Hedge Fund

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Hedge Fund</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="5%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="40%" align="left" valign="top"><p class="word_list"> <a href="#Amaranth_Advisors">Amaranth Advisors</a><p class="word_list"> <a href="#David Askins">Askins, David</a><p class="word_list"> <a href="#A.W. Jones & Co.">AW Jones & Co.</a><p class="word_list"> <a href="#backfill">backfill</a><p class="word_list"> <a href="#John D. Barry">Barry, John D.</a><p class="word_list"> <a href="#Beacon Hill Asset Management">Beacon Hill Asset Management</a><p class="word_list"> <a href="#Michael Bergers">Bergers, Michael</a><p class="word_list"> <a href="#Eifuku Master Fund">Eifuku Master Fund</a><p class="word_list"> <a href="#F-3 hedge funds">F-3 fund</a><p class="word_list"> <a href="#funds of funds">fund of funds</a><p class="word_list"> <a href="#Granite Fund">Granite Fund</a><p class="word_list"> <a href="#Hedge funds">hedge fund</a><p class="word_list"> <a href="#high-water mark">high-water mark</a><p class="word_list"> <a href="#hurdle rate">hurdle rate</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="55%" align="left" valign="top"><p class="word_list"> <a href="#Alfred W. Jones">Jones, Alfred W.</a><p class="word_list"> <a href="#John Koonmens">Koonmens, John</a><p class="word_list"> <a href="#Lancer Offshore Fund">Lancer Offshore Fund</a><p class="word_list"> <a href="#Michael Lauers">Lauers, Michael</a><p class="word_list"> <a href="#Lipper Convertible Fund">Lipper Convertible Fund</a><p class="word_list"> <a href="#Long Term Capital Management">Long Term Capital Management</a><p class="word_list"> <a href="#Manhattan Fund">Manhattan Fund</a><p class="word_list"> <a href="#Nicholas_Maounis">Maounis, Nicholas</a> <p class="word_list"> <a href="#Maricopa">Maricopa Funds</a><p class="word_list"> <a href="#David M. Mobley">Mobley, David</a><p class="word_list"> <a href="#National Securities Markets Improvement Act">National Securities Markets Improvement Act</a><p class="word_list"> <a href="#prime broker">prime broker</a><p class="word_list"> <a href="#Edward Strafaci">Strafaci, Edward</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body"><b><a name="Hedge funds">Hedge funds</a></b> are popularly perceived as small, secretive investment funds run by financial gurus who earn extraordinary <a href="../articles/return.htm">returns</a> managing money for the super rich. Another perception is provided by <i>Forbes Magazine</i>, which describes hedge funds as "the sleaziest show on Earth ... a business rife with exorbitant fees, phony numbers and outright thievery." What is undeniable is the fact that hedge funds have proliferated since 1996, and investors are pouring money into them. This article explores what hedge funds are and why they have become popular.</p> <p class="body">There is no precise definition of what is or is not a hedge fund. The term generally refers to a limited partnership or <a href="../articles/corporation.htm">corporation</a> that manages investments and is structured in a manner that largely exempts it from financial regulation. Hedge funds generally take leveraged positions in publicly traded <a href="../articles/common_stock.htm">equity</a>, debt, foreign exchange and <a href="../articles/derivative_instrument.htm">derivatives</a>. For this reason, venture capital funds, private equity funds, commodity pools and real estate partnerships are not generally considered hedge funds.</p> <p class="body">Hedge fund's charge investment fees that typically include a management fee, which is calculated as a fixed percentage of assets under management, and an incentive fee, which is calculated as a percentage of the fund's returns. Other "administrative" fees may also be charged. A fund might charge a 2% management fee and a 0.4% administrative fee in addition to a 20% incentive fee. If this fund managed <a href="../articles/currency_codes.htm">USD</a> 100<a href="../articles/mm.htm">MM</a> and earned USD 18MM in income and capital gains over a year, the combined fee for the year would be:</p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" height="36" id="table6"> <tr> <td width="100%" align="center"> (0.024) (USD 100MM) + .20 (USD 18MM) = USD 6.0MM</td> <td width="5%" align="right">[1]</td> </tr> </table> <p class="body">For ease of exposition, this example assumes fees are paid annually. In practice, they are charged monthly or quarterly.</p> <p class="body">The incentive fee may be subject to a <b> <a name="hurdle rate">hurdle rate</a></b> or <b><a name="high-water mark">high-water mark</a></b> provision. With the former, the performance fee is paid on only returns in excess of some hurdle rate. If there were a 5% hurdle rate in the above example, the total fee would be reduced to</p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" height="36" id="table7"> <tr> <td width="100%" align="center"> 0.024 (USD 100MM) + .20 (USD 18MM – USD 5MM) = USD 5.0MM</td> <td width="5%" align="right">[2]</td> </tr> </table> <p class="body">A hurdle rate may also be set equal to some variable index, such as <a href="../articles/libor.htm">Libor</a>. About one in five hedge funds employ a hurdle rate of some sort.</p> <p class="body">With a high water mark, a hedge fund must recover any losses—return to the last high-water mark—before incentive fees can be charged. For example, if a hedge fund loses USD 10MM one year but earns USD 12MM the next year, any performance fee for the second year will be based on only the USD 2MM gain in excess of the prior year's loss. Since investors may join the fund at different times, high water marks must be tracked  individually for each investor. About four out of five hedge funds employ a high-water mark provision.