How were hedge funds founded and developed

Hedge funds. Structures, strategies and effects on the financial markets

1. Mutual Funds

1.1 Basic idea and legal regulations of traditional funds

The basic idea of ​​the investment business is "to enable private investors to invest even with small amounts of money according to the principle of risk diversification, which is managed and managed by professionals with a focus on success."[1] The legal basis for the investment business in the Federal Republic of Germany is the law on capital investment companies (KAGG) and the AuslInvestmentG, the law on the distribution of foreign investment units and the taxation of income from foreign investment units.

In the KAGG, capital investment companies are defined as companies "whose business area is directed to the principle of risk diversification in their own name for the joint account of the depositors"[2] to put on. The deposits and the assets acquired from them form a special fund, which is to be kept separate from the assets of the investment company.[3] The investor receives a unit certificate (investment certificate) for the amount of the contribution.[4] A capital investment company has the option of forming several special funds, which, however, must differ in their names and must be kept separate.[5] While the certificates of public funds can be acquired by anyone, capital investment companies also set up special funds for institutional investors.

Depending on the type of capital raised, one differentiates between open[6] (open-end-funds) and closed-end-funds. Open-ended investment funds are constantly striving to find new investors in order to keep or increase the capital stock of the investment fund as constant as possible. On the other hand, closed-end investment funds, "which are comparable to a holding company,"[7] and the KAGG are not subject to capital only when they are founded. The capital stock remains fixed for the entire duration of the fund's existence.

Depending on the type of assets, a distinction is made between investment funds as follows:

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Figure 1: Investment funds by type of asset[8]

Since many small investors do not have the opportunity to participate directly in developments in the financial markets or the economy, investment savings are the only alternative for these investors to participate in global trends. Figure 2 compares the advantages and disadvantages of investment saving.

To protect investors, the German legislator has laid down strict guidelines for the operation of an investment fund in the KAGG. According to Section 1, Paragraph 1 of the KWG[9] Investment companies have "the status of credit institutions and are therefore subject to banking supervision."[10] In contrast to other countries, especially the Anglo-Saxon countries and some areas of the Caribbean, German investment funds are not allowed to participate in other funds (so-called umbrella funds or fund-of-funds).[11]

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Figure 2: Advantages and disadvantages of investment saving[12]

Leverage funds and hedge funds are also forbidden in Germany because, in addition to special assets, they also use loans for speculative purposes. The risk of investing in these funds increases because parts of the investment fund are deposited as collateral. However, does the legislature permit in § 9 KAGG "in special cases for a short time"[13] borrowing "up to the amount of 10 percent of the fund,"[14] this can be justified. Such a situation is conceivable if, in spite of a generally positive expectation, suddenly (perhaps only by chance) massive participation certificates are returned. Borrowing can then prevent the fund from having to sell assets in order to meet its disbursement obligations. The limitation and reporting requirement[15] The borrowing is likely to stem from "the mistrust of the legislature in relation to the efficiency of the fund administration, especially with regard to the speculative tendencies of foreign fund managers who have recently appeared."[16] For reasons of investor protection, the KAGG stipulates maximum amounts and also the values ​​that may be acquired by an investment company for a special fund.[17]

The details of the investment company's investment policy can be found in the contractual conditions for the respective special assets, which must be approved by the Federal Banking Supervisory Office,[18] can be removed. At the end of a financial year, the investment companies are obliged to submit an annual report and to publish it in the Federal Gazette.[19]

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Figure 3: The determination of the value of a securities fund[20]

Since German investment certificates are not traded on the stock exchange, the investment companies determine an issue and redemption price for the unit certificates every day after the stock exchange closes. The basis for the calculation is the net asset value. The value of the investment fund is divided by the number of unit certificates. The net asset value corresponds to the redemption value. When the investment certificates are issued, a surcharge on the net asset value may be required depending on the contractual conditions.

1.2 Alternative Investment Funds

1.2.1 Non-traditional funds and investment programs

The choice of assets for traditional, legally highly regulated investment funds is small and limited to stocks, bonds or real estate in developed markets. Derivatives are only used for hedging purposes and the opening of 'short positions' or the use of borrowed assets is also very limited. Traditional investment funds mainly take long positions.

In contrast to this are the "non-traditional investment funds and programs,"[21] whose investment options cover a wider range. The mutual funds engage in areas that are not covered by the traditional funds or activity is restricted by law. They use all investment techniques including opening short positions. You can find these non-traditional investment funds mainly in the following segments:

- Markets in developing countries or regions with growth potential (emerging markets)
- Trading in high-yield and thus high-risk bonds (high yield and junk bonds)
- Provision of venture capital
- real estate
- Raw materials
- Trading in listed and over-the-counter derivatives
- Trading in structured products

1.2.2 Managed Futures

When standardized forward sales of grain took place for the first time on the Chicago Board of Trade (CBOT) in 1865, the cornerstone for modern futures trading was laid.[22] However, more than a hundred years passed before the first financial futures were finally concluded on the Chicago Mercantile Exchange in 1972, and options on futures were only offered in the 1980s. 'Financial futures' are already more important than commodity futures and represent an important segment of the financial markets.[23]

Originally, managed futures were created as an alternative to direct investment in a commodity. Actual trading exclusively in futures was developed in the USA after the Second World War.[24] Trading and coordinating positions were time-consuming, however, and it was only through the development of data processing that it became possible to use computer-aided trading systems from the mid-1960s. Now traders were able to observe a large number of stocks at the same time, calculate trends and react very quickly to changes. In the 1970s, the models and systems were refined more and more and the first managed futures funds were created, which initially focused on currencies, interest rates and indices. Today these funds can be found in all financial markets.[25]

Due to different national regulations, futures trading could not prevail in all countries. Today the USA is the most important market for 'managed futures'. In addition to the term' managed futures', the literature also contains the terms' futures funds' or 'managed derivatives.' All of these terms ultimately only describe the core business of ' managed futures funds: 'Investments mainly in futures and derivatives.

