Overview of Hedge Funds

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HEDGE FUNDS
INDEX

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Sr. No. Content Page No.
01 Introduction 3
02 Selected Definitions Of "Hedge Fund" 4
03 Key Characteristics Of Hedge Funds 5
04 Facts About The Hedge Fund Industry 6
05 The Growth Of Hedge Funds 7
06 Notable Hedge Fund Management Companies 10
07 Why Hedge Funds Are Attractive? 10
08 InformationShouldInvestorSeekBefore InvestingInA Hedge
Fund Or A Fund Of Hedge Funds?
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09 Hedging Strategies 14
10 Benefits Of Hedge Funds 14
11 Hedge Fund Styles 15
12 Advantages Of Hedge Funds Over Mutual Funds 18
13 Impact Of Hedge Funds On Capital Market 19
14 Role Of Hedge Funds In The Capital Markets 20
15 Investor Protection 22
16 The Federal Reserve And Hedge Funds 23
17 Bibliography 29
INTRODUCTION

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The term 'hedge fund' is used to describe a wide variety of institutional investors
employing a diverse set of investment strategies. Although there is no formal definition of
'hedge fund,' hedge funds are largely defined by what they are not and by the regulations to
which they are not subject. As a general matter, the term 'hedge fund' refers to
unregistered, private investment partnerships for wealthy sophisticated investors (both
natural persons and institutions) that use some form of leverage to carry out their
investment strategies.
The term 'hedge fund' is undefined, including in the federal securities laws. Indeed,
there is no commonly accepted universal meaning. As hedge funds have gained stature and
prominence, though, 'hedge fund' has developed into a catch-all classification for many
unregistered privately managed pools of capital. These pools of capital may or may not
utilize the sophisticated hedging and arbitrage strategies that traditional hedge funds
employ, and many appear to engage in relatively simple equity strategies. Basically, many
'hedge funds' are not actually hedged, and the term has become a misnomer in many cases.
Hedge funds engage in a variety of investment activities. They cater to sophisticated
investors and are not subject to the regulations that apply to mutual funds geared toward
the general public. Fund managers are compensated on the basis of performance rather
than as a fixed percentage of assets. 'Performance funds' would be a more accurate
description.

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SELECTED DEFINITIONS OF "HEDGE FUND"
"Hedge fund" is an expression believed to have been first applied in 1949 to a fund managed
by Alfred Winslow Jones.1 Mr. Jones's private investment fund combined both long and short
equity positions to "hedge" the portfolio's exposure to movements in the market. Today,
hedge funds are no longer defined by a particular strategy and often do not "hedge" in the
economic sense. The following is a selection of definitions and descriptions of the term
"hedge fund" showing the diversity of views among commentators.
"The term 'hedge fund' is commonly used to describe a variety of different types of
investment vehicles that share some common characteristics. Although it is not statutorily
defined, the term encompasses any pooled investment vehicle that is privately organized,
administered by professional money managers, and not widely available to the public."
--THE PRESIDENT'S WORKING GROUP ON FINANCIAL
MARKETS, HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF
LONG-TERM CAPITAL MANAGEMENT 1 (1999).
"The term 'hedge fund' refers generally to a privately offered investment vehicle that pools
the contributions of its investors in order to invest in a variety of asset classes, such as
securities, futures contracts, options, bonds, and currencies."
--THE SECRETARY OF THE TREASURY, THE BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM, THE
SECURITIES AND EXCHANGE COMMISSION, A REPORT TO
CONGRESS IN ACCORDANCE WITH § 356(c) OF THE USA
PATRIOT ACT OF 2001 (2002).
"A hedge fund can be broadly defined as a privately offered fund that is administered by a
professional investment management firm (or 'hedge fund manager'). The word 'hedge'
refers to a hedge fund's ability to hedge the value of the assets it holds (e.g., through the use
of options or the simultaneous use of long positions and short sales). However, some hedge
funds engage only in 'buy and hold' strategies or other strategies that do not involve hedging

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in the traditional sense. In fact, the term 'hedge fund' is used to refer to funds engaging in
over 25 different types of investment strategies .…"
--MANAGED FUNDS ASSOCIATION, HEDGE FUND
KEY CHARACTERISTICS OF HEDGE FUNDS
 Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns
and minimize the correlation with equity and bond markets. Many hedge funds are
flexible in their investment options (can use short selling, leverage, derivatives such
as puts, calls, options, futures, etc.).
 Hedge funds vary enormously in terms of investment returns, volatility and risk.
Many, but not all, hedge fund strategies tend to hedge against downturns in the
markets being traded.
 Many hedge funds have the ability to deliver non-market correlated returns.
 Many hedge funds have as an objective consistency of returns and capital
preservation rather than magnitude of returns.
 Most hedge funds are managed by experienced investment professionals who are
generally disciplined and diligent.
 Pension funds, endowments, insurance companies, private banks and high net
worth individuals and families invest in hedge funds to minimize overall portfolio
volatility and enhance returns.
 Most hedge fund managers are highly specialized and trade only within their area of
expertise and competitive advantage.
 Hedge funds benefit by heavily weighting hedge fund managers’ remuneration
towards performance incentives, thus attracting the best brains in the investment
business. In addition, hedge fund managers usually have their own money invested
in their fund.

