The hedge fund book a training manual for professionals and capital raising executives

Additional Praise for The Hedge Fund Book
“Those new to the hedge fund industry will benefit immensely from the
chapter devoted to answering frequently asked question about hedge funds
as well as the easy-to-understand explanations of all major areas of hedge
funds throughout the book. Experienced hedge fund professionals reading
this book will also gain valuable insight from other managers and service
providers on current issues facing hedge funds. Whether you are looking
to raise more capital, improve your fund’s operations and due diligence,
launch a new hedge fund, or just learn more about hedge funds, this book
is a must-read.”
—Theo O’Brien, Associate, Private Equity Investment Group
“Richard’s new book is a terrific testament to the knowledge that he and
his team have of the hedge fund industry. From novice to expert hedgers, I
recommend this training manual. Its information makes for a sharp, timely
evaluation of where hedge funds are and where they are likely to be heading.”
—Thomas J. Powell, CEO, ELP Capital Advisers, Inc; Author, Standing in
the Rain: Understanding, Surviving and Thriving in the Worst Financial
Storm since the Great Depression.
“Richard Wilson is the best single source for practical answers on the hedge
fund industry. For people new to the industry or considering launching their
own fund, look no further. You’ll find it all here.”
—Richard Zahm, Portfolio Manager, Second Angel Fund I
“This book caters to hedge fund aspirants as well as finance professionals.
Richard does a wonderful job of demystifying any misconceptions that the
hedge fund industry faces today. Through a combination of interviews with
industry professionals, a top down approach to both the basic and more
complex nuances of running a hedge fund and colorful examples of the
industry, Richard has been able to achieve what so many other hedge fund
books aspire to. To capture the reader in both an enjoyable and informative
book that will soon become a standard in the finance education industry.”
—Curtis Birchall, Longbow Capital, Inc.

“The Hedge Fund Book provides an “inside baseball” look at the hedge
fund industry and should be required reading for someone looking to get
into the business.”
—Scott Freund, Senior Family Wealth Advisor, GCC Family
Wealth Management


“I wish this book had been around when we got started. This piece accelerates the ramping up period for hedge fund management company founders
and executives. Most people think that to have a hedge fund all you need is
a good trader and a Bloomberg terminal. They are shocked when they learn
what it really takes to be successful. This book does a phenomenal job of
explaining and exploring these keys to success.”
—Pratik Sharma, Hedge Fund Manager
“The Hedge Fund Book is one of the few books that specifically address
the “business” of hedge funds. Make no mistake, running a hedge fund
is a business just like any brick and mortar store that requires attention
to operations, sales and marketing, compliance, etc. as well as investment
returns. Now more then ever, institutional investors are placing an emphasis
on back/middle office functions. The Hedge Fund Book offers practical
insight and advice from seasoned professionals on these overlooked aspects
of a hedge fund business.”
—Nakul Nayyar, U.S. Long/Short Hedge Fund Trader
“The Hedge Fund Book: A Training Manual for Professional and Capital
Raising Executives by Richard Wilson is an excellent guide for established
and developing hedge fund managers, and can be used as a point of reference
in the administration of best practices of hedge funds and investor relations.”
—Valerie Emanuel, President, Valerie Emanuel & Associates


The Hedge

Fund Book
A Training Manual
for Professionals and
Capital-Raising Executives

RICHARD C. WILSON

John Wiley & Sons, Inc.


Copyright

C

2010 by Richard C. Wilson. 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, or online at />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 for 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:
Wilson, Richard C.
The hedge fund book : a training manual for professionals and capital-raising executives /
Richard Wilson.
p. cm. – (Wiley finance series)
Includes index.
ISBN 978-0-470-52063-5 (cloth)
1. Hedge funds. I. Title.
HG4530.W546 2010
332.64 524–dc22
2010003434
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1


This book is dedicated to my wife, Adriana Wilson, for being
a wonderful person and a constant balancing force in my life.
Despite my passion for business and marketing, the Brazilian
in her makes sure that on some level I work

to live and not live to work.


