This video provides an introduction of how hedge funds are structured, the typical fees charged by them, and how the managers get paid.

The most common structure followed by hedge funds is the general / limited partnership. In this model, the general partner will be responsible for managing the fund and will also have an investment in it. The limited partners will have their funds invested in the fund, and will be liable upto the amounts invested. The total number of partners or investors cannot be more than 99.

The general partner itself will be a limited liability company (LLC).

Hedge funds charge much higher fees comparied to the other mutual funds.

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Structure of Hedge Funds and the Fees

The hedge funds generally have a suspicious or a negative tone associate to them. This video analyzes the hedge funds business and highlights some of the characteristics which make it good and bad for different people.

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Are Hedge Funds Good or Bad?

The market for hedge funds has grown significantly and there are many types of hedge funds around the globe. These hedge funds can be classified based on their size, global reach, and investment strategies among others. However, these classifications are not exclusive and there is some degree of overlap. Presented below is one type of classification of hedge funds:

<strong>Long/Short Funds</strong>

These are the most common form of hedge funds that take long and short bets in stocks. The long and short exposures will be based on forecasts. If the stock prices are expected to rise the fund will take  a long position, and if the prices are expected to fall, they will take short positions. The funds will make heavy use to leverage in their positions. The funds will generally not be market neutral and will maintain a positive or negative market exposure.

<strong>Market-neutral Funds</strong>

These are a type of long/short funds that take long and short positions so that their net exposure is zero. The total value of all long positions will equal the total value of all short positions.  Such a portfolio will be dollar neutral and beta neutral. These funds also use leverage. Market-neutral funds use various strategies such as long/short equity, fixed-income arbitrage, pairs trading, warrant arbitrage, mortgage arbitrage, convertible bond arbitrage, closed-end fund arbitrage, and statistical arbitrage, among others.

Note that even though we see terms such as arbitrage and market-neutral, these funds are not actually risk-free.

<strong>Global Macro Funds</strong>

These funds place directional bets on stocks, currency, interest rates, commodities, and macroeconomic variables. These funds are highly leveraged and use derivatives extensively. Within global macro funds there are specialized funds, such as futures funds, and emerging market funds.

<strong>Event-driven Funds</strong>

Event-driven funds place bets on events affecting companies or securities. For example, if a company is in financial difficulty and is undergoing restructuring, the fund may buy its securities at a deep discount (distressed securities), and stands to earn well if the company is successful. Another example is mergers and acquisition related events. When a company announces its merger or acquisition, its stock will sell at a discount before the effective date of the acquisition. The hedge fund may indulge in risk arbitrage by buying stocks of company being acquired and at the same time selling stocks of the acquiring company.

Types of Hedge Funds

Even though hedge funds are very popular, they are not accessible to small investors because of the higher amount of investment required. An alternative is a fund of hedge funds that allows all kinds of investors easy access to the hedge funds. Unlike a hedge fund that invests in stocks, bonds and other securities, a fund of funds invests in a selection of hedge funds. As an FOFs client base grows, it can invest larger amounts of money in hedge funds.
<h2>Benefits</h2>
Funds of Funds provide several benefits to investors:
<ul>
	<li><strong>Retail investors:</strong> Using FOFs, even retail investors get access to huge funds.</li>
	<li><strong>Access:</strong> Sometimes a hedge fund may not be accessible to investors because it has reached maximum number of investors or any other factor. An FOF may be able to provide investment in such hedge funds.</li>
	<li><strong>Diversification:</strong> Instead of investing in a single hedge fund, an investor can diversify its portfolio.</li>
	<li><strong>Expertise:</strong> Individual investors may not have the skill and expertise to find good hedge funds. Funds of funds provide the expertise of the managers who have experience and skill in selecting hedge funds.</li>
	<li><strong>Due Diligence Process:</strong> While selecting a hedge fund, even institutional investors have to perform due diligence which is a specialized process and is also time consuming. An FOF may be more suited for this job.</li>
</ul>
<h2>Drawbacks</h2>
Funds of Funds also have some drawbacks:
<ul>
	<li><strong>Fees:</strong> The total fee can be very high because the investors also have to pay the manager's fees apart from the fee charged by each hedge fund.</li>
	<li><strong>Performance:</strong> It's not necessary that an FOF will perform better or provide consistent performance.</li>
	<li><strong>Diversification is not always good:</strong> Mixing high performing hedge funds with other funds to lower the risk may defeat the overall purpose of investing in hedge funds.</li>
</ul>

Funds of Hedge Funds

There are two important points that need special mention while discussing hedge funds. One, hedge funds make extensive use of leverage. Some people believe that leverage is the major source of risk for hedge funds, while others argue that using leverage combined with risk management enhances hedge fund returns. Second, hedge funds face certain unique risks that make them more risky.

Let's discuss these two aspects in more detail:
<h2>Leverage</h2>
Most hedge funds (but not all) use leverage in their trading strategies. In certain strategies such as arbitrage, leverage is essential because of the small profit margins in these arbitrage trades. Just like leverage enhances your profits, it also magnifies your losses. With a leverage of 10:1, you stand to lose as much as 10 times compared to a trade with just your own funds.

Hedge funds normally have a leverage of 2:1 to 10:1. However, some hedge funds have run leverage as high as 100:1. Within a hedge fund, there will usually be specified maximum limits for leverage, and the fund manager will be legally bound by that limit.

