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CALLAN
INSTITUTE
April 2017
Research
The Hedge Fund Edge: Still Sharp or Too Dull?
A Primer on the Four Key Traits That Differentiate Hedge Funds
Why should investors bother with hedge funds? The original proposition behind them was their differentiated
performance: better risk-adjusted returns with a lower correlation to traditional capital markets. However,
recent history suggests that the current generation of hedge funds lacks the edge of its predecessors.
Do hedge funds still have an inherent advantage in their quest for better risk-adjusted returns, or did they
lose their edge with today’s more efficient markets? This white paper looks at the key distinguishing traits
in the DNA of hedge funds—and why they still offer an advantage for investors looking to adapt quickly
with changing markets.
“Notwithstanding the challenges of
manager selection and implementation
risks, the inherent competitive advantages
of hedge funds are still worth considering,
especially for investors looking beyond
traditional solutions.”
Jim McKee, Director of Callan’s Hedge Fund Research group
Knowledge. Experience. Integrity.
Hedge Fund DNA
In nature, DNA at its core has four building blocks1 that map
out the structure of every living being. And just like nature, we
observe that “hedge fund DNA” has four differentiating elements which endow these investment vehicles with a competitive advantage over other investment options. The four key
traits of hedge fund DNA are:
1. Fewer regulatory limitations
2. Less constraint on strategies
3. Better alignment of interests
Less
Regulated
4. Stronger capital base
Alone, each of these qualities is appealing, but together the
properties of each interlock with the others to provide a compelling solution for investors—if managed well and priced
appropriately.
Fewer Strategy
Constraints
But the combination of these four attributes can be a dangerous proposition. Think about it. Giving the average adult—let
alone a teenager!—the right to do whatever he or she wants
with a pool of money is a strategy of hope, likely to lead to
disappointment. In fact, statistical evidence indicates that the
Aligned
Interest
average hedge fund manager has not met expectations over
the last decade. After adjusting for embedded market risks,
net-of-fee returns have often been less than zero, particularly
in recent years.
Even in the hands of an above-average manager, the attri-
Stronger
Capital Base
butes that enable hedge funds to excel are not for all investors.
Those that prefer more transparency, more liquidity, lower-cost
solutions, or more regulatory protection are a poor fit for hedge
funds. Furthermore, the differentiating qualities that give hedge
funds an edge for generating better performance in more complex strategies are also not appropriate for simpler strategies
that are highly commoditized or otherwise easily implemented.
An investor should not consider a hedge fund to implement an
index-like strategy.
1
2
The four nucleotide building blocks of DNA are adenine, guanine, thymine,
and cytosine.
Notwithstanding the challenges of manager selection and implementation risks, the inherent competitive
advantages of hedge funds are still worth considering, especially for investors looking beyond traditional
solutions. This paper examines the four traits of hedge fund DNA, particularly within the context of relevant regulations and related exemptions. Understanding how these traits fit together in a hedge fund
will help investors decide whether these alternative vehicle structures are well positioned to provide the
desired solution for a given investment program.
Fewer Regulatory Limitations
To be broadly marketed to the public, mutual funds and other registered investment funds must comply
with regulations requiring the disclosure of investment strategy and other material information. For investment managers that do not need a broad investor audience, the hedge fund vehicle is an attractive alternative. While hedge fund managers are not free from regulations, they do have a competitive advantage
and can implement their best ideas more quickly across all market environments. And they do not need
to disclose to their competitors how to implement these ideas.
A number of key regulations in the U.S. govern all investment offerings and investment advisers, including
hedge funds. With each of these regulations, hedge fund managers face less of a distinct burden, enabling
them to deliver potentially better performance for their investors.
Securities Act of 19332
To help investors make informed decisions, the Securities Act governs the public issuance of securities
with rules regarding the transparency of financial statements and protections against misrepresentation
and fraudulent activities.
Section 5 of the act dictates that all non-exempt securities must be registered with the Securities and
Exchange Commission (SEC). As registered securities, mutual funds must file publicly available registration statements that contain significantly more information about the portfolio and its manager than hedge
funds need to reveal. These statements must be periodically amended to remain an accurate representation of the investment solution.
This disclosure has another effect besides enabling a security’s investors to make informed decisions.
It also allows other market participants to assess the proposed offering and decide whether to compete
against it. Any proprietary edge that a manager has to generate excess returns may be lost with the public
disclosure required for SEC registration.
Section 5 also outlines the conditions under which investment offerings can receive an exemption for
reporting about the securities transaction or the securities themselves. The most common exemption that
2www.sec.gov/about/laws/sa33.pdf
Knowledge. Experience. Integrity.
