Concept of Hedge Funds

A hedge fund is an investment fund that can undertake a wider range of investment and trading activities than other funds, but which is only open for investment from particular types of investors specified by regulators. These investors are typically institutions, such as pension funds, university endowments and foundations, or high net worth individuals. As a class, hedge funds invest in a diverse range of assets, but they most commonly trade liquid securities on public markets. They also employ a wide variety of investment strategies, and make use of techniques such as short selling and leverage. Hedge funds are typically open-ended, meaning that investors can invest and withdraw money at regular, specified intervals. The value of an investment in a hedge fund is calculated as a share of the fund's net asset value, meaning that increases and decreases in the value of the fund's assets (and fund expenses) are directly reflected in the amount an investor can later withdraw. Most hedge fund investment strategies aim to achieve a positive return on investment whether markets are rising or falling. Hedge fund managers typically invest their own money in the fund they manage, which serves to align their interests with investors in the fund? A hedge fund typically pays its investment manager a management fee, which is a percentage of the assets of the fund, and a performance fee if the fund's net asset value increases during the year. Some hedge funds have a net asset value of several billion dollars. As of 2009, hedge funds represented 1.1% of the total funds and assets held by financial institutions. The estimated size of the global hedge fund industry is US$1.9 trillion. Because hedge funds are not sold to the public or retail investors, the funds and their managers have historically not been subject to the same restrictions that govern other funds and investment fund managers with regard to how the fund may be structured and how strategies and techniques are employed. Regulations passed in the United States and Europe after the 2008 credit crisis are intended to increase government oversight of hedge funds and eliminate certain regulatory gaps. The origin of the first hedge fund is uncertain. During the US bull market of the 1920s, there were numerous such vehicles offered privately to wealthy investors. Of that period, the best known today owing to the legacies of one of its founders

was the Graham-Newman Partnership founded by Benjamin Graham and Jerry Newman. Warren Buffett, in a 2006 letter to the magazine publication of the Museum of American Finance asserted that the Graham-Newman partnership of the 1920s was the first hedge fund he was aware of, but suggested others may have preceded it. Sociologist, author, and financial journalist Alfred W. Jones is credited with coining the phrase "hedged fund", in contrast to prior nomenclatures, and is often erroneously credited with creating the first hedge fund structure in 1949. To neutralize the effect of overall market movement, Jones balanced his portfolio by buying assets whose price he expected to increase, and selling short assets whose price he expected to decrease. Jones referred to his fund as being "hedged" to describe how the fund managed risk exposure from overall market movement. This type of portfolio became known as a hedge fund. Jones was the first money manager to combine a hedged investment strategy using leverage and shared risk, with fees based on performance. A 1966 Fortune magazine article reported that Jones fund had outperformed the best mutual funds despite his 20% performance fee. By 1968 there were almost 200 hedge funds, and the first fund of funds that utilized hedge funds was created in 1969 in Geneva. Many of the early funds ceased trading during the Recession of 196970 and the 19731974 stock market crash due to heavy losses. In the 1970s hedge funds typically specialized in a single strategy, and most fund managers followed the long/short equity model. Hedge funds lost popularity during the downturn of the 1970s but received renewed attention in the late 1980s, following the success of several funds profiled in the media. During the 1990s the number of hedge funds increased significantly, with investments provided by the new wealth that was created during the1990s stock market rise. The increased interest from traders and investors was due to the aligned-interest compensation structure and an investment vehicle that was designed to exceed general market returns. Over the next decade there was increased diversification in strategies, including: credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy, among others. During the first decade of the new century, hedge funds regained popularity worldwide and in 2008, the worldwide industry held $1.93 trillion in assets under management. However the 2008 credit crunch was hard on hedge funds and they

declined in value and hampered "liquidity in some markets" causing some hedge funds to restrict investor withdrawals. Total assets under management then rebounded and in April 2011 were estimated at almost $2 trillion. As of January 1, 2011, the largest 225 hedge fund managers in the United States alone held almost $1.3 trillion, with the largest hedge fund manager, Bridgewater Associates having $58.9 billion. In 2011, the largest hedge funds were Bridgewater Associates ($58.9 billion), Man Group ($39.2 billion), Paulson & Co. ($35.1 billion), Brevan Howard ($31 billion), and Och-Ziff ($29.4 billion). As of February 2011, 61% of worldwide investment in hedge funds comes from institutional sources.