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table8"> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body">The origins of even the word "hedge fund" are obscure. Hedge funds play more the role of speculators than of <a href="../articles/hedging_and_diversification.htm">hedgers</a>. The name may have arisen to reflect the fact that many hedge funds focus on <a href="../articles/market_neutral_strategy.htm">market neutral</a> trading strategies. By putting on <a href="../articles/short_sale.htm">long-short positions</a>, they seek to hedge themselves against broad market moves while profiting from changes in the relative value of the instruments they go long or short.</p> <p class="body">This was largely the strategy pursued by <b> <a name="Alfred W. Jones">Alfred W. Jones</a></b>, who was a pioneering hedge fund manager. He launched his fund, <b> <a name="A.W. Jones & Co.">A.W. Jones & Co.</a></b>, in 1949 and ran it continuously through the early 1970s. He put on <a href="../articles/leverage.htm">leveraged</a> <a href="../articles/short_sale.htm">long</a> and <a href="../articles/short_sale.htm">short</a> positions in equities. While he didn't follow a strict market neutral strategy, his main source of returns was relative bets made between individual equities. Jones is purported to have achieved excellent returns with his strategy.</p> <p class="body">Today, hedge funds pursue a variety of investment or trading strategies. These go by various names, and there is some overlap between strategies. Generally, they fall into three categories:</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/directional_strategy.htm">Directional strategies</a> involve taking positions that will benefit from broad market rises or declines.</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/market_neutral_strategy.htm">Market neutral strategies</a> involve taking offsetting long and short positions within a specific market. The goal is to avoid net exposure to the overall market while benefiting from changes in the relative value of individual instruments within that market.</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/event_driven_strategy.htm">Event driven strategies</a> seek to exploit temporary mispricings associated with some corporate event, such as a merger or divestiture.</p> <p class="body">Many of the strategies employed by hedge funds entail (directly or indirectly) providing <a href="../articles/liquidity.htm"> liquidity</a> to markets and earning a liquidity spread when they do so. In effect, the hedge fund provides a service to the market, and this allows them to make money fairly consistently. Of course, simply earning liquidity spreads won't make anyone wealthy. To make attractive returns, hedge funds leverage themselves. For example, over any year, a USD 100MM hedge fund might earn USD 1MM deploying its <a href="../articles/capital_allocation.htm">capital</a> to provide liquidity to markets. If <a href="../articles/liquidity_risk.htm"> liquidity risk</a> were the only <a href="../articles/risk.htm">risk</a> it took, the fund would also earn the risk free return on its capital. Suppose for this example that the risk free rate is 3%. Then the hedge fund would earn in total USD 4MM a year—a 4% annual return. To boost this, the hedge fund might leverage itself. If it borrowed USD 900MM, it would have USD 1,000MM to deploy and would earn USD 10MM providing liquidity to markets. Add this to the same USD 3MM it would still earn investing its capital at the risk free rate, and the fund would earn USD 13MM a year. On USD 100MM capital, that is a respectable annual return of 13%. After fees, investors might earn 9%.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table9"> <tr> <td align="right" width="9"> <p style="margin-top: 0; margin-bottom: 0"> </td> <td width="336">  <p style="margin-top: 8; margin-bottom: 2" class="ad_legend"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I4"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82402"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82402;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> </table> <p class="body">This, in a nutshell, is how many hedge funds make their returns. They earn liquidity spreads and leverage themselves to make the returns attractive. For an experienced trader, this is all quite mundane. It also entails considerable risk. When you provide liquidity to markets, you are in essence accepting positions that will be difficult to unwind in an emergency. You are agreeing to be the party left "holding the bag" when things fall apart. That is why markets compensate liquidity providers in the first place! Seen in this light, the returns these hedge funds earn are not leveraged profits so much as leveraged insurance premiums. The hedge funds are like unregulated insurance companies writing insurance policies to other market participants and pocketing the insurance premiums. When markets crash, they tend to lose money. Because they are highly leveraged, they can lose enormous sums of money. It is not atypical for hedge funds to lose most, if not all their capital. This is what happened to the hedge fund <b><a name="Long Term Capital Management">Long Term Capital Management</a></b> (LTCM) back in 1998. Other spectacular hedge fund failures can be attributed to excessive leverage, including:</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="David Askins">David Askin's</a></b> <b><a name="Granite Fund">Granite Fund</a></b> lost all its USD 600MM capital in February 1994 when the <a href="../articles/united_states_financial_regulation.htm">Federal Reserve</a> raised interest rates and the fund's leveraged <a href="../articles/collateralized_mortgage_obligation.htm">CMO</a> positions plummeted. </p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="John Koonmens">John Koonmen's</a></b> Japan-based <b><a name="Eifuku Master Fund">Eifuku Master Fund</a></b> was heavily leveraged with just a few concentrated positions when it lost essentially all its USD 300MM capital over a one week period in 2002. </p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="Nicholas_Maounis">Nicholas Maounis'</a></b> massive <b><a name="Amaranth_Advisors">Amaranth Advisors</a></b> fund folded after losing USD 6.5 billion—70% of its capital—betting on natural gas prices in 2006.