Since an investment in futures and options always triggers a strong leverage effect, managed futures funds are particularly exposed to the leverage effect. Their predominant activity in markets with high liquidity requires a great deal of flexibility and the use of trading systems that are capable of recognizing trends. Instead of many investment instruments, the fund managers often only use futures and concentrate on certain markets. Since there are strict publicity regulations for this type of fund in the USA, managed futures funds allow the investor greater transparency.

Compared to a direct investment, managed futures have the following advantages:[26]

- The markets on which futures are traded are often more liquid than cash markets
- The determination of a price can be made more precise, since the steps in which the prices can rise or fall are smaller than on the stock or bond exchanges. Futures tie up less capital. 'Short positions' are easy to open.
- Investing in futures can be beneficial from a tax point of view in some countries.

Managed futures funds and hedge funds are not the same, although both are similar in their investment strategy.

2. Hedge funds: development, size, successes

This chapter is intended to provide an overview of the industry, its current structures and successes. First, the development of hedge funds is described and, using the available data, their development, their successes and the behavior of some large funds in the event of macroeconomic events are shown.

2.1 The development of hedge funds

The term 'hedge fund' can be used very broadly and applies to a large number of investment funds. In public opinion, however, these funds tend to be viewed negatively, as speculators in high-risk businesses, instead of risk-conscious investors.

In order to get a better understanding of this type of fund, the development of the industry will first be described here.[27]

2.1.1. The model of Alfred Winslow Jones

"Alfred Winslow Jones is considered to be the actual founding father of hedged portfolio strategies, who has been successfully dealing with hedging theses since 1940 - long before standardized hedging products were available on the market."[28] Jones was born in Melbourne, later emigrated to the USA, where he graduated from Harvard University with a degree in sociology in 1924. In the 1940s he worked as a journalist and published for magazines on economic issues Fortune and Time.

"While preparing his through Fortune published article 'Fashion in Forecasting' ... Jones came into contact with the most renowned technicians and analysts on Wall Street, who strongly influenced his financial thinking. "[29] Thereupon Alfred Jones, who is actually inexperienced in speculation, developed his investment model. Thus began its unbelievable success and that of an entire industry.[30]

On January 1, 1949, the Jones Hedge Fund as the first hedge fund to start operations. Alfred Jones founded the fund named after him, the first investment fund of this new type. By using instruments and techniques that were already available in the financial markets, he wanted to eliminate some of the market risk that a securities portfolio is subject to.

The technique of 'short selling', i.e. the sale of borrowed securities for short-term speculation, has been known since the beginning of futures trading. The effect of the leverage effect when loans are used for speculative purposes was also known. Profits can be increased in this way, but this is offset by an increase in the event of possible losses.[31]

Jones' idea was to compare the securities that he had in his portfolio with a 'long position', a 'short position' in order to reduce the risk of the exposure. The now lower risk allows larger sums to be used, which are to be provided by borrowing. The instruments that Jones wanted to use for this were: 'short selling' and 'leverage.'

In the Jones model, there were only two risks to which a security is subject: the general market risk and the risk of a price movement of the individual security. The latter risk can also be referred to as the risk of choosing the wrong value. From this, Jones concluded that the general market risk could be offset by opening a 'short position'. Because if the prices of the securities held in the portfolio fall, the value of the 'short position' rises and offsets the loss. The general market risk was eliminated and the income risk of a portfolio, which depends on the entry or exit of a market, could be converted in such a way that the investment risk only depends on the choice of securities and no longer on the market movement.[32] Jones was successful with that.

In fact, Jones was the first to combine short selling, leverage, and manager compensation based on fund performance[33] and found in the "private partnership"[34] the ideal form of company to guarantee you as an investor maximum flexibility in the markets. With his strategy, he wanted to build a 'short' and 'long position' in parallel[35] - Increase the returns on his investment while limiting the risk of price fluctuations. The fund's gain consisted of "buying undervalued stocks on credit while shorting overvalued stocks without actually owning them."[36] The market risk was balanced or could be controlled and Jones could now increase his profits almost at will with the help of the leverage effect. All he had to do was concentrate on choosing the stocks.[37]

'Short positions' are traditionally short-term commitments in order to benefit from a market movement. "Leverage" is used to generate large profits quickly while increasing the risk at the same time.