Hedge Fund: Antecedents and Origins

Hedge funds have become the focus of a great deal of attention over the past five yearsboth from investors and regulators. For investors, hedge funds have become investment vehicles synonymous with high returns. Everyone wants to invest in a hedge fund once they are convinced that the term is synonymous with 25 percent-plus annual returns. Regulators sometimes act as if they believe that any investment vehicle earning extraordinarily high returns must either be extraordinarily risky or crooked. So, the reasoning goes, investors, especially the less wealthy ones particularly eager for high returns, must be protected from investing in hedge funds. Few investors, not to mention pension fund managers and regulators, have stopped to ask themselves what is so special about hedge funds? How do they relate to mutual funds? Are hedge funds characterized by a unique approach to investing, the possession of special knowledge that enhances the rate of return on their investment activities, or simply by a unique fee structure? Hedge fund is now a term covering what has come to be a far more heterogeneous collection of money managers than was the case even a decade ago. The growing and changing role of hedge funds in financial markets today is derived from the way in which the ongoing process of storing and enhancing wealth has been managed (largely in the United States) over the past seventy-five years. No doubt, the scope of the investigation of such a compelling process as the storage and enhancement of wealth could be expanded over a longer period of time and across a broader social spectrum. But an

examination of the process, in what has become the wealthiest country in the world, since just before the Great Depression, provides ample scope for an investigation of the origins and evolution of hedge funds. We shall begin our story with the Great Depression and the role of financial markets therein and end it with some thoughts on the future of hedge funds. Among the lessons derived from the Great Depression was the firm conviction that unregulated financial markets led to rampant speculation, eventual market bubbles, and ruin for unprotected investors. The result was the imposition of strict government controls regulating the access of investors to investment vehicles. Financial institutions were constrained with regard to the types of investment activities they could undertake while being labeled for investors. Money managers could run stock funds or bond funds, but usually not both. And they could either invest in their primary investment vehicle (stocks), or hold cash (treasury bills) if they thought, as they seldom did or needed to do, that stock prices were going down. What evolved after World War II was the mutual fund industry aimed at helping households that owned investable assets over and above owner-occupied real estate and normal savings to acquire the means to store and enhance wealth. The mutual fund industry was structured on a benchmark return basis. That means that mutual fund managers could offer to households various categoriesstock funds, bond funds, growth funds, value fundsthe performance of which was gauged by comparison with other funds in that category. Mutual fund managers collected a fee of 12 percent of the money under management and strove to outperform either the other funds in the industry, the overall stock market, and/or the benchmark return on riskless U.S. government securities. While some households chose to manage their own investments without the aid of intermediaries like mutual funds, the great bulk of U.S. household assets and pension fund assets held in trust for U.S. households were managed by a growing industry of mutual funds. The aim of mutual funds was to get as much money under management as possible thereby increasing the total fees available to the managers of the mutual fund

