Hedge fund investing 2nd edition

Hedge Fund
Investing


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Hedge Fund
Investing
A Practical Approach
to Understanding Investor
Motivation, Manager Profits,
and Fund Performance
Second Edition

Kevin R. Mirabile


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Copyright © 2016 by John Wiley & Sons, Inc. All rights reserved.

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This book is dedicated to my wife, Maureen,
and my children, Sarah, Andrew, and Will.


Contents

Preface

ix

Acknowledgments

xiii

About the Author

xv

Part One

Overview
Chapter 1
The Basics of Hedge Fund Investing

3

Chapter 2
Hedge Fund Strategies, Performance Measurement, and Risk

21

Chapter 3
Who Invests in Hedge Funds and Why?

39

Chapter 4
Industry Trends, Flows, and Characteristics

65

Part Two

Understanding the Strategies
Chapter 5
Global Macro Investing

87

Chapter 6
Equity-Oriented Styles

109

vii

viii

Contents

Chapter 7
Fixed-Income–Oriented Strategies

143

Chapter 8
Multistrategy Funds, Funds of Hedge Funds, and Replication Products

173

Chapter 9
Portfolio Financing and Secondary Market Trading 

191

Part Three

Evaluating Individual Fund Risk and Reward
Chapter 10
Measuring Performance and Performance Persistence

213

Chapter 11
Impact of Fund Characteristics and Terms on Performance

233

Chapter 12
Performing Due Diligence on Specific Managers and Funds

247

Chapter 13
Evaluating the Roles of Service Providers

271

Chapter 14
Observations and Outlook

299

Glossary

309

References and Additional Reading

319

Index

335

Preface

T

his book is designed to provide an overview of alternative investments
and, in particular, instill in readers a working knowledge of that portion
of alternative investments known as hedge fund investing.
The second edition of this book includes important updates related to
industry flows and performance, plus new material covering the exciting
new world of hedged mutual funds, secondary trading in hedge fund investments, and more information about the various techniques and instruments
used by hedge fund managers to finance their portfolios.
The original motivation to write this book was to deliver a holistic view
of hedge fund investing. That has not changed. The intention was to provide
a cradle‐to‐grave perspective for first‐time investors, for practitioners dealing with hedge funds as clients or counterparties, and for students wishing
to learn how the sector operates from both a theoretical and a practical perspective. My personal experiences as a banker, accountant, service provider,
investor, and partner in a hedge fund and a fund of hedge funds allows me
to deliver some practical insights that I believe will facilitate learning.
The goal for this second edition is to once again present a comprehensive
view of the reasons people invest in the sector, discuss how the managers,
funds, and strategies interact, and recommend criteria people can use to select managers and funds—all without getting lost in too much detail. The
approach is to cover a wide range of material in sufficient detail to familiarize
readers with the issues, without getting lost in the multitude of regulations
and mathematics needed to fully investigate any single topic. The hope is that
by “keeping it simple” readers will learn enough about the asset class and the
process of investing to give them confidence to move forward with asking the
questions needed to become a great investor. Importantly, one of the goals
for this book, if not its primary goal, is to make the asset class accessible and
to demystify what is at times presented as an overly complex and esoteric
category of investing. My approach is to deliver a balanced discussion of the

broad spectrum of information needed to invest in hedge funds; however, it
is inevitable that certain sections garner more emphasis than others.
The vast majority of information in this text comes from my personal
experience in providing services to, trading with, lending to, or investing
in hedge funds over the past 25 years. It also includes the advice and input

ix


x

Preface

of former colleagues and friends in the industry who share my interest in
promoting educational efforts about hedge fund investing. It is only through
education that the myths of hedge fund investing can be debunked and the
opportunities can be assessed objectively. In this way, more people can reap
the rewards and benefits of hedge fund investing while also fully understanding the risks of this exciting asset class.
The book is designed for those who have a basic knowledge of financial
instruments, markets, asset allocation, and portfolio management. A rudimentary knowledge of statistics and some of the basic principles of calculus
is also helpful, although not a requirement.
The book is organized into three parts related to basic concepts and market
characteristics, an explanation of the individual strategies and financing tools
used by hedge fund managers, and an overview of the process needed for the
evaluation and analysis of individual managers and funds, including approaches
to performing a due diligence process on any one fund. Each chapter has its
own individual objectives and illustrations that can be read on their own or as
part of the complete text.
Part One of the book provides readers with an overview of alternative investments. It highlights the similarities and differences among various
types of alternatives, including hedge funds. It establishes the framework