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FACTS ABOUT THE HEDGE FUND INDUSTRY
 Estimated to be a $1 trillion industry and growing at about 20% per year with
approximately 8350 active hedge funds.
 Includes a variety of investment strategies, some of which use leverage and
derivatives while others are more conservative and employ little or no leverage.
Many hedge fund strategies seek to reduce market risk specifically by shorting
equities or through the use of derivatives.
 Most hedge funds are highly specialized, relying on the specific expertise of the
manager or management team.
 Performance of many hedge fund strategies, particularly relative value strategies,
is not dependent on the direction of the bond or equity markets -- unlike
conventional equity or mutual funds (unit trusts), which are generally 100%
exposed to market risk.
 Many hedge fund strategies, particularly arbitrage strategies, are limited as to
how much capital they can successfully employ before returns diminish. As a
result, many successful hedge fund managers limit the amount of capital they
will accept.
 Hedge fund managers are generally highly professional, disciplined and diligent.
 Their returns over a sustained period of time have outperformed standard equity
and bond indexes with less volatility and less risk of loss than equities.
 Beyond the averages, there are some truly outstanding performers.
 Investing in hedge funds tends to be favored by more sophisticated investors,
including many Swiss and other private banks that have lived through, and
understand the consequences of, major stock market corrections.
 An increasing number of endowments and pension funds allocate assets to
hedge funds.

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THE GROWTH OF HEDGE FUNDS
In the entire financial services area, the sector showing the most growth is clearly the area
of hedge funds. While brokerage commissions continue to decline, investment banking fees
start to come under pressure and the entire financial services industry worries about
intensified regulatory scrutiny, the hedge fund industry with its rapid growth stands out
from the crowd. New funds are starting up every week and many are beginning with an
excess of a billion dollars under management from day one. The amount of money under
management with hedge funds has gone up four times between 1996 and 2004 and is
expected to further triple between now and 2010 to over $2.7 trillion. Public funds,
endowments, and corporate sponsors have all increased their allocations to hedge funds
within the context of an increased allocation towards alternative investments more
generally. This move towards increased investments in real estate/private equity/hedge
funds (alternative investments) is driven by the need for a higher return to compensate for
the expected lower returns from more conventional investment strategies focused on US
bonds and equities. There is also a clear desire among this investor base to be more focused
on absolute-return strategies rather than relative return. Given the current level of
allocations most of these large long-term investors have towards alternative investments,
and their professed long-term target allocation, the flow of funds to these asset classes will
remain strong.
One of the intriguing developments in the hedge fund world is the clear desire and
ability of the newer funds to charge higher fees and impose more stringent terms on
investors. No longer are funds charging a 1 per cent management fee and 20 per cent of
profits -- the norm for the first generation of funds set up in the early to mid 1990s. As per
an interesting study done by Morgan Stanley's prime brokerage unit, about a third of the
funds opening in the past six months are charging a 2 per cent management fee and 20 per
cent of profits or higher, while the majority are charging a 1.5 per cent management fee and
20 per cent of profits. Many of the new funds have more stringent lock-ups and stiff
penalties if you redeem early, as well as modified high-water marks.

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The hedge fund business thus seems to have the unique characteristic of being
possibly the only business that I know of wherein new players (most of whom are unproven)
have the ability to charge more and get better terms than the established operators. This
implies a negative franchise value for the established large fund complexes which have
survived and prospered through the years. Given that most of the best hedge fund
complexes are closed to new investors, the new guys seem to be taking advantage of the
huge demand-supply mismatch for quality money managers. There is a feeding frenzy
currently under way in the world of alternative investments and clients are paying up the
higher fees for fear of being locked out from these funds at a later date, if they actually
survive and grow.
One reason why the new boys are focusing more on fees and lock-ups could be the difficulty
all hedge funds are having in generating adequate alpha (excess return) to ensure an
adequate payout for themselves.
In a study done by Morgan Stanley on the excess returns generated by hedge funds
over the last decade, this trend of declining returns was very apparent. In the study they
defined excess returns as the return of the Hedge Fund research composite over one month
LIBOR (a proxy for cash returns).
In the 1995-97 period, excess returns were 14 per cent; these returns have
consistently declined dropping to as low as 5 per cent in 2001-03 and have dropped further
since.
The current huge inflows into funds focused on emerging markets make sense if you
look at performance numbers over the past three years.
Hedge funds focused on the emerging markets had the best returns with an 18 per
cent annual return during 2001-04, closely followed by distressed debt focused funds at 17
per cent. More conventional hedge fund strategies of tech at 0 per cent and risk arbitrage at
3 per cent annual return lagged far behind. Given the constant inflows into new hedge
funds, clients do not yet seem to be bothered about paying higher and higher fees for lower
returns, but this is a discussion that I am sure will come up at some stage in most