At the beginning, Jones created the “long” and “short positions” from stocks from the same industry. This type of risk limitation itself was called 'hedging'[38] and the only risk was to choose the right stocks. As is well known, the problem of market direction was eliminated.[39]

By adding undervalued stocks to the portfolio and short selling overvalued stocks, Jones ‘Mutual Funds were independent of any market movement. His fund was fully hedged against the effects of the market as his portfolio consisted of stocks that made gains in both upward and downward trends. This is how the name came about Hedge funds.[40] The use of loans for speculative purposes can intensify these effects (leverage).[41] Although Jones attaches great importance to the selection of securities, the so-called "stock picking"[42] he nevertheless tried to shape the risk of the portfolio according to his market assessment. Short sales were then carried out to a lesser extent in anticipation of a general upward trend.

Jones always controlled the risk of his portfolio in relation to general market risk. For this he used the formula:[43]

Risk 'long position' - risk 'short position'

Market risk =

capital employed

A simple example explains this.[44] A typical Jones portfolio structure would look something like this. With a given capital of US $ 1,000 shares are bought. In addition, a loan is taken out, so that shares with a value of US $ 1,100 can be bought with this leverage. $ 400 worth of shares will be sold 'short'. The proceeds from this sale will be posted as collateral. The gross amount is therefore US $ 1,500 ($ 1,100 + $ 400) - 150% of the starting capital - invested. Since the risks of the positions taken cancel each other out, the net market risk only exists for invested US $ 700 ($ 1,100 - $ 400), i.e. less than the capital originally invested. The portfolio is then called "70 percent net long"[45] designated.This "net-market exposure"[46] Jones was able to influence depending on the market assessment by increasing or decreasing the positions entered.

There are two fundamental risks in any portfolio: “the volatility of the stock and the volatility of the overall market.[47] As is well known, Jones structured his theory in such a way that he tried to minimize the risk of the overall market. In this way, although he was able to reduce the risk of the market in his model, the risk of suffering losses due to incorrect stock selection was increased. In the example mentioned, the 'long position' of US $ 700 is not hedged, while US $ 800 ($ 400 long and $ 400 short) is "within the hedge"[48] are. Since the commitments 'within the hedge' 'short' and 'long positions' are of the same value, they are almost neutral to the market. The loss in value of a stock position held is offset by the increase in value of the 'short position' entered. Thus, US $ 700 is exposed to all market risks, US $ 800 is only subject to the risk of wrong stock selection. The market movements are no longer relevant.

But how did Jones make a profit? In an upward trend, a well-selected 'long position' rises above average in value compared to the rest of the market, and the 'short position' is characterized by a below-average decline. The profit arises from the fact that the value movements of the positions "within the hedge" do not run absolutely parallel. Although 70% of the investment is not 'hedged', there is no risk of a total loss for this position. Even if this position should be threatened by a decline in value, the portfolio is structured in such a way that it realizes its loss in value more slowly than the market. The Jones model was designed in such a way that through a clever selection of stocks the long positions entered into should generate above-average profits and, in fact, its success was enormous.[49]

In addition, Jones himself did not endeavor to keep his portfolio neutral, but deliberately relied on the volatility of the market. The degree of changes in the value of his positions 'within the hedge' he called "velocity"[50] and put these in relation to the movements of the rest of the market. In order to generate profits, he had to react faster to these movements than the other market participants through a clever selection of values. Jones stuck to this concept for decades because he never found a way to predict price fluctuations or extrapolate trends.

In 1952 Jones changed his investment fund, which had previously been run under a 'private partnership', to a 'limited partnership'. At the same time he employed several managers who independently managed his portfolio, so that the Jones Hedge Fund was also the first 'multi-manager hedge fund'.[51] As a result, other funds began using the techniques of the early 1950s Jones Fund to take over and the hedge funds came into being.

None of the characteristics of hedge funds were invented by Jones himself. His brilliant idea was simply to combine them successfully. Hence, Jones can rightly be called a pioneer of professional investment.[52]

Another feature of the Jones Fund The remuneration of the fund managers was based on the fund's performance and not on the amount of the deposits managed. The managers' fees amounted to 20% of the realized profit. They also received special payments when impending losses were minimized.

2.1.2. 1966-1969: The first boom in hedge funds

At the beginning of 1966, the number of active hedge funds was still small. Until the mid-1960s, Jones, despite his great success, always operated in the background and the other hedge funds known up to that time also carried out their business according to the Alfred Jones model.[53]

That changed when Carol J. Loomis appeared in the magazine's issue Fortune published a report on Jones in April 1966. "A hedge fund run by an unknown sociologist"[54] outperformed all other investment funds in terms of performance. The enormous success of Jones amazed the entire financial industry, as his fund outperformed all investment strategies of institutional investors despite manager salaries of 20% of the fund's income.[55]

Between 1955 and 1965 the Jones Fund a profit of 670%,[56] while the S&P 500 index rose by only 222% in comparison.[57] In the five-year investment segment, the most successful mutual fund, the Fidelity Trend Fund, from Jones Fund, even after deducting all taxes and fees, outperformed by 44 percent, the front runner in the investment period of ten years, the Dreyfus Fund, even by 87 percent.[58] Many professional investors recognized the opportunities that exposure to a hedge fund could bring and within a few years the number of hedge funds rose to over a hundred.[59] During this time, George Soros also founded his Quantum Fund.

