By Paul Oranika
Hedge funds: Background Issues and Controversies

Hedge funds are simply pools of money from individuals and or groups of qualified investors who met the requirements of the SEC. Unlike mutual funds, they do not trade on exchanges, and are not registered with the Securities and Exchange Commission; their investors are not granted the same consumer-protection benefits extended to mutual funds through the 1940 Investment Company Act.

Most investors knew very little about Hedge funds prior to the 1998 LTCM debacle. Many lessons were drawn from the failure of LTCM; one of those lessons among others deals with the question of what levels of leverage should fund managers employ in their trading decisions. Today levels of leverage employed by fund managers have been drastically reduced; such issue which played a big role in the huge losses incurred by LTCM does not pose dangers to hedge funds today.

The next controversy surrounding hedge funds seem to deal with the issue of transparency, today such controversy has run into a cul de sac, or dead end, because transparency of hedge funds have increased to the point that one can log into hedge fund information portals such as www.Hedgeco.net, and examine up to date information on hedge fund data such as short and long term returns, funds investment philosophy, or strategies used by such head fund managers. Even some hedge fund managers do provide a breakdown of the funds current weightings.

Hedge Fund Fraud cases

There is also the issue of hedge fund fraud; some cite a small example of fraudulent hedge fund managers who have used false reports to deceive investors while they use their assets to pursue other interests. In a recent conference of the Investment Company Institute {ICI} in Washington DC, Paul Roye, the Director of investment at the Securities and Exchange Commission {SEC} told the conference attendees about the increases in hedge fund fraud cases. As part of his opening remarks, Roye stated, “In recent years, as hedge fund assets have grown, we have also seen an unfortunate growth in hedge fund related-fraud, the Commission has had to bring far too many hedge fund fraud cases in circumstances where the losses to investors have been substantial”

Such charges usually cite cases such as Michael Berger, Edward Jung, or David Mobley. In my previous interview with David Friedland former President of Hedge Fund Association and also the President of Magnum U.S. Investments, based in Miami Florida, I asked him his views about hedge fund fraud and the magnitude of the problem within the hedge fund industry.

Friedland said fraud happens in other industries, pointing to the case of Enron, Arthur Anderson, or World Com to name a few. In Friedland’s view, while transparency is increasing, a manager with increased transparency could still provide fraudulent documents. Friedland told me that the only reason why there is more hedge fund fraud cases in US compared to other countries is simply because 80% of the global hedge funds are located in the United States. A fact usually ignored by those using hedge fund fraud cases to make their argument for hedge fund regulation is that the ratio of fraud in the hedge fund industry is by far much smaller than that of Wall Street, which is regulated by the SEC.

Hedge Fund Regulations

Today there is so much talk about hedge fund regulations, not only here in the United States, but also in England. The two leading financial market regulators, the Securities and Exchange Commission [SEC], and Financial Services Authority [FSA] seem to be slowly but steadily moving in that direction.

Another financial services regulator, the Securities and Exchange Board of India [SEBI] recently made a decision to ban investments through participatory notes by unregulated entities. Hedge fund market analysts think such move has other motives, and has nothing to do with regulation of capital markets. The new law according to analysts has more to do with capital account convertibility, than anything

As hedge funds growth in popularity continues year after year, the issue that has to be addressed is how such growth would impact the broader markets. According to Richard J. Herring, finance professor at Wharton and co-director of the Wharton Financial Institutions Center, “The important issue that hasn’t been much discussed publicly is the potential implications for the industry if hedge funds do reach a broader market.”

Herring thinks that regulation of hedge funds would be an irrevocable mistake, explaining further that “Regulation is in some sense incompatible with the fundamental role and character of hedge funds”, adding that “hedge funds are designed by law [to operate] with maximum flexibility.”

Growth of Hedge Funds

The accelerated growth of hedge funds comes from partly two reasons; expertise, and superior performance. Hedge fund managers are among some of the brightest the financial services industry had to offer. The average return of hedge funds easily beat the average major market indexes like the S&P index or the MSCI. As long as hedge funds continue to provide absolute returns to investors, its growth is all but inescapable.
Hedge fund Managers

Part of the reason why hedge funds are doing well, comes from hard work and experience of many hedge fund managers, in addition to their analytical skills. Hedge fund managers are generally quick to recognize changing market trends, and they try to profit from such developing trends before other mainstream investors see such trends. Part of the reason why hedge fund managers are quick to act is because they are granted full freedom and flexibility to utilize their skills for the benefits of the fund’s investors.

Through diversification, many hedge funds limit their risk exposure levels, a strategy which serves as a defense mechanism in case of a sudden change in market trend. Other hedge fund managers apply advanced asset allocation techniques through analysis of traditional data in combination with technical analysis to decide asset allocation models which best suits their interests.

What would increased hedge fund regulations result in?

Increased regulation of hedge funds would only destroy or at least reduce the natural setting under which hedge funds operate.

Market forces would always play the role of the ultimate regulator; lessons drawn from failed hedge funds also support such statements. The LTCM debacle is not the first time nor would it be the last that economic genius would fail over market reality. Even veteran investors such as George Soros lost millions of dollars during the technology meltdown a few years ago. According to published reports, Irving Fisher, the great American economist, manager of Yale’s endowment investment portfolio, lost much of the fund’s assets in the market crash of 1920s. The famous economist, John Maynard Keynes is said to have lost much of his wealth trading foreign exchange markets. Arguments about failed hedge funds should not provide a basis for additional hedge fund regulations.

The hedge fund industry has done a very good job for the most part regulating itself. Fraudulent hedge fund managers have been and should be prosecuted to the full extent of the law. This article maintains a view that additional regulation of hedge funds, is absolutely unnecessary, it is simply another way that government bureaucrats are attempting to grab more power.

Hedge fund current regulations have served its purpose well, hedge funds are prospering [current hedge fund assets are in excess of US$800 billion} because of the dedication and hard work of fund managers and administrators, the hedge fund investment process and system is not broke, and should be left alone.

Thanks to globalization for adding another acronym to my already information-overloaded brain. This one is called “IRO” or Investment Research Outsourcing. Over the next five years it is an acronym you will hear again and again.  IRO, loosely defined, is the offshoring of front-office work to a 3^rd party provider.  In this article, I will look at the potential of integrating an IRO workstream into the Buy-side and Hedge Fund World.

GROWTH OF INVESTMENT RESEARCH OUTSOURCING

The growth of investment research outsourcing was initially driven by economics.  Sell-side Banks no longer had revenue streams to support the free distribution of research and therefore looked for a cheaper way.  The answer was tapping into offshore brain pools that could produce high quality White Label research at a lower cost.  By some estimates, you can get 3 analysts in India for the same price of 1 analyst in New York or London.

Given today’s bear market, write-offs, and reduced budgets at investment banks, outsourcing of front-office analysis will only continue to grow.  Estimates of IRO 2008 growth rate range from 20% to 40%.  The growth rate would probably be even larger except for the ability to scale resources.

BUY-SIDE MOTIVATION VS SELL-SIDE ECONOMICS

While the Sell-side is clearly motivated by cost, the Buy-side has a completely different motivation.  Most IRO firms tout time, depth of research, and resource scarcity as reasons for Buy-side motivation.  While these perceptions are on the right track they don’t fully explain the value that IRO brings, especially around the time dimension.  IRO firms state that an IRO workstream frees up higher level traders/analysts to spend more time on investment ideas while passing-off the “grunt” work of detailed research.  This may be true but it is only half the picture.  The value of IRO is the ability to create a 24*6 “Follow The Sun” investment process which moves from idea genesis through trade execution at a much quicker pace.  In essence, when your research day is ending in New York or London, it is just beginning in India.  In a world of clustered investment decisions, the ability to supercharge your investment process is the real-key to the buy-side IRO approach.