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investment committees. At some stage if the hedge fund community continues to show
declining alpha (excess returns), clients will need to question whether the proliferation of
hedgies has reduced returns because the field has become too competitive.
The beauty of the hedge fund business and the reason why the upward drift in fee
structure is even more surprising is the ease of entry of new players into the game. The
average long short hedge fund needs only about six back office staff per billion dollars, while
a global macro fund needs about 11 people for a fund of similar size (Morgan Stanley
survey). The typical long short US equity manager has only nine investment professionals
and three in the back office. These funds are also not really regulated and have very limited
disclosure requirements, if any. The start-up costs of these vehicles are also minimal and
most funds will be able to break even at sub $100 million in assets under management.
There is no other industry that I am aware of where exit and entry are as simple.
Hedge funds till date in 2005 have had a tough year; there have been few strong
trends to capitalise on and most funds are struggling to show a positive return. If the hedge
fund industry ends the year flat or even (god forbid) negative after disappointing relative
performance in 2003 and just about average numbers in 2004, some of the more
sophisticated clients may migrate back to more conventional forms of investing with lower
fee structures. Hedge funds are clearly here to stay, and continue to attract the best talent
because of their payout structures; however, their ability to continue to command a
premium fee structure will eventually be limited by their ability to differentiate themselves
from their long-only brethren on the performance front.

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NOTABLE HEDGE FUND MANAGEMENT COMPANIES
Sometimes also known as alternative investment management companies.
• Amaranth Advisors
• Bridgewater Associates
• Caxton Associates
• Centaurus Energy
• Citadel Investment Group
• D. E. Shaw & Co.
• Fortress Investment Group
• Goldman Sachs Asset Management
• Long Term Capital Management
• Man Group
• Pirate Capital LLC
• Renaissance Technologies
• SAC Capital Advisors
• Soros Fund Management
• Marshall Wace
WHY HEDGE FUNDS ARE ATTRACTIVE?
There are a large number of investment vehicles that offer you good and stable returns.
Products like diversified mutual funds, blue chip stocks and property are some of them. But
for high net worth individuals (HNIs), there are more routes, especially in the international
markets. Here we look at one such vehicle, namely hedge funds. A hedge fund is a common
term used to describe private unregistered investment partnerships. Since most of them are
not registered with financial regulators in their countries of origin, they do not need to meet

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the eligibility requirements to register as institutional investors. This is good in a way but
could turn sour as well because there are no guidelines binding them. At present, there are
no hedge funds operating out of India. But internationally, there are a large number of such
funds.
These funds are very manager-centric as the entire onus of their success or failure falls on
the fund manager's ability to exploit existing market conditions. No wonder then that they
charge a fixed fee of around 2 per cent a year of assets under management, along with a
very high profit sharing percentage, which is mostly 20 per cent. Of course, they have to
assure returns as well. Thus, profit sharing may start on the returns over and above say, the
first 10 per cent returns. The fee is also based on a high watermarking concept, which
means that the fund manager is entitled to a share of profits the first time. Thereafter, if the
fund incurs losses and then recoups, the fund manager will not be entitled to any share of
the recouped losses. The next time he will be entitled is when he beats his earlier
performance.
However, given the plethora of opportunities worldwide, the fund manager has the luxury
of making investment decisions in stocks, bonds, commodities, currencies etc. The basic
idea is to generate aggressive returns. The most important feature of hedge funds is that
they seek to deliver absolute, rather than benchmarked returns. For example, equity mutual
funds are benchmarked against an index like the Nifty or BSE 200, or a banking sector
mutual fund could benchmark its returns against the banking index on a stock exchange and
can show the investors how much better/worse he has performed. However, hedge funds
managers do not have any such luxuries.
Since they are not regulated, most countries do not allow them to raise money from the
general public through a prospectus or advertisements. A few are registered with the
regulators in their countries because their main investors are universities, pension funds
and insurance companies.
Most of the marketing is done through investment advisors or personal contacts, with their
main investors being restricted to sophisticated HNIs. With the Reserve Bank of India [Get
Quote] (RBI) allowing Indian residents to invest up to $200,000 abroad per head a year, it is

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another opportunity for HNIs to tap these funds as the minimum limit of many of them start
from $100,000. But you need to remember that the amount invested is not very liquid and
may be subject to a lock-in period, with quarterly, half-yearly or yearly exit windows.
Those seeking to invest in hedge funds can approach a wealth manager, securities broker or
investment consultant abroad, who can advise them on the available options and select the
hedge fund they wish to invest in, based on its track record and management style. After
that they can approach their bank in India to arrange for the foreign remittance to the
hedge fund. Whenever they wish to redeem their investment, as permitted by the hedge
fund, they can repatriate the proceeds to India into their bank account.
WHAT INFORMATION SHOULD INVESTOR SEEK
BEFORE INVESTING IN A HEDGE FUND OR A FUND OF
HEDGE FUNDS?
 Read a fund's prospectus or offering memorandum and related materials. Make
sure you understand the level of risk involved in the fund's investment strategies and
ensure that they are suitable to your personal investing goals, time horizons, and risk
tolerance. As with any investment, the higher the potential returns, the higher the
risks you must assume.
 Understand how a fund's assets are valued. Funds of hedge funds and hedge funds
may invest in highly illiquid securities that may be difficult to value. Moreover, many
hedge funds give themselves significant discretion in valuing securities. You should
understand a fund's valuation process and know the extent to which a fund's
securities are valued by independent sources
 Ask questions about fees. Fees impact your return on investment. Hedge funds
typically charge an asset management fee of 1-2% of assets, plus a "performance
fee" of 20% of a hedge fund's profits. A performance fee could motivate a hedge
fund manager to take greater risks in the hope of generating a larger return. Funds
of hedge funds typically charge a fee for managing your assets, and some may also

