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Few firms in the hedge fund industry can be classified into the "diamond in the rough" category like HedgeCo. We first became acquainted with HedgeCo back when our fund launched and we were looking for a reputable firm to design our website. As we were perusing other fund's sites, we noticed a general theme that many happened to be designed by the same firm, HedgeCo Websites. We reached out to them and found ourselves talking directly with the CEO himself, Evan Rapoport, which was a nice touch. Evan's extremely dynamic and energetic personality along with his command in the hedge fund world gave us the confidence to engage them to design our site. The team was quick to begin, met deadlines on time and the end product has garnered much praise from fellow managers. Later, realizing that HedgeCo also facilitated capital raising opportunities, we reached back out to them. HedgeCo helped smoothly transition a move to a new broker platform that could better suit our needs while at the same time putting us in touch with a number of institutional investors that has turned out to be extremely fruitful. They invited us out to an emerging manager's conference in Chicago which helped amplify our exposure to the hedge fund arena. HedgeCo's efforts has helped us triple our firm's assets under management within a year. Evan and his team have been an unrelenting source of information and help as our firm maneuvers through the emerging manager stage and would be an indispensible asset to anyone in the hedge fund business.

Kevin Lennil
Partner, Chief Investment Officer
Exagroup, LLC




What is a hedge fund?

Hedge funds are defined by their structure rather than any specific investment method. These pooled investment vehicles are commonly set up as limited partnerships in which the manager acts as the general partner while the investors act as the limited partners. Oddly, the term ‘hedge fund’ is a misnomer. Not all hedge funds are hedged. Hedge funds invest in any number of strategies regardless of the common term that attempts to corral them. These strategies include investing in asset classes such as stocks, bonds, commodities, currencies, and return enhancing tools such as leverage, derivatives, and arbitrage. Some funds, however, are simply 100% long equity securities.

 
What does it mean to hedge?

"Hedging" roughly means managing risk. Typically, a money manager employs a particular hedging technique in order to mitigate a particular type of risk. For instance, market risk - the risk of a decline in the overall market - can be hedged against by selling a broad collection of securities short in equal proportion to one's long exposure. The same end could also be accomplished by buying put options on an index like the S&P500. Other types of risk often hedged against include interest rate, inflation, and large weightings in a sector, region, single company, or currency. Tools and techniques of hedging include: raising cash, selling short, buying or selling options, futures, commodity and/or currency futures, etc.

 
Are there restrictions as to who can invest in hedge funds?

Yes. Hedge Funds are restricted from accepting investors who are not "accredited."  If you can meet one of the following criteria, you are an accredited investor:

1.  You have an individual net worth, or you and your spouse have a combined net worth, in excess of $1 million.

2.  You had individual income, excluding any income attributable to your spouse, of more than $200,000 in the previous two years, and you reasonably expect to do the same this calendar year.

3.  You and your spouse had joint income of more than $300,000 in the previous two years and reasonably expect to do the same in this calendar year.

Institutions and pension accounts are subject to more complex criteria, and should consult an accountant.

There is a difference between an accredited investor and a qualified client.  While if you meet the standards above, you are able to invest in a hedge fund, most managers would much rather work with qualified clients.  The reason being managers can only charge the 20% performance fee to qualified clients.  You are considered a qualified client if:

1.  You have an individual net worth, or you and your spouse have a combined net worth, in excess of $1.5 million

2.  You have at least $750,000 under the management of the investment adviser

Can a qualified client place IRA or ERISA assets in a hedge fund?

Usually qualified clients may invest IRA or ERISA assets in hedge funds; however, funds are limited in the amount of these assets they may accept. IRA investments in hedge funds makes a great deal of sense because of the deferral of taxes on capital gains. The details of this deferral should be discussed before making an investment.

How much money is invested in hedge funds?

It is estimated that there is close to $3 trillion currently being managed by hedge funds.  Because hedge funds don't have to "report" anything to the government, we can only estimate this number.  It is believed that a large portion of this number is invested in offshore hedge funds.

What kind of fees do most hedge funds charge?

The majority of U.S. hedge funds charge the standard "one-and-twenty": 1% of assets and 20% of profits, annually (more precisely, the 1% fee is usually charged in .25% increments quarterly, in advance while the 20% is usually calculated annually). These are known as the "management fee" and "performance fee" respectively. There are many variations and embellishments, some fairly common. For instance, most funds observe a "high-water mark". This simply means that if, in a given performance fee period, a fund loses part of its investor's money; the investors will not be charged in later periods until the losses have been recovered. Another common variation is the "preferred return." This means that a fund will not collect a performance fee until a certain return is achieved. This is often fixed, say at 10%, or ‘floats’ along with some risk-free interest rate indicator.

Are Hedge Fund Returns Reported Before or After Fees?

Most funds report their returns from previous years "net of all fees." This means net of management fees and net of incentive/performance fees. However, don't assume this; look carefully and if you are not sure, ask. Some funds report gross returns or returns net of management fees but gross of incentive /performance fees. Still others will report audited net of all fees returns with estimated/pre-audited net of all fees performance for the current year's performance. But regardless of which method is used, almost all funds state that their pre-audit figures are subject to adjustment by the partnership's auditor after the end of the year. These adjustments are almost always minor. If the adjustments are large, you should look for an awfully good explanation.

