Hedge Funds

INTRODUCTION

Famed hedge fund manager Mario Gabelli wrote in 2002: "Today, if asked to define a hedge fund, I suspect most folks would characterize it as a highly speculative vehicle for unwitting fat cats and careless financial institutions to lose their shirts." This characterization stems from the hedge fund's recent history, which

* began with the headline-making collapse of Long Term Capital Management in 1998 and

* continued with the sensational meltdown of the Tiger Funds in March of 2000,

* followed by the reorganization of the once high-flying Quantum Fund in April of 2000

* and just ten days back Amaranth went broke losing

$6 billion because of bad natural gas trades in less than one month

These high-profile incidents overshadow more than half a century of hedge fund history that began when Alfred Winslow Jones launched the first hedge fund in 1949.

WHAT'S A HEDGE FUND?

An aggressively managed portfolio of investments that uses

* advanced investment strategies such as

* leverage (Arbitrage inefficiencies are very small and in order to get a sizeable return, high turnover is required. Leverage accomplishes the same. This precisely is what makes investment in hedge funds a very risky proposition while at the same time allowing them to gain huge profits.)

* long, short and

* derivative positions

* in both domestic and international markets

* with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

Legally, hedge funds are most often set up as private investment partnerships that are open to a

* limited number of investors and

* require a very large initial minimum investment.

* Investments in hedge funds are illiquid as they often require investors keep their money in the fund for a minimum period of at least one year.

For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors.

In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of over $1 million, along with a significant amount of investment knowledge.

HEDGE FUND Vs MUTUAL FUND

You can think of hedge funds as MUTUAL FUNDS FOR THE SUPER-RICH.

SIMILARITIES

Hedge funds are like mutual funds in two respects:

(1) they are pooled investment vehicles (i.e. several investors entrust their money to a manager) and are professionally managed

(2) they invest in publicly traded securities.

DIFFERENCES

But there are important differences between a hedge fund and a mutual fund. These stem from and are best understood in light of the hedge fund's charter:

"Investors give hedge funds the freedom to pursue absolute return strategies."

Thus, the hedge fund has far more flexibility in its investment strategies.

1) MUTUAL FUNDS SEEK RELATIVE RETURNS VS HEDGE FUNDS (ACTIVELY) SEEK ABSOLUTE RETURNS

Mutual Funds Seek Relative Returns

Most mutual funds invest in a predefined style, such as "small cap value", or into a particular sector, such as the Internet sector.

To measure performance, the mutual fund's returns are compared to a style-specific index or benchmark. For example, if you buy into a "small cap value" fund, the managers of that fund may try to outperform the S&P Small Cap 600 Index. Less active managers might construct the portfolio by following the index and then applying stock-picking skills to increase (over-weigh) favored stocks and decrease (under-weigh) less appealing stocks.

A mutual fund's goal is to beat the index or "beat the bogey", even if only modestly. If the index is down 10% while the mutual fund is down only 7%, the fund's performance would be called a success.

On the passive-active spectrum,

* pure index investing is the passive extreme

* mutual funds lie somewhere in the middle as they semi-actively aim to generate returns that are favorable compared to a benchmark and

* hedge funds lie at the active end.

Hedge Funds Actively Seek Absolute Returns

Hedge funds lie at the active end of the investing spectrum as they seek positive absolute returns, regardless of the performance of an index or sector benchmark. Unlike mutual funds, which are "long-only" (make only buy-sell decisions), a hedge fund engages in more aggressive strategies and positions, such as short selling, trading in derivative instruments like options and using leverage (borrowing) to enhance the risk/reward profile of their bets.

HEDGE FUNDS ARE POPULAR IN BEAR MARKETS

This activeness of hedge funds explains their popularity in bear markets. In a bull market, hedge funds may not perform as well as mutual funds, but in a bear market - taken as a group or asset class - they should do better than mutual funds because they hold short positions and hedges. The absolute return goals of hedge funds vary, but a goal might be stated as something like "6 to 9% annualized return regardless of the market conditions".

2) FREEDOM AND FLEXIBILITY

Investors, however, need to understand that the hedge-fund promise of pursuing absolute returns means hedge funds are "liberated" with respect to

1. registration