Contents

Preface
My Story
Disclosure of Financial Interests

Acknowledgments
Introduction
CHAPTER 1
Hedge Fund Fundamentals
Hedge Fund Mechanics and Statistics
History of Hedge Funds
Media Portrayal of Hedge Funds
Hedge Fund Ecosystem
Future of the Hedge Fund Industry
Chapter Summary
Review Questions

CHAPTER 2
Institutionalization and Operations
Stephen Abrahams, Vice President of Marketing for a
London-Based Hedge Fund
Bob Pardo, CEO and President, Pardo Capital Limited
Vinod Paul, Managing Director of Service and Business
Development, Eze Castle Integration
Nakul Nayyar, Quantitative Trading/Support, Quad Capital
Hendrik Klein, CEO, Da Vinci Invest Ltd.

Sheri Kanesaka, Associate, Michelman & Robinson, LLP
Eric Warshal, CEO, Fund Associates
Lance Baraker and William Katts, Senior Managing
Directors, TradeStation Prime
Chapter Summary
Review Questions

xi
xii
xiii

xv
1
5
6
8
9
10
13
13
14

17
18
19
21
24
26
29
30

32
36
36

vii


viii

CONTENTS

CHAPTER 3
Hedge Fund Marketing Pro
Bad News
Public Relations Management
Educational Marketing
Forget about Contacting More Investors
E-Mail Marketing Best Practices
Copy Writing
Case Profile
Stephen Abrahams, Vice President of Marketing for a
London-Based Hedge Fund
Pratik Sharma, Managing Director, Atyant Capital
Hendrik Klein, CEO, Da Vinci Invest Ltd.
Chapter Summary
Review Questions

CHAPTER 4
The Shooting Star
18 Lessons from Shooting Star Hedge Funds

Rick Nummi, Partner and General Counsel,
Accounting and Compliance International (ACI)
Thomas Powell, Chief Executive Officer, ELP Capital
Chapter Summary
Review Questions

CHAPTER 5
Hedge Fund Start-Up Guru
Top Five Tips for Starting a Hedge Fund
Hedge Fund Pitch Book Creation
Syed Ali, CEO, Saturn Partners, LLC
Nakul Nayyar, Quantitative Trading/Support, Quad Capital
Chapter Summary
Review Questions

CHAPTER 6
Dedicated to Due Diligence
Scott Freund, President, GCC Family Wealth Management
Brian Reich, President and Founder, Atrato Advisors LLC
Richard Wilson, Hedge Fund Group, CHP
Designation, HedgeFundBlogger.com
Due Diligence Effects on Hedge Funds

39
40
41
42
43
45
49

50
54
55
59
60
61

63
63
65
72
74
74

77
78
80
81
86
89
90

93
94
95
98
102


Contents

Chapter Summary
Review Questions

CHAPTER 7
Giant Hedge Funds
Best Practices from $1 Billion-Plus Hedge Funds
Richard Zahm, Portfolio Manager, Second Angel Fund
Scott Cohen, President and CEO, Hedge Solutions
Chapter Summary
Review Questions

CHAPTER 8
Governance Best Practices
Andrew Main, Managing Partner, Stratton Street
Capital LLP
David R. Koenig, CEO of the Governance Fund, LLC
Chapter Summary
Review Questions

ix
105
106

109
109
111
117
119
120

123
124
130
134
134

CHAPTER 9
Frequently Asked Hedge Fund Questions

137

Hedge Funds 101
Hedge Fund Operations
Hedge Fund Marketing and Sales
Hedge Fund Careers

137
139
142
156

APPENDIX A
Bonuses of $1,779
APPENDIX B
Example Due Diligence Questions
Questionnaire