</p> <p class="body">Fraud is another problem with hedge funds. Because they avoid most financial regulation, there is little oversight of hedge fund activities. Some don't release audited financial statements. Their positions are often illiquid and difficult to <a href="../articles/valuation.htm">mark to market</a>. Combine this with the generally secretive nature of hedge funds—the so called transparency issue—and there is little to stop a fund manager from misleading his investor, should he choose to do so.</p> <p class="body">This is what happened with <b> <a name="Michael Bergers"> Michael Berger's</a></b> <b><a name="Manhattan Fund">Manhattan Fund</a></b>, which shorted technology <a href="../articles/common_stock.htm">stocks</a> between 1996 and 2000 when those stocks were soaring. Berger and his investors perceived that a bubble was forming, but their timing was off. The fund lost money consistently. Berger falsified brokerage statements, so the fund's audited financial statements reported annual returns of between 12% and 27%. Based on those claims, the fund continued to attract new investments, and Berger used them to pay his mounting <a href="../articles/collateral.htm">margin calls</a>. In August 1999, Berger reported to investors that the fund had net capital of USD 426MM when in fact it had only USD 28MM. In January 2000, Berger failed to meet his margin calls, and the fund collapsed. Investors lost about USD 400MM. Following his arrest, Berger skipped bail and was placed on the FBI's most wanted list.</p> <p class="body">Fraud has played a role in the collapse of many other hedge funds, including</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="David M. Mobley">David M. Mobley</a>, Sr.</b>, manager of the <b><a name="Maricopa">Maricopa</a> funds</b>, invested fund assets in his own businesses, most of which failed. He also tapped fund assets to make donations to charities and to pay for a luxurious lifestyle for himself and his family. Between 1993 and 2000, he reported annual returns of about 50% after his 30% fee. In 2000, he claimed the funds had assets of USD 450MM when they really had only USD 33MM. Authorities intervened shortly thereafter.</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">Lipper & Co's <b><a name="Lipper Convertible Fund">Lipper Convertible Fund</a></b> lost heavily in <a href="../articles/market_neutral_strategy.htm">convertible arbitrage</a> trading between 1996 and 2002. The fund's manager, <b> <a name="Edward Strafaci">Edward Strafaci</a></b>, falsified returns during much of that period. He claimed a 7.7% return for 2001 when the fund actually lost 40%.</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="John D. Barry">John D. Barry</a></b> and the other managers of <b> <a name="Beacon Hill Asset Management">Beacon Hill Asset Management</a></b> lied about losses in their <a href="../articles/market_neutral_strategy.htm">market neutral</a> hedge funds during 2002. SEC filings claim they also defrauded hedge fund investors by transacting trades at off-market prices between the hedge funds and other accounts they managed. Between August and October 2002, the hedge funds lost 54% of their value.</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="Michael Lauers">Michael Lauer's</a></b> <b><a name="Lancer Offshore Fund">Lancer Offshore Fund</a></b> invested in distressed small cap stocks. It was successful for a while but suffered heavy losses during the bear market of 2000-2003. Lauer reported gains to investors while the fund's capital plunged USD 571MM.</p> <p class="body">Today, hedge funds are increasingly being promoted to institutional investors, who insist on better disclosures. In this context, the mystique of hedge funds as exclusive firms secretively earning spectacular returns can no longer be maintained. Instead, hedge funds are promoted as exclusive firms secretively earning returns that </p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10">offer an attractive risk-reward tradeoff, and </p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10">are largely uncorrelated with returns on traditional stock or <a href="../articles/coupon_bond.htm">bond</a> portfolios, making them an excellent means for <a href="../articles/hedging_and_diversification.htm">diversifying</a> institutional portfolios.</p> <p class="body">Reported hedge fund returns would seem to justify thee claims. Exhibit 1 presents average returns and volatilities for several categories of hedge funds. The same data is graphed in Exhibit 2.</p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="300" cellpadding="0" id="table10"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Hedge Fund Average Returns and Volatilities</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td> <div align="center"> <center> <table border="0" cellpadding="0" cellspacing="0" width="277" style="border-collapse: collapse; width: 300pt" bgcolor="#FFFFCC" id="table11"> <colgroup> <col width="149" style="width: 112pt"> <col width="64" span="2" style="width:48pt"> </colgroup> <tr height="17" style="height:12.75pt"> <td height="17" width="149" style="width: 160; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; border-left: medium none; border-right: medium none; border-top: medium none; border-bottom: 1px solid #CC9966; padding-left: 1px; padding-right: 1px; padding-top: 1px" bgcolor="#FFFFFF"> <p style="margin-bottom: 3"> </td> <td width="64" style="width: 70; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; border-left: medium none; border-right: medium none; border-top: medium none; border-bottom: 1px solid #CC9966; padding-left: 1px; padding-right: 1px; padding-top: 1px" align="center" bgcolor="#FFFFFF"> <p style="margin-bottom: 3"><b>Mean Return</b></td> <td width="64" style="width: 70; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: middle; white-space: nowrap; border-left: medium