According to an investigation by the Securities Exchange Commission (SEC)[60] In 1968 there were already 215 investment partnerships, ‘[61] including 140 hedge funds[62] and deposits under management were approximately US $ 2 billion.[63] The markets, which are always on the upswing, allowed the fund managers to speculate without hesitation. Ledermann notes that some managers even saw it as a waste of time and unnecessary costs to hedge risks with "short positions" in emerging markets. Instead, loans were used to participate even more in these upward movements.[64] Ledermann calls this risky posture without any form of protection: "swimming naked."[65]

2.1.3. The boom is ebbing

"You don’t know who’s swimming naked until the tides goes out."[66]

In 1969/70, however, the development ended abruptly when investments in the capital markets decreased. "Excessive quantity usually goes hand in hand with reduced quality"[67] and the hedge fund industry has been hit. The economic crisis of 1968/69 showed how vulnerable these funds are when risky transactions lead to losses. The reckless behavior of many managers was severely punished.[68]

As a result, some funds suffered heavy losses and even had to cease operations. The 28 largest hedge funds at the time lost around "70% of their assets" between 1968 and 1974 through repayments or losses.[69] Smaller funds have been hit even harder by the crisis. The number of hedge funds shrank to less than 100 by the 1980s, with assets of just a few billion US $.[70] George Soros and Michael Steinhard were among the few managers who survived this period with their funds. In the period that followed, hedge fund activities received little attention in the financial world and there were only a few start-ups until the mid-1980s. However, among these new hedge funds was one of the most successful funds and the industry was on the upswing again.[71]

2.1.4. "The New Modalities"

In the years after 1974, the hedge funds had almost completely disappeared from the public eye and conducted their business without regard to the rest of the financial world.[72] This reluctance continued until around the mid-1980s. Now, like in 1966, another press report played an important role, drawing the attention of the financial world to hedge funds, in particular to 'macro funds'. These had meanwhile increasingly deviated from the original hedging model of Alfred Jones and operated successfully as speculators in all sectors of the financial world. The business magazine reported in May 1986 The Institutional Investor on the amazing performance of a fund led by Julian Robertson[73] and suddenly changed the situation. Hedge funds had become interesting again.

Robertsons Tiger Fund had generated a cumulative net profit of 43% (after deducting all costs) in just five years. In comparison, the S&P Index rose by only 18.7%. The amazing thing about this extraordinary success, however, is that Julian Robertson was not a securities dealer, but only acted as a major investor. Following the principle of "investing and not gambling", he always hedged his portfolio with "short positions", following the example of Jones.[74] Robertson, however, found the profit that could be achieved with the Jones model too low and therefore used completely new instruments for the first time, which he himself called "the new modalities"[75] designated. New legal simplifications in many countries made it possible to align a portfolio internationally and according to different values. Furthermore, there were developments in the area of ​​derivative instruments that strengthened this action. The improvement in securities lending made it possible to open large 'short positions'. Robertson took advantage of all of this.

At the beginning of 1985, Julian Robertson conceived his first major "global macro play."[76] Expecting the US dollar to depreciate against European currencies and the yen, the Robertson-led one bought Tiger Fund and its off-shore daughter jaguar for around US $ 7 million call options on D-Mark, Swiss Francs, Yen and Sterling. When the dollar actually lost value, Robertson's profits exceeded the capital employed by several hundred percent. For the first time it was proven: a good manager, a skilful selection of values, combined with the optimal use of the available information, can with calculable risk[77] lead to extraordinary profits.[78]

As a result, a boom in the hedge fund industry set in in the following years, so that the number of hedge funds operating at this time can be assumed to be over 1,000.[79] The 'new modalities' used by Robertson should only represent the use of futures and options. They are not enough to describe the current development of hedge funds.[80] The various strategies are hard to keep track of and the definition of the term 'hedge fund' is becoming increasingly blurred when every investment fund that pays its managers after success can be described as a hedge fund.

2.1.5. The development in the 90s

In the 1990s, many hedge funds suffered heavy losses due to bad speculation. So recorded the Quantum Fund from Soros in 1994 a loss of approximately 5.5% (US $ 600 million) of its fund assets and the Granite find Askin suffered a total loss of US $ 600 million. As a result, many managers realized that their funds had reached dimensions that "no longer allowed optimal management and investment."[81] For the first time, capital was voluntarily returned to investors. In addition, in recent years managers have been repeatedly accused of threatening entire economies, which has led to mostly negative headlines. Indeed, in 1992 the British pound had to leave the European monetary system after the Quantum Fund which George Soros had allegedly speculated against the British currency in such a way that the bandwidths of the exchange rate system could no longer be adhered to.[82]

Hedge funds are also said to have played a major role in the turmoil in the Asian financial markets in 1997/98 and the recent crisis in the Brazilian financial system. Finally, there is the near-collapse of the American one Long Term Credit Management Funds mentioned in autumn 1998, whose bankruptcy could be prevented at the last moment by a bank consortium and the cooperation of the American central bank.

Most market participants see the enormous growth of hedge funds as a further development of the financial sector and an additional opportunity to diversify a portfolio.[83] For their part, large banks and investment houses want to use their good reputation to attract customers to invest in hedge funds or similar investments. There is a risk for a customer that the offers become confusing. It is also difficult to make a clear distinction between hedge funds and other institutional investors.[84] Given the astonishing profits made by some funds, the risks taken should by no means be concealed.