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include a performance fee based on profits. These fees are charged in addition to
any fees paid to the underlying hedge funds.
 Understand any limitations on your right to redeem your shares. Hedge funds
typically limit opportunities to redeem, or cash in, your shares (e.g., to four times a
year), and often impose a "lock-up" period of one year or more, during which you
cannot cash in your shares.
 Research the backgrounds of hedge fund managers. Know with whom you are
investing. Make sure hedge fund managers are qualified to manage your money, and
find out whether they have a disciplinary history within the securities industry. You
can get this information (and more) by reviewing the adviser’s Form ADV. You can
search for and view a firm’s Form ADV using the SEC’s Investment Adviser Public
Disclosure (IAPD) website. You also can get copies of Form ADV for individual
advisers and firms from the investment adviser, the SEC’s Public Reference Room, or
(for advisers with less than $25 million in assets under management) the state
securities regulator where the adviser's principal place of business is located. If you
don’t find the investment adviser firm in the SEC’s IAPD database, be sure to call
your state securities regulator or search the NASD's Broker Check database for any
information they may have.
 Don't be afraid to ask questions. You are entrusting your money to someone else.
You should know where your money is going, who is managing it, how it is being
invested, how you can get it back, what protections are placed on your investment
and what your rights are as an investor. In addition, you may wish to read NASD’s
investor alert, which describes some of the high costs and risks of investing in funds
of hedge funds.

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HEDGING STRATEGIES
Wide ranges of hedging strategies are available to hedge funds. For example:
 Selling short - selling shares without owning them, hoping to buy them back at a
future date at a lower price in the expectation that their price will drop.
 Using arbitrage - seeking to exploit pricing inefficiencies between related securities -
for example, can be long convertible bonds and short the underlying issuer’s equity.
 Trading options or derivatives - contracts whose values are based on the
performance of any underlying financial asset, index or other investment.
 Investing in anticipation of a specific event - merger transaction, hostile takeover,
spin-off, exiting of bankruptcy proceedings, etc.
 Investing in deeply discounted securities - of companies about to enter or exit
financial distress or bankruptcy, often below liquidation value.
 Many of the strategies used by hedge funds benefit from being non-correlated to the
direction of equity markets
BENEFITS OF HEDGE FUNDS
 Many hedge fund strategies have the ability to generate positive returns in both
rising and falling equity and bond markets.
 Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and
volatility and increases returns.
 Huge variety of hedge fund investment styles – many uncorrelated with each other –
provides investors with a wide choice of hedge fund strategies to meet their
investment objectives.
 Academic research proves hedge funds have higher returns and lower overall risk
than traditional investment funds.
 Hedge funds provide an ideal long-term investment solution, eliminating the need to
correctly time entry and exit from markets.
 Adding hedge funds to an investment portfolio provides diversification not otherwise
available in traditional investing.

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HEDGE FUND STYLES
The predictability of future results shows a strong correlation with the volatility of
each strategy. Future performance of strategies with high volatility is far less
predictable than future performance from strategies experiencing low or moderate
volatility.
Aggressive Growth: Invests in equities expected to experience acceleration in
growth of earnings per share. Generally high P/E ratios, low or no dividends; often
smaller and micro cap stocks which are expected to experience rapid growth.
Includes sector specialist funds such as technology, banking, or biotechnology.
Hedges by shorting equities where earnings disappointment is expected or by
shorting stock indexes. Tends to be "long-biased." Expected Volatility: High
Distressed Securities: Buys equity, debt, or trade claims at deep discounts of
companies in or facing bankruptcy or reorganization. Profits from the market's lack
of understanding of the true value of the deeply discounted securities and because
the majority of institutional investors cannot own below investment grade securities.
(This selling pressure creates the deep discount.) Results generally not dependent on
the direction of the markets. Expected Volatility: Low - Moderate
Emerging Markets: Invests in equity or debt of emerging (less mature) markets that
tend to have higher inflation and volatile growth. Short selling is not permitted in
many emerging markets, and, therefore, effective hedging is often not available,
although Brady debt can be partially hedged via U.S. Treasury futures and currency
markets. Expected Volatility: Very High
Funds of Hedge Funds: Mix and match hedge funds and other pooled investment
vehicles. This blending of different strategies and asset classes aims to provide a
more stable long-term investment return than any of the individual funds. Returns,
risk, and volatility can be controlled by the mix of underlying strategies and funds.
Capital preservation is generally an important consideration. Volatility depends on
the mix and ratio of strategies employed. Expected Volatility: Low - Moderate - High