for understanding fund‐level profit or loss calculations, performance measurement, and risk. It also provides readers with an understanding of the
rationale for investing in hedge funds as well as the flows experienced by
the sector over time.
Part Two is designed to explore several of the most prominent hedge
fund investing strategies in more detail. It provides straightforward explanations of the important terms, definitions, trades, organization structures,
portfolio constructions, performance measurements, and risk assessments
used in each strategy. Strategies are organized into those that are not directly
correlated to the traditional stock and bond market, those that are equity
or fixed‐income oriented, and those that are multistrategy in nature. It also
includes new sections on the financing market and the secondary market for
trading in hedge fund investments.
Part Three explores the nature of absolute, relative, and risk‐adjusted
performance measures; the impact of fund characteristics related to compensation arrangements; fund terms; and environmental conditions that
motivate behavior and influence performance. This section also covers the
due diligence process for selecting a single hedge fund for investment from
a universe of peers. Topics covered include how to quickly assess and evaluate the people, pedigree, and processes that establish the DNA of any fund;
understanding the investment and risk management process of a fund; the
impact of the fund’s business model and counterparty risk on the fund’s


Preface

xi

performance and sustainability; and the role of a fund’s service providers
in creating opportunities for a fund, influencing a fund’s performance, or
protecting investors from fraud, blowups, or other calamities.
The book ends with some final observations, a review of the challenges
faced by the industry today, and the outlook or trends that are likely to
continue going forward.

This book can be used by commercial practitioners on a stand‐alone
basis or by educators in conjunction with supplemental material available
online that includes PowerPoint slides, Excel spreadsheets, end‐of‐chapter
discussion questions, and a test bank of over 100 questions. Educators can
download the test bank and other learning tools at Wiley’s Instructor Site.


Acknowledgments

T

his book is possible only as a result of the support of my family, Maureen,
Sarah, Andrew, and Will, and all the terrific people I have had the chance
to work with during my career, both in industry and in academia. I am also
grateful to the alternative investor community at Fordham University and
its many alumni, as well as all my friends and former colleagues who have
lectured in my classroom or otherwise provided insights and information that
contributed to this book and to my knowledge of the hedge fund industry
over the years.

xiii


About the Author

Kevin R. Mirabile is currently a clinical assistant professor of finance at
Fordham University where he teaches courses on the principles of finance,
alternative investing, derivatives, and hedge funds. Mr. Mirabile has over
30 years of business development, regulatory, financing, accounting, trading,
sales, and asset management experience in the United States and abroad. He

is a former COO of Larch Lane Advisors, managing director and executive
committee member at Barclays Capital, senior VP and operating committee
member of Daiwa Securities, a principal at Morgan Stanley, and president of
the Morgan Stanley Trust Company. His areas of expertise are in banking,
asset management, and hedge fund investing.
Mr. Mirabile is an active industry consultant on the topics of hedge fund
investing and operational and business model risk assessment. He has given
lectures across the United States and abroad on the topics of alternative
investing, hedge funds, and trends in asset management.
Mr. Mirabile is a CPA, a member of the AICPA, a member of the Greenwich Roundtable’s Founders Council, and a contributor to its “Best Practices” series on alternative investing. He is also a member of the Hedge Fund
Association’s Education Committee.
Mr. Mirabile received his BS in accounting from SUNY Albany in 1983,
earned his MS in banking and finance from Boston University in 2008, and
completed his doctoral studies with a DPS degree in finance and economics
from Pace University in May 2013.

xv


Part

One
Overview



Hedge Fund Investing: A Practical Approach to Understanding Investor
Motivation, Manager Profits, and Fund Performance, Second Edition
By Kevin R. Mirabile
Copyright © 2016 by John Wiley & Sons, Inc.