INTEGRATING AN IRO WORKSTREAM

Developing an IRO workstream can be as simple as making a call/sending an email or as complex as having an on-site IRO resource serve as a communication gateway to a dedicated external team.  In developing the IRO workstream, it is important to first understand your investment process.  Then, ask how an external resource can fit for specific time-bounded tasks. 

While the Sell-side IRO model grew via a  “hand over the wall” approach.  The Buy-side model is much more dependent on communication and investment process integration.   Thus, it is much more vital to define how, when, why, and what.  It is also important to think about how your resources will be affected by having external IRO resources. 

Most firms start out with a “direct connect” model of having a single dedicated IRO resource connect with 1 to many internal analysts.  The IRO team grows organically as they prove their worth.  As with any outsourced model, both teams have an implementation period where they “learn to dance with each other”.  A side benefit of the IRO workstream is the documentation and formalization of investment workflows.

BUY-SIDE SKILLS & IRO MARKET PERSPECTIVES

IRO firms vary in terms of geography and scale with the largest firms having research centers in India.  Most firms have experience in business due diligence, investment research, and valuation.  However, beyond these additional bandwidth skills, many firms have niche skills.  Some IRO firms have more experience with credit modeling while others offer abilities to perform quantitative modeling, or stress-testing.  A few offer complementary services such as business surveys and systems development. 

It is estimated that up to 20% of US Institutional Managers utilize IRO firms, with an annual global market size of $550 Million ($385M Sell-side & $185M Buy-side).  Given current conditions, this market will continue to grow rapidly.  This is the reason scale is perhaps the biggest challenge both for Buy-side clients as well as IRO firms.

EVALUATING AN IRO PARTNER

When looking at IRO partners, it is important to understand that the nature of the buy-side investment process is different from the sell-side roots of the industry.  A buy-side IRO workstream includes heterogeneous, time-bounded tasks that involve real-time communication.  A resource’s judgement is paramount.  Therefore, while past client experiences are helping in identifying domain expertise, the success ultimately rests on the IRO resource.  This is why you must see resume of potential resources, interview these resources, and “beta-test” any resources.

Scale is another key evaluation point.  With this industry growing rapidly and another growth wave coming from the sell-side, IRO firms have to balance the needs of new and existing clients.  This is not so easy in a high-growth environment where the experienced talent-pool is limited and resource scarcity raises expectations of employees.  Therefore, HR issues such as training and resource turnover become important factors.  The last thing you want to do as an asset manager is to train and re-train IRO resources.  Scale also includes issues such as physical infrastructure and ability to protect your intellectual property.  Lastly, a manager needs to understand how IRO firms manage the spectrum of client needs.  With scale concerns, it may not be good to be a small fish in a big pond.

Domain expertise specific to your investment strategy is also an important consideration.  Firms with domain expertise save learning curve time.  IRO firms with domain expertise also will likely have the potential of add-on and swappable resources.

SUMMARY

In today’s world of data overload and time-constrained decisions, an IRO workflow managed correctly, can make you a better manager.  It is also clear that this industry is moving beyond additional bandwidth into higher value service offerings.  An IRO workflow can serve as a key input to a “Follow the Sun” investment model.  Growth challenges lay ahead, but an IRO integration can streamline investment decisions

About the author:

Seth Berlin is Principal at Performance Thinking & Technologies ( www.p-t-t.com ).    PTT is a consulting firm that focuses on operations, reporting, and risk management for hedge funds and investors. He can be reached at www.p-t-t.com or at info@p-t-t.com. 

The Portfolio Manager, or hedge fund manager as they are also called, is the face and brains behind the fund. The PM has to be multi-functional as they not only call the shots, but also act as the salesman, convincing investors to trust in their strategy and hand over large amounts of capital.

Since hedge funds employ a wide array of strategies from long/short to asset based lending to global macro, firms want to find a portfolio manager who has experience in that specific sector. That is why this is probably the most competitive of positions within a hedge fund. Highly skilled portfolio managers are sought out by firms across the globe.

Some of the main duties of a Portfolio Manager include:

• Providing market research and implementing new investment product and strategies

• Create research and review platforms for new, existing and potential investment products

• Exceed client expectations with returns on investments

• Work closely with analysts and traders to ensure trading strategy is carried out correctly

• Construct and review performance reports to show to investors

• Work directly with marketer to relay investment strategy and risk measures for website and other forms of marketing for your hedge fund

• Performing due diligence visits and assessing investment management firms and quantitatively analyzing investment pools

• Having extensive knowledge of industry policies and regulations set in place by the SEC

• Focusing on capital introductions and networking to sign up new investors to your fund

While most positions within a hedge fund are generously salaried, it’s the Portfolio Managers who can potentially reap the big bucks. As explained by one manager to New York Magazine:

“Fifty million, sadly, leaves one flying commercial. Hedge fund money can put you into exhilarating conversations about the virtues of Gulfstreams versus Falcons.”

Here are some facts about the highest paid hedge fund managers as published by Alpha Magazine:

• Five of the managers on this year’s list each made more in 2007 than the $1.2 billion that JPMorgan Chase & Co. agreed to pay for the almost failed 85-year-old Bear Stearns Cos.

• When we published our inaugural list, in 2002, Soros led the way with $700 million, a showing that this year would have put him at No. 9. Back then it took $30 million to crack the top 25; this year, $360 million.

• The grand total earned by the top 25 in our 2003 ranking, almost $2.8 billion, was less than what any of the top three managers made this year and less than one fifth of what the top ten made altogether ($16.1 billion).

• Though we doubled the size of our list from 25 to 50 this year, longtime New York–based star managers Mark Kingdon of Kingdon Capital Management and Raj Rajaratnam of Galleon Group both miss the cut, despite each making about $200 million. This year’s minimum: $210 million.

Typically, a hedge fund manager’s salary depends directly on performance. Managers usually charge a standard 2/20 fee, which means 2% management fee and 20% performance fee. This may vary, with some managers charging 1% or 0% management fee while some charge upwards of 30-40% management fee. Since their “salaries” are considered capital gains, they are only required to pay the standard tax rate of 15%.

Quantitative analysts use their extensive math skills to develop software that analyzes statistical models for computerized financial trading strategies. Most quant hedge funds aim to be market-neutral by balancing both short and long positions. Global macro hedge funds are known for employing quantitative analysis to locate discrepancies in prices around the globe and capitalizing on them. The funds make their money when those prices return to normal.

As a quant, basic duties include:

• Conceive new trading ideas

• Partake in extensive research projects

• Find ways to reduce transaction costs and increase profitability

• Locate discrepancies in pricings throughout the market

• Develop software that locates price anomalies within the market

• Prepare written reports with supporting statistics to senior level management

No matter how good the quants are however, it is still up to the Portfolio Manager to call the shots on the actual trades. If the PM chooses to use high amounts of leverage while making risky bets, the hedge fund may still experience losses, no matter how good the quant is. That is why we saw many quant funds experience declines last year. The use of leverage magnifies even the smallest of losses, so even a fund “uncorrelated to the market” is still affected by market circumstances. Others explain the recent losses experienced by quant funds in another way. The sheer popularity of them makes for dozens of funds chasing the same dream, and using the same strategies thus reducing returns and raising risk.