169
171

171

APPENDIX C
Top Hedge Fund Web Sites

177

Glossary

179

About the Author

185

Index

187

Contact the Author

191


Preface

his book was created as a training manual for professionals who work
in the hedge fund industry or who would like to work more closely with
hedge funds as clients or business partners. Over the past seven years I have
read most of the hedge fund books that are available. There are great books

on hedge fund investment strategies, the history of hedge funds, financial
modeling, and risk management. I never could find a book, though, that
provided unfiltered advice, insights, and hard lessons learned from hedge
fund managers. This gap in the marketplace and the growing needs of our
Certified Hedge Fund Professional (CHP) Designation program is what led
to this book being created.
Within this book, I hope that every reader will learn:

T

How hedge fund managers of any hedge fund may increase their operational effectiveness immediately.
Why most hedge fund managers struggle to raise capital, and how being
proactive within the right areas can allow a small team to raise a large
amount of capital.
How to implement governance best practices that will improve investor
confidence, enhance decision-making processes, and decrease the risk of
some types of fraud.
How to emulate the best practices of $1 billion-plus giant hedge funds
that have learned many lessons the hard way.
Why what you read about hedge funds in the general media is off-base
80 percent of the time.
How to double the effectiveness of your capital-raising efforts by focusing on your unique process and positioning more than on your numbers.
How small to medium-size hedge funds in the real world are improving
their business structure and processes without spending millions on
infrastructure.
The intended audience for this book includes CHP Designation participants, hedge fund managers, professors, traders, third-party marketers,
students, service providers, investors, and consultants. The book provides

xi

xii

PREFACE

a fundamental understanding of how hedge funds operate at a high level,
while also taking the reader down to very granular, real-world steps that
hedge fund managers can take to improve how they manage risk, operate,
select service providers, govern their own organization, and raise capital.
This text should help readers shortcut the process of interviewing 30 hedge
fund managers and veterans, by providing their advice, tips, strategies, and
painful lessons learned here within one concise book. If you add up all
the time of the managers and consultants who were involved within these
interviews, the book contains over $80,500 worth of advice yet costs less
than $75.
In addition to the chapters of the book that focus on niche subjects
such as institutionalization, capital raising, governance, or best practices of
$1 billion-plus hedge funds, this book contains multimedia resources that
should help the reader comprehend and absorb the advice provided herein.
We have created over 50 video and audio resources, which you will see
referenced through this book. These may be used to supplement university
course lectures or sent to team members who may also want to learn more
about hedge funds and how they operate. To access these resources, please
visit HedgeFundTraining.com.

MY STORY
To provide some background as to why this book was written, here’s a short
explanation of how I entered the hedge fund industry. My first experience in
working with hedge funds was in 2001 when I completed an internship for
a currency/commodity-based hedge fund in Europe. I helped them complete

leading-indicator trading research on the currencies and commodities of
Japan, New Zealand, and Australia and analyzed the relationships between
them.
After completing this work, I started learning more about marketing
and sales and found myself drawn more to finding out how to raise capital
and connect with investors. This led me to independently negotiate and sign
contracts to raise capital for a boutique investment bank in New York and
one of the early fund of hedge funds groups based out of South Africa.
I helped them raise capital by identifying potential institutional investors,
completing market research, and reaching out to investors.
After working within this area while also consulting within the area of
risk management for three years, I took a position with a third-party marketing firm. This firm raised capital for three to five fund clients at a time, and
I was in charge of completing the hands-on marketing of three clients: an
$80 billion long-only portfolio optimization firm, a $30 million U.S. hedge


Preface

xiii

fund manager, and an $800 million global macro hedge fund manager. This
unique set of clients and my responsibilities of researching new potential investors, building organic investor databases, e-mailing investors, completing
educational marketing, calling investors, working conferences, and creating
marketing materials taught me a lot about how things should and should
not be done. In this role I raised a depressing $0 the first 11 months, and
then started raising $100,000 a week. Eventually, after 18 months, raising
a minimum of $1 million to $3 million a week.
While marketing these funds, I found that due to the fragmented structure of the industry, most fund marketers simply follow their competitors’
strategies. In addition, most have few resources to leverage, focus little on
positioning, complete no capital-raising training, and ignore the power of

