Hedge Fund Investing. Mirabile Kevin R.

for the fund.

      • Commissions are fees paid to dealers to buy and sell stocks or other investments on behalf of a fund. Commissions are normally included in the net purchase or sale price of a security and are a reduction of trading profit or loss.

      • Cost of carry refers to the net interest, dividend and coupon, and borrow fee to hold a position for the term of investment or annualized for one year. Carry can be positive or negative.

      • Interest income or expense measures the amount paid to or received from dealers who provided financing to buy securities or where the fund held cash on deposit that was received from investors or generated via short sales. Interest is generally incurred or earned related to cash balances, margin activity, or the use of repurchase agreements.

      • Coupons and dividend income or expense are the receipts or payments of income associated with stock or bond positions held by the fund. Owners of the stock or bond receive coupons or dividends, and short sellers of stocks or bonds pay coupons or pay dividends to those institutions or banks that provided the securities loans to the funds.

      • Borrow fees are incurred by funds to rent the securities borrowed from a bank or institution to sell short.

      • Fees and expenses are usually deducted after the computation of the gross trading profit and carry figures each month. Fund expenses include the legal, audit, or research-related expenses chargeable to the fund plus the fund’s management fee payable to the fund manager and any performance or incentive fees.

      • Fund operating expenses can be related to audit fees, legal fees, and other costs borne by the fund directly. Only certain types of operating expenses can be charged directly to the fund according to each fund’s operating agreement.

      • Management fees refer to fixed fees charged by a manager to the fund for its services. These fees can typically range from a 1 percent to a 5 percent flat fee.

      • Performance or incentive fees refer to the variable fees charged by a manager to the fund for its services. These fees typically range from 0 to 50 percent of the fund’s performance, after all costs and after deducting the fixed management fee.

      Every strategy and fund generates a unique combination of trading, coupon, dividend, and financing sources of income and expense. In addition, different funds generate varying degrees of long- and short-term capital gains. When reviewing a manager, make sure the components of performance are consistent with the nature of the fund. For example, funds with lots of leverage, such as a relative value fund, should show significant interest income and expense. Funds with low degrees of leverage and little trading, such as a distressed fund, should show very little interest expense, high coupons on debt, and few borrow fees. Funds that use listed futures, such as global macro funds, should not incur any interest costs and should, in fact, generate interest income.

      Funds normally report results to investors monthly. It is common practice that funds report performance net of all fees, including the management and performance fees they pay to the manager.

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      Illustration 1

      A sample calculation of a fund’s net performance for a single month is illustrated here for a fund whose manager charges a typical 2 percent management fee and a 20 percent performance fee, known as a 2 and 20 deal:

      In this example, the manager received approximately 31 percent of total gross return on investment, and the investor received 69 percent. A manager who generates a loss in any year is not entitled to any incentive compensation.

      In fact, a manager who generates a loss in any given year is not entitled to any incentive compensation going forward until the loss is recovered. This feature in a hedge fund compensation contract is referred to as a high-water mark. Some managers may also have an annual minimum performance that must be achieved before an incentive fee is earned. This is referred to as a hurdle rate.

IMPACT OF LEVERAGE, SHORT SELLING, AND DERIVATIVES

      One of the essential parts of a hedge fund’s value proposition is its ability to enhance the basic return from security selection and directionality with leverage, short selling, and derivatives.

      Hedge funds effectively combine traditional securities with leverage, short selling, and the use of derivatives to generate unique outcomes, such as higher returns and lower volatility.

      Leverage refers to the ability of a hedge fund to buy or sell more market value in shares or derivatives than the amount of capital it has raised from its investors. A fund that raises $100 million and buys $150 million or short-sells $200 million does so by combining its capital with money or shares borrowed from a bank or obtained via a derivative instrument, such as a listed or OTC option or futures contract.

      Short selling refers to the ability of a fund to sell a stock, bond, or futures contract today that it plans on buying in the future. A short seller profits from a fall in the value of the instrument or security sold. A fund can borrow shares for short selling from a bank or dealer or can obtain short exposure and profits via a derivative instrument or futures contract.

      A derivative can be a listed instrument, such as an option or a futures contract, that is exchange traded or an OTC instrument negotiated with a bank directly. The derivative can be used to provide leverage and short selling capability and can also modify income, tax, or other payoffs associated with the underlying stock, bond, or currency.

      The primary sources of leverage and the ability to sell a security short come from the use of a margin account, repo transaction, or OTC derivatives with a bank, or it is embedded in products such as futures or options. The use of leverage and short selling by hedge fund managers is fundamental to their ability to create unique results relative to traditional managers. In the most basic sense, leverage allows a manager to magnify the effects of both gains and losses. Short selling permits a manager to profit from falling prices on stocks, bonds, or indices and can give the manager the ability to lower portfolio volatility. Access to OTC and listed derivatives can improve fund liquidity, allow a fund to change the character of its income or expense, and improve access to new trade opportunities, sources of leverage, or ability to sell short certain types of securities. Derivative instruments can enhance performance and reduce risk or provide additional sources of profits beyond those available in the traditional stock or bond market. Derivatives can also introduce unwanted credit exposure to a fund based on the country party with whom the fund executed the contract or the exchange on which it was traded.

      In the United States, leverage is created for hedge funds as a result of their access to margin accounts, repo agreements, and derivatives. The Federal Reserve Regulation T regulates the amount of credit that can be extended using margin accounts. Its purpose is to regulate the extension of credit by brokers and dealers to third-party customers. The regulation provides details for the use of margin accounts to buy or short-sell securities. Margin accounts are primarily used by hedge funds to finance equity and some corporate bond securities. The Federal Reserve also governs repo transactions. They are used by hedge funds to finance short-term positions in government bonds and, sometimes, corporate bonds. In addition to regulating the market, the Federal Reserve is also a repo market participant and uses the market to inject or contract the money supply based on instructions from the open market committee and the board of governors.

      A debit balance in a margin account is the amount that a fund is currently borrowing to finance securities purchased from a bank or dealer. A debit balance will cause a fund to incur margin interest expense. A credit balance is any excess cash in a margin account. A fund receives interest income on any unused cash balances held at a bank or dealer. A repo transaction is the borrowing or selling of a fixed-income security under an agreement to return or receive the security back in a short period of time, usually overnight. The difference in the opening and closing repo values represents interest income or expense.

      An Example of a Leveraged Long Position in a Margin Account or