Quants generally are the former straight A student who excels in math, computer science and engineering. They usually hold a PhD in Finance or Quantitative Mathematics. They have a vast understanding of statistics and calculus and can apply those theories to solve practical modeling and application problems. They are able to work independently but will also correspond on a daily basis with managers, clients, trader, IT personnel and other various groups. Junior quants may start off at around $80K, while more experienced Senior Quants can make upwards of $500K depending on the strategy and how successful it is.

That is why an extensive amount of study and research must go into the investments made within a hedge fund. Hedge funds have the luxury of investing in anything from traditional stocks and bonds to currencies to strip clubs. Anything goes. Therefore hedge fund managers realize that there is a world of opportunity awaiting them, they just need to find where the potential lies.

An analysts’ main job is to seek out these investment opportunities for hedge funds based on extensive research by locating undervalued securities or commodities, mispriced currencies, distressed companies, or a number of other situations which may eventually reap great returns. Analysts partake in growth studies of various companies to see if they are worth investing in. They look at numbers, trends, management or any factor that may tell a tale about their potential.

Risk analysis is another position employed by hedge funds. Risk analysts will work closely with the portfolio manager to assess risks on investments and tailor the strategy accordingly. They will also analyze market risks across various asset classes while developing risk models or profiles.

To sum it up, duties of analysts may include:

• Seeking out investment opportunities

• Locating undervalued securities and other discrepancies to capitalize upon

• Using quantitative methods to analyze market trends

• Looking at Risk vs. Reward

• Analyze and report hedge fund performance with suggestions on how to improve

• Working closely with the legal and compliance departments as well as the Portfolio Manager and traders

• Maintain reports of data, findings and valuation methodologies

• Creating monthly, quarterly and annual reports

To secure a job as a hedge fund analyst, a vast understanding of trading and hedge funds is required. Analysts have strong math and quantitative skills, along with knowledge of securities, equities, options, futures, commodities and currencies. Most analysts also have a degree in Finance. Interpersonal skills and excellent writing skills are also a must since you will be working very closely with others within the hedge fund, especially the VP and those at the top, presenting documents that you have constructed based on your research. Starting positions in the analysis field are generally around 40K, but Senior Analysts can make upwards of $250,000 a year or more, depending on the size of the hedge fund.

Hedge funds have a few options. They may outsource this task to compliance professionals or they may designate the duties to a specific person within the firm. This person may or may not have other duties within the hedge fund. For a large hedge fund, the Chief Compliance Officer generally will not hold another position. Hedge funds may also choose to hire new staff to complete these functions.

According to the SEC, the following requirements must be met by advisors:

• Registration by filing a Form ADV under which hedge fund advisers must disclose information about their business, affiliates and owners as well as disciplinary history

• Comprehensive compliance procedures

• Designation of a Chief Compliance Officer

• Specific procedures governing proxy voting

• A code of ethics including requirements for personal securities reporting

• A commitment to a program of compliance controls combined with SEC examinations in order to foster a culture of compliance by advisers

There are several areas within a hedge fund that require compliance. Marketing for example, requires the compliance professional to be familiar with all of the do’s and don’ts associated with hedge fund advertising. For instance, a hedge fund website has many rules and regulations that must be abided by. Since hedge funds are generally considered riskier than other traditional investment vehicles, only accredited investors may have access to the site. Therefore not only does the website content have to be monitored and secured, but it must be verified that any users are in fact, accredited and able to invest in hedge funds. Other compliance issues stemming from websites include the use of language. Hedge funds must be careful not to “guarantee” anything, but rather present their product in a somewhat transparent light as possible while also portraying the various risks.

Compliance officers also must be familiar with the anti-money laundering procedures, which were set in place after 9/11 and ensures that companies establish anti-money laundering systems and supervisory systems. Compliance is also needed for the formation of the fund, from the set-up procedures to the step-by-step process needed to launch a hedge fund. Generally, a good legal team will require an adviser to disclose every aspect of how they plan to do business via the offering documents. Good compliance programs will outline exactly what an adviser says they will do, and abide by it. Otherwise, an investor may feel misled should the fund go awry and can claim an adviser did something wrong, a significant risk to the hedge fund. Making sure employees, especially the traders, are adhering to all standards is also up to the compliance department, along with investment management and monitoring risks involved. Here are a few of the standard tasks that may be assigned to you:

• Compliance training of new hires within the firm

• Support compliance testing and monitoring

• Prepare written documents to address any compliance problems within the company

• Preparing reviews on a quarterly and annual basis

• Conduct background checks on managers

• Maintain onshore and offshore fund documentation

• Draft documents such as resolutions and amendments

• Maintain compliance as outlined by the Investment Advisors Act of 1940 and the SEC

• Completion of subscription and redemption forms

Taking a job as a compliance professional requires several things. Usually a bachelors degree is preferred, along with some experience in working with investment advisory firm. Extensive knowledge and understanding of SEC guidelines is a must. Chief Compliance Officer positions require a law degree, but salaries generally range from 400,000 to over 1 million a year. CCO positions also usually require a minimum of 5 years experience and the ability to handle multiple large tasks.

In 1998, trading losses started to accumulate. It was clear that the Bayou strategy was not garnering the kind of returns that Israel had promised his investors. Instead of altering the strategy or closing up shop, Israel opted for another alternative. He started a fake corporation to audit Bayou, and produced false documentation overstating gains, understating losses and positioning Bayou in a light that actually made it look successful. In reality, the fund never made any money. Israel would consistently send out performance reports to investors and at one point claimed the fund was worth $450 million.

But Israel wasn’t necessarily losing money. He funneled all of the hedge funds trades through Bayou Securities, reaping huge commissions since hedge funds trade millions of dollars worth of stocks every day. So even as the hedge fund lost money, Israel still banked through his securities firm.

While investors were pleased with the façade of a brilliant investment, Israel and Marino were living the high life. Israel settled into a mansion just north of New York City that he rented from Donald Trump for $32,000 a month while Marino was parading around the east coast in his new Bentley.

In 2004, Israel started to panic and was desperate to make back what he lost in the fund. He suspended the fund’s trading activities and wired $150 million to a bank account overseas and proceeded to launch a “prime bank instrument” fraud. Basically, in this type of fraud, investors are promised above average returns, (in this case, 100% a week), since the manager supposedly has access to a “secret” trading platform. Of course, this is never the case as there is no “secret” trading platform in existence.

In July 2004, officials were alerted when an abnormally large transfer of $99 million was made into a Wachovia account in New Jersey, prompting the initial investigation and the ensuing demise of Bayou.

What was amazing about Bayou was how Israel managed to dupe investors into giving him such a substantial amount of money. One of the biggest obstacles new hedge funds face is securing initial capital. Israel not only did that, he did it to the tune of $300 million. He even got well established fund of funds to invest in Bayou, establishments that are adamant on conducting extensive background checks. Israel had the charm, contacts and Wall Street background to gain the trust of very affluent individuals. In retrospect, investors wish they had noticed some of the red flags accompanying Israel. For one, the fake accounting firm. With large hedge funds, there is almost always an established, big-name accounting firm used, which was not the case here. Also, Israel never charged a management fee, an action almost unheard of with hedge funds. He also gave no resistance to investors who wished to pull out, another tactic not usual in the hedge fund industry.

In April of this year, Israel was sentenced to 20 years in prison after pleading guilty to fraud. He was also ordered to pay $300 million back to investors.

