THE STRUCTURE AND OPERATIONSOF HEDGE FUNDS

First Hedge FundFormed by Alfred Winslow Jones in 1949

Started with $100,000Between 1955-1965 had returns of 670%

Primarily long positions, but also short

Black Box FundsEsoteric Portfolio TheoryHighly complex mathematical formulas

Computer drivenQuants

Hedge Fund a private investment vehicle that

engages in the active trading of various types of securities and commodities, employ sophisticated investment techniques, such as arbitrage, leverage, and hedging and whose structure and operations are designed to promote the goal of absolute returns.

Pooled/Partnerships of Investment advisors registered with the Securities & Exchange Commission Frequently invested in one or more upper

tier partnerships Low turn over of investments Low turn over of partners and partners are

often committed to additional contributions There are usually no distributions until

investment in upper tier is sold

Long Term CapitalWhen Genius Failed byRoger Lowenstein

Players James Simons John Paulson

Former Math ProfessorCode Breaker for

Department of DefenseUses computer driven models to

detect pricing anomalies in stocks,commodities, futures, and options

Charges 5 and 44Earns over 20% for his partners over

a multi-year period

Worked in mergers & acquisitions at Bear Stearns

Founded his own hedge fundwith $2 million and 2 employees

Under his direction, Paulson & Co. capitalized on the problem in the foreclosure and mortgage backed

securities market In 2007 alone his firm earned $15 billion! He

personally made $3.7 billion

In 2008, his firm hired former Fed Chairman, Alan Greenspan

Management Fee% of total assets in fund usually 2%

Incentive Fee % of net income – usually 20% High water mark –

Meaning no compensation for manager if he/she has net income in year one but, falls behind in year 2, than no more incentive until he gets back to where he was.

High water mark may only apply for 2 years

Absolute Return Strategy vs. Relative Return Strategy Relative is relative to something else, i.e.,

Standard & Poors You can’t eat relative returns! Absolute returns stand alone Alpha producing returns not tied to an

index

Four Primary Characteristics Organized as partnerships with the General Partner

having a significant investment Managers are compensated based on fund

performance Investors purchase interest in fund for a % of a fund

profit.Interests are significant, restricted transferability and

limited redemption Provide liquidity and capital to the market place• A role that has been vacated by the large brokerage firms

as they have shut down their proprietary trading desks

Limited Partnerships/LLCFees typically are 2 and 20Normally utilize a high water mark or

hurdle rate Claw back provision

No rules Unlimited types of investments Shorts permitted Margins permitted

Limited redemption opportunitiesGoverned by the partnership agreementApproximately 8,000 hedge funds with

more than $2.68 trillion currently

Types of Funds Fund of Funds Master Feeder Funds• Assets are pooled into one account and managed as a single

portfolio• Profits and losses are allocated on where funds come from

(capital contributions/distributions) 3(c)(7) Fund– under 500 investors, limited to only

qualified investors (investors with over $5 million in liquid, investable assets)

3(c)(1) Fund– under 100 investors and limited to 35 non-accredited sophisticated investors (accredited investors have excess of $200,000 of annual income or a minimum of $1 million in net worth exclusive of Primary residence

Except for the exemption under Sec. 3(c)(1) or Sec. (c)(7) above, hedge funds would fall under the regulations for regulated investment companies

Entry normally limited to yearly, quarterly, or monthly per partnership agreement

Sold through a private placement memorandum Partnership Agreement Subscription Agreement

Administration/Operations Prime Broker• Execution of trades done monthly through

trading screens piped through the internet to a broker• Provides portfolio reporting, securities lending,

office space, technology help, leverage, etc. Hedge Fund Hotels• Could be the prime broker or a non-clearing

broker• Provides office space, computer, and the rest

of build out in the office quarters

Administrator Provide general ledger accounting The allocation of income and expenses and

gains and losses to the partners Calculation of management and incentive

fees, high-water-marks and hurdle rates There is an interface between what the

prime broker provides and what the administrator provides• The prime broker often provides a special

trade date run that complies with U.S. GAAP

Accounting Break Period• Occurs as partners ownership percentages

changes through purchases and redemptions Aggregate Method vs. Layering Method• The Aggregate Method does not take into

account each partners individual portion of unrealized gain or loss for each security held by the fundAllocations are based on the unrealized gain or

loss of the partnership’s securities as a whole• The Layering Method accounts for each

partner’s share of unrealized gain or loss generated on each security over a period of time

Rule 206(4), an investment advisor registered with the Sec and acting as general partner to a pooled investment vehicle, such as a hedge fund, and has custody of the client’s assets is subject to this rule. 1

Must maintain client’s funds and securities with a qualified custodian

Must be audited annually Must distribute audited U.S. GAAP financial statements to

all investors within 120 days of the end of the fiscal year or 180 days for Fund-of-Funds

Must have a compliance officer

1 Hedge funds must register with the Securities and ExchangeCommission when they have $100 million in assets.