while maintaining a rate of return comparable to other funds and slightly superior to the return on what were viewed as less risky assets, like U.S. notes and bonds. Another notable feature of mutual funds was a long-only orientation. That is, a typical mutual fund posted a sign that said, in effect, we invest in stocks or some subcategory of stocks, and were thereby constrained by Securities and Exchange Commission regulations to continue to do so. The managers of the fund had a simple choice. They either owned the class of assets they advertised as characterizing the fund or they went into casha somewhat misleading term used to describe short-term treasury securities. It is probably no accident that most mutual funds preferred to characterize the choice available to investors as either stocks or cash, leaving aside, for example, government or corporate bonds, another large category of wealth storage vehicles. The bond segment of the U.S. financial markets tended to be managed by professionals who usually earned a good living trading bonds in a market reserved for professionals by virtue of a fee structure that made it unattractive for individuals to participate. The long-only-cash-benchmark structure of mutual fund investing characterized the wealth management strategy for most American households and/or pension funds during the 1950s and 1960s and into the early 1970s. Markets for commodities like oil, gold, silver, copper, currencies, and bonds were left to the professionals. Household access to the returns earned by those professionals was limited by custom and lack of information. With the early 1970s came, first, the August 1971 breakdown of the Bretton Woods system, which meant that exchange rates could fluctuate, thereby providing another trading vehicle for investors with a trading orientation. Also, during the 1970s, options and futures markets developed to enable highly leveraged trading in financial instruments, currencies, and commodities. The breakdown of the Bretton Woods system and flexible exchange rates was followed by the first oil crisis in 197374, which sharply increased the volatility of the prices of many commodities.

As inflation persisted throughout the 1970s, the opportunities for individuals skilled in commodities trading rose exponentially. This was fertile ground for the first hedge fund managerscommodity traders who had a large and immensely profitable job to do. The skillful ones saw that getting to equilibrium prices in relatively thin currency and commodity markets at a time when the shocks hitting those markets were immense was a very profitable activity. Pools of capital began to emerge to exploit these opportunities and a class of super traders emerged that attracted funding, largely from wealthy investors anxious for the extraordinary 50 to 100 percent rates of return on a relatively small portion of their total wealth. The performance of hedge fund managers wasnt measured relative to any benchmark, but in absolute terms. During bad years, mutual funds that lost money would report to investors that, although the fund was down by 5 percent for the year, the benchmark or the average return for that category of fund was down by 8 percent, thereby hoping to offer the investor some consolation. The biggest mutual fund winners during a bad year were the ones who held the most cash, since mutual funds didnt go shortthat is, sell shares that they did not own in hopes of buying them back at a lower price. In sharp contrast, the new class of hedge fund managers growing up trading largely in the commodities sphere was far less constrained than the typical mutual fund. First of all, they werent limited to investing in or trading any particular category of asset. They traded currencies, commodities, stocks, bondswhatever moved. Second, if they thought the price was going down, they sold. That is, they could be long or short any of the things they traded. Their default option was not cash (actually treasury bills) as was the case for mutual funds, but rather to sell something whose price was going down. In this sense, they were far less constrained than mutual funds, having a broader category of assets to trade and not being constrained by the cash-long choice faced by mutual funds. As a result of these lower constraints and of the high level of volatility in many of the commodity markets, the skillful traders made extraordinarily high returns and so were judged simply by the level of those returns rather than by comparing those returns with some other class of asset.

The early hedge fund managers were regulated not by the Securities and Exchange Commission, but rather by the markets. Highly volatile commodity and currency markets along with the leveraged access to trade those markets (available through options and futures contracts) required highly skillful, disciplined risk management and simple gut fortitude to be a successful manager. Many didnt make it, but those who emerged as successful became legendary. By the early 1980s, wealthy investors pursued the most successful hedge fund managers to enhance their available capital in hopes of sharing in the extraordinary returns they were earning by trading volatile markets in an unconstrained manner. Traders like Bruce Kovner, George Soros, Julian Robertson, Paul Tudor Jones, and Louis Bacon set up companies to enable them to manage other peoples money. Total funds under management at the largest hedge funds during the early 1980s tended to be, at the outset, around several hundreds of millions of dollars, extraordinarily small by todays standards. With the successful hedge funds earning 50 to 100 percent annually, funds under management rose extraordinarily rapidly through internal growth, but also as wealthy investors pressed hard for the most successful funds to manage more of their money. By the early 1990s, the largest hedge funds were managing over a billion dollars each and total money under management in the hedge fund industry totaled about 100 billion dollars. With the remarkable returns earned by hedge fund managers, investors were willing to buy into the hedge fund fee structure. The hedge fund managers usually took a 2 percent fee, comparable to the fee charged by mutual funds, and then kept 20 percent of the profits. For a manager running a $500 million fund, often with few employees and relatively little overhead, a 50 percent rate of return meant $250 million in profits with $50 million of that going to the manager. As the fund doubled in size, the relatively small number of highly successful hedge fund managers were clearing over $100 million a yearfar in excess of the compensation earned by the captains of industry and finance.

