutions with total assets over $5 million;
or no less than $25 million in investments or
investable assets
MFA has created an infographic about who can invest in hedge funds and
the due diligence process.

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Who invests in hedge funds?

About 65 percent of global hedge fund assets come from
institutional investors such as pension funds, and university
and nonprofit endowments.

The rest comes from individual investors.

Source: Preqin Ltd., October 2012

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Who invests in hedge funds?

University and college endowments were some of the first
institutional investors to partner with hedge funds to help meet
their financial needs and expand educational opportunities
nationwide.
According to a recent NACUBO-Commonfund study,
endowments allocate - on average - 36% of their alternative
asset portfolio to marketable alternative strategies, including
hedge funds.
Hedge funds are of particular importance to larger institutions.
Endowments with over $1 billion in assets allocate an average
of 61% to alternative investments with various hedge fund
managers and strategies.
Source: 2012 NACUBO-Commonfund Study of Endowments
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Who invests in hedge funds?

Pension plans across the U.S. and around the world invest in
hedge funds to: help diversify their portfolio, manage risk,
and deliver reliable returns over time. These investments
help build retirement security for hundreds of millions of
workers and retirees.
According to a report by Preqin, public and private pension
plans accounted for 38% of institutional investor assets held by
hedge funds as of February 2013.

Source: Preqin Ltd., February 2013

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Who invests in hedge funds?

Today, the 200 largest investors utilize hedge funds at a
growing rate and continue to increase their investments each
year.

Public Pension Plans

Union Pension Plans

Corporate Pension Plans

Universities

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Today, the 200 largest U.S. retirement funds

utilize hedge funds at a growing rate.
Their investments total $134.7 billion.

Source: Pensions and Investments, February 2013

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Why invest in hedge funds?

Hedge funds are important tools for diversification.
They provide investors with the latitude to tailor their
investment strategies based on current market conditions in
order to manage risk and maximize return.

The hedge fund industry is diverse, as well. Over the past

10 years, managers have employed an increasing
number of new investment strategies in increasingly global
markets.

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Why invest in hedge funds?

Hedge funds offer investors
the ability to diversify and
achieve risk-adjusted returns,
offering protecting in volatile
markets.

In addition, investors also

factor in a number of other
elements that they consider
when evaluating when to
invest in a specific fund or
management team.

Source: Advent Hedge Fund Investor Survey, 09/2013

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Institutional Trends
In a 2013 Preqin study, 67% of investors said they expect to maintain or
increase their allocation to hedge funds in 2013.

The Robert Wood Johnson Foundation held nearly $1.58 billion in hedge
fund investments at the end of 2012, approximately 17% of total assets.
In 2012, General Motors $68.7 billion pension fund had hedge fund
investments totaling $3.7 billion.

Our increased allocation toward hedge funds in recent years has

lowered the risk exposure of our pension plans while delivering solid
returns. That approach is consistent with our goals to lower GMs risk
profile, strengthen our balance sheet and fully fund our pension plans.
Walter Borst, General Motors Asset Managements CEO, President and
Chief Investment Officer, 2/7/11

Source: 2013 Preqin Global Hedge Fund Outlook;

Robert Wood Johnson Foundation; General Motors

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How do hedge funds invest?

Global Macro
Investment managers use economic variables and the impact these have
on markets to develop investment strategies.
Managers employ a variety of techniques including discretionary and
systematic analysis, quantitative and fundamental approaches, and long
and short-term holding periods.
Strategies are based on future movements in underlying instruments rather
than the realized valuation discrepancies between securities.

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How do hedge funds invest?

Event Driven
Investment managers maintain positions in companies currently or
prospectively involved in corporate transactions including mergers,
restructurings, financial distress, tender offers, shareholder buybacks, debt
exchanges, security issuance or other capital structure adjustments.
Managers pursue strategies based on fundamental characteristics (as
opposed to quantitative) and specific future developments.
Position exposure includes a combination of sensitivities to equity markets,
credit markets and company-specific developments.

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How do hedge funds invest?

Relative Value
Investment managers maintain positions based on valuation discrepancy in
the relationship between multiple securities.
Managers employ a variety of fundamental and quantitative techniques;
investments range broadly across equity, fixed income, derivative or other
security types.
Positions may involve future corporate transactions, but these positions are
predicated on realization of a pricing discrepancy between related securities
rather than the outcome of the corporate transaction.

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How do hedge funds invest?