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issuers of private securities rely upon is Regulation D3 as further defined under Rules 504,4 505,5 or 506.6
Complying with the restrictive terms of this exemption provides a safe harbor7 against SEC regulations
promulgated under the Securities Act. Restrictions for such exemptions may involve a limit on the type or
number of investors, the size of the offering, or interstate dealings.
Under Section 5, hedge funds with U.S. investors typically rely on Rule 506. A key requirement under Rule
506 is the “accredited investors”8 rule. This standard, as defined by the investor’s net worth (i.e., greater
than $1 million for an individual or $5 million for an entity) or income (i.e., greater than $200,000 per individual in each of the two most recent years), represents a suitability test for those considering a security
exempt from SEC registration. The presumption behind this test is that an investor with such financial
well-being can understand or otherwise afford the additional risks of an unregulated offering.
Raising capital without the burden of SEC regulations involves a private placement, which is generally
related to the sale of securities to a relatively small number of qualified investors. These private placements are not freely traded on secondary markets. Also, since they are not registered with the SEC, they
are not subject to any liquidity requirements. To offer private placements, hedge funds are required to file
a notice of an exempt offering, known as a Form D,9 with the SEC.
Securities Exchange Act of 193410
Another important law designed to protect the general public is the Securities Exchange Act. But this
law also introduces additional hurdles for managers capitalizing on investment ideas. It governs securities transactions after issuance (i.e., trading on secondary markets) and regulates the exchanges and
broker-dealers. The act imposes ongoing reporting requirements on companies, including mutual funds,
registered with the SEC under the Securities Act. For example, mutual funds must file semi-annual shareholder reports and disclose their portfolio holdings quarterly. While the reporting requirements help investors make informed decisions, these disclosures also allow other market participants to assess the security issuer’s risk exposures and possibly trade against them.
Hedge funds and other private investment funds avoid the ongoing-reporting requirements of the
Securities Exchange Act by qualifying for exemption from registration under the Securities Act, as noted
above. As a result, hedge funds can communicate privately and less frequently with investors to preserve
their informational advantage over counterparties with which they trade.
3www.sec.gov/answers/regd.htm
4www.sec.gov/answers/rule504.htm
5www.sec.gov/answers/rule505.htm
6www.sec.gov/answers/rule506.htm
7
A “safe harbor” refers to the provision of a law or regulation that specifies which actions or behaviors will be deemed not to violate
the law or regulation. For instance, a law may penalize “reckless” driving but include a safe harbor provision that driving under 25
miles per hour is not reckless under any circumstances.
8www.sec.gov/answers/accred.htm
9www.sec.gov/answers/formd.htm
10www.sec.gov/about/laws/sea34.pdf
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Investment Advisers Act of 194011
The Advisers Act requires those offering investment advice, analysis, or recommendations to register with
the SEC and be subject to its regulations governing how they conduct business.
Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act12, many hedge fund managers
were able to avoid registering with the SEC by restricting the number of investors or clients. However,
Dodd-Frank requires substantially all hedge fund managers to register. An exemption exists for investment advisers that have less than $150 million in assets and for “foreign private advisers” that have no
place of business in the U.S. and have less than $25 million from U.S.-based investors. Since hedge fund
managers now must comply with the Advisers Act, they shoulder the same regulatory burdens as a firm
with registered securities.
For such registered investment advisers (RIAs), one important public disclosure required under the
Advisers Act is the Form ADV.13 The form has two parts. Part 1 describes the business operations of the
adviser and background information about the controlling individuals. Part 2 documents the services to be
rendered, fees imposed, conflicts of interest, and other information material to investors. Part 2 must be
given to investors and updated annually, or more frequently if the RIA makes material changes.
These requirements help ensure that advisers of private placements are held to similar standards of
fiduciary care as firms with registered securities when managing client assets. While most hedge fund
managers can no longer avoid being an RIA, they remain unburdened by disclosure requirements related
to the offering and trading of securities registered with the SEC, as noted above.
Investment Company Act of 194014
The backbone of regulation defining the structure and governance of open-end mutual funds and closedend funds is the Investment Company Act. This law generally requires investment companies, such as
mutual funds, to register with the SEC. Under the act, mutual funds face restrictions on liquidity, leverage,
short-selling, and other investment tools that involve implementation risks beyond what generally apply to
traditional long-only investment strategies.
Hedge funds can be exempt from registration under the act in one of two ways. Under Section 3(c)(1),
funds with no more than 100 “accredited investors” pursuant to Regulation D, as noted above, are exempt.