"Hedge funds that offer extraordinary profits will have to assume extraordinary risks."[85]

2.2. Hedge Funds in Numbers

2.2.1. Determination of the data

If you try to quantify the hedge fund industry, you run into great difficulties. Since these funds are mostly located in countries in which they are not subject to disclosure requirements, it is not possible to make a reliable statement about the number of active hedge funds and their transaction sizes. If data is available, it comes from voluntary information provided by the funds themselves or is used for information purposes for potential investors. The companies Managed Account Reports Inc. (MAR / Hedge), Hedge Funds Research (HFR) and Van Hedge Fund Advisors (VHFA) regularly publish reports and data on hedge funds. You can be accepted as serious. Publications from banks or the hedge funds themselves present the results in a way that is too inexpensive to particularly impress new investors.[86] Therefore, all information must be questioned and one must be aware that the figures presented do not represent a complete picture of the industry.[87]

Another problem is that positions entered into can cancel each other out and investments in other hedge funds, so-called 'fund-of-funds', do not reveal the exact amount of the invested capital.

"The line between what is and what is not a 'hedge fund' is a hazy one."[88]

The various representations of the term 'hedge fund' cause further difficulties. MAR / Hedge provides a narrow definition and characterizes a hedge fund as follows: the managers' fees are performance-related, the use of 'leverage' and protection of the portfolio through hedging techniques . HFR, on the other hand, is more general. Accordingly, a hedge fund is a 'private investment partnership' that manages investments professionally. VHFA emphasizes the investment strategies: A hedge fund invests primarily in government bonds, currencies and derivatives. This also includes the 'mutual funds' if they hedge their risks through hedging.

2.2.2. The distinction according to investment strategies

The difficulties described in defining a hedge fund continue with the determination of investment techniques. As is well known, Hedge Fund Research (HFR) characterizes a hedge fund as a 'private investment community', which at the same time addresses the problem of classification. There is no systematisation for these funds and their activities, so that ultimately, even with HFR, only the statement remains that the funds invest according to many different strategies. The range of possibilities is very extensive and includes hedging techniques without leverage, risk-reducing arbitrage transactions as well as transactions with a large leverage effect and activities aimed only at one situation.[89] However, since not all hedge funds are active in the same way, MAR / Hedge sees a possibility of dividing these funds into eight categories.[90] MAR / Hedge emphasizes, however, that its classification is based on interviews with the fund managers and press articles.[91] Overlapping with other types of funds is quite possible.

'Macro fund'

Macro funds examine the effects of macroeconomic changes and trends in one or more national economies on the financial markets. They take their positions to consciously speculate on these changes. Speculative objects are therefore mostly currencies, interest rate instruments or stocks. Their behavior is top-down and they usually have the largest assets. Derivatives are used on a large scale to enforce the strategies.

'Global fund'

These funds specialize in certain regions or invest exclusively in 'emerging markets'. They also try to identify trends, but, in contrast to 'macro funds', are bottom-up in that individual, particularly promising markets, stocks, etc. are favored . The use of derivative instruments is not as pronounced.

'Long-only fund'

These traditional equity funds only enter into 'long positions'. What they have in common with the hedge funds is that the managers are rewarded after the success of the fund and also use loans for speculation.

'Market-neutral fund'

"Market-neutral funds" try to reduce the market risks by simultaneously building up a "short" and "long position".They are the only funds that hedge their investments according to the original Jones model "and are considered conservative due to their risk structure."[92] Therefore, 'market neutral funds' can be used as the actual hedge funds, i.e. hedged Funds are called. "[93] Your profits are realized through arbitrage deals.

'Sectoral hedge funds'

You concentrate on values ​​of an industry, region or a product in raw material markets.

'Short-only fund'

This type of fund specializes in opening short positions or short sales. The fund borrows shares and other values ​​"from fundamentally overvalued companies" through brokerage houses.[94] which are sold on the stock exchanges. The point of this strategy is to earn money with borrowed stocks. The managers expect the stocks to fall and buy them cheaper before the redemption date.[95] The profit consists of the price difference between the shares sold and the purchase price of the shares that are returned to the broker. The leverage effect is very important here. 'Short-only funds' are often the partners of the 'long-only funds' or address investors who speculate on a decline in the market.

'Event-driven funds'

Event-driven funds try to speculate on a company's special situations. These can be mergers, reorganizations, new patents, changes in the law or bankruptcies and bankruptcies. It is well known that exchange rate fluctuations are greatest when special events become known. Then the strongest arbitrage profits can be made. Distressed securities funds, which invest in shares and debt securities of companies that are close to or that are already bankrupt, work in a similar way. "The speculation is based on profiting from the corresponding rise in the price of the securities if the financial situation improves."[96]

'Funds of funds'

These funds are also known under the term “fund of funds”. Funds of funds do not invest directly in investment instruments, but indirectly in another (hedge) fund. Here, too, shares in other hedge funds can be acquired by means of loans. The risk is particularly high as management cannot influence the policy of the fund of funds manager.

