Investment Forms and Vehicles Used in Hedge Fund Investments

Recap: Hedge Funds

A hedge fund is typically structured as a private investment partnership. This can be either onshore, like in the United States, or in a tax-advantaged offshore location, such as the Cayman Islands. The offering of the hedge fund is subject to certain legal restrictions, which vary by jurisdiction.

Investment in Hedge Funds

Investors in hedge funds purchase a share of the fund or partnership. In return, they receive a fixed percentage of the fund returns after the deduction of applicable fees. A typical fee structure is the “2 and 20” structure, where the management fee is 2% of the total assets, and the performance fee is 20% of the profits.

Another example of the fee structure is 1 or 30, which implies that the manager earns the greater of a 1% management fee or an incentive fee of 30% of the fund’s alpha or outperformance against a benchmark rather than a performance fee based on total profits.

The fund’s legal and contractual relationship between the fund manager and the investor is established through fund documents, such as the private placement memorandum, partnership agreement, and articles of incorporation. These documents also establish the operational structure of the fund.

Forms of Hedge Fund Investment

Direct Hedge Fund Investment Forms

Master Feeder Structure

The master-feeder structure, widely used in hedge funds, is tailored for maximum tax efficiency and involves an offshore feeder fund and an onshore feeder fund. To illustrate, consider a hedge fund based in the United States (onshore feeder fund) that also attracts investments from Europe (offshore feeder fund).

The feeder funds feed into a master fund that invests the capital based on its contractual partnership agreements. The investment returns, after management and performance fees, flow back to the feeder funds to the investors.

Side Letters

Apart from the partnership agreement that outlines duties, hedge funds frequently employ side letters to address an investor’s particular legal, regulatory, tax, operational, and reporting needs. These side letters supplement and, at times, override the terms specified in the fund’s documents. They are commonly utilized when an investor in a hedge fund needs certain accommodations without altering the private placement memorandum, partnership agreement, or articles.

On occasion, specific privileges are granted to a particular investor, such as expanded information rights. For instance, a side letter might grant an investor more detailed quarterly reports compared to other investors.

Separately Managed Account (SMA)

Larger investors in the hedge fund arena might opt for a “fund of one” or a separately managed account (SMA) structure. These setups consist of distinct investment accounts where the investor maintains more control. With the “fund of one” arrangement, the hedge fund is established solely for one investor. In the case of an SMA, the investor establishes their personalized investment entity, with the assets held and registered under the investor’s name.

Nonetheless, the everyday management of the account is entrusted to the hedge fund manager. These structures may necessitate additional agreements and service providers for smooth and efficient operation.

Advantages and Disadvantages of SMA

An SMA structure provides a tailor-made portfolio featuring investor-specific investment directives, improved transparency, efficient capital allocation, and increased liquidity, giving the investor more control while maintaining lower fees.

Nevertheless, SMAs involve more operational complexity and require higher governance oversight, making them better suited for larger institutional investors.

In contrast to a commingled fund, the managers lack a stake in the fund investments. Investors negotiate for reduced fees and fund expenses but may, in turn, receive allocations only to the fund manager’s most liquid investment trades. As a result, the managers’ overall motivation for investment performance might be diminished.

Indirect Hedge Fund Investment Forms

Investing indirectly in hedge funds is a strategy designed to render hedge fund exposures more attainable for smaller institutional and larger retail investors. The rationale for pursuing indirect exposure often involves minimizing management expenses, enhancing performance visibility, and bolstering liquidity.

For example, a retail investor with limited familiarity with the complexities of hedge fund management might select an indirect investment to access a diversified hedge fund portfolio without the need to oversee the investments directly. This approach enables them to leverage the expertise of professional fund managers while also reducing their risk exposure.

Fund-of-Hedge-Funds Approach

One prevalent indirect investment approach is through fund-of-hedge-funds strategies. These funds pool investments from various investors and allocate the funds into a diversified array of hedge fund investments across different strategies, regions, and management styles. This method offers direct diversification benefits.

Fund-of-hedge-funds generally present lower investment minimums, shorter lockup periods, and typically more favorable exit liquidity. However, this strategy entails higher fees. The fund of funds manager applies additional fees atop the existing hedge fund management fees, which reduces the initial gross returns for the end investor and could mean paying fees multiple times for managing the same assets.

