TeAM YYePG Digitally signed by TeAM YYePG DN: cn=TeAM YYePG, c=US, o=TeAM YYePG, ou=TeAM YYePG, email=yyepg@msn.com Reason: I attest to the accuracy and integrity of this document Date: 2005.07.06 09:10:35 +08'00' Hedge Fund Course ffirs.qxd 10/8/04 10:06 AM Page i Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and fi- nancial instrument analysis, as well as much more. For a list of available titles, visit our Web site at www.WileyFinance.com. ffirs.qxd 10/8/04 10:06 AM Page ii Hedge Fund Course STUART A. MCCRARY John Wiley & Sons, Inc. ffirs.qxd 10/8/04 10:06 AM Page iii Copyright © 2005 by Stuart A. McCrary. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008. Note: Some of the material in this book is very technical and involves issues where professional judgment is imperative. Material may be outdated. Many hedge funds display unique aspects that may contradict statements in this book. The information in this book is believed to be reliable but it is up to the reader to confirm everything with lawyers, regulators, accountants, investment professionals, or tax professionals. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: McCrary, Stuart A. Hedge fund course / Stuart A. McCrary p. cm. — (Wiley finance series) Includes bibliographical references and index. ISBN 0-471-67158-4 (pbk.) 1. Hedge funds. I. Title. II. Series. HG4530.M379 2005 332.64'524—dc22 2004015547 Printed in the United States of America. 10987654321 ffirs.qxd 10/8/04 10:06 AM Page iv To my loving wife, Nancy ffirs.qxd 10/8/04 10:06 AM Page v ffirs.qxd 10/8/04 10:06 AM Page vi Contents Preface ix Acknowledgments xiii About the Author xv CHAPTER 1 Introduction 1 CHAPTER 2 Types of Hedge Funds 19 CHAPTER 3 Types of Hedge Fund Investors 35 CHAPTER 4 Hedge Fund Investment Techniques 59 CHAPTER 5 Hedge Fund Business Models 73 CHAPTER 6 Hedge Fund Leverage 87 CHAPTER 7 Performance Measurement 107 CHAPTER 8 Hedge Fund Legislation and Regulation 127 CHAPTER 9 Accounting 135 vii ftoc.qxd 10/8/04 10:06 AM Page vii CHAPTER 10 Hedge Fund Taxation 157 CHAPTER 11 Risk Management and Hedge Funds 175 CHAPTER 12 Marketing Hedge Funds 193 CHAPTER 13 Derivatives and Hedge Funds 203 CHAPTER 14 Conclusions 217 Answers to Questions and Problems 225 Index 275 viii CONTENTS ftoc.qxd 10/8/04 10:06 AM Page viii Preface B usiness bookstores contain many different books on the general topic of hedge funds. Most of these books are written for potential investors. These books focus primarily on the investment characteristics of hedge funds, admittedly the most important topic related to this investment alter- native. Some of these texts are little more than marketing devices designed to encourage greater use of hedge funds in investor portfolios. An investor considering an investment in a hedge fund for the first time should read one or two of these books before making an investment. To reach a large market, these investment books are mostly written at a very simple level. They generally do not presume any prior knowledge of investments, finance, mathematical methods, accounting, or the law. The authors develop a survey that usually leaves the reader less than an expert after reading the text. After getting a general background, the investor will likely need to hire some combination of investment professionals, tax ad- visers, accountants, and lawyers before making an investment. A small number of books have been written for professionals. Usually, these books are not sold commercially. Instead, they are distributed by law firms and accountants to their customers, and most readers cannot get copies of them. Even if available, these books, while they are extremely valuable to professionals, should provide little value to most readers be- cause of the highly technical treatment of narrow topics. The academic research on hedge funds is accumulating. The ambitious student can read a survey of the important papers concerning hedge funds and develop a good understanding of this important investment product. But few people have the time or background to learn about hedge funds from academic papers. Some books have been written for the entrepreneur who wants to start a hedge fund. I wrote one of these for John Wiley & Sons a couple of years ago and have discovered that there is considerable demand for a book that bridges the gap between the nontechnical texts written for mass appeal and the technical books and academic papers. Although the previous book was a bit more technical than most others on the market, it also included infor- mation needed by hedge fund venture capitalists. This book serves to bridge another gap. It provides an extensive survey ix fpref.qxd 10/8/04 10:07 AM Page ix [...]