Under Section 3(c)(7), a fund is exempt if it only has investors defined as a “qualified purchaser,” which
is either an individual with a minimum of $5 million in net investments or an entity with a minimum of $25
million in net investments. Section 3(c)(7) funds may technically have unlimited investors but normally
cap the number at 2,000 to avoid registration under the Securities Exchange Act as a publicly traded
partnership. Because of the high threshold for investment, the 3(c)(7) exemption is typically used only by
established funds backed by institutional investors. Startup funds are often structured as 3(c)(1) funds
because of the lower investor suitability requirements.
11www.sec.gov/about/laws/iaa40.pdf
12www.sec.gov/about/laws/wallstreetreform-cpa.pdf
13www.sec.gov/about/forms/formadv.pdf
14www.sec.gov/about/laws/ica40.pdf
Knowledge. Experience. Integrity.
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To charge its investors an incentive fee, a private fund that is otherwise exempt from registration under
the Investment Company Act must also accept only a “qualified client,” as defined under Rule 205-3 of the
Advisers Act, meeting either of these two requirements:
1. The client has a net worth (together, in the case of a natural person, with assets held jointly with a
spouse) of more than $2.1 million at the time the contract is entered into, exclusive of primary residence; or
2. The client has at least $1 million under management of the investment adviser.
These thresholds are adjusted for inflation every five years, with minimum increments of $100,000.15
Employee Retirement Income Security Act of 1974 (ERISA)
A hedge fund becomes subject to significant increased regulatory obligations and fiduciary liability if more
than 25% of the fund’s assets under management are subject to ERISA and therefore deemed to be
“plan assets.” Entities subject to this law include corporate pension plans, Taft-Hartley plans, and other
qualified pension plans. In calculating the ERISA percentage of assets under management, all assets
owned by the general partner or its affiliates are excluded from the denominator. In a fund with multiple
share classes, the calculation must be made on a class-by-class basis and if any class deemed to be
a “plan asset” holds more than 25% of the total fund’s assets under management, the fund becomes a
“plan asset” fund. Venture capital firms or real estate operating companies are exempt from this ERISA
requirement.
ERISA restricts hedge funds from conducting “prohibited transactions,” in which the investment adviser
has a conflict of interest in a transaction where the adviser can benefit at the expense of ERISA clients,
however disclosed. Unless a hedge fund is specifically targeting ERISA assets as a client, most limit their
investor base to less than 25% ERISA-related assets to avoid restrictions that might limit the flexibility or
scope of their transactions.
The Hedge Fund Advantage: Less Regulation
By relying upon exemptions available under the Securities Act, the Exchange Act, and the Investment
Company Act, hedge funds are able to avoid disclosures of proprietary information that would dilute
their competitive advantage as well as minimize burdensome costs associated with the regulations.
These regulatory exemptions also enable hedge funds to consider less constrained investment strategies, better alignment of interests, and a more stable capital base. Hedge fund managers, with few
exceptions, must still register under the Advisers Act, but that regulatory burden is appropriate to
keep all investment advisers equally accountable as fiduciaries.
15www.sec.gov/rules/other/2016/ia-4421.pdf
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Less Constraint on Strategies
In addition to avoiding public disclosures, exemptions from the regulations highlighted above enable
hedge funds to invest in a relatively unconstrained manner that can maximize their risk-adjusted return
potential. With no specific restrictions on liquidity, leverage, and short selling, hedge funds enjoy a significant tactical advantage over other investment solutions registered under the Investment Company Act
and the Securities Act.
Illiquidity
Investments that cannot be readily sold at their current market value are considered to be illiquid. The difference between the prices at which an investment can be purchased and sold is a measure of liquidity.
The narrower the difference, also known as the bid/ask spread, the more liquid the investment. Securities
traded daily will typically have narrower spreads than those traded less frequently. By itself, illiquidity can
be considered a source of risk premium in which the holder of the security seeks to be compensated for
the risk of not readily finding a buyer at a price close to the security’s last sale. Given their less regulated
status, hedge funds are better positioned than SEC-registered funds to pursue this illiquidity risk premium.
Under the Investment Company Act, mutual funds must hold at least 85% of the underlying portfolio in
liquid securities, generally defined as those that can be sold under normal conditions within seven days
at a given value. Less-liquid segments of the market, such as distressed debt, are not likely to meet the
liquidity test. Since hedge funds are relatively immune to such liquidity regulations, they can hold material
exposures to illiquid sectors when other market participants, like mutual funds, are forced to sell to meet
daily liquidity requirements. Thus, a significant part of a hedge fund’s value-added proposition can be this
illiquidity premium—getting paid for buying undervalued securities sold by forced sellers and selling these
positions when markets have calmed down and priced the securities more rationally. Mutual funds have
little hope of capturing that risk premium.
Leverage
If the cost of borrowing is less than the expected return on an investment, leverage is an attractive option.