Chapter

1

The Basics of Hedge
Fund Investing 

A

newcomer to hedge fund investing can easily get overwhelmed by the
complex terminology and unique characteristics associated with this
type of investing. There is a lot to know and not always a lot of time to
learn it. This chapter is meant to present the basics of hedge fund investing,
including defining alternative investments, discussing the characteristics and
structures of hedge funds on a standalone basis and relative to mutual funds,
and evaluating the impact of hedge fund trading on the broader markets.
This chapter lays the foundation for the rest of the book. Let’s get started.

What Are Alternative Investments?
Alternative investments is a term used to describe investments in nontraditional asset classes. Traditional asset classes include stocks, bonds, and
sometimes commodities, and foreign exchange. Alternative investments
include hard assets, collectables, real estate funds, private equity, venture
capital, managed futures funds, hedge funds, and sometimes even structured
products like CLOs and CDOs. Every institution seems to have its own set
of rules for what is and is not an alternative investment.
Investors obtain alternative exposure by investing in vehicles such as
private limited partnerships and alternative mutual funds. Alternatives may
offer attractive portfolio benefits to investors, although on a stand-alone
basis they can be more volatile or less liquid than traditional investments.

The more established and better understood traditional asset classes can
be described as having large global markets, significant pools of liquidity, a
high degree of price transparency, and regulation, along with well-established
market microstructures. Stocks and bonds have been available to investors
for centuries. Even mutual funds have been around in various shapes and

3


4

Overview

sizes for well over 100 years. Alternatives and hedge funds, on the other
hand, by even the broadest measures, only started in the late 1960s and
really only began to grow in the early 1990s.
Alternative investing is not a mature industry. Alternative investments
are considered relatively young in terms of life cycle and track records.
Hedge funds are perhaps the newest form of alternatives and as such may
also be the least understood. Their business models are also not as stable,
well developed, or mature as those associated with traditional investing or
even earlier forms of alternatives, such as real estate and private equity. The
market value of publicly traded equity and debt is well over $250 trillion
today. There are more than $15 trillion of investments in traditional stock
and bond mutual funds in the United States and over $30 trillion globally.
This compares to about $3 trillion invested globally in hedge funds at the
end of Q1 2015.
So what exactly constitutes an alternative as opposed to a traditional
investment? There are a few broad categories that most professionals would
agree make up the universe of alternative investment opportunities.

Real estate investing includes direct investments or funds that invest
in commercial or residential real estate or mortgages that produce
rental income, interest income, and capital appreciation. Most funds
are organized in specific regions or by specific types of properties.
Private equity investing includes direct investments or funds that take
equity ownership in existing private companies in the hope of
streamlining or improving management, negotiating favorable leverage
terms with banks, and improving performance so that the fund
may ultimately profit from an initial public offering (IPO) of the
company’s shares.
Venture capital investing includes direct investments or funds that
provide day-one capital to fund new business ideas. These early-stage
investors hope to profit by sale of the company to a strategic investor or perhaps to a private equity fund that ultimately will help the
company go public.
Managed futures investing includes funds that are specially dedicated
to trading futures contracts based on directional or trend-following
models. These funds are similar to hedge funds in many ways. They
are different from hedge funds in that they are restricted to trading
listed futures contracts and are regulated by the Commodity Futures
Trading Commission (CFTC).
Hedge fund investing includes investments in either private investment
partnerships, mutual funds or UCITS that trade stocks, bonds,