writing strong copy and using educational approaches to marketing to investors. At the same time, my online networking association, the Hedge
Fund Group, grew to over 30,000 members and my blog, HedgeFundBlogger.com, was taking off and quickly became the number one most widely
visited web site on hedge funds.
I decided to fly solo and start my own firm in 2008. We now run three
main product and service lines:
1. Our training programs such as the CHP Designation, Hedge Fund
Startup Kit, and Hedge Fund Marketing Mechanics hedge funds
2. Our blog network on hedge funds, private equity, mutual funds, alternative investments and capital raising where we provide over 5,000
original articles, videos, and interviews
3. Our capital-raising tools and investor databases, which have now been
used by over 1,600 fund managers and include HedgeFundDirectoryPro.
com, HedgeFundInvestorDirectory.com, PrivateEquityDirectory.com,
Investor Databases.com, and CapitalRaiserPro.com
Our firm and team are small but growing. We have a total of 25 full- and
part-time employees and contractors now who help us offer and constantly
update the CHP Designation, blogs, and these capital-raising tools.

DISCLOSURE OF FINANCIAL INTERESTS
In the spirit of transparency and full disclosure which I recommend within
this text, I think it is only appropriate to disclose my own interests. I was
only able to write this book based on my current relationships, consulting
projects, capital-raising experience, and services that my firm offers. Because
of this, there are overlaps between examples in this book and my own


xiv

PREFACE

clients and products. For example, I have asked my closest circle of 30 or

so clients to review my book for feedback or a quote. Also, three out of the
25 professionals I interviewed within this book have used my consulting
services in the past, and my firm has financial interests and/or ownership
in the following web sites and resources mentioned within the rest of this
book: CHP Designation (HedgeFundCertification.com), InvestorDatabases
.com, HedgeFundInvestorDirectory.com, PrimeBrokerageGuide.com, Third
PartyMarketing.com, HedgeFundBlogger.com, HedgeFundStartupGuru
.com, ThirdPartyMarketing.com, HedgeFundsBook.com, HedgeFund
Premium.com, and FamilyOfficesDatabase.com. My hope is that the over
250 hours of consulting advice and over 50 video modules within this book
are worth far more than any distraction by the handful of mentions of the
web sites or services that we provide.


Acknowledgments

hank you to my father, Thomas Wilson, for pushing me to write my
first “real book” based on the consulting, marketing, and writing I have
already done. Thank you to my wife, Adriana, for patiently supporting me
in everything we have been aiming to accomplish. Thank you to Jonathan
King, who woke me up and spurred me to stop floating through business, to
take control of where I was headed, and to work toward something greater
than average.
Also, a quick thank-you to someone who is probably too busy to ever
read this sentence: Jeffrey Gitomer. If it were not for the inspiration obtained
through his writing, I would have never learned to kick my own or started a
blog, newsletter, or book. My constant push to give away more writing and
free educational materials can be attributed directly to Gitomer.
Above all else, thank you to the more than 900,000 professionals who
have e-mailed our team, downloaded our free hedge fund blog book, completed our CHP Designation hedge fund training program, and used our

capital, raising resources. Your support, loyalty, and feedback are what
drove me to publish this text, and have been the source of ideas for every
product and service we offer. Thank you for sharing your time and thoughts
with me.

T

xv


The Hedge Fund Book: A Training Manual for
Professionals and Capital-Raising Executives
by Richard C. Wilson
Copyright © 2010 Richard C. Wilson

Introduction

hat if you sat down with 30 hedge fund veterans and picked their brains?
What if you spent over $80,000 hiring professionals with seven to
30 or more years of experience to provide you their insights on what is
developing in the hedge fund industry, and what is important now?
This is the premise on which I constructed The Hedge Fund Book:
A Training Manual for Professionals and Capital-Raising Executives.
This book is a discussion, a captured forum, not a dissertation, letter to
Congress, or formal legal document. You will find less formality here than
in most books, because that is how I am used to writing and transferring
knowledge through speeches, e-mails, and blog posts. Some may appreciate
this approach and form of communication; others will surely not.
The Hedge Fund Book: A Training Manual for Professionals and
Capital-Raising Executives will provide many benefits to those seeking to

understand and work in this field. Our team at the Hedge Fund Group has
raised millions of dollars of capital for hedge funds and personally worked
with over 1,000 fund managers over the past several years. In the past we
have freely shared our knowledge through our blogs, which you may still
access today. They include:

