Hedge Funds: Myths and Reality

Hedge funds initially, since their appearance, were the subject of mythmaking. This happened thanks to a resounding and unusual name, the impact of which is still growing at the expense of the appeal of the action that is meant by this term. As a hedge in the practice of financial management refers to a set of activities aimed at providing coverage of financial risks, it is usually suggested that the hedge fund and is therefore called upon to deal with. This view has created the preconditions for the emergence of the myth of the high profitability of hedge transactions, which was confirmed by records of hedge funds on their activities.

Hard to say what has caused greater harm to the very idea of applying hedge for the purposes of covering the financial risks: lack of knowledge of the foundations of a rather subtle and complex science of risk management or the use of hedge funds used by labels. But the fact remains that most people believe that hedge funds are established and operate in the market solely to comply with the orders of their clients in the area covering the financial risks are: price, interest, currency exchange, etc.

What is a hedge fund?
In reality, of the hedge funds, as an organization exclusively engaged in risk management, it is not true. It is likely that for some companies this may be true, but for the most part, the title does not define the terms of transactions that hedge fund performs in the market. Follow-up actions on the market, falling under the concept of hedging is merely an additional element of asset management, and is mandatory for all financial institutions in today's market conditions.

The American understanding of hedge fund is, as a rule, a private investment partnership, to invest primarily in publicly traded securities or financial derivatives. However, some of the funds do not limit their activities to these areas, and also worked in other markets, such as cash. In principle, the market segment, which focused around the interests of financial institutions is entirely determined by their objectives persecuted.

In hedge funds, there are two types of partners: General Partner and Limited Partner. General Partner - is the founder of hedge fund. He maintains all the daily activities of the Fund. The limited partners capital, but did not participate in the trade and the daily activities of the fund. A typical form of organization of the General Partner - LLC (Limited Liability Company - a company with limited liability), while it is unlimited liability partnership. The limited partner of the investment partnership is responsible only to the extent of their investment in the partnership.

For all types of services provided by General Partner, enabling it receives a fee determined by partnership agreements. Usually it is about 20% of net profit partnership. In addition, appointed another, and administrative fees, which typically amounts to 2-3% of net assets. The performance of hedge fund is distributed among all partners in proportion to their shares. All relationships are established in detail Partners partnership agreement, which is the most important part of any hedge fund.

As the hedge fund is a private investment partnership, the U.S. Commission on Securities and Exchange Commission (Securities and Exchange Commission, SEC) limits the number of investors who can enter into it, up to 99. In doing so, at least 65 of them should have a status of "accredited". The status of "accredited" investor is defined by the criterion of net value of the equity contribution, which has a bar. It could be very high and a value of $ 1 million Given that such investments classified as risky, then "accredited" investor may be required to prove their right to dispose of such amount, without prejudice to the family budget. In other words, give the necessary assurances that the million is not the last.

Offshore hedge funds are typically mutual fund (mutual fund), a resident of preferential tax zones - such as Bermuda. They are also available, the same technology investment, and that hedge funds, it is in this perspective, they are related. But nevertheless, there are some differences that are not always easily seen. Basically, it concerns the distribution of income from operations, the principles of entry and exit from the partnership, as well as the transparency of the performance of the business.

How are hedge funds
The difference between hedge funds from other forms of financial institutions is largely in the fact that he is free to choose the investment style. In addition, the investment strategies that hedge fund can practice, are not limited to the purchase of securities, and hedging through stock options, which usually is limited exposure to risk, the residual value which can be substantial. Numerous and extensive opportunities in the market of financial derivatives can be significantly higher degree of freedom used by managers of hedge funds, unlike other forms of investment organizations.

The reason for this situation is that the existing legislation and regulations severely limit the actions of many large investment companies. Paradoxically, but they determine the overall situation in the market. Basically, it concerns the possibility of extensive use of strategies related to the sale of securities without a cover, as well as the use of a large arsenal of strategies and technology options, and futures markets. This is not necessarily "make money" in the falling market. It is in such moments especially evident advantage of hedge funds, have the opportunity to fully apply the full range of trading strategies.

The advantage becomes especially apparent when the market is only vibrational motion in a range of prices. It is in this situation, hedge fund, which could easily apply the options to create different combinations, as well as the use of conversion operations, the nature of arbitration, and therefore a risk in nature, continues to produce revenues that are available other market participants to a much lesser extent.