none; border-right: medium none; border-top: medium none; border-bottom: 1px solid #CC9966; padding-left: 1px; padding-right: 1px; padding-top: 1px" align="center" bgcolor="#FFFFFF"> <p style="margin-bottom: 3"><b>Volatility</b></td> </tr> <tr> <td height="17" style="height: 12.75pt; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 160; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> <p style="margin-bottom: 3; margin-left:6"> <a href="../articles/directional_strategy.htm">Long/Short Equity</a></td> <td align="right" x:num="0.12101835465623645" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 12.1%</td> <td align="right" x:num="0.10487714817808576" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 10.5%</td> </tr> <tr> <td height="17" style="height: 12.75pt; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 160; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" align="center" class="explanatory_text"> <p align="left" style="margin-bottom: 3; margin-left:6"> <a href="../articles/market_neutral_strategy.htm">Equity Market Neutral</a></td> <td align="right" x:num="0.10268620698711484" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 10.3%</td> <td align="right" x:num="2.9868761122249919E-2" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 3.0%</td> </tr> <tr> <td height="17" style="height: 12.75pt; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 160; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> <p style="margin-bottom: 3; margin-left:6"> <a href="../articles/directional_strategy.htm">Dedicated Short Bias</a></td> <td align="right" x:num="-3.5974959895523018E-2" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> -3.6%</td> <td align="right" x:num="0.17373778662280254" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 17.4%</td> </tr> <tr height="17" style="height:12.75pt"> <td height="17" style="height: 12.75pt; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 160; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> <p style="margin-bottom: 3; margin-left:6"> <a href="../articles/market_neutral_strategy.htm">Convertible Arbitrage</a></td> <td align="right" x:num="9.6896181823565408E-2" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 9.7%</td> <td align="right" x:num="4.6749370717044068E-2" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 4.7%</td> </tr> <tr height="17" style="height:12.75pt"> <td height="17" style="height: 12.75pt; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 160; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> <p style="margin-bottom: 3; margin-left:6"> <a href="../articles/event_driven_strategy.htm">Merger Arbitrage</a></td> <td align="right" x:num="8.1482985846985656E-2" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 8.1%</td> <td align="right" x:num="4.3478391645727962E-2" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 4.3%</td> </tr> <tr height="17" style="height:12.75pt"> <td height="17" style="height: 12.75pt; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 160; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> <p style="margin-bottom: 3; margin-left:6"> <a href="../articles/market_neutral_strategy.htm">Fixed Income Arbitrage</a></td> <td align="right" x:num="6.8085812177307137E-2" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 6.8%</td> <td align="right" x:num="3.8844704842640548E-2" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 3.9%</td> </tr> <tr height="17" style="height:12.75pt"> <td height="17" style="height: 12.75pt; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 160; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> <p style="margin-bottom: 3; margin-left:6"> <a href="../articles/directional_strategy.htm">Global Macro</a></td> <td align="right" x:num="0.13927596145749077" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 13.9%</td> <td align="right" x:num="0.11489589572771092" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> 11.5%</td> </tr> <tr height="17" style="height:12.75pt"> <td height="17" style="height: 30; color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 160; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" class="explanatory_text"> <p style="margin-bottom: 6; margin-left:6">S&P 500</td> <td align="right" x:num="0.1285" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" height="30" class="explanatory_text"> <p style="margin-bottom: 6">12.9%</td> <td align="right" x:num="0.20379999999999998" style="color: windowtext; font-size: 10.0pt; font-weight: 400; font-style: normal; text-decoration: none; font-family: Arial; text-align: general; vertical-align: bottom; white-space: nowrap; width: 70; border: medium none; padding-left: 1px; padding-right: 1px; padding-top: 1px" height="30" class="explanatory_text"> <p style="margin-bottom: 6">20.4%</td> </tr> </table> </center> </div> </td> </tr> <tr> <td> <div style="border-top: 2px solid #CC9966"> <p class="exhibit_legend">Average annual returns and <a href="../articles/volatility.htm">volatilities</a> for selected CSFB/Tremont hedge fund indexes and the S&P 500 over the eleven year period from 1994 through 2004. Index returns are after fees. Volatilities were calculated from monthly returns and then annualized.</div> </td> </tr> </table> </center> </div> <p class="body"> </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table12"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Graph of Exhibit 1 Results</span><br> <span class="exhibit_subheader">Exhibit 2</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td> <img border="0" src="../images/ex2_hedge_fund.gif" width="400" height="273"></td> </tr> <tr> <td> <p class="exhibit_legend">Graph of results from Exhibit 1.