But simultaneously, their investors, even after fees, were earning 40 and 50 percent rates of return, extraordinary by any standard. The elements of extraordinarily high returns for hedge fund managers and their investors were a combination of investment style unconstrained by the long-only cash benchmark approach of mutual funds, the introduction of leverage-enhancing vehicles in the futures and options markets, and the emergence of large markets in currencies, commodities, and financial instruments where prices moved enough to generate extraordinary profits for those on the right side of the trade. The new trading style, the emergence of volatile prices, and the leverageenhancing instruments were all necessary conditions to generate the high returns earned by the most successful hedge fund managers. However, they were not sufficient. Survival required the unique skills as traders and, more importantly, as risk managers that distinguished the most successful and resilient hedge fund managers. The more successful they became, the more people wanted them to manage their money and, as experience would prove, the more difficult it became to earn the extraordinary rates of return that characterized the early history of the hedge fund industry from the late 1970s to early 1990s. As hedge funds reached the billion-dollar mark of funds under management, the most innovative hedge fund managers began to take steps to maintain high returns on a larger body of investable funds. They hired more traders and strategists and pursued alternative strategies hoping that the returns on such alternative strategies would not be highly correlated with one another, thereby easing the problem of managing risk as the size of the fund grew. The evolution of hedge funds to larger entities able to manage multiple billions of dollars of funds was mixed during the 1990s. As all of the large hedge funds undertook alternative strategies, they all tended to move into the same collection of positions, meaning that any outside shock that forced an exit from those positions produced a highly

correlated movement of prices and that added to the volatility of returns thereby complicating the problem of managing risk in multi-strategy hedge funds. The ability of hedge funds to grow was also constrained by the simple fact that great traders of volatile financial instruments, those able to earn a rate of return of 25 percent or more on half a billion dollars or more of tradable capital, proved to be rare indeed. A category of solid second-tier traders emerged who could manage between $100 and $300 billion a year, earning about 20 to 25 percent on that amount. That reality meant that it took about five traders, having consistently good years, to return 20 percent on a billion dollar fund. After fees, the 20 percent return on a billion-dollar fund yields investors a little bit less than 15 percentfairly attractive, but not extraordinary when compared to the 8 percent long-run average available on equity investments with mutual funds. The 15 percent returns were also a far cry from the 40 and 50 percent rates of return earned during the early years by the most successful traders. During the 1990s, the reality emerged that the hedge fund activity earning the remarkably high returns of the early phase of the industry was limited in scale. It was one thing to have an extraordinarily skillful hedge fund manager returning 50 or 60 percent annually on a billion-dollar fund. It was quite another to see such returns on substantially larger funds. Some of the hedge fund managers who had developed their skills trading equities were able to scale-up their activities somewhat more successfully through a combination of highly leveraged plays in large-scale equity markets, but even those activities reached their limits as fund size grew to above $10 billion. Some funds elected to enhance their rate of return by reducing size and returning funds to investors. The reality that a fund structured to earn 40 to 50 percent rates of return was not infinitely scalable to the upside was disappointing to most investors, many of whom had to learn the hard way that all funds cant earn such extraordinary returns under all conditions.