In addition, the hedge fund has more than free to choose those strategies that give the best effect in the current circumstances. In the face of market volatility as the market gives them continuously in large quantities. For instance, while trade in different markets are often brings a higher income, allowing you to profit from the difference in prices for the same assets. Also, almost constantly, there are situations when it is possible to construct such a tool, which will have the characteristics of the asset without risk, but allows you to generate a significantly higher yield than securities with similar parameters. Typically, the yield is at a level between the rate without the risk and secondary market, ie between 8% and 16%, but sometimes can exceed these values.

It is essential that the requirements on margin is quite different depending on the type of account with which transactions are carried out. In this sense, is quite illustrative example of comparison of alternatives to open a position on the futures on the S & P500 index with conventional investment account, which makes access to the market of securities, and accounts with the brokerage company, servicing operations in the commodity markets:

Also keep in mind that the calculation marzhevyh claims on commodity markets is carried out using the SPAN-Margin, which takes into account absolutely all your open positions, rather than vychlenyaet portfolio only part of them. This leads to extremely inflated values of the margin in the conduct of operations in the securities market are not always exactly meet the real parameters of risk. The result is simple: a synthetic manner generated a portfolio of tools for the commodity market requires 2-3 times less capital than in the case of similar actions in the securities market and options on them. Hedge funds, because of the freedom of determining the direction of its activities, has the opportunity not only to choose the most interesting financial instruments, but use the best opportunities in the field of management by them. This allows to operate simultaneously on different markets with the lowest-cost world, given the resulting balance of the entire portfolio as a whole, regardless of where and how to conduct the operation.

And finally, the problem of creating a diversified portfolio, which is virtually impossible for the core number of investors, it is easily solved in the hedge fund. By combining their funds, investors are able to co-sharing the portfolio, which, introducing a set of assets, in very much reduces the risk. Often, the most attractive investment is inaccessible to ordinary investors because the shares may be too expensive. United in a common pool that money hedge fund allow operation with much less risk, reaping significant benefits from this. Because each of the assets inherent in certain indicators of the average yield, deviations from it, the ability to respond to certain external events, etc. Individually, these assets are capable of carrying a high price risk, but collectively they are in a strong degree of mutual repaid. This fact is a cornerstone in the theory of portfolio and is widely used not only in the securities market, but in practice financial management.

Of course, there are options for investment in capital markets through the acquisition of shares of mutual fund, open a separate investment account with a bank or a specialized company. However, all these ways, one way or another, lead to negative results, the effects are often difficult or even impossible to remove.

Income distribution in the hedge fund
Calculation of income in the hedge fund DE produced the conditions specified in the partnership agreement. After deduction of administrative charges and pay the General Partner, the funds are distributed among all partners according to their assessed contribution. In fact, this procedure is not very different from the mechanism for determining the value of mutual fund. It uses the same principles. However, less transparency, compared with hedge funds often misleading investors, and brings them to the disappointment in the outcome of return on capital. After determining the current value of the assets and income, due to each partner of hedge fund, for his contribution prisovokuplyayutsya a "dividend", which is also known as a "paper profit." Despite that designation, they are absolutely real, because the assets can be withdrawn at any time sold or transferred in cash. Defining the same amount that will be received after all deductions and paid partners, carried out by hedge fund at the date of each regularly - so-called "transition date", enshrined in the partnership agreement. Usually this is the last day of each month. The most insightful and literate investors prefer to accumulate this kind of profits accruing in the value of the contribution, as well as over time, begins to work the effect of accumulation, because the fund consistently produces reinvestment. In the small time intervals is not a large profit, but for a sufficiently long period, the effect is manifested in an extremely strong degree and can exceed all the expectations. This fact is equally true for any mode of investment in the securities market, but it is the case with hedge funds is reflected in the best. This is because he has the opportunity to lead a little more aggressive as compared to mutual funds, especially in the case of restructuring of the portfolio.

The tendency of investors to leave their deposits for a sufficiently long period is largely driven by policies of hedge funds on options to exit the partnership procedures. Usually, this requires advance notice of withdrawal with the definition of the term in a rather long range (up to 2 - 3 months). Sometimes provides an alternative - an immediate contribution for the realization of cash, which is ensured by a self-declared hedge funds buy and sell prices of shares. Naturally, the difference between them is very significant.

In the introduction, withdrawal, or withdrawal of a contribution from the hedge fund investments of each partner being revised, and reveals a new share balance. Those partners who do not move their assets, such actions do not affect, and value their contribution in monetary terms does not change. Revision of the subject only to equity ratio of deposits.