The Basics of Hedge Fund Investing  

5

commodities, or derivatives using leverage, short selling, and other
techniques designed to enhance performance and reduce the volatility

of traditional asset classes and investments.
In addition to the more established categories of alternative investments
mentioned here, there continue to be newer emergent or exotic alternative strategies that come to the market every year. These exotic alternative
investments include direct investments or funds that invest in life insurance
settlements, farmland, weather derivatives, or collectables such as artwork,
comic books, vintage automobiles, and rare coins (even Bitcoins). Most of
these exotic and collectable investments still lack a minimum level of liquidity or price transparency, and are subject to greater fraud risk or are very
difficult to value. These investments tend to remain in the domain of pure
speculators, hobbyists, and those who are equal parts product enthusiasts
and investors.
Most of the established and exotic alternative investments share at least
a few common attributes or qualities. Most, if not all, alternative investment
managers are experts in their area of investment, are major investors in the
fund they manage, and get paid both a management and an incentive fee.
Many also use leverage to enhance returns; some create portfolios that are
illiquid at times; most only provide limited transparency to investors; and
some alternative investments can be difficult to value.
When thinking about an alternative investment, here are seven things
to consider:
1.Expert management. Does the manager of the investments have significant experience in a specific market segment, industry, or area of
investment? This extra level of skill and focus can allow the manager to
identify unique values or opportunities not readily seen by the investor
community at large.
2.Manager co-investment. Do the manager and many of the partners or
employees of the management company have a significant investment
in the fund? This serves to align the interests of the investors with those
of the manager.
3.Performance fees. Does the manager get paid a percentage of the profits
of the investments, in addition to any flat fees for managing the fund?
The widespread use of an incentive fee is based on the principle that it

further aligns the interest of the manager with that of the investor.
4.Leverage. How much money or securities does the fund borrow to make
investments? The use of a fund’s investor capital, plus leverage obtained
from banks or derivatives, allows the fund to magnify gains or losses
from each investment and achieve higher rates of return.


6

Overview

5.Illiquidity. How long do investors need to lock up money in the fund before they can sell or redeem? Many times funds require investors to lock
up their money for an extended period of time before they can redeem
their investment.
6.Limited transparency. Does the fund disclose its investments to its investors on a daily basis? Many times a manager may restrict the amount of
periodic information provided to investors related to positions, strategy,
leverage, or risk.
7.Hard to value. Can the investment or the underlying instruments owned
in the portfolio be valued on an exchange or do they require an
over-the-counter (OTC) quotation or price, a model price, or an
independent valuation to determine the value? An illiquid market,
third-party valuations, or the use of model price for an instrument
can lead to more subjective portfolio pricing and less accurate fund
valuations.
Alternative investment managers are usually trying to generate an
absolute return and not managing money to beat a benchmark. This gives
them the freedom to focus on narrow opportunities, with significant barriers to entry, requiring a high level of expertise. A commercial real estate
fund might employ a property manager who is an expert on shopping
malls in Chicago. A private equity fund may focus on infrastructure projects or telecommunications and may employ former industry executives
and engineers to evaluate potential investments. A hedge fund that invests

in equities related to the biotech industry may have doctors on staff who
work as consultants or research analysts who recommend companies to the
portfolio manager.
Most professional managers who start a private equity or hedge fund
also invest the majority of their personal net worth in the fund. Managers
do this to align interests and to signal confidence to investors that they
believe in what they are doing and that they are not merely managing other
people’s money.
Managers of alternative investments usually command a performance
fee in addition to a fixed fee for managing assets. Managers getting an
incentive or performance fee share in the upside when they produce positive
results and generally do not get paid when they produce negative results.
The effect of the performance fee is to give the manager a tangible incentive
to generate the highest possible absolute level of return and to minimize
variation and volatility over a complete business cycle.
Alternative investments are generally less regulated than traditional
investments. This opens the door to the use of leverage, short selling, and


The Basics of Hedge Fund Investing  

7

derivatives on a much grander scale. Leverage is a powerful tool for
magnifying winning outcomes and enhancing returns. Short selling is another form of leverage that particularly applies to managed futures and
hedge funds and allows managers to make money when prices fall and magnify outcomes. It also enables them to mitigate volatility and reduce risk.
Derivatives can be used by real estate funds to hedge interest rate risk or by
hedge funds to place bets on the market.
Managers of alternatives can be quite secretive and at times even a bit
paranoid about disclosure. They routinely do not provide much information to their investors and, rather, expect investors to rely on incentives and

co-investment to align interests rather than active monitoring of positions.
Some institutions struggle with the limited transparency that many alternative investments offer. Managers are also terribly afraid of their strategies
being leaked and replicated if they provide too many details.