</td> </tr> </table> </center> </div> <p class="body">The analysis is based on eleven years of return data for hedge fund indexes maintained by CSFB/Tremont. It seems to indicate that all hedge fund categories offer superior risk-return characteristics over the S&P 500. The sole exception is <a href="../articles/directional_strategy.htm"> dedicated short bias</a> hedge funds. While the above analysis was performed specifically for this article, it is typical of analyses that are widely distributed in books and hedge fund marketing literature. It is because of such analyses that many investors believe hedge funds offer attractive risk-reward characteristics and can reduce risk by diversifying other investments.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table13"> <tr> <td width="336">  <p style="margin-top: 8; margin-bottom: 2" class="ad_legend"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I5"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82402"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82402;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> <td width="9"> </td> </tr> </table> <p class="body">On the surface, these results may appear too good to be true. During much of the 20th century, but especially since the 1960s, an extensive scholarly literature has supported the notion that public debt and equity markets are efficient—that any trading strategy based on publicly available information can be expected to sometimes outperform or underperform the overall markets, but none can be expected to consistently outperform over the long term. The literature includes both empirical and theoretical studies, some of which were published by Nobel Prize winners. The theory isn't perfect. Scholars have searched for and discovered minor imperfections. However, the results presented in Exhibits 1 and 2 represent more than a minor imperfection in efficient markets theory. If valid, they represent an imperfection the size of Texas.</p> <p class="body">Actually, the analysis of Exhibits 1 and 2 is based on biased data, and the same can be said of all similar analyses. While there are different providers of historical data on hedge fund performance, all their indexes are constructed in a manner that introduces biases. </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="400" cellpadding="0" id="table14"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Hedge Fund Index Providers</span><br> <span class="exhibit_subheader">Exhibit 3</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="475" bgcolor="#FFFFCC" id="table15"> <tr> <td width="45%" class="explanatory_text"> <p style="margin-left: 10; margin-top:3; margin-bottom:3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Alternative Asset Center</p> <p style="margin-left: 10; margin-top:3; margin-bottom:3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Blue Chip Hedge Fund Index</p> <p style="margin-left: 10; margin-top:3; margin-bottom:3"> <img border="0" src="../images/bullet.gif" width="20" height="10">CSFB/Tremont (HEDG)</p> <p style="margin-left: 10; margin-top:3; margin-bottom:3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Dow Jones</p> <p style="margin-left: 10; margin-top:3; margin-bottom:3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Edhec Alternative Indexes</p> <p style="margin-left: 10; margin-top:3; margin-bottom:3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Eurekahedge Indexes</p> <p style="margin-left: 10; margin-top:3; margin-bottom:3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Evaluation Associates</p> <p style="margin-left: 10; margin-top:3; margin-bottom:3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Feri Alternative Assets</p> <p style="margin-left: 10; margin-top:3; margin-bottom:3"> <img border="0" src="../images/bullet.gif" width="20" height="10">FTSE Hedge</p> <p style="margin-left: 10; margin-top:3; margin-bottom:3"> <img border="0" src="../images/bullet.gif" width="20" height="10">HedgeFund.Net</p> </td> <td width="55%" class="explanatory_text"> <p style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Hedge Fund Intelligence</p> <p style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Hedge Fund News</p> <p style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Hedge Fund Research (HFR)</p> <p style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Hennessee Group</p> <p style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Managed Account Reports (MAR)</p> <p style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">MondoHedge</p> <p style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">MSCI Hedge Fund Indexes</p> <p style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Standard & Poor's</p> <p style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">TalentHedge</p> <p style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">Van Hedge Fund Indexes </p> </td> </tr> </table> </td> </tr> <tr> <td> <p class="exhibit_legend" style="margin-top: 12">A list of organizations that maintain hedge fund indexes.</td> </tr> </table> </center> </div> <p class="body">Most providers have some vested interest in the success of the hedge fund industry, and that vested interest may color the decisions they make about how to construct their indexes. Also, hedge funds aren't required to contribute their performance data to anyone. They will have a natural inclination to contribute their data to those providers that they perceive as most friendly to the hedge fund industry. Here are some biases that affect some or all hedge fund indexes.:</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="backfill">backfill</a></b> bias: When a hedge fund is added to an index, the fund's past performance may be "backfilled" into the index. For example, if the fund has been in business for two years at the time it is added to the index, past index values are adjusted for those two years to reflect the fund's performance during that period. Not all indexes backfill, but those that do introduce a bias. Usually, a hedge fund will start contributing data to an index to draw attention to recent strong performance. One of the oldest tricks in investment management is to launch multiple investment funds and then market those that happen to perform well. The practice is also common among hedge funds, who report the winners to indexes while closing down the losers. Also, index providers generally have criteria for adding a new fund to an existing index. This may include a minimum assets under management requirement, and successful funds are more likely to satisfy this criteria than unsuccessful ones. In summary, successful funds are more likely to be added to an index than unsuccessful ones, so this biases indexes that backfill. While backfilling is obviously a questionable practice, it is also quite understandable. When a provider first launches an index, they have an understandable desire to go back and construct the index for the preceding few years. If you look at <a href="../articles/time_series_stochastic_process.htm">time series</a> of hedge fund index performance data, you will often note that indexes have very strong performance in the first few years, and this may be due to backfilling.