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Income: Invests with primary focus on yield or current income rather than solely on
capital gains. May utilize leverage to buy bonds and sometimes fixed income
derivatives in order to profit from principal appreciation and interest income.
Expected Volatility: Low
Macro: Aims to profit from changes in global economies, typically brought about by
shifts in government policy that impact interest rates, in turn affecting currency,
stock, and bond markets. Participates in all major markets -- equities, bonds,
currencies and commodities -- though not always at the same time. Uses leverage
and derivatives to accentuate the impact of market moves. Utilizes hedging, but the
leveraged directional investments tend to make the largest impact on performance.
Expected Volatility: Very High
Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking
offsetting positions, often in different securities of the same issuer. For example, can
be long convertible bonds and short the underlying issuers equity. May also use
futures to hedge out interest rate risk. Focuses on obtaining returns with low or no
correlation to both the equity and bond markets. These relative value strategies
include fixed income arbitrage, mortgage backed securities, capital structure
arbitrage, and closed-end fund arbitrage. Expected Volatility: Low
Market Neutral - Securities Hedging: Invests equally in long and short equity
portfolios generally in the same sectors of the market. Market risk is greatly reduced,
but effective stock analysis and stock picking is essential to obtaining meaningful
results. Leverage may be used to enhance returns. Usually low or no correlation to
the market. Sometimes uses market index futures to hedge out systematic (market)
risk. Relative benchmark index usually T-bills. Expected Volatility: Low
Market Timing: Allocates assets among different asset classes depending on the
manager's view of the economic or market outlook. Portfolio emphasis may swing
widely between asset classes. Unpredictability of market movements and the
difficulty of timing entry and exit from markets add to the volatility of this strategy.
Expected Volatility: High

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Opportunistic: Investment theme changes from strategy to strategy as opportunities
arise to profit from events such as IPOs, sudden price changes often caused by an
interim earnings disappointment, hostile bids, and other event-driven opportunities.
May utilize several of these investing styles at a given time and is not restricted to
any particular investment approach or asset class. Expected Volatility: Variable
Multi Strategy: Investment approach is diversified by employing various strategies
simultaneously to realize short- and long-term gains. Other strategies may include
systems trading such as trend following and various diversified technical strategies.
This style of investing allows the manager to overweight or underweight different
strategies to best capitalize on current investment opportunities. Expected Volatility:
Variable
Short Selling: Sells securities short in anticipation of being able to rebuy them at a
future date at a lower price due to the manager's assessment of the overvaluation of
the securities, or the market, or in anticipation of earnings disappointments often
due to accounting irregularities, new competition, change of management, etc.
Often used as a hedge to offset long-only portfolios and by those who feel the
market is approaching a bearish cycle. High risk. Expected Volatility: Very High
Special Situations: Invests in event-driven situations such as mergers, hostile
takeovers, reorganizations, or leveraged buyouts. May involve simultaneous
purchase of stock in companies being acquired, and the sale of stock in its acquirer,
hoping to profit from the spread between the current market price and the ultimate
purchase price of the company. May also utilize derivatives to leverage returns and
to hedge out interest rate and/or market risk. Results generally not dependent on
direction of market. Expected Volatility: Moderate
Value: Invests in securities perceived to be selling at deep discounts to their intrinsic
or potential worth. Such securities may be out of favor or under followed by
analysts. Long-term holding, patience, and strong discipline are often required until
the ultimate value is recognized by the market. Expected Volatility: Low - Moderate

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ADVANTAGES OF HEDGE FUNDS OVER MUTUAL
FUNDS
Hedge funds are extremely flexible in their investment options because they use
financial instruments generally beyond the reach of mutual funds, which have SEC
regulations and disclosure requirements that largely prevent them from using short selling,
leverage, concentrated investments, and derivatives.
This flexibility, which includes use of hedging strategies to protect downside risk, gives
hedge funds the ability to best manage investment risks.
The strong results can be linked to performance incentives in addition to investment
flexibility. Unlike many mutual fund managers, hedge fund managers are usually heavily
invested in a significant portion of the funds they run and shares the rewards as well as risks
with the investors. "Incentive fees" remunerate hedge fund managers only when returns are
positive, whereas mutual funds pay their financial managers according to the volume of
assets managed, regardless of performance. This incentive fee structure tends to attract
many of Wall Street’s best practitioners and other financial experts to the hedge fund
industry.
In the last nine years, the number of hedge funds has risen by about 20 percent per
year and the rate of growth in hedge fund assets has been even more rapid. Currently, there
are estimated to be approximately 8350 hedge funds managing $1 trillion. While the
number and size of hedge funds are small relative to mutual funds, their growth reflects the
importance of this alternative investment category for institutional investors and wealthy
individual investors.

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IMPACT OF HEDGE FUNDS ON CAPITAL MARKET
The hedge fund universe is expanding rapidly, with more than 7,300 funds managing some
$1.7 trillion in assets by mid-2007. The three largest hedge funds each manages at least $30
billion in investors' assets, and have estimated investment positions in financial markets of
up to $100 billion. MGI projects that the value of hedge fund assets under management will
more than double over the next five years to $3.5 trillion.
Hedge funds have benefited capital markets by increasing liquidity and spurring financial
innovations. Yet worries persist that their growing size and heavy use of borrowing could
destabilize financial markets. When Long Term Capital Management ran into trouble in
1998, the fund's catastrophic losses prompted the Federal Reserve to coordinate a $3.6
billion rescue by a group of large banks.
More recently, several multibillion-dollar hedge funds suffered big losses in mid-2007 as
rising defaults on subprime mortgages caused turmoil in the debt and equity markets. Some
smaller and midsize funds shut down. So the question arises again: could a hedge fund
meltdown trigger a broader financial-market crisis?
MGI's research suggests that several developments over the past decade may have
reduced—but certainly not eliminated—the risks. Hedge funds have adopted more diverse
trading strategies, reducing the likelihood that many would fail simultaneously. The banks
that lend to hedge funds have improved their assessment and monitoring of risk, and they
have reasonable financial cushions—collateral and equity—to protect them in case one or
more of their hedge fund clients were to fail (as we saw last summer). The largest hedge
funds have begun to raise permanent capital in public stock and bond markets, while
imposing more restrictions on investor withdrawals—changes that should improve their
ability to weather market downturns. Once financial-market mavericks, hedge funds are
joining the mainstream.