On June 10^th, 2008, the same day he was supposed to start his 20-year sentence, Israel’s SUV was found abandoned on the banks of the Hudson River, with the words “Suicide is Painless” scrawled through the dust of the window. However, officials are reluctant to confirm his suicide for several reasons. For one, no body has turned up. The Bear Mountain Bridge, where Israel supposedly plunged to his death, has been used by others as a sure-fire suicide method. However, those bodies have turned up on the banks of the Hudson, usually only days after the jump.

Marino was sentenced to a 20 year term as well. Oddly enough, he also took the suicide route, writing a 6-page confession/suicide note. However, officials found him before he could act on it, and he is currently serving his sentence.

James Marquez is serving his 4 ½ year sentence for his role in the crime, which was determined to be around $6 million.

Due Diligence. In 2008, there is also a noticeable trend toward increased review of funds by investors and counterparties (e.g., prime brokers, fund administrators, and auditors). Fiduciaries have a duty to perform due diligence to ensure that a fund’s investment decisions are sound and compatible with their client’s risk profiles. Prospects may submit a due diligence checklist to management, requesting extensive information covering every major aspect of the fund’s organization, operation and management. Prospects may seek meetings with the officers of the fund and other persons significantly involved in the fund’s business.
How does a forex fund work? A forex fund requires infrastructure in the form of corporate entities. In the United Sates, we use a limited partnership as the fund and use an S corporation (or LLC) as the general partner (and forex adviser to) of the limited partnership. When set up outside the United States, both the forex fund and its advisor are set up as corporations in a low or zero tax country or other jurisdiction.
Managed Accounts. A CTA (commodity trading adviser) manages individual accounts, while a CPO (commodity pool operator) manages a fund (also called a “pool”). In our experience, many people lose interest in a managed account business when they experience the administrative hassles of managing separate accounts. However, some choose to be both.
Advertising and Attracting Investors. Unless listed on a recognized securities exchange, a forex fund cannot advertise to solicit new investors in the fund. A forex trader managing accounts, however, can advertise his or her managed account services. A few countries have rules similar to those of the United States in this regard. Prospective investors in the fund like to see that you have invested your own capital in the fund. It is also a good idea to show prospects that you take fees subject to a hurdle rate, which means that you earn fees only when trading profits exceed a minimum percentage. An investor in a forex fund should be sophisticated enough to understand the risks associated with forex trading. Many investors would be interested in forex funds if they had the opportunity. Because advertising of the fund and any other non-personal communications are prohibited, and the media has touted the risks over the benefits, investors must be sought in more direct and creative ways. A trader may find that in addition to family and close friends, many colleagues and casual acquaintances may be potential investors. If you are interested in getting investors for your fund, your selling efforts must be personally directed toward investors who are known to you. Advertising and any other non-personal communications are prohibited. For the forex trader who wants to trade for his family and friends, this is obviously no problem at all. Since the forex fund is an ideal vehicle to pool the resources of a small group of investors, forex funds can be especially appealing.
How do I set up a forex fund? In 2008, forex traders remain positioned to launch a forex fund quickly without much red tape. In short, starting a forex fund means hiring a legal adviser with the proper expertise to prepare the required documents and provide you with tax and regulatory advice. You will have to work closely with your lawyer to prepare the private placement memorandum (PPM), fund’s limited partnership agreement, and subscription agreement. A forex
fund can be developed and launched within 2 weeks (on an expedited basis) but the normal development time is about 4 weeks. Offshore funds, while they can be incorporated quickly, take a little longer to establish due to the time required to open a bank and brokerage account for the fund.
Favorable Tax Treatment. There are two ways to trade foreign currencies and they have different tax rates. “Foreign currency contracts” are taxed by Internal Revenue Code Section 988. Currency futures, otherwise known as “regulated futures contracts” are taxed under Section 1256. Forward contracts and over-the-counter options in other traded currencies for which there is also trading in regulated futures qualify as “Section 1256 contracts.” Gains from futures trading are taxed at a blended rate of 60% long-term gains and 40% short-term gains (regardless of how long a position is held). This 60/40 split gives futures traders an advantage over forex traders. While the long-term rate is capped at 15%, the short-term (or “ordinary”) rate can go as high as 35%. The maximum blended 60/40 rate is 23%. Forex gains are taxed at the short-term (“ordinary”) rates. Forex traders do not necessarily have to live with the higher “ordinary income” tax rates as they can “elect out” of ordinary income tax rates. Traders who do this will have their currency positions treated as Section 1256 contracts, and their gains will be taxed at the blended 60/40 rate. In addition, the fund will most likely qualify as a “trader in commodities” so that investors are able to deduct the fund’s expenses.
Securities Act of 1933. Forex funds are private and are not required to report returns, unlike mutual funds that are publicly traded and post their net asset values daily. In the United States, private (hedge) funds are unregistered securities offered as a private placement under the Securities Act of 1933. Also, in the United States, a forex fund is a Regulation D (Rule 506) offering in that it is an unregistered security offered as a private placement. Regulation D provides a safe harbor that exempts the private offering from compliance with the registration and prospectus delivery requirements of U.S. securities laws. However, Regulation D does not exempt an offering from compliance with the anti-fraud provisions of the law. You must supply all investors in your fund with offering documents (also called “disclosure documents”) disclosing comprehensive information about the fund.
Commodity Exchange Act. The Commodity Exchange Act (CEA) gives the Commodity Futures Trading Commission (CFTC) limited anti-fraud and anti-manipulation jurisdiction over off-exchange (also called over-the-counter or OTC) foreign currency futures and options transactions. “Forex transactions” are leveraged off-exchange foreign currency transactions where one party is a customer. The term does not include transactions that result in actual delivery within two days or that create an enforceable obligation to deliver between parties who are capable of making and taking delivery for business purposes.
Must I register with the CFTC? If you plan to trade currency futures contracts, currency futures options, or forward contracts, your fund must be approved by the CFTC. In addition, you must register with the National Futures Association (NFA) and become a CPO. The CEA defines a commodity pool as an “investment trust, syndicate or similar form of enterprise operated for the purpose of trading commodity interests.”
CFTC Exempt. A person who operates a commodity pool must register as a CPO unless an exemption applies. If you operate a pool that limits its trading solely to forex and only trades with authorized counterparties, it is not required to register as a CPO, but may do so voluntarily. Forex managed account managers are generally not required to register with the CFTC or become Members of NFA. Understand that any NFA Member forex dealer that services your customer accounts, or you introduce accounts to, is subject to NFA enforcement action for your conduct should your conduct violate NFA requirements. Violations can mean disciplinary action against your dealer even if it acts diligently and has no knowledge of your conduct. As a result, there is a trend among forex dealers to require NFA registration of forex traders managing customer accounts (including a fund). NFA compliance rules address the general issues of following just and equitable principles of trade and avoiding fraudulent behaviors.

Commodity Pools. If your forex fund trades in commodity futures or interests, it is also a commodity pool and you are a CPO. Any person who is involved with the commodity pool must register as an associate of the CPO. A registered CPO is required to provide a detailed disclosure statement (the prospectus) to prospective participants in the pool. Your Disclosure Documentmust also be filed with the NFA at least 21 days prior to the delivery of the documents to a prospective participant and updated often. There are exemptions from the CPO registration requirements.

Investment Adviser Registration. If you plan to execute more than an occasional equity trade in your forex fund, you might also have to register as an investment adviser. If you manage less than $30 million, you are not eligible to register with the SEC (unless you are based outside the United States or you are based in Wyoming) but are subject to applicable state law. Each state has its own registration requirements.