2.2.3. Number, sizes and domiciles of the hedge funds

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Figure 4: Growth in hedge funds (assets under management in billion US $)[97]

2.2.3.1 Number of Hedge Funds Operating

"All estimates suggest that the hedge fund industry has experienced explosive growth since the mid-1980s, measured either by number of funds or by assets under management, and continues to grow robustly."[98]

In the 1990s, the number of operating hedge funds increased tenfold. In 1990, MAR / Hedge only had 127 hedge funds.[99] In 1997, 1,115 hedge funds were operating worldwide, including 262 fund-of-funds with assets of US $ 109.6 billion.[100] These numbers are based on MAR / Hedge's rather conservative definition of a hedge fund. Other sources give far higher numbers. Eichengreen suspects more than 3,000 active hedge funds with assets of $ 368 billion[101] if a generous definition is taken. Hedge Fund Research (HFR) names 1,561 funds and US $ 189 billion in assets, while Van Hedge Fund Advisor names 1,990 funds and US $ 146 billion in assets.[102] The differences in the information result from the fact that there is no uniform definition of a hedge fund and that the figures given here also include very small funds. The publications by MAR / Hedge, HFR etc. are based in part only on interviews with fund managers, the information from which must be regarded as not representative. The published data usually serve to impress new customers and often portray the fund's activities too positively. Nevertheless, it can be assumed that the data from MAR / Hedge most closely describe the reality.[103]

Cottier also admits that it is hardly possible to give information about the number and size of hedge funds and puts the number of hedge funds operating in 1995 at 1,300 to 4,000.[104] At the same time, he limits the fact that the actual number lies somewhere between the two extremes.[105]

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Figure 5: Number of active hedge funds[106]

The difficulties of classifying mutual funds have already been mentioned elsewhere.[107] For example, where can you draw the line between hedge funds and the 'mutual funds' that are so important in the USA? The traditional 'mutual funds' - their roots can be traced back to the 19th century - are companies that manage the capital of institutional investors with the same goals.[108] They are similar to hedge funds, but always exist as open funds and also allow smaller investors to participate. The investment strategy of this type of fund is not that aggressive. There are many forms of these 'mutual funds', most of which speculate on a specific market or a certain risk. They can be compared, for example, with the 'special funds' offered in Germany. 'Mutual funds' can in turn invest in hedge funds or use the same investment techniques.

While in the USA and elsewhere in the Anglo-Saxon economic area investment funds are largely independent of the banking sector, in Europe the majority of funds are set up by banks themselves.[109] In Germany and Switzerland, over 80% of the fund market is managed by banks, while in the USA this share is only around 20%.[110] Bekier sees further difficulties in the fact that there are hedge funds that manage the assets of a single person, family or company, but are not counted among the “funds”, since a “fund” must consist of several investors. However, the funds managed can be substantial. As institutional investors, the banks play a dual role. On the one hand, they set up investment funds and thus manage their customers' investments. On the other hand, the banks themselves act as investors and speculators, letting their own trading departments manage their portfolios. Although the same techniques are used, these banks are not classified as hedge funds. It is understandable, therefore, that there is no reliable information on the number and size of hedge funds.[111]

2.2.3.2 Hedge Fund Assets Under Management

It has already been mentioned that hedge funds have seen tremendous growth since the mid-90s and continue to be one of the fastest growing segments of the financial markets. Growth rates of individual funds of 20% p.a. are nothing unusual.

In terms of assets, hedge funds are larger than futures funds.[112] On average, hedge funds in the US manage US $ 132.9 million, compared to US $ 85.7 million for non-US resident funds.[113] However, these averages are influenced by some extremely large funds because there are enormous differences in size within hedge funds. According to a study by Managed Account Reports Inc., 51% of all hedge fund assets managed between US $ 10 million and US $ 99 million in 1995, 16% of funds managed between US $ 100 million and US $ 499 million and only 3% had a principal of more than US $ 500 million. The 34 largest hedge funds are said to manage assets totaling US $ 57 billion.[114]

The development of 'macro funds' was of particular importance. In terms of their number, they are small, but not the amount of assets they manage. Some of the 'macro funds' combine very large sums of capital, so that in 1997 these funds managed an average of US $ 488 million. In the case of 'global funds', this figure was only US $ 76 million.[115]

However, it must be added to the figures given that only a few hedge funds publish the sum of their assets and some figures are therefore based on estimates.

Figure not included in this excerpt

Figure 6: Deposits managed by hedge funds (figures in US $ million)[116]

2.2.3.3 The domiciles of the hedge funds

The founders of a hedge fund must first consider the following points when choosing a company headquarters:[117]

- Target group of investors: Which structures do investors prefer and which domiciles are accepted? How large should the number of investors be? Would you like a diversification of the shares among many investors or a private investment community? Should the fund be registered?
- Legislation for investment funds: Are the fund operators obliged to publish their activities? Which strategies and investment instruments are allowed? Are there special regulations for the use of derivatives, leverage and short sales? Are there any rules regarding the composition of the portfolio or what restrictions exist for subscribing for units? Is it mandatory to use a domestic custodian bank and a domestic administrator?
- Taxes: What taxes are levied on income, interest, profits or capital growth? Is there a way to avoid taxation? Do you have double taxation agreements with other countries?
- Judiciary and Infrastructure: Does the country in which the hedge fund intends to set up have an efficient judicial system to resolve disputes? Does the public administration, telecommunications work or is corruption to be expected? Are expropriations to be expected? Do the banks located there offer a professional service? Do the business hours differ from the working hours of the fund managers (due to the time difference)?