Importance of Hedge Funds

I want to use this opportunity to share some perspectives on hedge funds and the policy implications of their evolving role in the financial system. The term hedge fund is used to describe a diverse group of financial institutions, which together play an increasingly important role in our financial system. The rapid growth in their numbers and their assets under management suggests they provide, or are perceived to provide, significant economic value to investors that is not available in other investment vehicles. If hedge funds demonstrate continued value as investment vehicles, then given the relatively small share of the world's savings they account for today, we could see meaningful further increases both in the aggregate size of the hedge fund sector and in the relative significance of their role in financial markets. In the conventional wisdom, hedge funds are conspicuous more for their perceived risks to the financial system than for the positive contribution they make to how financial markets function. In fact, however, they provide a variety of very positive contributions to our financial system. Hedge funds play a valuable arbitrage role in reducing or eliminating mispricing in financial markets. They are an important source of liquidity, both in periods of calm and stress. They add depth and breadth to our capital markets. By taking risks that would otherwise have remained on the balance sheets of other financial institutions, they provide an important source of risk transfer and diversification. They don't perform these functions out of a sense of noble purpose, of course, but they are a critical part of what makes the U.S. financial markets work relatively well in absorbing shocks and in allocating savings to their highest return. These benefits are less conspicuous than the trauma that has been associated with hedge funds in periods of financial turmoil, but they are substantial. Hedge funds combine the classic mix of factors that have been associated with institutions at the center of past instances of stress in financial markets. They can be highly leveraged and can be vulnerable to pressure to liquidate assets quickly if they sustain significant losses. They can be active in complex instruments, and assessing the risks in their exposures is formidably challenging. Additionally, they are not subject to the public disclosure or regulatory reporting requirements that apply to a range of other financial institutions. And they operate largely outside the

framework of other requirements established by regulatory authorities to protect the stability of the financial system. They are not unique in these attributes. Some of the same things are true of other types of financial institutions. It's the combination of the capacity for leverage, the complexity in assessing the risks they present, together with their apparent importance in many markets that makes hedge funds an important focus of attention from a systemic perspective. For policy makers, the concerns associated with hedge funds range from investor protection, to market practices and potential manipulation, to the potential conflicts and reputational risks they present to the financial institutions they transact with, and to potential risks to the stability of the financial system. I want to focus on the latter set of concerns -- those associated with systemic risk. These systemic concerns have two dimensions: First is the possibility that the behavior of hedge funds in periods of market stress could amplify rather than mitigate the shock, induce larger moves in asset prices, or cause broader damage to the functioning of markets when it is most important they function well. Second is the possibility that the failure of a major hedge fund or group of funds could significantly damage the viability of a major financial institution, both through direct exposure to the fund and losses resulting from the impact on other market risks to which the institution is exposed? These concerns existed before the events associated with Long-Term Capital Management (LTCM) in 1998, but that episode provided a powerful example of both sets of risks, and how the erosion of counterparty discipline can magnify those risks. How significant are these risks today? This is not a question that can be answered by a clear set of facts that can inform a judgment of probabilities. And of course how the financial system responds to a shock is substantially dependent on the nature of the event. In assessing this question today, there are numerous factors to consider: The number of hedge funds, and their total assets under management, have increased dramatically since 1998, significantly more rapidly than total financial assets. Although they still represent a relatively small share of total financial assets, they play a significant role in some market segments. Total exposure of the

major bank and non-bank financial intermediaries to hedge funds as a group may be larger today, but that exposure is probably more diversified than in 1998. Market participants seem to believe that average leverage in the hedge fund community, and the extent of leverage for the more highly leveraged hedge funds, is lower than in 1998, but clearly it is difficult to assess these issues with any precision. On balance, the quality of risk management by counterparties to hedge funds has, we believe, improved substantially since 1998. This is important, given the gaps revealed in market practice at that point. More on this later. Capital in banks and in the parts of the financial system affiliated with banks has increased significantly in absolute terms -- that is, the major intermediaries are significantly larger than in 1998. However, when bank capital is measured relative to the risk of the activities it is intended to support, the resulting measures -- while strong -- are not significantly different from 1998 levels. The earnings capacity of the largest institutions has increased substantially and in some cases the volatility of those earnings has declined with the increased scope of their operations. The infrastructure of the financial system, meaning the clearing and settlement system is stronger and seems better able to handle much larger volumes, which is an important source of resilience in periods of stress. Our overall judgments is that the U.S. financial system today is significantly stronger than it was in 1998. It has proven to be quite strong in the face of a number of fairly substantial recent adverse events. And there is some evidence that hedge funds have helped contribute to this resilience, not just in the general contribution they provide by taking on risk, but as a source of liquidity in periods of increased stress and risk aversion in the rest of the financial system. And yet, hedge funds and financial leverage more generally still present a source of potential risk to the financial system. The nature of these risks are worth reassessing, given the rapid growth in the hedge fund sector, the increased complexity of their interactions with major dealers, and concerns about unevenness in risk management practices and some recent possible erosion in the quality of counterparty discipline across the financial sector. How can these risks best be mitigated in practice? Let me comment on the range of possible options that stop short of direct regulation. Prudential regulations, in the form of capital or leverage requirements, have not been considered a necessary or