... combined hedge fund assets have grown at 22.6 percent annually.8 10 HEDGE FUND COURSE $12 0 $10 1.23 $10 0 $85. 71 $86.67 $77.42 $80 $60 $ 51. 18 $50.34 $46 .10 $39. 61 $40 19 95 19 97 19 98 19 99 2000 $53.34 $46 .17 19 94 $53.64 $80.00 $42 .13 $35 .19 $33.89 $30.59 $20 $0 19 88 19 89 19 90 19 91 1992 19 93 19 96 20 01 2002 2003 FIGURE 1. 3 Estimated Hedge Fund Average Size (AUM $Millions) Source: ©2004 by Van Hedge Fund Advisors... $300 $ 311 19 97 19 98 $2 61 $ 217 $200 $17 2 $18 9 19 93 19 94 $12 0 $94 $10 0 $42 $58 $67 19 89 19 90 $0 19 88 19 91 1992 19 95 19 96 19 99 2000 20 01 2002 2003 FIGURE 1. 2 Estimated Hedge Fund Assets under Management ($Billions) Source: ©2004 by Van Hedge Fund Advisors International, LLC, and/or its licensors, Nashville, TN, USA Because the assets under management have been growing faster than the number of hedge funds,... irregular, the industry has grown every year 9,000 8 ,10 0 8,000 7,500 7,000 7,000 6,500 6,200 5,830 6,000 5,500 5 ,10 0 5,000 4,700 4 ,10 0 4,000 3, 417 2,848 3,000 2,373 1, 977 2,000 1, 648 1, 373 1, 000 0 19 88 19 89 19 90 19 91 1992 19 93 19 94 19 95 19 96 19 97 19 98 19 99 2000 20 01 2002 2003 FIGURE 1. 1 Estimated Number of Hedge Funds Source: ©2004 by Van Hedge Fund Advisors International, LLC, and/or its licensors,... Nashville, TN, USA $800 $700 Fund of Funds Direct $600 200 $500 12 5 550 90 $400 475 70 410 60 $300 45 50 330 290 $200 35 245 250 30 $10 0 25 16 5 12 0 $0 95 19 94 FIGURE 1. 4 19 95 19 96 19 97 19 98 19 99 2000 20 01 2002 Estimated Hedge Fund Assets under Management ($Billions) Source: Tass Research 2003 11 Introduction WHY INVEST IN HEDGE FUNDS? Marketing literature describes a number of reasons why investors should put... fairly close 8 HEDGE FUND COURSE For example, in Figure 1. 1, Van Hedge Fund Advisors International has estimated the number of hedge funds worldwide at 8 ,10 0 Other estimates are generally within about 10 percent of this estimate The number of hedge funds has risen by about 12 .6 percent annually since 19 88.3 This total represents the new funds created and the funds that shut down Hedge fund professionals... singlemanager hedge funds Figure 1. 4 shows the assets under management including both direct investments and investments through a fund of funds intermediary Single-manager funds (funds that implement hedge fund strategies other than fund of funds strategies) have grown at 21. 5 percent annually.6 Fund of funds investments in hedge funds have grown at 26.0 percent annually.7 For this time period, the combined hedge. .. investors have not needed to move into hedge funds to get excellent returns During 12 HEDGE FUND COURSE the downturn in 20 01 2002, most hedge fund performance was higher than stock returns During this period, although some investors have been motivated by the higher performance, an increasing number of investors looked for a nondirectional return Investing in Hedge Funds to Reduce Risk Hedge fund investors. .. Chapter 10 Hedge Fund Taxation Tax reporting is one of the most complicated topics affecting hedge fund investors Taxes have a powerful impact on the after-tax return of investors yet tax reporting is one of the least-discussed topics affecting hedge fund investors Chapter 11 —Risk Management and Hedge Funds Risk management is more than risk measurement, but measurement is the first step Some hedge funds... with hedge funds As a starting point, begin with a rather typical definition of a hedge fund: A hedge fund is a loosely regulated investment company that charges incentive fees and usually seeks to generate returns that are not highly correlated to returns on stocks and bonds Many traits of hedge funds aren’t useful in defining what is and what is not a hedge fund 1 2 HEDGE FUND COURSE Regulation and Hedge. .. of hedge funds But this first hedge fund bears a close resemblance to the most common hedge fund strategy today, called long/short equity T DEFINITION OF HEDGE FUND Definitions of hedge funds run into problems because it is exceedingly difficult to describe what a hedge fund is without running into trouble with funds that don’t fit into the rules There are investment pools that closely resemble hedge funds . 10 Hedge Fund Taxation 15 7 CHAPTER 11 Risk Management and Hedge Funds 17 5 CHAPTER 12 Marketing Hedge Funds 19 3 CHAPTER 13 Derivatives and Hedge Funds 203 CHAPTER 14 Conclusions 217 Answers to Questions. 1 Introduction 1 CHAPTER 2 Types of Hedge Funds 19 CHAPTER 3 Types of Hedge Fund Investors 35 CHAPTER 4 Hedge Fund Investment Techniques 59 CHAPTER 5 Hedge Fund Business Models 73 CHAPTER 6 Hedge. University. xv flast.qxd 10 /8/04 10 :07 AM Page xv flast.qxd 10 /8/04 10 :07 AM Page xvi Hedge Fund Course flast.qxd 10 /8/04 10 :07 AM Page xvii flast.qxd 10 /8/04 10 :07 AM Page xviii CHAPTER 1 Introduction T he