Hedge Fund Characteristics and Structures
Hedge funds use a wide range of legal entities and domiciles to gather assets
from investors. Each entity is designed for a specific purpose and a specific
type of investor. Domestic funds in the United States tend to be organized
as limited partnerships or limited liability companies, and investors tend to
be individuals. Offshore funds are generally organized in tax or regulatory
advantaged locations such as Cayman Islands, Bermuda, Luxembourg, or
Ireland. These funds cater to certain types of U.S. not-for-profit investors
and international investors. Other structures, such as mutual funds, are designed for retail investors or institutions who want more regulation and
surveillance of the structures offered. Regardless of the structure used, each
fund must also appoint a manager to make decisions and run the day-to-day
operations, either as the general partner or under a contract established by
the fund board between the fund and the manager.

Strutures and Domiciles
A hedge fund is a specific type of alternative investment. It is a legal entity,
not an asset class per se. Generally, hedge funds are commingled vehicles
that allow many investors who qualify to be aggregated and invested as
a single pool of capital. A hedge fund is generally lightly regulated and
combines leverage, short selling, and derivatives with active security selection, macro views, and advance portfolio construction methods to generate
returns and manage risk.


8

Overview

Traditionally, hedge funds were limited in the structures they used to
gather assets. They were generally organized as either onshore funds or offshore funds. Onshore funds are funds organized in the United States as either
partnerships or limited liability companies. Offshore funds are investment
companies organized outside the United States, typically in a tax haven such
as the Cayman Islands or Luxembourg. Today, hedge fund strategies are
also available to retail investors and are offered as mutual funds or UCITS
(Undertakings for Collective Investing in Tradable Securities) products.
Onshore funds are U.S. entities that are formed as limited partnerships (LP) or limited liability companies (LLC). Onshore funds are typically
formed in Delaware and managed by a general partner (GP). The managing member or manager typically manages an LLC. Investors in an LP are
limited partners, and investors in an LLC are simply members. The GP or
managing members are responsible for portfolio trading and take actions
on behalf of the fund.
Offshore funds are most typically offered to qualified U.S. taxable
investors or investors located outside the United States. The vehicle used
is normally a listed portfolio company. Funds are typically formed in
jurisdictions that do not impose tax on fund income (e.g., Cayman Islands,
Bermuda, British Virgin Islands). A board of directors is required to govern
the company and appoint a professional investment manager to manage the
portfolio. The manager is responsible for portfolio trading and takes actions
on behalf of the fund.
Mutual funds are a type of U.S. investment company created under
the Investment Company Act of 1940. Mutual funds are collective investment vehicles investing in a wide array of products and instruments. An
investment manager, who is generally also registered with the Securities
and Exchange Commission (SEC), is appointed to manage the portfolio on
behalf of the fund. Mutual funds also have a board of directors to govern
the fund and appoint service providers. Mutual funds are subject to a higher
level of regulatory oversight than onshore or offshore funds, and, in most
cases, diversification, leverage, short selling, and liquidity restrictions are
imposed on the fund.

UCITS funds are similar to mutual funds. They are highly regulated
collective investments that can be offered to either institutional or retail
investors in Europe and elsewhere.

Management Company Responsibility and Organizational Design
A hedge fund manager is the company, individual, or partnership that is
empowered by the fund to manage its investments and bind the fund to
legal obligations. Figure 1.1 shows the position of the hedge fund man-


9

The Basics of Hedge Fund Investing  

Fund A
Onshore
L.P.