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ROLE OF HEDGE FUNDS IN THE CAPITAL MARKETS
The role that hedge funds are playing in capital markets cannot be quantified with any
precision. A fundamental problem is that the definition of a hedge fund is imprecise, and
distinctions between hedge funds and other types of funds are increasingly arbitrary. Hedge
funds often are characterized as unregulated private funds that can take on significant
leverage and employ complex trading strategies using derivatives or other new financial
instruments. Private equity funds are usually not considered hedge funds, yet they are
typically unregulated and often leverage significantly the companies in which they invest.
Likewise, traditional asset managers more and more are using derivatives or are investing in
structured securities that allow them to take on leverage or establish short positions.
Although several databases on hedge funds are compiled by private vendors, they cover
only the hedge funds that voluntarily provide data. Consequently, the data are not
comprehensive. Furthermore, because the funds that choose to report may not be
representative of the total population of hedge funds, generalizations based on these
databases may be misleading. Data collected by the Securities and Exchange Commission
(SEC) from registered advisers to hedge funds are not comprehensive either. The primary
purpose of registration is to protect investors by discouraging hedge fund fraud. The SEC
does not require an adviser to a hedge fund, regardless of how large it is, to register if the
fund does not permit investors to redeem their interests within two years of purchasing
them. While registration of advisers of such funds may well be unnecessary to discourage
fraud, the exclusion from the database of funds with long lock-up periods makes the data
less useful for quantifying the role that hedge funds are playing in the capital markets.
Even if a fund is included in a private database or its adviser is registered with the SEC, the
information available is quite limited. The only quantitative information that the SEC
currently collects is total assets under management. Private databases typically provide
assets under management as well as some limited information on how the assets are
allocated among investment strategies, but they do not provide detailed balance sheets.
Some databases provide information on funds’ use of leverage, but their definition of

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leverage is often unclear. As hedge funds and other market participants increasingly use
financial products such as derivatives and securitized assets that embed leverage,
conventional measures of leverage have become much less useful. More meaningful
economic measures of leverage are complex and highly sensitive to assumptions about the
liquidity of the markets in which financial instruments can be sold or hedged.
Although the role of hedge funds in the capital markets cannot be precisely quantified, the
growing importance of that role is clear. Total assets under management are usually
reported to exceed $1 trillion. Furthermore, hedge funds can leverage those assets through
borrowing money and through their use of derivatives, short positions, and structured
securities. Their market impact is further magnified by the extremely active trading of some
hedge funds. The trading volumes of these funds reportedly account for significant shares of
total trading volumes in some segments of fixed income, equity, and derivatives markets.
In various capital markets, hedge funds clearly are increasingly consequential as providers of
liquidity and absorbers of risk. For example, a study of the markets in U.S. dollar interest
rate options indicated that participants viewed hedge funds as a significant stabilizing force.
In particular, when the options and other fixed income markets were under stress in the
summer of 2003, the willingness of hedge funds to sell options following a spike in options
prices helped restore market liquidity and limit losses to derivatives dealers and investors in
fixed-rate mortgages and mortgage-backed securities. Hedge funds reportedly are
significant buyers of the riskier equity and subordinated tranches of collateralized debt
obligations (CDOs) and of asset-backed securities, including securities backed by
nonconforming residential mortgages.
At the same time, however, the growing role of hedge funds has given rise to public policy
concerns. These include concerns about whether hedge fund investors can protect
themselves adequately from the risks associated with such investments, whether hedge
fund leverage is being constrained effectively, and what potential risks the funds pose to the
financial system if their leverage becomes excessive.

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INVESTOR PROTECTION
Hedge funds and their investment advisers historically were exempt from most provisions of
the federal securities laws. Those laws effectively allow only institutions and relatively
wealthy individuals to invest in hedge funds. Such investors arguably are in a position to
protect themselves from the risks associated with hedge funds. However, in recent years
hedge funds reportedly have been marketed increasingly to a less wealthy clientele.
Furthermore, pension funds, many of whose beneficiaries are not wealthy, have increased
investments in hedge funds.
Concerns about the potential direct and indirect exposures of less wealthy investors from
hedge fund investments and hedge fund fraud contributed to the SEC’s decision in
December 2004 to require many advisers to hedge funds that are offered to U.S. investors
to register with the commission.
The SEC believes that the examination of registered hedge fund advisers will deter fraud.
But fraud is very difficult to uncover, even through on-site examinations. Therefore, it is
critical that investors do not view the SEC registration of advisers as an effective substitute
for their own due diligence in selecting funds and their own monitoring of hedge fund
performance. Most institutional investors probably understand this well. In a survey several
years ago of U.S. endowments and foundations, 70 percent of the respondents said that a
hedge fund adviser’s registration or lack of registration with the SEC had no effect on their
decision about whether or not to invest because the institutions conducted their own due
diligence.
In the case of pension funds, sponsors and pension fund regulators should ensure that
pension funds conduct appropriate due diligence with respect to all their investments, not
just their investments in hedge funds. Pension funds and other institutional investors seem
to have a growing appetite for a variety of alternatives to holding stocks and bonds,
including real estate, private equity and commodities, and investments in hedge funds are
only one means of gaining exposures to those alternative assets. The registration of hedge