Equity Funds
Investment managers maintain long and short positions in equity and equity
derivative securities.
Managers employ a wide variety of techniques to arrive at an investment
decision, including both quantitative and fundamental techniques.
Strategies can be broadly diversified or narrowly focused on specific sectors
and can range broadly in terms of levels of net exposure, leverage employed,
holding period, concentrations of market capitalizations and valuation ranges
of typical portfolios.

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How do hedge funds invest?

Quantitative Funds
An investment fund that trades positions based on computer models built to
identify investment opportunities.
These models can utilize an unlimited number of variables, which are
programmed into complex, frequently-updated algorithms.
Quantitative funds models are used as a means of executing a number of
other hedge fund strategies.

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How do hedge funds invest?

Multi-Strategy Funds
Investment managers maintain a variety of processes to arrive at an
investment decision, including both quantitative and fundamental techniques.
Strategies can be broadly diversified or narrowly focused on specific sectors
and can range broadly in terms of levels of net exposure, leverage, holding
period, concentrations of market capitalizations and valuation ranges.

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How do hedge funds invest?

Managed Futures Trading (CTAs)
Managed futures tradersalso known as commodity trading advisors
(CTAs)are able to invest in up to 150 global futures markets.
They trade in these markets using futures, forwards, and options contracts in
everything from grains and gold, to currencies, stock indexes, and
government bond futures.
Because they can go both long and short they have the ability to make
money in both rising and falling markets.
CTAs have been regulated by the Commodity Futures Trading Commission
(CFTC) since 1974 and are overseen by the National Futures Association
(NFA), a self-regulatory organization.

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Historically, hedge funds produced

consistently higher returns with
substantially less volatility.
Risk vs. Return
Hennessee Hedge Fund Index vs. Benchmarks
(1987-2012)

Source: Hennessee Group LLC

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Hedge funds protect on the downside.

Hennessee Index in the Worst 15
Months of S&P Decline (1993-2012)

Source: Hennessee Group LLC

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Hedge fund managers are partners with

fund investors; their financial interest is
directly linked to fund performance.

Since every hedge fund manager is invested in his or her own fund
(sometimes as much as 80% of the funds value), he or she has a significant
amount of money at stake with every investment decision.
Managers arent rewarded for poor performance. Unlike corporate executives
and mutual funds, managers are only rewarded when investors are
rewarded.
Fee structures vary, though 2 and 20 fees are typical: 2% management fee
for administrative expenses; 20% performance allocation over a specific high
water mark.

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Hedge funds do not pose a systemic risk:

Their size is small compared to the broader
financial services industry
Hedge funds are not highly leveraged
They arent susceptible to runs

I would not think that any hedge fund or private equity fund would become
a systemically critical firm individually.
Ben Bernanke, Federal Reserve Board Chairman
Testimony to U.S. House Financial Services Committee, October 1, 2009

We conclude that hedge funds do not currently pose systemic risk to the
Australian financial system or the wider economy.
Greg Tanzer, Commissioner, Australian Securities & Investments Commission
Speech Detailing ASIC Report, September 2013

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Compared to other U.S. markets, there is far

less concentration among hedge funds.
Assets Under Management
(in trillions)
U.S. Bank Holding Companies: Top 5 Hold >60% of Assets
$13.8 trillion

$8.5 trillion

U.S. Mutual Funds: Top 3 Mutual Fund Families Hold >35% of Assets
$4.5 trillion

$11.6 trillion

U.S. Hedge Funds: Top 5 Hold < 9% of Assets

$2.51 trillion
$223.6 billion
Source: FFIEC, 12/31/2011; Bloomberg News, 2/15/12; fund websites, Hedge Fund Research, Q3 2013;
Absolute Return Billion Dollar Club, 09/2013

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Hedge funds leverage risk is low.

Hedge fund leverage is governed largely by private relationships
with its prime brokers. A fund posts collateral with this prime
broker to secure its trades and the broker uses its own risk
matrix to determine how much to lend.
At Height of Financial Crisis
Hedge Funds

Investment
Banks

Hedge Funds

Investment Banks

1 : 2.5(1)

1 : 9.35(2)

1 : 1.41

1 : 69.5

(1) Credit Suisse U.S. Monthly Chartbook, July 2013

(2) bankregdata.org, Q2 2013

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Since hedge funds have long lead times

to return capital to investors and to adjust
credit agreements with creditors, they are
not susceptible to runs on capital.

Other
Institutions

Hedge
Funds

Equity

Mutual funds must be

able to return capital to
investors immediately

By contract, most hedge

funds return capital over
months or years

Debt

Banks rely on daily

liquidity from deposits
and commercial paper to
meet depositor demands

Hedge funds credit

agreements with prime
brokers are set for 30 days
but can extend to two years
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Resources:

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