Hedge Funds

Hedge funds play a significant and controversial role in the global economy. Hedge funds are private investment pools that are typically organized as limited partnerships. The manager of a hedge fund often serves as the general partner, while investors in a hedge fund serve as limited partners. Unlike mutual funds that are heavily regulated by national regulatory agencies, such as the U.S. Securities and Exchange Commission (SEC), hedge funds have been traditionally exempted from SEC registration and disclosure requirements. The special regulatory exemption of hedge funds has been found in the U.S. Securities Act of 1933 and in the Investment Company Act of 1940. Typical hedge fund investors include wealthy individual investors and institutional investors such as pensions, foundations, and endowments. These accredited investors are assumed to have full knowledge of hedge fund risks and the capability of performing due diligence before investing in them. Each fund is restricted to no more than 100 investors.

Hedge funds have tremendous flexibility in the use of leverage, derivatives, short selling, investment strategy, and compensation structure. Unlike most mutual funds that use market indices as relative performance benchmarks, hedge funds often [Page 786]seek total return above certain absolute return benchmarks. In addition to charging a management fee around 1–2% of the assets under management, hedge funds generally impose an incentive fee that is greater than 20% of the above benchmark profit. Hedge fund managers are often subject to a high watermark, which requires that they make up any previous below-benchmark performance before being considered for a new round of incentive fees.

Hedge funds can be classified by the strategies that they pursue. The most commonly pursued hedge fund strategies include equity market neutral, equity long/short, dedicated short bias, sector funds, fixed income arbitrage, convertible arbitrage, merger arbitrage, event driven, emerging markets, global macro, and fund of funds. Hedge fund strategies, such as equity market neutral, fixed income arbitrage, and merger arbitrage, are nondirectional strategies that are designed to exploit temporary relative mispricing or efficiency in the market. Other strategies, such as sector funds, emerging markets, and global macro, are directional strategies that bet on a certain sector of the market. Instead of pursuing a single strategy, some funds pursue multiple strategies depending on the manager's belief of the market outlook. As an important group of participants in the financial markets, hedge funds promote price discovery, provide liquidity across market conditions, and profit from asset mispricing.

Although mutual funds are required to report their portfolio return and composition to the SEC on a quarterly basis, the reporting of such information is not required for hedge funds. Hedge fund managers have full discretion over their reporting to hedge fund database providers, and providers typically do not audit the reported return data. Hedge fund performance data are subject to several biases. Backfill bias occurs when hedge fund managers report their results at some later date than the inception date and only include favorable results from the past. Survivorship bias develops when a failed hedge fund leaves the hedge fund databases, leaving only successful funds surviving in the data. Xiaoqing Eleanor Xu, Jiong Liu, and Anthony Loviscek identify a “hidden survivorship bias” attributed to the lack of reporting during the final months of the eventual demise of a hedge fund. Liquidity bias occurs when hedge fund managers intentionally smooth the net asset value of their fund shares when some of their investments are in infrequently traded securities, resulting in overestimated risk-adjusted return performance. In addition, Nicolas P. B. Bollen and Veronika K. Pool document patterns of hedge fund return distribution that could be signs of misreporting and fraud.

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