[...]



[1] Grill-Perczynski, p. 387

[2] KAGG, § 1

[3] KAGG, § 6: “The money deposited with the investment company ... and the assets acquired with it form a special fund. ... The special fund is to be kept separate from the capital investment company's own assets. "

[4] KAGG, § 1

[5] KAGG, § 6: “The investment company may set up several special funds. These have to be distinguished by their designation and are to be kept separate. "

[6] In Germany, only open funds are permitted, because Section 11 (2) of the KAGG stipulates: "Every unit holder can request that his share in the investment fund be paid out to him in return for the unit certificate."

[7] Büschgen, Das kleine Börsenlexikon, p. 376

[8] Grill-Perczynski, p. 389

[9] KWG, Section 1, Paragraph 1: “Credit institutions are companies that conduct banking business. ... banking transactions are ... the transactions described in Section 1 of the Law on Investment Companies (investment business). "

[10] Büschgen, Das kleine Börsenlexikon, p. 372

[11] KAGG, Section 8, Paragraph 6: "Units in another fund cannot be acquired for a fund."

[12] Grill-Perczynski, p. 394

[13] KAGG, Section 9, Paragraph 3

[14] ibid.

[15] KAGG, Section 9, Paragraph 3 "The taking out and repayment of loans according to sentence 1 must be reported to the banking supervisory authority."

[16] Hans E. Büschgen, Profitability and Risk of Investment, p. 65

[17] see § 8 KAGG

[18] see § 15 KAGG

[19] see § 25 KAGG

[20] Grill-Perczynski, p. 393

[21] Cottier, p. 7

[22] Cottier, p. 7f describes the development of trading in 'managed futures'

[23] ibid., p. 8: "Financial futures and options based on individual stocks, stock indices, interest rate products and currencies have become far more important than commodity futures and options."

[24] The first managed futures fund started operations in the USA in 1949.

[25] Cottier, p. 9: “Nowadays, managed futures funds and programs can be found in many industrialized coun- tries.”

[26] Cottier, p. 12f

[27] Chadha / Jansen, S. 27: “Since the term 'hedge Fund' is currently applied to a wide variety of funds, and popular notions often depict hedge funds as highly leveraged risk-takers or speculators rather than as risk averse hedgers, it is useful to begin with a little story. "

[28] Keller, p. 11

[29] ibid.

[30] Ledermann / Klein, p. 6: “This amateur investor established his investment partnership.”

[31] Chadha / Jansen, S. 27: “Similarly the use of leveraging as an investment strategy, which entails the use of credit to increase the value of investments, appears principally to have been used to 'raise the stakes' that is, for increasing profits but amplifying, of course, also the size of possible losses. "

[32] Ledermann / Klein, p. 7: "His goal was to shift the burden of performance from market timing to stockpicking and he succeeded."

[33] Cottier, p. 13: "Jones was the first to use short sales, leverage and incentive fees in combination."

[34] Bekier, p. 73

[35] ibid .: "Jones reasoned that having both short and long position in a portfolio could increase returns while at the same time reduce risk due to the lesser net market exposure."

[36] Finanztest Nr. 1, 1999, p. 51

[37] Chadha / Jansen, p. 27: “Thus controlling market risk, he used leverage to amplify his returns from picking individual stocks.”

[38] hedge, engl.: the hedge, narrow down something

[39] Eichengreen, p. 5: "Performance‘ within the hedge ’would thus depend on stock selection rather than market direction."

[40] Chadha / Jansen, p. 27: “By going long on stocks that were 'undervalued' and short on those that were 'over- valued', the expectation was that the fund would gain regardless of the direction in which the market moved. The fund was considered 'hedged' to the extend that the portfolio was split between stocks that would benefit if the market went up, and short positions that would gain if the market went down. Thus the name hedge funds.”

[41] Bekier, p. 73: "Leverage could further enhance these effects."

[42] Chadha / Jansen, p. 27

[43] Ledermann / Klein, p. 7

[44] Ledermann / Klein, p. 7f

[45] ibid.

[46] ibid.

[47] Keller, p. 12

[48] Ledermann / Klein, p. 7

[49] ibid., p. 8: “In theory, Jones’s hedge fund system would provide superior performance relative to well managed, long-only portfolios. In practice, it did. "

[50] ibid., p. 9

[51] Cottier, S. 13: "In 1952, he converted his general partnership fund into a limited partnership investing with several independent portfolio managers and created the first multi-manager hedge fund."

[52] Ledermann / Klein, p. 8: "None of these ... characteristics were original or unique when Jones established his fund, but the way in which he combined them was."

[53] Chadha / Jansen, p. 27: “Jones operated his fund with spectacular success and in relative secrecy until the mid-1960s.”

[54] Carol J. Loomis, The Jones Nobody Keeps Up With, Fortune, April 1966

[55] Cottier, p. 13: “In 1966, an article in Fortune magazine about a 'hedge fund' run by a certain A. W. Jones shocked the investment community. Apparently, the fund had outperformed all the mutual funds of it's time, even after accounting for a heavy 20% incentive fee. "

[56] Bekier, p. 74

[57] ibid.