Attorneys
Auditors

Management
Company or
Gernal Partner

Brokers
Prime Brokers
Banks
Exchanges

Mutual
Funds or
UCITS

Fund B
Offshore
Company

Figure 1.1  Position of the Hedge Fund Management Company

ager or general partner at the center of all decision making, transactions,
and business relationships. Under certain circumstances, particularly with
offshore funds and mutual funds, a board of directors or group of advisors
also has the authority to commit the fund to contracts or make decisions on
behalf of the fund. In most cases, these decisions, if retained by a board, are
in practice delegated to the manager and reviewed by the board or advisors.
The fund manager is the entity that has staff, occupies space, pays bills,
buys and sells stocks, and manages risk. The fund owns the securities purchased and any liabilities in the form of loans, borrowed shares, derivative
obligations, or payables created on its behalf as a result of manager actions
or omissions.
Funds can be formed in a number of U.S. and offshore jurisdictions.
Common U.S. jurisdictions include Delaware and New York. Common offshore jurisdictions include the Cayman Islands, Ireland, the British Virgin
Islands, and Luxembourg. The primary purposes of the offshore fund are
to solicit international investors, create eligibility for certain investments
whose sale is prohibited or restricted in the United States, and facilitate
the needs of U.S. tax-exempt investors. Most funds create both a domestic onshore fund and an offshore fund when they launch to broaden their
appeal and accessibility to the widest range of investors possible. Retail
mutual funds or UCITS funds normally do not get established until after

10

Overview

the manager has been in operation for a year or more and has established
a track record.
The management company organizes the initial setup of the business
and runs each fund investment vehicle under its domain on a day-to-day
basis. The management company usually includes many people and teams
responsible for executing trades, designing the portfolio, performing research,
and managing risk, in addition to those needed to run operations and accounting, market the firm, and offer the funds to investors.
Hedge fund management companies share a number of common
organization design features; however, the specific organization of any
management company is highly variable and dependent on its size, age,
strategy, jurisdiction, and product mix and the personality of the founding partner. A fund manager who launches with $50 to $100 million in
a single fund would require at least three to five people to manage and
run the business effectively today. The days of launching a fund with the
proverbial “two men and a dog” and later becoming highly successful are
no more. A management company responsible for managing one strategy
and two funds (onshore and offshore) with similar or identical mandates
and $500 million to $5 billion in assets could operate out of a single location or office and might only need to employ 10 to 20 people to run the
business, build effective internal controls, and provide reporting to investors. A fund that managed more than $5 billion would most likely employ
over 100 people and operate in multiple offices and locations around
the world with a well-defined business model and diverse functional
responsibilities.
A private fund manager in the United States may be required to register
with the SEC, depending on the assets under management (AUM) of the
organization. The rules today require managers to register with the SEC
if they manage more than $150 million in assets. Managers with lesser
amounts may be required to register with their state authorities under

certain conditions.
A fund that is managed by a specific fund manager and offered for
sale may also be exempt from registration as a security under the 1933
and 1934 Acts if the fund is limited to fewer than 99 investors under safe
harbor rule c3-1 or is limited to fewer than 499 investors under safe harbor
rule c3-7 and if the investors meet certain qualifications based on income
and net worth tests. This allows the funds to be classified as private placements rather than as public securities, which have to follow more onerous
regulatory specifications and restrictions similar to mutual funds. Historically, private funds could not be advertised and sales were limited to known
investors. The JOBS Act, signed in 2012, has provisions that allow managers


The Basics of Hedge Fund Investing  

11

of private funds to use more advertising and promotions, although few
hedge funds have taken advantage of these provisions.
All mutual fund managers, including those using hedge fund strategies,
are required to register with the SEC, and all mutual funds must comply
with the provisions of the Investment Company Act of 1940.
Typically, the general partner or management company hired to run
a fund by the fund’s board is wholly owned by the founder or senior
partners of the firm. The general partner or management company employs the functional experts such as the portfolio manager, trader, director of research, treasurer, risk manager, COO, CFO, CCO, controller,
head of information technology, head of human resources, and head of
operations. Each department head would employ analysts and staff to
support each function. Most organizations are relatively flat, with many
direct reporting lines to the general partner, who is usually also the firm’s
CIO. The management company earns a fee from the fund for carrying
out its responsibilities.
The specific roles and responsibilities of each individual supporting a