To obtain financing for leverage, an investor needs a margin account.16
Under the Investment Company Act, mutual funds must have an asset coverage ratio of 300% versus the
amount of debt applied. Constraints on leverage can also apply to the use of derivatives contracts (e.g.,
options, futures, swaps) where a mutual fund must maintain enough assets on the balance sheet to cover
any liabilities tied to derivatives contracts outstanding. In contrast, hedge funds do not face any regulations limiting leverage, except to the extent that a counterparty,17 such as a prime broker,18 is unwilling to
16 A margin account allows investors to borrow money from a brokerage firm to buy securities. The brokerage firm charges interest
against any outstanding funds borrowed within the margin account and retains custody of securities or cash as collateral.
17 A counterparty is the opposing side, or party, of any transaction. Counterparty risk refers to the concern that the opposing buyer
or seller will not follow through with its contractual obligations.
18 A prime broker is a central broker through which the fund executes most or all of its trades and that acts as custodian of the fund’s
assets. When the hedge fund executes trades through other brokers, the prime broker works with the executing brokers to settle
and transfer all assets through the prime broker. This custodial relationship facilitates simpler reporting of the fund’s positions
(which in turn simplifies the work of the administrator and auditor). In addition to custodial services, prime brokers can provide
leverage and margin, facilitate short sales, provide soft-dollar arrangements, and perform portfolio analysis, stress testing, and
other services.
Knowledge. Experience. Integrity.
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finance the transaction. Consequently, many hedge fund strategies that use multiple degrees (or “turns”)
of leverage, like convertible arbitrage, fixed income arbitrage, merger arbitrage, and statistical arbitrage,
would be severely handicapped under a more regulated structure. To adapt to lower leverage constraints
(as well as the greater liquidity needs described earlier), managers of strategies within a more regulated
structure need to either reduce return expectations or increase risk.
Leverage can create an issue for U.S. tax-exempt investors. According to the Internal Revenue Service,
income generated by such financing is deemed to be unrelated business taxable income (UBTI) and thus
subject to tax.19 To avoid the UBTI tax, investors can use an offshore corporation that implements the strategy.
Short Selling
To profit from falling stock prices, an investor can sell a stock short by borrowing shares from its broker,
selling them at current prices, and later purchasing those shares at the then-prevailing prices. The difference between the original sale and subsequent purchase is the profit or loss. Short selling may be
prompted by speculation of future price declines or to hedge the downside risk of a long position in the
same security or a related one. Under the Investment Company Act, mutual funds that engage in short
selling must comply with the regulations constraining leverage described above.
The Hedge Fund Advantage: Fewer Strategy Constraints
Investment offerings like mutual funds registered under the Investment Company Act are subject to
specific restrictions on liquidity, leverage, and short selling. Such restrictions leave the manager with
less flexibility for implementing an investment strategy. Free of such restrictions, a hedge fund manager can more precisely target desired risks that yield attractive returns while being better equipped
to protect against unattractive risks.
Better Alignment of Interest
Incentives to perform complex tasks with a variety of potential outcomes are a powerful tool to improve
the likelihood of success. They are often used to solve all sorts of economic, social, or political challenges
with the classic principal/agent dilemma where two parties with different vested interests work together.
One party is a principal seeking a desired result, while the other is a skilled agent compensated to deliver
that result. The principal’s risk is that the agent enriches itself at the principal’s expense, particularly when
the desired result is difficult for the agent to achieve and/or costly for the principal to monitor. When the
agent lacks accountability for a worse-than-expected result but participates in any actual rewards, it can
be morally hazardous—particularly in the short run. Examples of this principal/agent problem include:
• Voters and their elected officials seeking reelection with short-term spending gimmicks at the expense
of longer-term community solutions;
• Stockholders and corporate management pursuing share buybacks to enhance stock options in lieu
of long-term investment growth;
19www.irs.gov/pub/irs-pdf/p598.pdf
8
• Patients and their doctors recommending optional tests by affiliated labs;
• Investors and their fund managers motivated to grow assets at the risk of diluting value-added
performance.
If these agents can demonstrate some sort of “skin in the game” that shares both the pains and gains of the
principal, both sides are more likely to enjoy a successful long-term relationship, or at least a more trusting
one. In contrast to passive index managers needing to match well-defined benchmarks, managers with less
constrained risk budgets—such as hedge funds—often need to show aligned interest. They need to win the
investor’s confidence that they will apply their best efforts while also keeping their own team focused on
meeting or beating the stated goal(s).
Hedge funds usually demonstrate such alignment of interests in two complementary ways: eating their
own cooking, and eating what they kill.
Eat Your Own Cooking
To demonstrate an owner’s mentality of maximizing profits while preserving capital, nearly all successful
hedge fund managers commit a significant portion of their personal net worth to the investment strategy.