Offering Documents. Investors in your fund must receive all material information about the offering and the offering documents should be provided to all investors. Any investor who is not an accredited investor must have sufficient knowledge and experience in financial and business matters to be able to evaluate the merits and risks of your hedge fund. Since the PPM usually is the starting point for those conducting due diligence, it remains a crucial document.
Accredited Investors. Regulation D limits the number of non-accredited investors to 35. Generally, accredited investors includes persons whose net worth (or joint net worth with that person’s spouse) exceeds $1,000,000, or whose income was in excess of $200,000 in each of the two preceding years (or, together with that person’s spouse, in excess of $300,000 in each of the two preceding years) and who reasonably expect to reach the same level of income in the current year. There are numerous other categories of accredited investors.

Performance-based Compensation. Performance-based compensation for fund advisers are paid as an allocation of profits, typically 20%, associated with the growth of the fund. There are state regulations regarding performance based fees and these regulations vary considerably. In some instances, the compensation agreement specifies that funds be only paid when the profits of the fund exceed a hurdle rate.

Blue Sky. Within 15 days of the first sale of your offering, an SEC Form D Notice of Sale must be filed with the SEC. Your fund must also comply with state blue-sky laws. In most states, Form U-2 must be filed. Conclusion. Forex funds are about making money and running a forex fund is a great way to do so. The desire to pool assets in a way that is proper, both from a business and a legal standpoint, has led many forex traders to start their own forex funds. For a successful forex trader, a forex fund is an efficient, legal, and professional way to trade your own money along with the money of those who want to benefit from your expertise. No longer just for the elite, forex funds will continue to grow in varying financial conditions because of their complete market freedom.

The private investment fund industry has years of success ahead of it. Talented forex traders will find profitable outlets for their skills, regardless of government regulation. Forex funds are about making money and running a forex fund is a great way to do so.

By Hannah M. Terhune, Esquire 2008©

Capital Management Services Group

hterhune@capitalmanagementservicesgroup.com

Many countries are competing against each other to provide the best playing field from a legal standpoint for private investment (hedge) funds. For a new, low budget offshore fund, Anguilla or the British Virgin Islands and not the Cayman Islands may well be the best choice. While many countries have increased services to meet the rising need for offshore funds and companies, the lawyers, fund administrators, and accountants in the better-known countries have also increased their fees significantly in the past few years. There is increased use of offshore companies and offshore banking services to protect against identity theft and the loss of wealth due to the global decline of the U.S. dollar. Many are surprised to learn how easy it is to operate offshore.

Experienced investors are not as worried about where the fund is located as you may think. Funds tend to be formed in countries that are relatively interested in helping them set up (meaning that they have good laws and a good reputation as a country to associate with) and operate without a lot of initial and residual expense. Always remember that the domicile of the fund need not be the same as that of its administrator and custodian. In our experience with fund organizers, it is their inexperience with international business formations and bank regulatory matters that causes the most problems in terms of starting and launching the fund in a timely fashion.

For all the rave about the Cayman Islands, it is important to keep in mind that it was a blacklisted country until 2001, about the time when it hired a lobbyist and a public relations firm in the United States to delete the American perception that it was a hotbed of money laundering. In recent years, Cayman representatives have “visited” the SEC, the Senate Banking Committee and the Vice President to promote the image that it is a law-abiding, well-run version of “Delaware.”
However, it is home some very recent and high profile fund disasters and the 700 or so Enron secret companies. In short, it hosts as much financial crime as the next country.

Best Location for an Offshore Fund. The short answer is no one place is best. You can form an offshore fund in any location that make sense and is affordable. There are many areas of the world that are considered prime offshore centers. The most widely used (and most expensive) locations are Bermuda, the Cayman Islands, Guernsey, Hong Kong, the Isle of Man, Jersey, Luxembourg, the Mauritius, Singapore, and Dublin. These locations provide a welcoming climate for funds in terms of the ample (and pricey) supply of sophisticated lawyers, bankers, and consultants offering legal and accounting advice. To appease the United States and the OECD, many of these jurisdictions have enacted “heavy handed” regulatory schemes which renders the costs of establishing and maintaining a fund in these countries prohibitive to all but the very wealthy.

Anguilla and the British Virgin Islands maintain a minimal regulatory scheme and the costs of establishing and maintaining a hedge fund in these countries are low. These countries (and other offshore financial centers) are no different from Delaware in terms of what they offer a business.

Why Setup Offshore? Many investment fund managers want to know when the time is right to set up a fund. It is best to ask and answer a series of questions: Where are your investors located and what matters to them? If you have a suitable investor base then the time is right to set up offshore. Consider setting up an offshore fund if you manage money for clients outside of your home country. It is that simple. Why would an invest or that does not live in your home country want to pay taxes there (or have to worry about paying taxes there)?

For U.S. based fund managers, also consider setting up an offshore fund if your U.S. investors are tax-exempt person (for example, retirement accounts, pension funds, etc.). Under U.S. law, Tax-Exempt Persons (TEP) investing in a fund that borrows money to trade or generate investment income become taxable on such investment (or trading income) as Unrelated Business Taxable Income (UBTI), despite the TEP’s otherwise tax-exempt status. The exposure to UBTI can be managed in many cases by investing in certain types of offshore funds.

Offshore Planning Trends in 2008. As a result of a “tweak” to its laws in November 2006, the Cayman Islands quietly become a much less attractive place to form a small offshore fund (meaning less than $10 million of seed capital). Anguilla (a country near the Cayman Islands) assumed that honor. However, in July 2007, the Cayman Islands again changed its law. Despite the law change published in the Cayman Islands on August 6, 2007 as the Mutual Fund Law (2007 Revision), Anguilla (and the British Virgin Islands)remain one of the best places to start a private offshore fund.

Anguilla.  Anguilla enacted its current Mutual Funds Act in 2004. As a country, it offers a low cost and efficient regulatory environment for private investment funds. The laws of Anguilla allow for three (3) types of investment funds, two (2) of which are important to fund managers starting a small offshore fund (in our experience). Those types of funds are the Private Fund and the Professional Fund. The laws of the Cayman Islands allow for four (4) types of investment funds, two (2) of which are important to fund managers starting a small offshore fund (in our experience). Those types of funds are the Category 4(3) Fund and the Category 4(4) Fund.

Comparison of Mutual Fund Law in the Cayman Islands with that of Anguilla. Below is a modest comparison of the legal landscape of Anguilla with that of the Cayman Islands.

Anguilla Private Fund versus Cayman Islands Category 4(4) Fund Minimum Investment/Subscription.  In Anguilla, there is no minimum subscription amount for investing into a Private Fund. The same is true of a Category 4(4) Fund in the Cayman Islands.  However, in Anguilla, a Private Fund can have 99 investors while in the Cayman Islands, a Category 4(4) Fund is limited to 15 investors (all of whom can vote to remove you as operator of the fund).

Audit Requirements. Neither country requires an audit nor the preparation of a prospectus; although most fund operators do so as a matter of practice.

Number of Investors in Fund. In Anguilla, a Private Fund can have up to ninety-nine (99) investors. In the Cayman Islands, a Category 4(4) Fund) is limited to fifteen (15) investors. In Anguilla, investors have no vote in the matters of a Private Fund. You can remain in control of the fund. In the Cayman Islands, you could lose control of a Category 4(4) Fund as investors have voting power sufficient to remove you as the fund’s operator.