fund vary from firm to firm and from strategy to strategy; however, most
funds seek to establish a critical mass by filling certain roles needed to
launch and grow the business in a controlled fashion. Without this critical
mass, it is difficult for investors to take the fund seriously. When evaluating
a fund, it is critical to note whether the following positions are in place, and
if not, to ask why.
A general partner or owner of the management company, who is usually the firm’s founder and sole equity owner. The GP may also be
the CIO and the CEO of the firm. This is usually the case in funds
below $1 billion in AUM.
A portfolio manager, who is generally a partner or highly paid professional who manages a portion of the portfolio or a particular
sector or strategy of the fund and works directly with the CIO in
allocating capital and generating ideas.
A director of research, who is usually a senior professional or partner
responsible for economic, industry, or quantitative research to
support the idea generation process and capital allocation among
various opportunities.
A head trader, who is responsible for efficiently and cost-effectively
executing trades, based on instructions from the CIO, portfolio
managers, or CIO.


12

Overview

A risk manager, who is responsible for independently evaluating portfolio
risk and monitoring risk limits and policies of the fund designed to
mitigate losses.
A head of information technology, who is responsible for the firm’s
desktop, remote, and telephonic environment; the development

and maintenance of its software and hardware configuration; and
linkages to external service providers, brokers, and investors.
A COO, who is responsible for all non-investment-related activities and
the day-to-day running of the firm.
A CFO, who is responsible for the fund’s financial statements, tax
returns, and all record keeping related to both the fund and the
management company.
A Chief Compliance Officer, who is responsible for the design and effectiveness of the firm’s compliance program, employee training, and
regulatory reporting.
A head of operations, who is responsible for the day-to-day processing of securities purchases and sales, income collection or payment,
fund expenses, borrowing money, reinvesting cash, and reconciling
positions with traders, administrators, and brokers.
A general counsel, who is the primary legal officer of the firm and is
responsible for all internal and external legal matters, including the
fund’s offering documents and the firm’s relationships with outside
counsel.
A head of investor relations, who is responsible for sales and service of
the firm’s individual and institutional investors, as well as most of
the firm’s communications and reporting to investors.
A head of human resources or talent management, who is the person responsible for policies and procedures related to finding, onboarding,
and retaining talent at a firm.
A treasurer, who is the person responsible for managing the fund’s cash
flow, funding lines, credit facilities, and liquidity.
Figure 1.2 shows the typical roles and reporting lines for a well-established
hedge fund that is managing money on behalf of both high-net-worth individuals and institutional investors.
Although all these roles are certainly not essential on day one, most will
be added as the funds grow in size and complexity or as they attract more
institutional investors.

13

The Basics of Hedge Fund Investing  

General
Partner
Compliance
Legal

PM
Research

Treasury

Trading
and
Execution

COO
CFO
Controller
Head of
Operations

Risk
Management
and
Technology

Investor

Relations

Human
Resources

Individual Staff Members

Figure 1.2  Hedge Fund Organizational Model

Hedge Funds versus Mutual Funds
A mutual fund is a highly regulated investment vehicle managed by a professional investment manager. It aggregates smaller investors into larger pools
that create economies of scale and efficiency related to research, commissions, and diversification. Mutual funds have been available to investors in
a wide range of asset classes since the mid-1970s and became increasingly
popular in the 1980s and 1990s as a result of retail attention, product
deregulation, and solid returns. Mutual funds generally cannot use leverage or short selling and generally cannot use most derivatives. Collective
investment products originated in the Netherlands in the 18th century,
became popular in England and France, and first appeared in the United
States in the 1890s. The creation of the Massachusetts Investors’ Trust in
Boston heralded the arrival of the modern mutual fund in 1924. The fund
went public in 1928, eventually spawning the mutual fund firm known
today as MFS Investment Management. State Street Investors started its
mutual fund product line in 1924 under the stewardship of Richard Paine,
Richard Saltonstall, and Paul Cabot. In 1928, Scudder, Stevens, and Clark
launched the first no-load fund.
The creation of the Securities and Exchange Commission and the passage
of the Securities Act of 1933 and 1934 provided safeguards to protect investors in mutual funds. Mutual funds were required to register with the SEC
and provide disclosure in the form of a prospectus. The Investment Company
Act of 1940 put in place additional regulations that required more disclosures