And most experienced investors expect it. Aside from the extra fees charged to outside investors, the
experience of pains and gains in the manager’s performance is substantially the same. Given this shared
concern, managers tend to pay sharp attention to detail when it comes to the many risks that might undermine performance.
The argument for a manager’s skin in the game weakens if a substantial part of the fund’s performance
or risk is beyond the manager’s control. This is why index managers do not need to show aligned interest. They must track the index well, or someone else gets the job. Similarly, investing most or all of a
manager’s net worth in a strategy measured closely against a volatile benchmark is not prudent for the
manager’s financial well-being. It is good for investors to see such managers with some skin in the game,
but they should not expect a lot.
For a stable or growing hedge fund firm with a relatively less volatile strategy, the percentage of personal
liquid net wealth invested by the firm’s portfolio managers is often 50% or more. When managers tout
their significant stake beside investors, it is equally important to remain committed to that investment. If
managers reduce their stake, they should disclose why. Likely reasons cited may be exiting professionals, a divorce settlement, or tax/estate planning—but rarely do hedge fund managers confess to finding
a better investment strategy.
A manager’s primary source of net worth may often be invested in the firm’s initial stages of growth, leaving
little to invest later as the fund attracts outside investors. In these cases, where the firm’s future business
success is largely tied to investment success, the manager can claim some degree of aligned interests.
However, if the manager’s ownership stake is sold, the net-of-tax proceeds are often expected to be reinvested side-by-side with client capital. Otherwise, the manager’s unwillingness to keep skin in the game
can be an unmistakable sell signal to existing and prospective investors because it suggests a lack of conviction in the strategy’s future performance. In such cases, outside investors may be well served to skip the
formalities of putting the manager on a “watch list” and simply head for the exit.
Knowledge. Experience. Integrity.
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Eat What You Kill
Aligned interest among hedge funds is further demonstrated with a performance-based fee,20 which is
in addition to, or in lieu of, the fund’s management fee.21 To provide significant motivation to maximize
profits and minimize losses, nearly all hedge fund managers earn such an incentive fee for each calendar
year or otherwise agreed-upon time period. Ideally, these incentive fees (normally 20%) are applied after
exceeding an applicable hurdle rate.22 In some instances where the incentive is based on beating a nominal return hurdle, a “catch-up”23 provision is added. In situations where an incentive fee is accrued but not
paid, the investment terms may have a “clawback”24 provision. Currently, hedge fund incentive fees are
often based on any profit, net of the fund’s management fees and expenses. However, industry pressure
to reduce hedge fund fees is leading to the introduction of a hurdle rate that reflects any inherent market
risk embedded in a given strategy or a minimum acceptable return.
Incentive fees can also motivate the manager to limit the amount of assets raised. If a manager’s strategy
is capacity constrained in terms of total profits available, the amount of assets desired for maximizing
the manager’s incentive fees is less than what the manager might gather with a traditional flat fee as a
percentage of assets. Such pressure on the manager to close its strategy before getting too big is also in
the best interest of existing investors.
One commonly cited concern about hedge fund performance fees is that they represent a “free option” on
upside participation that does not involve downside risk. When downside risk is not equally shared, the
incentive fee can encourage unnecessary risk-taking. Since the managers themselves influence the volatility of their funds, this option of only upside participation introduces a serious moral hazard. To assuage
this concern, a “high-water mark”25 of performance is usually applied so that subsequent losses have to be
recouped before any new incentive fees are paid. In some instances, a modified high-water mark26 is used.
20 Also known as a carried interest or incentive allocation.
21 The fee charged for managing a hedge fund is typically between 1% to 2% of assets. Normally excludes certain direct expenses
such as legal, accounting, auditing, fund administration, and custody fees.
22 A hurdle rate refers to the targeted rate of return for a hedge fund against which an incentive fee is charged. Since the hurdle
rate is the minimum return that a hedge fund must generate before it can charge a performance fee, hurdle rates are generally
quoted as annual nominal return (e.g., 5%, 6%, or 8%) but they can also be a short-term interest rate (e.g., a 30-day Treasury bill
or LIBOR), or a market index return (e.g., the S&P 500).
23 A “catch-up” provision allows the incentive fee to be paid on 100% of the income after the hurdle rate has been met until the hedge
fund manager has been “caught up.” For example, if the hurdle rate is 8% and the incentive fee is 20% of profits, then once the
8% return has been achieved the manager receives 20% of the initial 8% return plus 20% of anything over that.
24 Clawback provisions are more common with private equity or venture capital funds but have recently made an entrance into fee
negotiations for some hedge funds. They require the fund to refund performance fees if achieved gains are erased in following
years. These provisions are generally met with great resistance and low acceptance in the hedge fund industry, primarily because
the manager’s incentive fees are taxable during the year they are earned.