desirable step to date within the official sector in the United States, and are not on the horizon. Investors in hedge funds have a compelling direct interest in ensuring they are well managed. A more discerning and pro-active approach by investors in hedge funds should help to reduce the risk of failure by a major fund. The increasing share of institutional money allocated to hedge funds and the growing role of funds of funds could help reinforce the ability of the investor class to provide such market discipline, in particular if these types of investors undertake more extensive due diligence. There has been and continues to be a lot of interest in inducing or requiring hedge funds to disclose information that would make it possible to know more about the scale of leverage in particular funds, the risk of concentrated positions that could amplify volatility if unwound quickly, and other aspects of the risk profile of the fund. These efforts are motivated in part by discomfort about what we do not now know and a sense that knowledge itself, by reducing uncertainty, could reduce risks. And they are also motivated by the view that greater disclosure would act as a desirable restraint on risk taking, and make it possible for market discipline to work more effectively. There have been several significant efforts to induce greater disclosure since 1998, notably by the President's Working Group on Financial Markets, by a committee under the auspices of the BIS, and by private sector groups in the United States. These efforts have fallen short of their objectives, in significant part because of the difficulties in designing a disclosure regime that would provide meaningful information about potential systemic concerns, without undermining the ability of hedge funds function profitably and provide the important benefits that I mentioned earlier. Thus, while the potential benefits of meaningful progress on hedge fund disclosures could be material, we must also be realistic about the inherent difficulties associated with such a challenge. Even if additional efforts are mounted in this area, progress is not likely to come easily or quickly. The most constructive avenues for mitigating concerns about systemic stability lie in the areas of comprehensive risk management of potential exposures to hedge funds, the overall strength of capital and risk management in the major financial institutions, and the resilience of the market infrastructure.

And we believe there is room for some further strengthening of market practice in these areas. To begin, let me acknowledge that the events of 1998, and the resulting recommendations of the private-sector Counterparty Risk Management Policy Group (CRMPG), and other groups, were followed by very significant improvements in risk management practices, including those related to hedge fund counterparty exposures. At a general level, these changes were significant because they offered the promise of limiting the overall hedge funds could take on, as well as the direct credit exposure of firms to hedge funds. Specifically, firms put in place stronger internal due diligence regimes to manage hedge fund exposures. They imposed stricter credit terms, required more collateral, adopted daily margining and more conservative practices for valuing collateral. They put greater emphasis on measuring potential future credit exposures, while adopting more sophisticated ways of measuring and stress testing those exposures. Firms have also sought to obtain more information from hedge funds about the risks the funds are taking on, although more often than not this seems to have taken the form of periodic onsite visits and informal discussions rather than through a regular and frequent flow of detailed risk reports. These improvements are notable, but a few qualifications are in order. First, progress has been uneven across the major dealers. Second, there are signs of some erosion in standards in response to competitive pressures, reflected in some lowering of initial margin requirements and a relaxation in other credit terms. In addition, changes in the market, specifically increasingly complex relationships that firms have with hedge fund counterparties, suggest the need for higher standards in some areas relative to what seemed appropriate in the wake of the events of 1998. Let me emphasize a few specific areas that my colleagues and I believe should be the focus of attention by market participants: First, firms need to give greater attention to the full range of exposures they face in the different, and often multiple, relationships they have with hedge funds including those related to prime brokerage and counterparty credit extensions, proprietary investments in hedge funds, the provision of structured hedge fund products, and the offering of external funds of funds and in-house managed hedge funds as investment products, among others things.