Nevertheless, with careful analysis of the consequences of failure of hedge fund investors can be found part of the likelihood of obtaining benefit from these actions, as well as management is able to settle with leaving fund shareholders are not too good investment. Leaving a more valuable asset, hedge fund after a short period of time may show a sharp increase in return on capital, as well as in the creation of income already participated capital, which was withdrawn, but did not manage to get his due share of profits. However, if the hedge fund will begin to leave, all partners, it could have consequences for ordinary cases of capital flight: the fall of the impact on capital and increase the risk of bankruptcy.

Hedge-fund and mutual fund - what is the difference?
There are plenty of differences between mutual funds and hedge funds. The most obvious differences relate to their management and structures. Mutual funds, generally speaking, limited investment in the purchase of "classic" of securities - such as stocks, bonds, mortgages, etc. Hedge funds, in addition to investment opportunities in all the tools available for the mutual fund may also use options, warrants, convertible bonds, commodities, margin transactions and short sales. This explains their ability to work in the falling market.

Another important difference: the mutual fund managers are paid exclusively from the percentage of assets under management. This means that the only way for the staff of these financial institutions to raise their income - this increase in size of assets under management. This is a significant difference from the hedge fund, which has a large part of the payment depends on the managers of the benefits fund. Sensibly arguing, you can understand that this situation carries a higher risk, because they do not encourage managers to improve the quality of governance. It is easy to understand that this is one of the reasons that mutual funds are losing hedge fund as a result of yield return, as well as a very great deal of effort spent on working with clients, rather than focus on improving the quality of engagement in the market.

Mutual funds are owned and managed investment companies. Capital for the mutual fund is going in such a way that only a very small proportion of the investment company's own money actually invested. Shares of the same investors involved in the winnings and losses in proportion to their participation, taking into account all costs. At about the same thing happens in the hedge fund, but the difference arises when managers are placing their money in hedge funds (which is normal). Often, the additional payment of managers is linked to the achievement of a certain level of return the fund, according to the formula "no less." The amount of the incentive pay is set in partnership agreements.

Why investors prefer hedge funds?
All the time, hedge funds significantly exceeded both the mutual funds and broad market indicators, not only to return on capital, but also by the criterion of risk, which is characterized by their lower levels. In addition, hedge funds provide better protection for investments in the falling markets.

Published data suggest that for nine and a half years, the average net return hedge funds was 17.6%, while for U.S. mutual funds, it is 14.5%. Here also the values of the following indices: MSCI World Equity Index - 9.6%, Lehman Brothers for the bonds - 9.0%, S & P500 - 17.9%.

Excellent value hedge funds is achieved with good characteristics of risk, which is considerably smaller in comparison with the performance MSCI World Equity Index, as well as in comparison with similar figures for U.S. mutual funds and S & P500. In comparison with an index of bonds with the lowest risk in the market of corporate securities, hedge funds offer significantly higher returns. This is achieved both by the availability of a wide range of strategies, as well as through better diversification. One of the main advantages of hedge fund - work in the market through the investment pool. Depositor it is a double win, which is the ability to pool their funds as with other investors, and is widely diversified assets. By combining their assets, investors receive the services of professional managers, the costs of which are shared among all partner world and for each individual person significantly reduced.

An equally important advantage is the availability of a wide range of strategies. Managers of hedge funds can use such strategies, which are managed by mutual funds are not always available. Consequently, the impact of hedge funds could be much higher. Below are details VAN Hedge Fund Advisors Int. for the third quarter of 1998 to the work of hedge funds.

1. The average value of five best funds do not have losses in the calendar year and the impact of not less than 20%:

* For five years - 30.5%

* Per year - 74.3%

2. The average value of five best funds with losses of no more than three quarters:

* For five years - 23.9%

* Per year - 68.3%

3. The average value of five best funds with the highest absolute returns:

* For five years - 37.4%

* Per year - 97.9%

Many insightful investment managers are considering investing in hedge funds as a pre-statochno promising and interesting, because they can significantly improve the return on capital without significantly increasing risk. Thus, traditional portfolios consisting of stocks and bonds, can significantly improve both the efficiency, as well as the risk when they hedge funds as a separate investment.

What could be the return on capital in hedge funds?
The above rates of return on capital of various hedge funds show very high efficiency of the assets. Even if we take the assumption of the risk level is exceeded, the permissible from the standpoint of an aggressive investor, it might seem that demonstrated the effectiveness of business in the field of investment management is not too true. However, this is absolutely not true. Conducted by research in the field determine the level of profitability from operations in the financial markets suggests that in the case of an unlimited horizon of planning and the availability of capital, over 10 million dollars benefiting asymptotically tends to the level of 110% per annum for sredneagressivnogo portfolio, and for vysokoagressivnogo - to 185%.