25 To prevent a manager from receiving duplicate performance compensation following periods of volatility, most funds allow investors to recoup past losses before the fund manager is entitled to receive additional performance compensation. To accomplish
this, a “high-water mark” is established immediately following the allocation of incentive compensation. Under the “loss carry
forward” terms, fund management is only entitled to be compensated for performance that exceeds the prior high-water mark.
The high-water mark is the highest market value the hedge fund has ever reached. For example, if the fund has an 8% hurdle with
a high-water mark provision, it can only collect an incentive fee if the return is greater than 8% and the market value is above its
high-water mark in any given year.
26 For a well-established manager trying to smooth the effect of this option payoff and retain key team talent, a “modified high-water
mark” is sometimes used instead so that half of the performance fee is accrued on gains after a loss; the full performance fee is
not applied until the investor recovers twice its prior loss or more.
10
High-water marks may not matter, though, if the manager goes out of business in subsequent years.
Many examples exist where a hedge fund manager gets compensated handsomely in one year for getting a trade right and then loses money in the next year when the trade reverses its prior gains, all without
forsaking the prior year’s incentive fee. One method to temper this one-sided payout is to establish an
appropriate period for incentives to be paid so that the trade’s duration more closely matches the periods
for harvesting incentive fees. Alternatively, a multi-year vesting period for incentive fees can be created to
enable a clawback of past incentive fees awarded but not paid in the event of a future loss.
In contrast, mutual funds and other registered securities offering daily liquidity are not able to charge
such incentive fees, except under highly restrictive terms. Consequently, the management fee-only
approach motivates the manager to grow its asset base, potentially compromising its ability to generate
above-average returns. A fee structure with performance-based compensation motivates the manager
to focus more on the trade-off between asset growth and the potential degradation of performance.
The Hedge Fund Advantage: Better Alignment of Interests
To achieve the best results from delegated tasks, particularly complex ones like those involved in
managing hedge fund strategies, incentives are an important tool. While registered investment offerings like mutual funds are limited in how they can create alignment of interest, hedge fund managers
typically are incentivized to perform their best in two important ways. First, to demonstrate that a
hedge fund has a vested interest to protect capital, the manager often commits a significant amount
of personal capital beside that of its outside investors. Second, incentive fees for achieving performance above an expected threshold motivate the manager to focus on maximizing risk-adjusted
returns, not growth of assets under management.
Stronger Capital Base
Given that hedge funds are private placements exempt from regulations, investors cannot enter and exit
these investments on a whim. While these restrictions are not popular features of hedge funds, they help
to create a stronger capital base. To be exempt from regulation or otherwise comply with other regulations, hedge funds need to document in the subscription process that investors meet the qualification
guidelines. To provide the desired liquidity for investors that is consistent with the underlying strategy,
hedge funds need to design an appropriate redemption process.
Subscription Process
To accept a new investor in a fund offering exempt from certain regulations, hedge funds must first
determine whether each investor is qualified with sufficient income or net worth, as defined by regulations described earlier. Depending on the exemption used, an investor must be a qualified client as well
as either an accredited investor or a qualified purchaser. A key part of this documentation process is the
fund offering’s subscription agreement, which is signed by investors attesting to their qualification and
awareness of investment risks. This vetting process helps to ensure the fund’s investor base is relatively
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sophisticated and less prone to panic during market stress. Given this higher financial standard and timeconsuming subscription process, hedge funds also often require higher minimum investments, such as
$1 million, for investors to be admitted. These tougher qualifications and higher minimums help create a
stickier capital base for hedge funds to lean upon when making longer-term investment decisions.
Redemption Process
Unlike mutual funds required to provide daily liquidity to investors, hedge funds can choose a redemption frequency that corresponds more closely to the length of the manager’s typical trade. The ability to
be patient with a trade during market stress enables the manager to avoid being a seller with the rest of
a panicking market and perhaps even be a buyer benefiting from prevailing price discounts. In contrast,
a mutual fund usually needs a cash buffer to anticipate liquidity needs, despite compelling opportunities
during a market sell-off.
The redemption process for hedge fund investors can vary widely depending on the needs of the strategy
or the manager’s preference. For strategies that involve particularly illiquid securities or long-term trades,
such as distressed and other event-driven strategies, a stronger capital base is necessary for the manager to be successful. Depending on the level of illiquidity in the underlying strategies, the manager can
choose between an open-end or closed-end structure.