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23
fund advisers simply cannot protect pension fund beneficiaries from the failures of plan
sponsors to carry out their fiduciary responsibilities.
As for individual investors, the income and wealth criteria that define eligible investors in
hedge funds unavoidably are a crude test for sophistication. If individuals with relatively
little wealth increasingly become the victims of hedge fund fraud, it may become
appropriate to tighten the criteria for an individual to be considered an eligible investor.
THE FEDERAL RESERVE AND HEDGE FUNDS
The President’s Working Group made a series of recommendations for improving market
discipline on hedge funds. These included recommendations for improvements in credit risk
management practices by the banks and securities firms that are hedge funds’
counterparties and creditors and improvements in supervisory oversight of those banks and
securities firms. As a regulator of banks and bank holding companies, the Federal Reserve
has worked with other domestic and international regulators to implement the necessary
improvements in supervisory oversight. Regulatory cooperation is essential in this area
because hedge funds’ principal creditors and counterparties include foreign banks as well as
U.S. banks and securities firms.
In January 1999, the Basel Committee on Banking Supervision (BCBS) published a set of
recommendations for sound practices for managing counterparty credit risks to hedge funds
and other highly leveraged institutions. Around the same time, the Federal Reserve, the SEC,
and the Treasury Department encouraged a group of twelve major banks and securities
firms to form a Counterparty Risk Management Policy Group (CRMPG), which in July 1999
issued its own complementary recommendations for improving counterparty risk
management practices.
The BCBS sound practices have been incorporated into Federal Reserve supervisory
guidance and examination procedures applicable to banks’ capital market activities. In

24. Hedge Funds
24
general terms, routine supervisory reviews of counterparty risk management practices with
respect to hedge funds and other counterparties seek to ensure that banks
(1) perform appropriate due diligence in assessing the business, risk exposures, and credit
standing of their counterparties; (2) establish, monitor, and enforce appropriate
quantitative risk exposure limits for each of their counterparties; (3) use appropriate
systems to measure and manage counterparty credit risk; and (4) deploy appropriate
internal controls to ensure the integrity of their processes for managing counterparty credit
risk. Besides conducting routine reviews and continually monitoring counterparty credit
exposures, the Federal Reserve periodically performs targeted reviews of the credit risk
management practices of banks that are major hedge fund counterparties. These targeted
reviews examine in depth the banks’ practices against the BCBS and Federal Reserve sound
practices guidance and the CRMPG recommendations.
According to supervisors and most market participants, counterparty risk management has
improved significantly since the LTCM episode in 1998. However, since that time, hedge
funds have greatly expanded their activities and strategies in an environment of intense
competition for hedge fund business among banks and securities firms. Furthermore, some
hedge funds are among the most active investors in new, more-complex structured financial
products, for which valuation and risk measurement are challenging both to the funds
themselves and to their counterparties. Counterparties and supervisors need to ensure that
competitive pressures do not result in any significant weakening of counterparty risk
management and that risk management practices are evolving as necessary to address the
increasing complexity of the financial instruments used by hedge funds.
The Federal Reserve has also sought to limit hedge funds’ potential to be a source of
systemic risk by ensuring that the clearing and settlement infrastructure that supports the
markets in which the funds trade is robust. Very active trading by hedge funds has
contributed significantly to the extraordinary growth in the past several years of the
markets for credit derivatives. A July 2005 report by a new Counterparty Risk Management
Policy Group (CRMPG II) called attention to the fact that the clearing and settlement
infrastructure for credit derivatives (and over-the-counter derivatives generally) had not
kept pace with the volume of trading. In particular, a backlog of unsigned trade