Anguilla Professional Fund versus Cayman Island Category 4(3) Fund Minimum Investment/Subscription. In Anguilla, a Professional Fund requires a minimum investment of USD $100,000 (or its equivalent in any other currency). The $100,000 limit does not apply to an investment made by the fund’s manager, administrator, or promoter. In the Cayman Islands, a Category 4(3) Fund requires a minimum investment of USD $80,000 and this requirement applies to the fund’s manager, administrator, or promoter. Prior to August 2007, a Category 4(3) Fund also required a minimum investment of USD $100,000.

Audit Requirements. A Professional Fund in Anguilla is not required to submit audited financial statements annually to the government. A Category 4(3) Fund in the Cayman Island is required to file the fund’s current prospectus with the government, pay a substantial annual registration fee and file a financial schedule. A Professional Fund in Anguilla is not required to issue a prospectus, albeit, most usually do as a matter of practice.

Number of Investors in Fund. Neither the Professional Fund nor the Category 4(3) Fund has any size restriction (but only a minimum subscription amount as stated above). In Anguilla, a Professional Fund is open to “professional” investors, generously defined in Anguilla as a person whose ordinary business involves dealing in investments or who has signed a declaration that he, whether individually or jointly with his spouse, has net worth in excess of USD $1,000,000 or its equivalent.

In Anguilla, a fund may be in the form of an Anguilla domestic company, international business company, limited liability company, limited partnership, partnership, unit trust or protected cell company, protected cell accounts, segregated portfolio company, or segregated portfolio accounts. The corporate entities are extremely useful because they allow for the issuance of series or classes of shares with different rights thus allowing for the creation of umbrella funds and master/feeder structures. The use of an Anguilla domestic company also allows for the use of companies limited by guarantee and shares, as well as private companies.

Always remember that the domicile of the fund need not be the same as that of its administrator and custodian. A fund’s service providers can hail from the other side of the world. Moreover, the service providers’ location usually is the more important issue.

Why Setup a Fund? Market conditions have never been better for setting up a fund. Investors prefer to have money managed on a personal basis. Investors are trending away from Wall Street and heading toward “Main Street” when looking for help with their portfolios. It is no small secret that customized funds have taken up residence on Main Street and are attracting investors in droves. Traders that only dreamed of making a living by managing money for others are
turning those dreams into reality for themselves.

1. Read a fund’s prospectus or offering memorandum and related materials

The offering memorandum is a set of documents constructed by the legal counsel of the fund. It outlines investment strategies, lists all of the fees associated with the fund, goes over the time line, lists the services providers, and is the basic operating manual for the fund. Make sure you familiarize yourself with the basic principles of the fund so there are no surprises along the way.

2. Understand how a fund’s assets are valued

Depending on what the hedge fund invests in, the fund may be either liquid, or high illiquid. When the fund invests in illiquid securities, many times, they are hard to value. Hedge funds that invest in exotic securities require a much more intense understand of the strategy and the investment, so that you can better gauge the fluctuation of value.

3. Ask questions about fees

Typically, hedge funds charge a management fee as well as a performance fee. A standard fee structure would be 2/20 where the fund manager charges 2% managing the assets and 20% of the fund’s performance. These numbers can change, with some managers only charging 1% to manage the assets, or no fee at all. Performance fees can go as high as 45% on occasions. It all depends on the manager, so make sure you are well aware of the fee structure before going into the fund. If you invest in a fund of hedge fund, you may be charged a double layer of fees, with one going to hedge fund manager, and the other going to the fund of fund manager. Also check to see if there is a high water mark, or hurdle rate, which will also affect the fee structure. Ask if there is a penalty fee for leaving the fund early, as well.

4. Understand any limitations on your right to redeem your shares

Find out if there is a “lock-up” period, which is a period where you cannot redeem your investment. This may be a year or two. Remember, even if there is no spoken lock-up period or penalty for cashing in early, hedge fund managers sometimes can freeze redemptions without any notice, making it impossible for investors to redeem cash. However, this usually is a red flag, and many times when redemptions are stifled, the fund’s demise comes shortly thereafter. Or, as in some cases, redemptions are only frozen until market conditions become more desirable for the fund.

5. Research the backgrounds of hedge fund managers

Everyday it seems, there are headlines that detail fraudulent hedge funds or scheming hedge fund managers. When choosing a hedge fund, and thus choosing a hedge fund manager, its important to find out, did the manger run any previous funds? What is the manager’s performance record, with both this fund, and the last? What is the managers employment history? Has the manager ever been convicted of a crime? Was the manager let go from his previous position and why? Does the manager have sufficient experience with this kind of strategy? Because hedge funds enjoy light regulation, a manager can tank a fund, close its door, and open up a new one with a different fund name, without a problem. That’s why background checks are crucial. After all, a hedge fund is only as good as its manager.

6. Don’t be afraid to ask questions

It’s your money. You should know exactly where it is going, when you can get it back, and what you expect to gain from this investment. Hedge fund managers many times have years of experience on Wall Street along with a financial background. This can make for some pretty complicated investments. If you don’t share a repertoire in finance, you may have to dig a little in order to fully understand the strategy and where exactly your money is going.

Not to be confused with asset based lending, although similar, real estate hedge funds can employ several different strategies. Some are focused mainly on opportunities in publicly traded securities of real estate companies, primarily Real Estate Investment Trusts (REITs).

A REIT is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. In return, REITs are required to distribute 90% of their income, which may be taxable in the hands of the investors. The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks.

Other real estate hedge funds focus on acquiring sub-performing properties either in one specific geographic location, or spanning the globe. They often purchase these properties at very attractive rates since the seller usually lacks liquidity.

Cliffwood has one of the original real estate hedge funds, launched in 1994. It engages in a long-short strategy and currently has about $100 million under management, along with a long-only fund. Total firm assets are about $586 million.

Blackacre Capital is another big name in real estate hedge funds. They often buy large hotels and projects with the goal of restructuring and developing. Blackacre just recently raised $890 million for their new real estate hedge fund.

Angelo Gordon & Co. launched it AG Long Short Realty Fund in 2003. The firm, which has amassed over $5 billion worth of real estate, focuses on investment grade rated securities that they feel are mispriced. They invest throughout the debt capital structure as well as in lower rated debt where if they see the opportunity for high returns.

In April of this year, The Praedium Group started to develop their new real estate hedge fund, attempting to profit from the disparities between indexes that track the public and private real estate markets.

]]> http://www.hedgeco.net/hedgeducation/hedge-fund-articles/real-estate-hedge-funds/feed/ http://www.hedgeco.net/hedgeducation/hedge-fund-articles/largest-hedge-funds/ http://www.hedgeco.net/hedgeducation/hedge-fund-articles/largest-hedge-funds/#comments Wed, 14 May 2008 20:32:59 +0000 Julie Scuderi http://www.hedgeco.net/hedgeducation/hedge-fund-articles/largest-hedge-funds/ Continue Reading]]> While hedge funds are estimated to manage almost $3 trillion in assets, the top hedge funds are responsible for a large chunk of that number. In fact, the largest hedge funds manage about $1.6 trillion, more than half of total assets under management. Despite hedge funds losing a combined $24 billion in 2007, total assets grew over 30% from the previous year. Here is the current list of the largest hedge funds.