Closed-End Fund Structure
If the underlying securities are not readily tradable and generally held for an indefinite amount of time
before being monetized, the hedge fund manager and its investors may be better served by a closed-end
structure. For hedge fund managers, closed-end funds have a specific term that is typically five years or
more and may be extended for one- to two-year terms at the discretion of the manager. (Private equity
firms generally require a longer term for closed-end fund structures.) A closed-end fund structure normally
has a commitment period and an investment period.
Commitment Period
Closed-end funds require investors to make a capital commitment that is drawn down from time to time
upon a specified period of notice (usually 5 – 10 business days) by the manager. Commitment periods
for closed-end funds managed by hedge fund managers usually range from one to two years from the
final closing date. Commitment periods for private equity funds are generally longer.
Investment Period
Closed-end funds usually have a limited period of time during which new investments may be made.
The investment period normally extends another three to five years beyond the commitment period.
As investments are monetized, capital is returned to investors. After investors receive their contributed
capital back, they then normally receive their preferred return (e.g., 8% or some nominal target return).
The manager and investors then split the excess returns over the preferred return, according to the
terms of the offering. The key feature of the closed-end fund’s liquidation process is that all investors
are treated equally with the distributions.
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Open-End Fund Structure
In contrast to a closed-end structure, the open-end fund allows the manager to make investments and
rebalance the portfolio on an ongoing basis. An open-end fund also typically requires the investor’s capital
to be contributed upon its acceptance in the subscription process.
Redemption Date
Because most hedge fund strategies involve publicly traded securities with varying degrees of liquidity, hedge funds generally rely upon an open-end vehicle structure where investors can redeem their
funds on a monthly, quarterly, or annual basis. For each redemption date, an investor needs to file
an advance notice of its request so the manager can anticipate upcoming cash needs. The investor’s
notice will need to be filed at least 30, 45, or 90 days before the redemption date, as defined in the
fund’s offering documents.
The redemption process for investors is normally influenced by the liquidity of the underlying securities. This flexibility helps to increase the manager’s ability to meet desired outcomes. However, in
some strategies where the underlying securities are extremely liquid—like managed futures and global
macro—the advantage of less frequent redemption periods than those of mutual funds is not meaningful for the manager’s success.
Lock-Ups
In some instances, a hedge fund may impose a lock-up period following the date of an investor’s initial
investment during which the investor is not allowed to redeem. This restriction prevents managers from
having to sell securities at potentially undesirable prices. The length is generally one to two years. A
“hard lock” prevents investors from withdrawing funds during this period under any circumstances,
while a “soft lock” permits withdrawals subject to a penalty fee (generally from 2% to 5%).
Gates
To avoid an unexpectedly large surge of investor redemptions at the same time, a hedge fund manager may impose a “gate” restricting the amount of withdrawals during a redemption period. The
amount of capital restricted can be applied at the investor level, fund level, or both. A gate invoked is
generally seen as a negative event but it can help to treat all investors equally by preventing forced
sales by the manager at inopportune prices. During the Global Financial Crisis, a large number of
hedge funds invoked gate provisions to prevent being forced to sell assets at unfavorable prices.
Side Pockets
To insulate a fund’s investment from a forced sale, hedge funds can create side pockets to hold illiquid
investments separate from the more liquid investments in the commingled fund. When an investment is
put into a side pocket, only current investors in the hedge fund own a share of it. Investors who redeem
their shares of the more liquid commingled fund interests will not receive their portion of the illiquid sidepocket investments until they are monetized.
Whether an investor considers an open-end hedge fund vehicle for ongoing redemptions or a closed-end
vehicle with a drawdown structure, the manager may offer “co-investments” and “side letters” to investors
to attract more capital.
Knowledge. Experience. Integrity.
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Co-Investments
Co-investments are more common with private equity but are used by hedge funds as well. A co-investment structure is usually a vehicle that participates in a specific investment on a commingled basis or
on behalf of a single investor alongside, or in lieu of, an investment manager’s main fund. The purpose
of such a vehicle is to enable an investor to participate in an investment opportunity that is too big, too
illiquid, or otherwise inappropriate for the hedge fund’s primary investment offering. A co-investment
is generally offered to the manager’s most loyal clients to further build a long-term capital base. Since
pressure on fees has increased in recent years, hedge funds have responded with fee discounts on
these co-investments (e.g., 10% carried interest only instead of the typical 2-and-20 fee structure).
Side Letter
To help secure a stronger capital base, hedge funds may offer a “side letter” to a prospective investor
that provides specially negotiated terms not available to other investors. Most offering documents allow
the hedge fund manager to negotiate such letters privately. Often the side letter involves better economic terms, such as reduced management or performance fees, in exchange for a larger investment
amount or a longer investment period. In other cases, the side letter may dictate additional disclosures
to that investor when the manager’s own capital is being removed from the fund at any time or when
other investors are seeking to exit the fund. SEC guidance strongly discourages providing better liquidity terms to one investor at the expense of another within the same pool of invested capital.