An important part of this involves managing the potential conflicts that arise from these multiple relationships and the legal and reputational risks entailed. Hedge fund-related activities need to be integrated into the broader compliance discipline. Second, improving the overall discipline of the stress testing regime is critical. This is an area where we see the greatest divergence in practice across firms and the greatest gap relative to the achievable frontier of best practice. Potential future exposure measures produce what can be misleadingly low overall measures of counterparty credit risk. Because they are based on value-at-risk (VaR) calculations, and reflective of recent historical market conditions and correlations, they do not necessarily provide an effective measure of vulnerability to loss under more severe conditions of market stress and illiquidity. Stress tests must be designed and applied to compensate effectively for these limitations. Designing an appropriate set of stress tests that can capture the underlying pressure points and concentrations across a broad range of relationships with many different hedge funds is not easy, but it's necessary. And, the results of these tests need to inform judgments by the firm on the scale of exposure that it is willing to take to individual funds, groups of funds with similar strategies, and to hedge funds as a whole. Moreover, firms need to find ways to consider assessments of their stress-level exposures to hedge funds in tandem with stress tests of their own market risks to inform an overall judgment on the extent of capital market trading-related risks that the firm is taking on -- especially in relation to low probability but high impact events. Third, and especially in light of the current competitive climate, we believe it is appropriate for dealers to have more exacting standards for the overall due diligence process, and to adjust credit terms on the basis of those higher standards. This is particularly important in those cases where there has been innovation in the manner in which credit is extended. For example, it is much more common today than in 1998 for hedge funds to seek arrangements that provide contingent credit and thus provide the hedge fund with protection against the need to liquidate positions too rapidly. Similarly, many hedge funds are today seeking to base margining agreements, including initial margins, on the results of VaR calculations that incorporate the effect of netting across multiple products. While both of these developments have their basis in sound risk management principles, firms extending such credit should carefully examine the impact of these and other innovations on their potential exposures to hedge funds in stress conditions, and set the terms for such credit accordingly.

A reinforced due diligence process also is critical in assessing the operational capabilities of the hedge funds, the quality of their risk management process and execution and compliance infrastructure. This may sound self evident, but it is not as common as one might think. Timely access to forward looking measures of risk by hedge fund counterparties is obviously important for assessing the risks in firms' exposures to hedge funds as a group, and for assessing the impact of hedge funds' activities on a firm's own positions. To the extent that information is not made available, and there seem to be a number of legitimate reasons why hedge funds may resist providing it and are sometimes successful in doing so, then it makes sense for the dealer to reduce the exposure it is willing to take to that fund. In general, credit terms should be calibrated to the quality of the information provided by the hedge fund counterparty. To the extent this is done generally across those funds that are less transparent, have weak risk management disciplines and/or inadequate operational infrastructure, they will be able to take on less leverage, which would limit the potential risk they may pose in a disruptive event. As these points suggest, it is not enough to simply manage the firm's direct potential future credit exposure to hedge funds within prudently low limits. This has to be complimented with a more exacting approach to the evaluation of a firm's overall vulnerability to market risk that includes full consideration of the potential impact of a large shock, including one that involves hedge funds. Alongside these enhancements to risk management practices, we believe that market participants should also intensify their efforts to improve the underlying infrastructure of the markets in which hedge funds are important. Weaknesses in close-out procedures for OTC derivatives were among the areas singled out by the CRMPG for collective action in the wake of LTCM, and important progress has been made in this area since. In addition, there are potentially valuable efforts underway to standardize documentation and improve the confirmation and execution process in these markets. But looking forward, given the size of the OTC derivatives markets and the participation of hedge funds in those markets, it is worth reflecting on whether central counterparty clearing arrangements for the more standardized portion of the OTC derivatives market could play a useful role. Certainly, there are many challenges associated with such a project, and its potential to mitigate risks effectively would have to be clearly demonstrated, but surely it is worth looking carefully at whether that or similar efforts could provide meaningful improvements