Taking the cake for the largest hedge fund manager is JPMorgan Chase , through both JP Morgan Chase Asset Management and Highbridge Capital Management. Despite posting losses of $8.5 billion through various funds last year, the company still overseas $44.7 billion in assets. JPMorgan Chase invests in everything from real estate to statistical arbitrage products while employing a diverse range of hedge fund mangers with differing styles and investment philosophies.

2 & 3. Bridgewater Associates and Farallon Capital Management

Tied for the number two position, these firms each manage $36 billion in assets. The Connecticut based Bridgewater prides itself on emerging markets, commodities, currency, global fixed income, bonds and equity investments.

The San Francisco based Farallon is the choice for many institutions and ultra-wealthy individuals. This hedge fund is very event driven and looks for opportunities to invest in, while shorting on others, in an attempt to hedge their risk. Farallon moved up three spots on the list since last year, mainly from capitalizing on the housing market situation.

4. Renaissance Technologies

Despite suffering losses from the U.S. subprime mortgage crisis, New York based Renaissance Technologies still managed to make the #4 spot, with $34 billion under management. The firm’s famed Medallion fund, which averages around 35% annual returns, charges investors a hefty 5% management fee and 44% performance fee. Renaissance employs a global macro strategy, and tends to hire experts with a scientific and mathematical background, rather than a financial one.

5. Och-Ziff Capital Management

After going public last year, Och-Ziff rose to the number 5 spot, managing $33.2 billion. The New York based hedge fund’s strategies include private equity, real estate, and equity restructuring, investing over half of their portfolio in foreign markets. The firm has been experiencing some recent trouble in 2008, with all four of their funds reporting losses in the first quarter. Executives attribute this to the $3.3 billion in expenses they incurred during the IPO and reorganization last November.

6. D.E. Shaw

Dropping a few spots on the list is DE Shaw, who manages $32.3 billion. The New York based hedge fund likes to buyout distressed companies, while financing and developing new companies. They also dabble in commodities, emerging markets, currencies, real estate, and venture capital. Like Renaissance Technologies, D.E. Shaw prides themselves on using math whizzes and computers to locate opportunities in the market. It is widely known that only 1 in every 500 applicants at D.E. Shaw makes the cut.

7. Goldman Sachs

Falling from the number two position is the New York based Goldman Sachs, who manages $29.2 billion, about $3 billion less than they managed last year. They generally invest in currency, real estate, private equity, and venture capital while using a multi-strategy approach. Goldman’s long-short Global Equity Opportunities fund and the Global Alpha fund both plummeted about 30 percent of their value last year as a result of the subprime fallout.

8. Paulson & Co

A new addition to the list, John Paulson and his company, Paulson & Co. now manage $29 billion after correctly betting that subprime loan holders would default on their mortgages. Paulson went down in history as having the biggest day ever on Wall Street, about $3 billion. The New York based hedge fund invests in public equity markets across the globe, and employs merger arbitrage, long/short, and event-driven strategies while using fundamental analysis to make its investments.

So what was the culprit behind the fund’s demise? Surprisingly, it all boiled down to one bad bet. The funds we have seen collapsing lately due to the subprime mortgage crisis and the credit crunch have all had a sort of “storm” of factors that have contributed to their demise. But with Amaranth, that wasn’t really the case, making the monumental loss even harder to believe.

By 2005, Amaranth had placed most of its capital into energy trades, mainly the natural gas market. The firms head trader, Brian Hunter, was garnering enormous profits for the hedge fund by placing huge bets on natural gas prices. Hoping to continue his streak of good luck, Hunter used 8:1 leverage to place more bets on the prices of gas using both long and short techniques. When prices went in the complete opposite direction of what Hunter had predicted, losses were catastrophic. With prices on natural gas being so volatile and depending on a number of different social, political, and economic events, making such heavy bets using massive amounts of leverage is not usually a smart move.

Amaranth suddenly had to inform investors that their $9 billion portfolio had experienced losses exceeding 65%. The fund suspended redemptions in the fall of 2006, then hired a liquidator only days later.

To make matters worse, the Commodity Futures Trading Commission (CFTC) charged Amaranth along with Brian Hunter with Attempted Manipulation of the Price of Natural Gas Futures, including making false statements to the New York Mercantile Exchange (NYMEX). These charges were in addition to the market manipulation charges brought on by the Federal Energy Regulatory Commission.

Apparently wanting to partake in the lawsuit frenzy, Amaranth filed a suit against JPMorgan Chase in late 2007, alleging that they had used their position as Amaranth’s clearing broker to prevent the hedge fund from transferring the remaining risk in its natural-gas derivatives portfolio to Goldman Sachs and Citadel Investment Group LLC. Amaranth is seeking $1 billion in damages.

The fund alleges that JPMorgan refused to execute a vital trade on Sept. 18, 2006, that would have transferred the fund’s natural-gas derivatives positions to Goldman Sachs in exchange for a concession payment of $1.85 billion from the fund. Amaranth accuses JPMorgan of wanting to take control of the portfolio themselves in hopes of gaining substantial profits.

“As a result, Goldman Sachs walked away from the trade,” the claim stated. “The effects on the fund were devastating.”

JPMorgan responded with their theory. “Amaranth’s lawsuit is an effort to rewrite history, and to blame JPMorgan for losses that were the result of Amaranth’s disastrous trading,” said Kristin Lemkau, a JPMorgan spokeswoman, in a statement. “JPMorgan’s conduct was entirely appropriate, and consistent with its rights and obligations as Amaranth’s future commissions merchant. The firm intends to defend this baseless lawsuit with the utmost vigor.”

The global macro manager usually uses leverage to make bets on price movements in any market of the world, hence the term “global.”  The term “macro” refers to the macroeconomic principles used by the manager to locate mispriced assets or market inefficiencies.  Because the manager may choose to invest in any market, in any corner of the globe, the possibilities are endless, and may be as risky or as conservative as that manager chooses.

It was George Soros who first catapulted the global macro approach onto the headlines.  His famous Quantum Hedge Fund used a global macro strategy to make him billions overnight, literally.  In 1992, Soros made a bet that the Bank of England would not support the pound participation in the European Exchange Rate Mechanism by jacking up interest rates in a depressed economy.  Soros was correct, and made his fortune when the Bank of England let the British currency devalue.  Investors were delighted when Soros’ fund returned 30% a year between its launch in 1968 and 2000.

Other global macro funds have also fared well, repeatedly showing a low correlation to the general markets.

Global macro trades can be either directional, where the manager bets on discrete price movements, or use relative value, where mispricings are highlighted between two similar assets, by betting on both the long and short sides.

Sometimes, a manger will correctly identify market inefficiencies, using a discretionary technique.  When a computer is used to do this, it is called a systematic approach.  Either way, it’s all about timing.  The hedge fund manager must capitalize on this swing in equilibrium, make the proper bets, and get out at the right time.  It is because of this limited window of time and risk that these hedge funds are able to produce vast returns in so little time.

Global macro hedge funds also exhibit a low correlation to the general equity market.  While they exact amount of assets under management is not known, global macro hedge funds are estimated to manage over $150 billion in capital, with that number rising every quarter.

In 2005, the housing market was booming. I can remember living in Miami, looking at one-bedroom condos, and not being able to get near them for less than $350,000. Demand was sky-high, and people who had purchased their homes for $150,000 a few years back, were suddenly making a killing on flipping them. Developers saw this demand and got greedy. Overnight it seemed, the skyline of Miami was flooded with cranes, and residential condos were being built on nearly every corner. Thousands of new units were springing up, leaving the obvious question: Are there enough buyers? The shortened answer was: No. This wasn’t confined to southern Florida, either. The entire country was experiencing the same dilemma on some scale.