</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">survivorship bias: When a fund is dropped from an index, past values of the index may be adjusted to remove that dropped fund's past data. Inevitably, a fund will be dropped from an index if it stops providing its performance data to the index provider, and a fund will be more likely to do so following poor performance than good. Also, providers may have criteria for dropping a fund, and this may naturally cause poor performers to be dropped more often than good performers.</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">liquidation bias: Due to their considerable leverage, hedge funds can fail suddenly. In the midst of such a calamity, the managers are going to have more important things on their minds than reporting their mounting losses to index providers. An index provider will have little choice but to drop the fund from the index. They may go back and purge the index of that fund's past performance or they may not. Either way, the index will not reflect the fund's staggering losses.</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">fraud bias: One hedge fund that misrepresents its performance can severely bias an index. Suppose an index is based on 25 hedge funds. One is fraudulent and misrepresents a 30% loss as a 20% gain. That one misrepresentation will bias the index return by about 2%.</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">mark-to-market bias: Many hedge funds hold illiquid positions that are difficult to value. Inevitably, there is some subjectivity in how they choose to mark those positions to market. Natural human optimism—as well as incentive fees and egos on the line—will create a natural tendency for managers to over-value rather than under value those positions. </p> <p class="body">All these factors tend to bias returns upward. There is also a problem with the <a href="../articles/volatility.htm">volatilities</a> of hedge fund indexes, which can have little resemblance to the volatilities of the funds that comprise those indexes. Several of the above biases may contribute to the problem. Liquidation bias obviously does, and fraud bias and mark-to-market bias may also do so. The bigger problem is diversification. Because indexes include multiple hedge funds, their volatilities are substantially lower than what would be experienced with a single hedge fund. In theory, because they entail no <a href="../articles/capital_asset_pricing_model.htm">systematic risk</a>, the volatility of <a href="../articles/market_neutral_strategy.htm">market neutral</a> hedge funds can be completely diversified away. Take another look at Exhibits 1 and 2. The hedge fund strategies that have the extraordinarily low volatilities are <a href="../articles/market_neutral_strategy.htm">equity market neutral</a>, <a href="../articles/market_neutral_strategy.htm">convertible arbitrage</a>, <a href="../articles/event_driven_strategy.htm">merger arbitrage</a>, and <a href="../articles/market_neutral_strategy.htm">fixed income arbitrage</a>. All are generally implemented as market neutral strategies. For this reason, the volatility of those indexes reflects more the degree to which the indexes are diversified than they do the volatilities of the individual hedge funds that comprise the indexes.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table16"> <tr> <td align="right" width="9"> <p style="margin-top: 0; margin-bottom: 0"> </td> <td width="336">  <p style="margin-top: 8; margin-bottom: 2" class="ad_legend"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I6"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82402"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82402;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> </table> <p class="body">As a practical matter, institutional investors do diversify across multiple hedge funds, but this can be expensive because the incentive fees on those hedge funds don't diversify. As a simple example, suppose an institution invests in two hedge funds, both of which have a 20% incentive fee. Suppose one fund earns USD 10MM while the other loses USD 10MM. The investor has realized a 0% return, but they still have to pay a USD 2MM incentive fee to the successful hedge fund.</p> <p class="body">This is a serious problem with <b> <a name="funds of funds">funds of funds</a></b>. These are hedge funds that invest exclusively in other hedge funds. They are marketed to investors as an easy way to diversify across multiple hedge funds. Not only do funds of funds pose the incentive fee non-diversification problem mentioned above, but they layer their own fees on top of the fees charged by the hedge funds they invest in. Typically, a fund of funds might charge a 1.5% management fee along with its own 5% or 10% incentive fee. This is on top of the perhaps 2% management fee and 20% incentive fee charged by the typical hedge fund in its portfolio.</p> <p class="body">Financial regulators tend to view the concept of funds of funds as abusive due to layering of fees. In the mutual fund industry, funds of funds are illegal. This is not an issue for funds of hedge funds, since they are largely unregulated. Now, so-called <b> <a name="F-3 hedge funds">F-3 hedge funds</a></b> are being formed. These are funds of funds of funds.