25. Hedge Funds
25
confirmations was growing, and the acceptance by dealers of assignments of trades by one
counterparty without the prior consent of the other, despite trade documentation
requirements for such consent, was becoming widespread.
To address these and other concerns about the clearing and settlement of credit derivatives,
in September 2005 the Federal Reserve Bank of New York brought together fourteen major
U.S. and foreign derivatives dealers and their supervisors. The supervisors collectively made
clear their concerns about the risks created by the infrastructure weaknesses and asked the
dealers to develop plans to address those concerns. With supervisors providing common
incentives for the collective actions that were necessary, the dealers have made remarkable
progress since last September. The practice of unauthorized assignments has almost ceased,
and dealers are now expeditiously responding to requests for the authorization of
assignments. For the fourteen dealers as a group, total credit derivative confirmations
outstanding for more than thirty days fell 70 percent between September 2005 and March
2006. The reduction in outstanding confirmations was made possible in part by more
widespread and intensive use of an electronic confirmation-processing system operated by
the Depository Trust and Clearing Corporation (DTCC). The dealers have worked with their
largest and most active clients, most of which are hedge funds, to ensure that they can
electronically confirm trades in credit derivatives. By March 2006, 69 percent of the
fourteen dealers’ credit derivatives trades were being confirmed electronically, up from 47
percent last September.
Supervisors and market participants agree that further progress is needed, and in March the
fourteen dealers committed themselves to achieving by October 31, 2006, a “steady state”
position for the industry. The steady state will involve (1) the creation of a largely electronic
marketplace in which all trades that can be processed electronically will be; (2) the creation
by DTCC of an industry trade information warehouse and support infrastructure to
standardize and automate processing of events throughout each contract’s life; (3) new
processing standards for those trades that cannot be confirmed electronically; and (4) the
creation of an automated platform to support notifications and consents with respect to
trade assignments. The principal trade association for the hedge fund industry has stated its
support for plans embodied in the dealers’ commitments.

26. Hedge Funds
26
Hedge funds clearly are becoming more important in the capital markets as sources of
liquidity and holders and managers of risk. But as their importance has grown, so too have
concerns about investor protection and systemic risk. The SEC believes that the examination
of registered hedge advisers will deter fraud. But investors must not view SEC regulation of
advisers as an effective substitute for their own due diligence in selecting funds and their
own monitoring of hedge fund performance.
After the LTCM episode, the President’s Working Group on Financial Markets considered
how best to address concerns about potential systemic risks from excessive hedge fund
leverage. The Working Group concluded that hedge funds’ leverage could be constrained
most effectively by promoting measures that enhance market discipline by improving credit
risk management by funds’ counterparties and creditors, nearly all of which are regulated
banks and securities firms. The Working Group considered the alternative of direct
government regulation of hedge funds but concluded that it would be more costly and
would be less effective than an approach focused on strengthening market discipline.
The Federal Reserve has been seeking to ensure appropriate market discipline on hedge
funds by working with other regulators to promote effective counterparty risk management
by hedge funds’ counterparties and creditors. It has also sought to limit the potential for
hedge funds to be a source of systemic risk by ensuring that the clearing and settlement
infrastructure that supports the markets in which they trade is robust.
1. Examples of hedge fund databases include Trading Advisors Selection System (TASS),
Centre for International Securities and Derivatives Markets (CISDM) Hedge Fund Database,
and Hedge Fund Research Database.
2. The commission decided not to require such funds to register because it had not
encountered significant problems with fraud at private equity or venture capital funds,
which are similar in some respects to hedge funds but usually require investors to make
long-term commitments of capital.

27. Hedge Funds
27
3. For a discussion of the definition and construction of economically meaningful measures
of leverage, see appendix A in Counterparty Risk Management Policy Group (1999),
Improving Counterparty Risk Management Practices (New York: CRMPG, June).
4. Some of these estimates may double count investments in funds of funds. At the end of
last year, and excluding fund of funds, the TASS database included funds that had $979.3
billion in assets. Of course, not all funds are included in this database.
5. Greenwich Associates estimates that hedge funds in 2004 accounted for 20 to 30 percent
of trading volumes in markets for below-investment-grade debt, credit derivatives,
collateralized debt obligations, emerging-market bonds, and leveraged loans, and 80
percent of trading in distressed debt. See Greenwich Associates (2004), Hedge Funds: The
End of the Beginning? (Greenwich Associates, December). These estimates were based on
interviews with hedge funds and other institutional investors that Greenwich Associates
conducted from February through April 2004.
The last few years have been good to investors, investment funds, and the M&A market.
Now, in another indication that the party may be over, capital investors are showing signs of
retreating from hedge funds. In response, hedge funds are making new offers and improved
terms in order to woo the investors that support them.
After two prominent Bear Sterns funds specializing in subprime mortgages collapsed, other
hedge funds in the same market began seeing requests from investors seeking to redeem
their investment. The crunch in the subprime mortgage market was followed by a decline in
the overall availability of credit and by falling share prices on the stock market. Since credit
and share values are important factors in the M&A marketplace, the recent high pace of
merger and acquisition deal activity is expected to slow, creating a challenge for funds that
invest in stocks and acquisitions.
Some of the hedge fund sector's prominent players, including AQR Capital Management,
Highbridge Capital Management, DE Shaw, and Goldman Sachs, have recently seen heavy

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losses. Investors, ranging from wealthy individuals to chief investment officers for
endowments and trusts, are becoming more cautious about risk.
Investment funds are preparing for the possibility that new investors may be difficult to find
and current investors may ask for their money back. KKR Financial Holdings, an affiliate of
Kohlberg Kravis Roberts & Co., stated that it could lose up to $290 billion in its investments
because investor faith in mortgages has been shaken.

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BIBLIOGRAPHY
 www.wikipedia.org
 www.investopedia.com
 www.moneycontrol.com
 money.livemint.com
 http://www.technofunc.com/
 www.finance-glossary.com
 (For definition of certain financial terms)
 Financial Management -by I. M. Pandey
 Financial Management- by Ravi Kishor