[58] Ledermann / Klein, p. 10

[59] Cottier, p. 13: "The first rush into hedge funds followed and the number of hedge funds increased from a handful to over a hundred within a few years."

[60] The SEC is the US securities and stock exchange regulator and oversees the entire securities market.

[61] An 'investment partnership' is not comparable to a capital investment company, since a 'partnership' is a partnership. There is no equivalent under German law.

[62] Chadha / Jansen, p. 27

[63] Bekier, p. 74

[64] Ledermann / Klein, p. 10

[65] ibid.

[66] ibid.

[67] Keller, p. 13

[68] Eichengreen, p. 5: "This rendered them vulnerable to the extend market downtown that started at the end of 1968."

[69] Keller, p. 14

[70] Bekier, p. 74: “By the 1980's, the number of funds had declined to less than 100, with assets under management in the range of a few billion US $.”

[71] Ledermann / Klein, p. 11: "During this period, comparatively few hedge funds were established, but among them was one of the best."

[72] Chadha / Jansen, p. 28: “In the decade following 1974, hedge funds appear to have returned to operating in relative obscurity.”

[73] Julie Rohrer, The red-hot world of Julian Robertson, in The Institutional Investor, May 1986, pp. 86 - 92: "... the incredible performance of Julian Robertson’s funds."

[74] Ledermann / Klein, p. 12: “Importantly, the article established that Robertson was an investor, not a trader, and that he always hedged his portfolio with short sales. This was textbook Alfred Jones investing. not high-stakes gambling. "

[75] ibid .: “Robertson called these instruments, not available to Jones in his prime , the new modalities.”

[76] Eichengreen, p. 5

[77] According to Robertson, even if the options were completely lost, only 2% of the total capital would be 'threatened.

[78] Ledermann / Klein, p. 12: “Citing this example ...demonstrated how a good manager, operating from a base of well hedged equities, developed strong convictions from the best available information, and, calculating risk, acted affirmatively on those convictions to generate exceptional profits. In essence, ... showed a new generation of professionals on Wall Street the difference between a well-run hedge fund and traditional equity management. "

[79] Bekier, p. 74: "From this low point, the number of hedge funds has grown to about 1000, with assets under management of about US $ 100 billion in 1994."

[80] Ledermann / Klein, p. 12: "Hundreds of hedge funds with specialized investing systems, bearing no retention to Jones’s equity hedging, have been established since 1980."

[81] Keller, p. 14

[82] Cottier, p. 14

[83] Eichengreen, p. 8: “Most market participants see the growth of the hedge fund industry as a normal corollary of financial development.”

[84] ibid .: "As these branded leveraged funds grow in number and size, the line of demarcation between hedge funds and other institutional investors becomes increasingly difficult to draw."

[85] ibid.

[86] Chadha / Jansen, p. 27: "Voluntary reporting means also that all statistics suffer from a self-reporting bias, as hedge fund managers would have an incentive to report results in a favorable light."

[87] ibid., p. 28: “Since all information available on these databases is voluntarily reported by hedge fund managers to these services and is not based on any publicly disclosed information, funds whose managers choose not to report are necessarily missing from the databases , and the data are obviously, therefore, incomplete. "

[88] ibid., p. 28 compares the various definitions.

[89] Chadha / Jansen, p. 28: "Investment strategies range from the non-leveraged, hedged and arbitraged to highly leveraged and directional."

[90] ibid., p. 29: "The MAR / Hedge database classifies hedge funds into eight broad categories of investment styles, as reported by the managers of the hedge fund."

[91] ibid. p. 28ff describes in detail the difficulties in collecting and evaluating the data.

[92] Keller, p. 21

[93] ibid.

[94] Keller, p. 25

[95] ibid. p. 26: "If the expected price loss of the short position occurs, this is closed out by repurchasing at a lower price and returned to the 'lender'."

[96] Keller, p. 25

[97] Bekier, p. 74

[98] Chadha / Jansen, p. 29

[99] ibid.

[100] Eichengreen, p. 8

[101] ibid., p. 6: "Other services put forth much larger numbers (as many as 3,000 funds and $ 368 billion in assets of September 1997) ..."

[102] ibid.

[103] Eichengreen's publication was commissioned by the IMF and there is a reason why he cites MAR / Hedge.

[104] Cottier, p. 23

[105] ibid., p. 22: “The real number must lie somewhere between these two extremes.”

[106] Chadha / Jansen, p. 30

[107] ibid., p. 28: "The line between what is and what is not a 'hedge fund' is a hazy one."

[108] Bekier, p. 195: "... individuals and institutions with similar financial goals."

[109] ibid., p. 144

[110] ibid.

[111] A detailed description of the difficulties mentioned is given by Bekier, p. 22f.

[112] Bekier, p. 22: “Hedge funds are larger in asset size than future funds and pools.”

[113] ibid.

[114] Cottier, pp. 22 and 24

[115] Chadha / Jansen, p. 31

[116] Bekier, p. 25

[117] Cottier, pp. 71f

End of the excerpt from 119 pages