</p> <p class="body">Why did hedge funds suddenly become popular after being a fringe industry for so many decades? The <b> <a name="National Securities Markets Improvement Act">National Securities Markets Improvement Act</a></b>, which Congress passed in 1996, may be the primary reason. Up until its passage, hedge funds had received exemption from regulation under Section 3(c)(1) of the 1940 <a href="../articles/united_states_financial_regulation.htm">Investment Company Act</a>. To protect the investing public, that section placed severe restrictions on the nature and number of investors a hedge fund might have. The Improvement Act added a new Section 3(c)(7). This liberalized those restrictions, dramatically increasing opportunities for hedge funds to attract investors. Large brokerage firms have helped hedge funds exploit this opportunity. </p> <p class="body">Hedge funds are frenetic traders who generate brokerage commissions out of proportion to their assets under management. While a typical institutional investor generates trading commissions that total less than 1% of their assets under management, for a hedge fund, that number can easily exceed 3%. Customers like these get red carpet treatment. Brokerage firms don't just execute and clear trades for them. They offer bundled services called prime brokerage. Typically, a hedge fund selects a firm to be its <b><a name="prime broker">prime broker</a></b>, and that firm provides services, including</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table17"> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">support in launching the hedge fund,</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">marketing,</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">office space, and</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">running funds of funds that invest in the hedge fund.</p> <p class="body">Prime brokers make it surprisingly easy to launch and run a hedge fund. The marketing they provide is critical. Due to their regulatory status, hedge funds are not allowed to publicly advertise. In the past, this seriously hampered a hedge fund's ability to raise capital. Prime brokers solve the problem by providing hedge funds with introductions to their clients. A typical large broker has an enormous client base that includes institutional investors and high net worth individuals. Introductions comprise more than a name and a phone number. Prime brokers are known for hosting lavish "introduction parties" at exclusive resorts.</p> <p class="body">By 2005, hedge funds accumulated a trillion dollars in total capital. That translates into perhaps 30 billion dollars a year in brokerage commissions. This is a huge sum of money for prime brokers. The 1996 Improvement Act opened the door, but it is marketing muscle from those prime brokers that is fueling the hedge fund industry's explosive growth.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table18"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table19"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/arbitrage.htm">arbitrage</a> <strong style="font-weight: 400"> A transaction which generates a risk-free profit</strong>.<p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/directional_strategy.htm">directional strategy</a> A trading or investment strategy that entails taking net long or short positions in a market.</p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/event_driven_strategy.htm">event driven strategy</a> Speculative trading strategy that seeks to exploit relative mispricings between securities whose issuers are involved in mergers, divestures, restructurings or other corporate events.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/leverage.htm">leverage</a> Debt financing or anything that can similarly magnify the risk and reward of an investment.<p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/liquidity.htm">liquidity</a> Term used in various senses, all relating to availability of, access to, or convertibility into cash.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/liquidity_risk.htm">liquidity risk</a> Risk due to uncertain liquidity.</p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/managed_futures.htm">managed futures</a> Portfolios of forwards or futures managed as an "alternative asset category."</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/market_neutral_strategy.htm">market neutral strategy</a> Speculative trading strategy that seeks to exploit relative mispricings between instruments while avoiding systematic risk.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/market_risk.htm">market risk</a> </strong>Exposure to the uncertain market value of a portfolio.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/soft_dollars.htm">soft dollars</a> A sometimes controversial inducement brokers offer investment managers to place trades through them.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/united_states_financial_regulation.htm">United States financial regulation</a> An overview.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table20"> <tr> <td width="100%"> <p class="explanatory_text">There are lots of hedge fund books available. A fun and highly enthusiastic introduction is Ineichen (<a target="_blank" href="http://www.riskbook.com/link/ineichen_a_(2002).htm">2002</a>). Balance his sales pitch for hedge funds with a more conservative book like Lhabitant (<a target="_blank" href="http://www.riskbook.com/link/lhabitant_f_(2002).htm">2002</a>). Another excellent book, which offers more the hedge fund manager's perspective, is McCrary (<a target="_blank" href="http://www.riskbook.com/link/mccrary_s_(2002).htm">2002</a>). For more experienced readers, Schacter (<a target="_blank" href="http://www.riskbook.com/link/schachter_barry_(2004).htm">2004</a>) offers excellent information. Lowenstein (<a target="_blank" href="http://www.riskbook.com/link/lowenstein_r_(2000).htm">2000</a>) is the definitive narrative on the collapse of Long Term Capital Management. It is a classic.