Hedge funds can create leverage in many forms such as:
<ol>
	<li>Borrowing external funds</li>
	<li>Buying on margin</li>
	<li>Using derivatives and other financial instruments</li>
</ol>
<h2>Unique Risks</h2>
Apart from market risk and other trading related risks, hedge funds face the following risks that are unique to them:
<ul>
	<li><strong>Liquidity risk:</strong> Hedge funds that trade in illiquid or thin markets can cause extreme lack of liquidity for them.</li>
</ul>
<ul>
	<li><strong>Pricing risk:</strong> Hedge funds invest in very complex financial instruments and many of them are traded over-the-counter. Such products are difficult to price, which can easily go wrong.</li>
</ul>
<ul>
	<li><strong>Counterparty credit risk:</strong> Hedge funds face significant counterparty risk, which can arise from many sources such as margin trading, and mortgage trading.</li>
</ul>

Leverage and Unique Risks of Hedge Funds

The information about hedge funds is not publicly available or listed on any exchange. Investors have to obtain this information directly from the hedge funds or data provider specializing in collecting hedge fund data.

Many such hedge fund data providers also publish indexes. These indexes allow easy tracking of the performance of hedge funds and also comparison across different funds. These indexes track both hedge funds and fund of funds.

Many institutions publish hedge fund indexes. Some of them are listed below:
<ul>
	<li>Specialized firms</li>
<ul>
	<li>Hedge Fund Research</li>
	<li>Van Hedge</li>
	<li>Hennessee</li>
	<li>Greenwich</li>
</ul>
	<li>Banks</li>
<ul>
	<li>Crédit Suisse/Tremont indexes (Based on the TASS database managed by Tremont/Owned by Lipper)</li>
	<li>ABN AMRO EurekaHedge</li>
</ul>
	<li>Index providers</li>
<ul>
	<li>MSCI</li>
	<li>S&amp;P</li>
	<li>FTSE</li>
</ul>
	<li>Educational institutes</li>
<ul>
	<li>CISDM</li>
	<li>EDHEC</li>
</ul>

</ul>
Hedge fund indexes can be equal-weighted or asset-weighted (weighted by assets under management for each fund.)

Asset-weighted indexes provide a better representation of the funds performance, however, some indexes still use equal-weights because they do not want to disclose the size of the funds.

There are no guiding principles on how individual hedge funds are included in an index. Most indexes are constructed by selecting funds from their database. So, if an index has volunteered to be included in a database, it can become a part of the index. Due to information asymmetry, the performance reported by various hedge fund indexes can vary significantly.

Another category of indexes, called investable indexes, includes only those funds that an investor can actually buy and sell. Such funds are called open funds. A hedge fund needs to have certain characteristics to become eligible for inclusion in such an index, for example, readily accept new investments, no lock-up periods, among others.

Hedge Fund Indexes

The hedge fund industry does not have a very evolved performance measurement framework. This makes it difficult for investors to depend on the historical records while allocating their funds.

The performance data provided by the hedge fund databases and indexes has several biases. Let's discuss some of these biases.

<strong>Self-selection:</strong> The inclusion in a hedge fund database is voluntary and the hedge fund managers can choose to include themselves or not to. In general, if a fund has poor track record it may not want to expose its performance and will decide not to be included in a database.

<strong>Backfilling:</strong> This means that when a new hedge fund is added to an index, the past performance of the fund is back-filled in the index. For example, if the hedge fund is 3 years old, it's record for the past three years will be added to the index, and the index values will be adjusted accordingly. The successful funds are more likely to be added to an index than an unsuccessful one, which creates a bias in the index. Studies suggest that backfill bias adds about 4% or more to hedge fund returns

<strong>Survivorship Bias:</strong> This is the situation where unsuccessful funds are removed from the index, and the past index values are adjusted to remove the data of the dropped fund. Since a fund is more likely to be dropped from an index because of poor performance, such actions create bias in the index. Studies suggest that survivorship bias adds about 3% or more to hedge fund returns.
<h2>Impact on Risk Measures</h2>
Even the risk measures of the hedge funds have biases.

<strong>Smooth pricing of infrequently traded assets:</strong> Hedge funds invest in many infrequently traded and illiquid assets such as real estate, and OTC instruments. Since these assets are traded less, and don't have regular price updates, they exhibit low volatility. This is called the smoothing effect, which creates a downward bias to the risk of the assets. Also, the low correlation of these alternative assets with regular asset classes such as equity, and fixed income can make the bias even larger.

<strong>Option-like investment strategies:</strong> Hedge funds have very non-linear investment strategies such as arbitrage strategies. These strategies make their returns highly skewed, and the funds exhibit high kurtosis (fat tails), and negative skewness. The traditional measures such as standard deviation and VaR will underestimate the risk of losses for these funds. Even Sharpe ratio is inappropriate for measuring performance.

<strong>Fee Structure:</strong> Hedge funds have a high fee structure, which also exhibits option-like features. There a 1-2% fixed fee plus an incentive fee of upto 20% if the returns are positive. This creates incentives for fund managers to take higher risks to maintain high performance.

To conclude, investors should study these funds carefully and account for these biases and risks before investing.

Biases in Hedge Funds Performance Data and Risk Measures

Hedge Funds

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Hedge Funds

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