CFA Level 1

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Alternative Investments - Hedge Fund Basics

If you're new to the concept of hedge funds, we recommend a read of the following two articles. Introduction to Hedge Funds -Part 1 discusses everything you need to know about the characteristics and strategies of hedge funds, while Introduction to Hedge Funds - Part 2 discusses the advantages and pitfalls of hedge funds and what factors should be considered before choosing one.

What is a Hedge Fund?
"Hedge fund" is a general, non-legal term that was originally used to describe a type of private and unregistered investment pool that employed sophisticated hedging and arbitrage techniques to trade in the corporate equity markets. Hedge funds have traditionally been limited to sophisticated, wealthy investors. In earlier markets, the term "hedge fund" referred to an asset class employing a strategy to offset its market risk exposure by taking an opposing position - for example, selling short or holding futures. In fact, a perfect hedge is one that totally offsets gains and losses, creating a position that is completely neutral. In today's markets, a hedge fund can be just about anything. They may or may not use leverage, make bets on a global basis or look at the technical aspects of a security in an attempt to find a mispricing in the marketplace. Over time, the activities of hedge funds broadened into other financial instruments and activities. Today, the term "hedge fund" refers not so much to hedging techniques, which hedge funds may or may not employ, as it does to their status as private and unregistered investment pools.

Hedge funds are similar to mutual funds in that they both are pooled investment vehicles that accept investors' money and invest it on a collective basis. Hedge funds differ significantly from mutual funds, however, because hedge funds are not required to register under the federal securities laws. That's because they generally only accept financially sophisticated, high-net-worth investors. Some funds are limited to no more than 100 investors.

Freed from regulation, hedge funds engage in leverage and other sophisticated investment techniques to a much greater extent than mutual funds (although they are subject to the antifraud provisions of the federal securities laws).

  • Direct Hedge: This is accomplished by hedging one asset, such as common stock, with another asset that shares similar price movements and trades in a similar fashion. An example of this would be hedging a common stock position with call options.
  • Cross Hedge: This involves hedging an instrument with an unlike instrument. An example of a strategy that failed in the crash of 1987 will exemplify the concept. This involved buying (long) preferred stocks and hedging the position with Treasury futures. Interest rates drive Treasury futures, and there are times when these two instruments track one another - about 85% of the time. In the 1987 scenario, the value of the preferred stock fell and the Treasury futures rose. Because this strategy involved shorting the futures, it proved unsuccessful on both sides.
  • Dynamic Hedge: Involves changing the amount of puts in a position over time, according to the market environment. This can protect against the downside risk associated with a long position. Options traders ordinarily hedge options by shorting a dynamic replicating portfolio against a long position in the option to eliminate all the risk related to stock price movement. It's essentially a technique of portfolio insurance or position risk management and includes any hedging that is done on an active and changing basis, not necessarily using options, although in most cases options are involved.
  • Static Hedge: This also strives to eliminate risk. Given some particular target option, a static hedge is constructed so that it will not require any further adjustment and will exactly replicate the value of the target option. This is referred to as a static replicating portfolio. It's a fixed and unchanging hedge that is set until maturity.


Hedge Fund Objectives
One thing all hedge funds have in common is their search for addition alpha or absolute returns. This is the objective of a hedge fund: absolute returns and making money for investors. This will be accomplished by using whatever type of market strategies the hedge fund believes will give it an advantage.

Legal Structure of a Hedge Fund
Hedge funds generally rely on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 to avoid registration and regulation as investment companies. Hedge fund legal structure is typically in the form of a limited partnership, as a limited liability corporation in the U.S., or as an offshore corporation. These structures provide the freedom that hedge fund managers need to operate without restrictions.

  • Funds are limited to 1,009 partners who must be "accredited investors" and the fund may not advertise.
  • Some funds are structured under section 3(c)(7) of the Investment Company Act and are exempt form most SEC regulations.
  • The minimum investment is typically $200,000 but that is beginning to change to the lower side of that number.


Fee Structure of a Hedge Fund
Fees are the lifeblood of a hedge fund. The manager usually gets a base management fee based on the value of the assets in the fund, such as 1% of the fund's assets. Managers also receive an incentive fee based on their performance that typically ranges between 15-30%. This fee typically occurs after the fund has reached the target return for investors. For any profit generated after that mark, the fund would receive the 15-30%.

Hedge Fund Classifications

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