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table21"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap369"> <area target="_blank" href="http://www.riskbook.com/link/ineichen_a_(2002).htm" shape="rect" coords="0, 0, 80, 124"> </map> <img border="0" src="../images/book_ineichen_a_(2002)_125.gif" usemap="#FPMap369" width="81" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table22"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/ineichen_a_(2002).htm"> Absolute Returns</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Alexander M. Ineichen</b></td> </tr> <tr> <td width="10%"><map name="FPMap370"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_5.gif" usemap="#FPMap370" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"><map name="FPMap371"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_1.gif" usemap="#FPMap371" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2002</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap368"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/ineichen_a_(2002).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap368" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table23"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap496"> <area target="_blank" coords="0, 0, 85, 124" shape="rect" href="http://www.riskbook.com/link/lhabitant_f_(2002).htm"> </map> <img border="0" src="../images/book_lhabitant_f_(2002)_125.gif" usemap="#FPMap496" width="86" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table24"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/lhabitant_f_(2002).htm"> Hedge Funds: Myths and Limits</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Francois-Serge Lhabitant</b></td> </tr> <tr> <td width="10%"><map name="FPMap494"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_4.gif" usemap="#FPMap494" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"><map name="FPMap495"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_1.gif" usemap="#FPMap495" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2002</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap384"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/lhabitant_f_(2002).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap384" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table25"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap497"> <area target="_blank" coords="0, 0, 80, 124" shape="rect" href="http://www.riskbook.com/link/mccrary_s_(2002).htm"> </map> <img border="0" src="../images/book_mccrary_(2002)_125.gif" usemap="#FPMap497" width="81" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table26"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/mccrary_s_(2002).htm"> <font size="2">How to Create & Manage a </font><br> Hedge Fund</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Stuart A. McCrary</b></td> </tr> <tr> <td width="10%"> <map name="FPMap499"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 1, 89, 16"> </map> <img border="0" src="../images/star_5.gif" usemap="#FPMap499" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap500"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_2.gif" usemap="#FPMap500" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2002</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap366"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/mccrary_s_(2002).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap366" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table27"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap498"> <area target="_blank" href="http://www.riskbook.com/link/schachter_barry_(2004).htm" shape="rect" coords="0, 0, 83, 124"> </map> <img border="0" src="../images/book_schachter_barry_(2004)_125.gif" usemap="#FPMap498" width="84" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table28"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/schachter_barry_(2004).htm"> Intelligent Hedge Fund Investing</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Barry Schachter (Ed.)</b></td> </tr> <tr> <td width="10%"> <map name="FPMap474"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 1, 89, 16"> </map> <img border="0" src="../images/star_5.gif" usemap="#FPMap499" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap427"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_2.gif" usemap="#FPMap500" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2004</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap37"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/schachter_barry_(2004).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap37" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table29"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap381"> <area target="_blank" href="http://www.riskbook.com/link/lowenstein_r_(2000).htm" shape="rect" coords="0, 0, 78, 124"> </map> <img border="0" src="../images/book_lowenstein_(2001)_softcover_125.gif" usemap="#FPMap381" width="79" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table30"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/lowenstein_r_(2000).htm"> When Genius Failed</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Roger Lowenstein</b></td> </tr> <tr> <td width="10%"><map name="FPMap379"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_6.gif" usemap="#FPMap379" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"><map name="FPMap380"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_0.gif" usemap="#FPMap380" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2000</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap382"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/lowenstein_r_(2000).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap382" width="146" height="20"></td> </tr> </table> </td> </tr> </table> </td> </tr> </table> </td> </tr> <tr> <td height="30" 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