to the core infrastructure of what is undoubtedly a systemically important set of markets. Taken together, these areas of focus are important to ensure that there is adequate capital not just against growing direct exposures to hedge funds, but the indirect exposures that could affect market conditions and firms' positions in a more stressful environment. We believe that the dealers that act as major counterparties to hedge funds have a collective interest in improving market practice in these areas. This is a good time for them to reassess how practice has evolved against the standards set out by the CRMPG in 1999, and to examine whether the bar established at that time is appropriate for the conditions that exist today. It took a major market event to expose the extent of weaknesses in market practice that prevailed prior to 1998 and to catalyze improvements across the financial community. Those reforms have played an important role in reducing risk in the system, alongside the overall improvements in capital, risk management, and the financial infrastructure. Further progress in strengthening risk management practices is an investment worth making, particularly at a time when the markets appear to be pricing in a relatively benign view of risk in the financial system and in the economy overall.

Definition
Definition of 'Hedge Fund' An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. Investopedia explains 'Hedge Fund' For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of

money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

Key Characteristics of Hedge Funds

Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc). Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded. Some hedge fund strategies have the ability to deliver non-market correlated returns. It is important to understand the strategy being employed, before investing. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns. They have learned this is the best way to attract large capital inflows and retain investors. Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent. Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns.

Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage. Hedge funds heavily weight managers remuneration towards performance incentives, thus attract the best talent in the investment business. Unfortunately, this can also lead to undue risks being taken. It is important to verify that managers have their own money invested in their fund.

Benefits of Hedge Funds

Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets. Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns. The huge variety of hedge fund investment styles many uncorrelated with each other provides investors with a wide choice of hedge fund strategies to meet individual investment objectives. Academic research shows hedge funds have higher returns and lower overall risk than traditional investment funds. Hedge funds can provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets. Adding hedge funds to an investment portfolio provides diversification not otherwise available in traditional investing. The two primary benefits hedge funds provide (externally of the fund itself that extends to financial markets) is they give necessary liquidity to markets that are otherwise illiquid by investing in rarely-traded instruments and secondly, they provide risk diversification that is not possible with more traditional stock and bond investments. A hedge funds diversification leaves only systemic risks (market risks). This risk cannot be diversified away. Other benefits of hedge funds are helping mitigate excessive price swings by taking small gains or losses and consequently, reduce the bid/ask spreads and market volatility.

Internally (within the fund itself), it is the potential to reduce portfolio risks by investing in non-financial commodities (oil, grains, futures, interest rate swaps, stock options, indexes, credit risk swaps, mortgages, currencies, etc.). This flexibility to invest in other vehicles gives hedge funds the potential to produce returns in up or down markets. This flexibility when combined with the specific skills-based strategy of the fund manager gives hedge funds their everlasting allure to investors. This is the compelling argument for hedge funds. A prime example of this is the Thames River Fund (a fund that invests in other hedge funds) managed

by Mr. Ken Kinsey-Quick. It had sold short the sub-prime mortgage sector since last year and this year reversed itself by buying the same cheap sub-prime assets. Hedge funds have recently found themselves a new role that of instigators of management change. Because funds always maximize the returns on their investments, they now take an activist role in the management of the firms they had invested in. They do this in many different ways but primarily, they demand that either management adopt their suggestions of improving company performance (and hence returns) or they will gather proxy votes during stockholders meetings to vote out the current management officers whom they view as not performing up to par. Managers of hedge funds are generally against so-called managerial capitalism, a situation that was also denounced by economist Adam Smith back in 1776. It is an agency problem that arises whenever one person allows another to act in his behalf as agent. This situation is true where shareholders allowed senior management (as their agents or proxies) to supposedly act in their best interests which sometimes do not happen. A glaring example of management not acting in the best interest or exercising anxious vigilance is when managers vote for themselves high salaries despite mediocre performance to the detriment of the shareholders. This activist style or role has engendered some positive changes and boosted performance.