What are the tax implications of becoming a limited partner/investor in a hedge fund?

At the end of each year a Hedge Fund as a limited partnership reports in a K-1 form gains or losses for the trades the fund made that year. These gains or loses are treated as are any other capital gain. It is important to note that the return of a fund is separate from the taxable gains and losses the fund has made over the course of the year. For example, it is possible that a fund may have "realized" a loss for tax purposes but have reported positive performance (capital appreciation) through unrealized gains. The opposite is also possible.

What is an Offshore Hedge Fund?

Funds structured under foreign law, or located outside the U.S. are designated as “offshore hedge funds.”  Offshore Hedge Funds are not registered United States or with the SEC, and therefore offer privacy benefits as well as tax advantages. These offshore hedge funds are not subject to U.S. income on distributions received from the fund or to U.S. estate taxes on fund shares. Generally, offshore hedge funds are exempt from withholding taxes because the funds are located outside the United States.  However, if the fund invests in businesses located within the United States, stricter control measures are enforced.  

Who Invests in Offshore Hedge Funds?

Generally, non-U.S. citizens and non-U.S. residents and who are present in the United States fewer than 180 days a year.  However, many tax-exempt investors, such as not-for-profit institutes, retirement funds, and endowments may invest in offshore hedge funds.  Both these foreign investors and U.S. exempt investors will invest in either a parallel fund of an existing U.S. fund, or they will invest in a foreign-feeder fund which is set up as a corporation.

Where are most Offshore Funds located?

While most investors set up offshore funds in the Caribbean and British Virgin Islands, a high number of new hedge funds are springing up all over the globe.  This includes places like Gibraltar, Hong Kong, Isle of Man, Jersey, Switzerland, Luxemburg, and Liechtenstein.  Offshore financial centers are attractive to U.S. investors since they adhere to the privacy of their clients, and anonymous transactions can be made easily.

What is the minimum investment in a hedge fund?

The minimum investment varies from fund to fund, and is set by the General Partner (GP). It is common for new hedge funds to open up with minimum investments of $250,000 or $500,000. Established funds can have much higher minimums; $10,000,000 is not unheard of. In most cases, the GP can waive the minimum at his sole discretion. This is often done to accommodate investors who intend to make an investment equal to or greater than the stated minimum over time, but do not want to start that high.

How is the Performance of a Hedge Fund Measured?

Managers may use many statistics to measure the performance of a fund.  It is important to use a variety of these techniques so that investors will have a clear picture of the funds success through use of charts, graphs and numbers.  Here are a few of the ways performance can be measured:


Sharpe Ratio – Measures return/risk. Return is the numerator and is defined as the incremental average return of an investment over the risk free rate. Rate is the denominator and is defined as the standard deviation of the investment returns.


Sortino Ratio – Measures return/risk. Return is the numerator and is defined as the incremental compound average period return over a Minimum Acceptable Return (MAR). Risk is the denominator and is defined as the Downside Deviation below a Minimum Acceptable Return (MAR).


Beta – A measure of the hedge fund's volatility, or systematic risk, compared to the market as a whole. A beta of 1 indicates the fund will move with the market. A beta of more than 1 means that the fund is more volatile than the market. A beta of less than 1 means the state of the market does not have as much impact on the fund.


Skewness – Describes a hedge fund's asymmetry in relation to a normal distribution.


Kurtosis – Describes trends in charts. A high kurtosis means the chart has fat tails and a low, even distribution. A low kurtosis means the chart has skinny tails and a distribution concentrated toward the mean.


Covariance – Measures the degree in which asset returns move in correlation to each other. A positive covariance means that asset returns move together, while a negative covariance means that asset returns move in the opposite direction of each other.


Annualized Return -  What the return of the fund would be if it were in effect for a year


Standard Deviation – Used to measure the fund's volatility. Also known as the historical volatility.


Treynor Ratio - A risk-adjusted measure of return based on systematic risk. It is similar to the Sharpe ratio, with the difference being that the Treynor ratio uses beta as the measurement of volatility.


Calmar Ratio - A ratio used to determine return relative to drawdown risk in a hedge fund. Usually, the higher the ratio, the better.


R – Explains the fund's relationship to the maket


R2 – A statistical measure that represents the percentage of a fund or security's movements that can be explained by movements in a benchmark index.


Alpha – Represents the value that the Portfolio Managers either adds to or subtracts from the fund. A positive alpha of 1% means the fund has outperformed its benchmark index by 1%. A negative alpha indicates an underperformance of 1%.


Compound Annual Growth Rate (CAGR) – The year over year growth rate of the hedge fund. The CAGR is not the actual return, but rather a number that portrays what the fund would have grown at if it grew at a steady rate.


Downside Deviation - A value representing the potential loss that may arise from risks as measured against a minimum acceptalbe return.


Maximum Drawdown – The % decrease in investment value from its peak to its trough. It is the largest drawdown that has ever occurred within a specific time frame.


Fund Cumulative Returns vs. Benchmark – Comparing the hedge funds cumulative return with a standard in the industry.


Rolling Performance – performance of the fund based on 12 months



 

 



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