In spite of the supplementary fees, investors opt for funds of funds because they offer access to underlying hedge funds that might otherwise be closed to new investors. Although funds of funds offer greater liquidity, this may lead to diminished performance due to fund redemptions during market turmoil.

Managers of fund-of-hedge-funds must possess expertise in evaluating hedge funds, monitoring both absolute and relative performance, and often have the leverage to negotiate better redemption or fee terms compared to individual investors.

Hedge Fund Replication ETFs

A growing array of exchange-traded products, including ETFs, aim to imitate hedge fund investment methodologies without directly investing in hedge funds themselves. Hedge fund replication ETFs endeavor to produce returns highly correlated with actual hedge fund returns.

Yet, these strategies frequently underperform pure hedge fund strategies for several reasons: they are subject to public trading, face stricter regulatory constraints, lack limitations on redemptions, and cannot leverage to the same extent.

These investments provide improved liquidity, lower fees, and increased transparency compared to similar hedge fund or fund-of-funds strategies. Their goal is to mirror the monthly returns of hedge fund indexes.

Question #1

Which of the following statements is most likely accurate about the role of the fund-of-hedge-fund managers? Fund-of-hedge-fund managers:

1. Do not need expertise in conducting hedge fund due diligence.
2. Are not responsible for monitoring both absolute and relative performance.
3. Are often able to negotiate better redemption or fee terms than individual investors can.

The correct answer is C.

Fund-of-hedge-fund managers are often able to negotiate better redemption or fee terms than individual investors can. This is because they manage a large pool of assets and have a significant bargaining power with the underlying hedge funds. They can use this power to negotiate more favorable terms for their investors, such as lower fees or more flexible redemption terms.

This can be particularly beneficial in times of market turmoil, when investors may need to redeem their investments quickly. In addition, fund-of-hedge-fund managers have the expertise and resources to monitor the performance of the underlying hedge funds and make informed investment decisions on behalf of their investors. They can also provide access to hedge funds that may be closed to new investors, offering further diversification benefits.

A is incorrect. Fund-of-hedge-fund managers do need expertise in conducting hedge fund due diligence. This is a critical part of their role, as they need to assess the quality of the underlying hedge funds, their investment strategies, their risk management practices, and their operational infrastructure. This due diligence process is essential for identifying potential risks and ensuring that the fund-of-hedge-funds is well diversified and aligned with its investment objectives.

B is incorrect. Fund-of-hedge-fund managers are indeed responsible for monitoring both absolute and relative performance. They need to assess the performance of the underlying hedge funds both in absolute terms and relative to their benchmarks or peers. This is a key part of their role and is crucial for ensuring that the fund-of-hedge-funds meets its investment objectives.

Question #2

Which of the is most likely the potential reasons for the returns from Hedge Fund Replication ETF not matching those of the actual hedge funds?

1. ETFs have higher fees and lockup periods compared to direct hedge fund investments.
2. ETFs do not use quantitative tools to imitate a broad spectrum of hedge fund returns or a specific style return.
3. ETFs are publicly traded, are subject to a much heavier regulatory burden, do not impose restrictions on redemptions, and cannot use leverage to the same level as actual hedge funds.

The correct answer is C.

The returns from Hedge Fund Replication ETFs might not match those of the actual hedge funds due to several reasons, and the most significant ones are encapsulated in Choice A. Firstly, these ETFs are publicly traded, which means they are subject to a much heavier regulatory burden than actual hedge funds. This can limit their investment strategies and potentially reduce their returns. Secondly, these ETFs do not impose restrictions on redemptions like actual hedge funds do.

This means they need to maintain a higher level of liquidity, which can also limit their investment strategies and potentially reduce their returns. Lastly, these ETFs cannot use leverage to the same level as actual hedge funds. Leverage can amplify returns, but it can also amplify losses. Therefore, the inability to use leverage to the same extent can result in the returns from these ETFs not matching those of the actual hedge funds.

A is incorrect. In fact, one of the main advantages of Hedge Fund Replication ETFs is that they typically have lower fees and no lockup periods compared to direct hedge fund investments. Therefore, this is not a reason why the returns from these ETFs might not match those of the actual hedge funds.

B is incorrect. Hedge Fund Replication ETFs do use quantitative tools to imitate a broad spectrum of hedge fund returns or a specific style return. This is one of the main strategies they use to replicate hedge fund investment styles. Therefore, this is not a reason why the returns from these ETFs might not match those of the actual hedge funds.