Desperate to rent out these units, banks started lending to anyone and everyone that wanted to buy a home, even people with ugly or no credit. These “subprime” candidates were often misled, with banks offering them attractive interest rates up front, and failing to convey that these low interest rates would increase after an initial period.

According to an article published on subprimelosses.com, the amount of mortgages that reset to higher interest rates are as follows:

Inevitably, these individuals started defaulting on their mortgages due to higher interest rates, and the fact that they probably couldn’t afford them in the first place.

However, subprime mortgage-backed securities and Collaterized Debt Obligations were already in wide circulation and were present in many investment vehicles, including hedge funds. Some feel that ratings agencies like Moody’s presented these securities with little risk, while they were in fact, extremely risky.

To make matters even worse, the supply of open units far outweighed the demand. People who couldn’t pay their mortgages were unable to sell their homes, or took huge losses due to declining home values. The result was an overwhelming number of foreclosures. Many buyers purchased homes thinking they would flip them and make a quick buck. Most of these buyers already had another mortgage to pay, resulting in more foreclosures.

The biggest problem of the subprime crisis was the domino effect it had through the world’s economy. Because so many investment vehicles were dependent on these mortgage-backed securities, assets started to plummet when all of these foreclosures starting happening. While agencies have started to adjust their ratings, and banks are much more careful about who they lend to, we will probably still feel the wrath from the subprime crisis for months to come.

Drake had suspended redemptions in December of 2007, after the fund lost 25% of its value and investors rushed to withdraw money. Investors were denied the action of “liquidating investments in a market characterized by unprecedented illiquidity.” After experiencing sharp declines due to the subprime mortgage crisis, management was pondering the decision of shutting down due to “sharply negative performance and the extreme volatility and illiquidity of certain capital markets.”

The Global Opportunities Fund was launched in 2002 by the firms founder, Anthony Faillace and Steve Luttrell. In it’s heyday, the fund was posting returns of 13.4% a year on average.

So what fueled the collapse of this once-thriving hedge fund that oversaw over $4 billion in assets? Like many other hedge funds in 2007, the Global Opportunities Fund was hit hard by the subprime mortgage crisis and the credit crunch that followed. Drake, like these other funds, used heavy amounts of leverage as part of their strategy to buy bonds backed by subprime mortgages. When homeowners started to default on their mortgages at a catastrophic rate, these bonds started to plummet in value. Their lack of ample liquidity to begin with made the situation even harder to get out of. Brokerage firms then started to demand more cash or collateral to back their loans to hedge funds. On top of that, investors rush to withdraw money when there is a rumor of a liquidity crunch. All of these factors contributed to the collapse of the fund.

“Under normal market conditions, these divergent interests could both be met by exiting positions and generating the necessary proceeds to redeem investors,” Drake said. “But present market conditions have effectively prevented us from following this course of action.”

Drake plans to start a new fund later this year, and investors who choose to transfer their capital to the new fund will not pay performance fees until their losses are recouped. The liquidation is expected to be complete by early 2009 and investors will likely get most of their money back, the letter stated.

Drake’s struggle comes at a time when many hedge funds that manage large amounts of assets are being forced to liquidate. Just this month, London based Peloton Partners closed their two hedge funds that once managed $3 billion after their lenders pulled back on credit.

Drake, a New-York based company run by former BlackRock Inc. employees, also manages two other hedge funds, the $1.3 billion Absolute Return Fund which declined over 14% last year, and the $160 million Drake Low Volatility Fund.

Top 10 Currencies Traded

1. U.S dollar
2. Euro
3. Japanese yen
4. British pound sterling
5. Swiss franc
6. Australian dollar
7. Canadian dollar
8. Swedish krona
9. Hong Kong dollar
10. Norwegian krone

Because of the variety of traders involved and the fact that currencies are traded 24 hours a day except on weekends, the foreign exchange market is unlike any other financial market. Far different from the stock market, where everyone has access to the same prices, the forex market is based on access. The more money someone is trading, the better level of access they have. This is why investment banking firms are usually at the top, usually trading billions of dollars daily.

Top 10 Currency Traders

1. Deutsche Bank
2. UBS AG
3. Citi
4. Royal Bank of Scotland
5. Barclays Capital
6. Bank of America
7. HSBC
8. Goldman Sachs
9. JPMorgan
10. Morgan Stanley

The biggest factor that affects forex is the exchange rate. Because the value of currency is completely correlated to supply and demand, the price of one currency in relation to another is constantly shifting. Because supply and demand are influenced by a number of different factors, the foreign exchange market is extremely complex and ever-changing, and could be impacted by almost any social or economic event, worldwide. In most countries, there are little or no restrictions on capital flows, leaving the exchange rates open to adjustments based on their perceived values by the market forces.

According to Wikipedia, hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds’ favor.

Hedge Funds, which have always been known to dabble in exotic investments, were therefore the perfect vehicle to trade in the foreign exchange market. Forex hedge fund managers must have a prolific understand of global economics. As with any hedge fund, the strategy employed in forex hedge funds depends entirely on the style of the manager, as there are many different strategies that may be used. Some popular ones include betting the position of the dollar against other currencies and a strategy where managers borrow in low-yielding currencies, then invest in higher-yielding units.

There are so many different strategies employed by by hedge fund managers, that the term “hedge” does not always apply. While some hedge funds are more risky than others, managers try to purvey the risks to investors, so they are fully aware what they are getting into.

There are many cases, however, where investors feel like managers weren’t being upfront with them about the inherent risks, like in the Bear Stearns case for example.

According to the Hedge Fund Association, there are 14 different common hedge-fund strategies, each with varying degrees of risk. The riskiest funds rely on market timing, investment in emerging markets with volatile growth, and short selling, which anticipates the future decline of a price of stock. Taking long/short positions and betting on both sides of events such as mergers, acquisitions and buyouts is thought to be a much more conservative strategy, along with investments in funds of funds.

Another popular hedge fund strategy that has increased dramatically in popularity due to its complete lack of correlation to the market, is asset-based lending. Since hedge funds that employ this type of strategy make their money off high interest payments from borrowers of their loans, the risk is more associated with defaulting by the borrowers, as opposed to volatility in the marketplace.

According to Citigroup, 93% of the return variance of equity non-hedge strategies could be explained by specific market factors. As for bond strategies, 24% of the performance moves among fixed-income arbitrage managers came from long-only market factors.

One of the most riskiest strategies used by hedge fund managers that has caused a handful of funds to implode is the use of heavy leverage backed by subprime mortgages. Many hedge fund managers did not predict that a number of these homeowners who had these types of mortgages would default, causing the bonds backed by them to plummet in value. Hedge funds like ones run by Bear Stearns and Drake Management lost billions of dollars resulting from the subprime mortgage crisis.

Let’s face it. If hedge funds had no risk attached to them, everybody would be throwing their money in. And you can’t reap rewards without taking a risk. This is why there are strict guidelines in place as to who may invest in hedge funds. Only accredited investors and qualified clients can place their money in hedge funds, since they are thought to be more educated than the typical investor and more aware of the risks involved.

These investors also must have a high net worth because there is a chance they may lose their entire investment. For investors who choose to pursue high returns in a short period of time, generally, there is more risk involved because the bets are higher. This is one of the staples of hedge funds, however. If investors wanted to take a more long-term approach, they may choose to invest in private equity or a mutual fund.