The Hedge Fund Advantage: Stronger Capital Base
Instead of being required to meet the daily liquidity needs of a registered fund offering, hedge funds
have the advantage of defining a liquidity schedule for their investors that is appropriate for the type
of strategy being implemented. For example, hedge funds with illiquid holdings can be either openend vehicles with infrequent redemption periods (e.g., annual or semi-annual) or closed-end vehicles
that pay back all investors after a defined investment period (e.g., three to five years). Hedge funds
with liquid holdings can still offer frequent redemption terms (e.g., monthly) with short notice periods
(e.g., 30 days) to meet most investor needs but still minimize the punitive costs of constantly holding
cash to meet the daily liquidity needs of registered mutual funds.
Harnessing the Hedge Fund Edge
The four-part structural advantage of hedge funds over registered investment vehicles provides the
potential for better performance:
• First, by foregoing access to the general public as an investor, the hedge fund faces fewer regulations
that force public disclosures of strategy details, portfolio composition, and other key considerations
behind generating any excess return over the market.
• Exempt from such regulations, the hedge fund is also unconstrained in its use of illiquidity, leverage,
shorting, and other investment tools to target a desired risk-adjusted profile. It can choose the degree
of risk it wants to hold and hedge the rest.
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• Given these greater implementation risks that accompany hedge funds, aligned interests such as sideby-side capital and performance incentives are important to motivate the manager to perform its best.
• Finally, without regulations dictating daily liquidity, the hedge fund can build a longer-term capital base
that enables it to buy when others are selling in a panic and to sell later after patiently waiting for
more rational markets.
Alone, each of these four hedge fund qualities is appealing, but together the properties interlock and can
result in an attractive investing solution.
While the competitive edge of hedge funds remains conceptually sharp, investors need to be mindful
of market dynamics which can dull that edge. The effect of competition on pricing is one such dynamic.
Aligned interest, one of the four key hedge fund traits, remains important for creating scarce alpha, but
incentive fees are less important when an investing strategy becomes easy to implement. If a hedge
fund’s strategy for creating alpha becomes widely adopted with a lower-cost systematic process, the need
for a hedge fund solution diminishes.
Another market dynamic for investors to consider is supply and demand of capital. If available capital for
a strategy becomes scarce, the prospect of better risk-adjusted returns will likely capture the attention of
hedge funds first, given their heightened financial motives to find such opportunities along with their lessconstrained investment guidelines and longer-dated capital to deploy. However, if capital is easily available
for an investing strategy, the higher cost structure of hedge funds becomes a liability. It is the investor’s
challenge to identify whether a given strategy and available capital warrant the cutting edge of hedge funds.
Taking advantage of these four hedge fund traits is no small task. To successfully execute hedge fund strategies requires experience, skill, and passion to perform. The successful hedge fund manager also needs to
be a capable business leader who can attract and retain talent and capital. While the hedge fund’s incentive
fee structure allows the manager to attract above-average talent, the quality of its net-of-fee returns determines whether the manager can retain client assets. These aspects of investment execution and business
management are unrelated to the hedge fund’s structural edges discussed above, but they have a defining
impact on how well the hedge fund delivers results to its investors. Adopting these key qualities of a hedge
fund does not preclude a manager from being a bad investor or a poor business leader. For this reason, the
manager selection process remains the key driver of a successful hedge fund program, regardless of any
inherent advantage of hedge funds over mutual funds and other heavily regulated products.
Editor’s Note: The purpose of this summary of regulations affecting hedge funds should not be interpreted
as a legal opinion but rather as part of an opportunity to begin a dialogue examining the impact of regulation on hedge funds and other alternative investments.
Knowledge. Experience. Integrity.
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About the Author
Jim McKee is a Senior Vice President and Director of Callan’s Hedge Fund Research group. Jim specializes in hedge fund research addressing related issues of asset allocation, manager structure, manager
search, and performance evaluation for Callan’s institutional clients. Jim is a shareholder of the firm.
Jim joined Callan in 1989. Prior to his career at Callan, Jim worked with the Pacific Stock Exchange (PSE)
from 1982 to 1989. Until 1985, Jim worked on the PSE’s options trading floor. Thereafter, as manager of
the PSE’s securities research department, he was responsible for developing and monitoring new stock,
bond, and option listings.
Jim earned an MBA in Finance from Golden Gate University in 1987. His graduate studies focused particularly on publicly traded securities and capital markets. He received his BA in Economics/Environmental
Studies from Dartmouth College in 1982.
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About Callan Associates
Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have
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© 2017 Callan Associates Inc.
Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be
reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this
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