The defining qualities of a “hedge fund” were traditionally held to include: offshore domicile; freedom from regulation; secrecy; restricted investor base; substantial manager co-investment; performance-related fee structures and an unconstrained investment mandate including the ability to hedge. Yet with every passing year most of these attributes, which we touch on in turn, are becoming less unique to hedge funds.
All sorts of funds, including long only ones, use offshore domiciles, and it is onshore-domiciled liquid alternative hedge funds - mainly ’40 Act funds in the US and UCITS in Europe - that have seen fastest asset growth in recent years.
Onshore and offshore jurisdictions alike permit unregulated fund structures, but we seldom see seasoned hedge fund managers using them. Hedge funds are usually regulated, albeit somewhat more lightly in some offshore fund domiciles. Hedge fund managers are nearly always regulated at least as heavily as other asset managers dealing with the same classes of investors.
Regulation is one source of portfolio transparency, along with most audit reports, some administrator reports, exchanges’ reporting requirements, and investors’ due diligence demands. A black box hedge fund is rare indeed.
Many hedge funds restrict access to variously defined professional/sophisticated/qualified investors, but many hundreds of millions of individuals outside these criteria have indirect exposure via pooled savings such as pension funds, and can invest directly through liquid alternatives.
US mutual fund managers’ holdings of their own funds have been disclosed since 2005. This has revealed that significant proportions of them are “eating their own cooking”, but clearly not to the same degree as hedge fund managers, some of whom have returned external capital altogether and become family offices.
It is primarily reinvestment of performance fees that has allowed certain hedge fund managers to grow most or all of their funds’ assets. Yet some listed investment companies, and long only mandates, also receive performance fees. Conversely a few hedge funds offer some share classes or strategies without performance fees, sometimes due to ’40 Act rules.
Hedge funds do not, of course, always hedge, with activist and distressed debt strategies most likely to be long only in our experience. Equally, non-hedge funds, including pension and insurance funds, could be hedging risks such as interest rate, inflation, longevity, volatility, fat tail and black swan risks. A growing grey area is the number of “total return” and “absolute return” funds that may have the ability to go short, but barely exercise it to any meaningful degree, if at all.
So, is the distinguishing feature of some hedge funds their unfettered freedom over investment universe, process and techniques? Hedge funds have often been the first to trade new markets, asset classes and instruments and, arguably, both systematic and discretionary shops are at the leading edge of applying new technology to both the investment process and trade execution.
Though in a maturing industry the distinctions between hedge funds and other funds are blurring, many hedge funds continue to demonstrate innovative qualities.