These values are obtained as a result of a simple theory for calculating available incoming cash flow resulting from the creation of hybrid financial products, including various financial instruments. In general, hedge funds, regardless of the manner in which asset classes they are formed as the main investment portfolio, and hedge their risks. First producing average returns. The second allows you to derive income from the "no less." In sum, both the portfolio significantly increases the return on capital, while less variability in benefits over time, as very different from common approaches to investment management, which in the modern world should recognize the anachronism.

Thus, it seems the real results are not unusual. Rather, it may be noted that the quality of management is not always the best and has a significant potential for growth. Trying to predict the situation, you must first say that the market in recent years has changed, provide the managers much greater number of financial instruments with high liquidity. The rapid development of communication and their influence on the speed of operation has also made a significant contribution to the process of investment management. All this suggests that the impact of hedge funds tends to increase at the same time as well to increase its variability. However, it is equally true for other principles of management, which in the case of non-hedge instruments will be absolutely clear loss for all indicators.

Invest or not to hedge funds?
It is believed that one of the best ways of investing in foreign capital markets is to enter into a hedge fund on the rights of a partner. By combining their financial resources for investment purposes, came in the hedge fund people are a significant cost savings, significantly reduce risks and have full access to information on the status of their assets.

All these points are very important and attractive to investors, as well as provide a net gain, as opposed to other options for placement of funds in capital markets (investments in mutual funds), as well as opening their own investment accounts for investment companies to make their own management . Given the fact that the spectrum of available services in any investment of almost the same, the best choice for the discriminating investor can safely call it hedge fund. For a second, hedge funds are often able to offer a much wider range of services than other professional organizations working in the market, particularly with respect to securities.

All of these circumstances is very attractive to investors, pre-start up an additional measure of risk in exchange for higher profits. This provides a large influx of capital into this industry, as well as the rapidly growing number of hedge funds. No wonder the bulk of the investments of the United States in the Asian market took place in the channels by the hedge funds. To use or not to hedge funds as a tool for investment - an issue for individual permits each investor. Counsel in this case can not be, especially when it comes to this type of investment, where the timing should be long enough. It should also be taken into account the fact that the contribution to the hedge fund is not freely traded on the market of the securities. Naturally, it can not be purchased by none other than near the foundation. In addition, the necessary information about the interests of financial institutions can be found only by direct contact.

Naturally, all this can be extremely burdensome, which is generally not too encouraging investors. Nonetheless, modern communication capabilities, and especially the Internet greatly facilitates the task of finding and providing contacts.

How can I use hedge funds?
First of all, hedge fund was interesting channel resource allocation in the market from the viewpoint of the ordinary investor does not want to burden yourself worrying about the decision-making. This question is quite clear: entered into a partnership and can only monitor the status of your funds.

Nevertheless, for the Russian reality, there is another point which is quite important not to walk past him. The fact that a hedge fund Russian enterprise - an important and integral element of modern business to meet the huge number of non-solvable at the current time problems, such as the question of risk management related to the implementation of export-import operations of nature. Now, these issues remain outside the attention of managers of domestic companies, or depend on the complexity of the legislation in this area.

Legitimately established hedge fund in this case is able to solve many problems, leaving it under control the whole chain of operations that can significantly improve the productivity of the operation of the core business. Especially this type of financial institutions should be of interest to businesses operating in the area of financial services, and in the first place - the banks. Having at its disposal effectively acting hedge fund as a valuable investment institutions, skilled labor, any banking institution or investment company can offer significantly more services, not only in quantity but in quality than that observed in the current time.

Some banking institutions, as far as known to the author, it do. But the whole problem is that the use of foreign financial institutions operating in order to conduct operations in the capital markets is limited only to the management of cash resources, in one way or another abroad. In terms of operations, mainly investments in restricted securities. It should be recognized that it is much better option than to leave them just in bank accounts or investment trust managers, whose only advantage is that they live and work abroad.

There is no doubt that a hedge fund, subject to the formation of its structure as a full-fledged business - a very promising, especially when it fits into the overall context of business. Given that the modern diversity of financial instruments traded in the market, requires considerable effort, if necessary, simultaneous operations, it is simply a necessary element of modern financial management. Moreover, hedge fund, with more freedom in the choice of governance principles, can best solve a problem in the field of financial engineering, which is today the driving force in the market of services in the management of assets and liabilities.

Michael Chekulayev