W

HedgeFundBlogger.com
HedgeFundsCareer.com
ThirdPartyMarketing.com
FamilyOfficesGroup.com
HedgeFundStartupGuru.com
CommoditiesAndFuturesGuide.com
PrimeBrokerageGuide.com
PrivateEquityBlogger.com
In addition to the more than 10,000 articles provided in these blogs,
our free e-book has also been downloaded more than 100,000 times. These
articles and resources were given away freely to develop relationships with
those who found value in the resources.
In an effort to now make this book worth more than the retail price, we
include many diverse types of educational resources including case studies,

1


2

THE HEDGE FUND BOOK

examples, interviews, best practices, review questions, and video resources
to help readers learn more about hedge funds. These interviews and videos
were produced by hedge fund principals and consultants who normally
either do not provide such advice or typically charge $200 to $475 per hour
for their time. My hope is that the value of these additional resources alone
will be worth more than what you paid to obtain this book. If you add up
the 250-plus hours that went into putting this book together with all of the
experienced professionals we interviewed, there is more than $80,500 worth
of advice contained in this text. Here are some more details on the different
resources included in this text and how they operate:
Interviews. Over 20 interviews complete this training manual for the
hedge fund industry, including many of the full transcripts in this text.
The advice comes directly from numerous veterans in the industry, so
individual readers do not need to interview all of them directly.
Video resources. We have also created a series of over 40 video resources
which act as a supplement to this training manual. Throughout this book
there are references to specific video resources, and the complete list of
videos available may be seen at />Frequently asked questions. Our team at the Hedge Fund Group has
received and sent over 800,000 e-mails since our firm was started in
2007. We have received thousands of e-mails on capital raising, starting
a hedge fund, institutionalization, and hedge fund careers. I have used
about 40 of the most frequent of these questions to create Chapter 9 of
this book. Some professionals may find this resource more valuable than
the rest of the chapter-by-chapter instruction and interview content.
Why important. Each chapter begins with a short section on why the
chapter is critical to the health and growth of the hedge fund as a
business. This provision guides the reader as to which chapters will be
most relevant to his particular career or business.
Chapter review questions. Each chapter concludes with several review
questions for those professors and trainers who have agreed to use this

manual as part of their university course. These will also be helpful
for those who are completing the hedge fund training and certification
program referred to in this text as the Certified Hedge Fund Professional
(CHP) Designation Program (www.HedgeFundCertification.com).
I recently participated in a training session with Eben Pagan in Los
Angeles at a marketing conference on how business is typically conducted.
He told an interesting story. Eben spoke about how the streets in Boston
are actually old cow paths that the city decided to just pave over to create
the roads of the city. The result is a very complicated maze of one-way


Introduction

3

streets that really only make sense to the most veteran cab drivers. This
is not the cows’ fault. They simply walked typically in the direction of
least resistance. Nobody stepped back and looked at where the cows had
wandered and asked if there was a better way to get the project done—they
simply followed where cows had walked in the past.
Eben’s point in telling this story was that in every business, every form
of marketing, and even in the hedge fund business, there are cow paths
everywhere. The question is whether you and your business are wandering
around on the cow paths of what others have done in the past, or building
a super highway straight toward your goal.
Areas to examine for hedge fund managers could include hiring, capital raising, employee management, performance reporting, transparency,
governance, and investor relations. It helps to step back and look at competitors, other industries, and steps needed to complete the work we are
trying to complete, to see if there is a more direct or efficient way of fully
accomplishing it.

BONUS VIDEO MODULE
To watch a video on hedge fund cow paths, please type this URL into
your Web browser: />

The Hedge Fund Book: A Training Manual for
Professionals and Capital-Raising Executives
by Richard C. Wilson
Copyright © 2010 Richard C. Wilson

CHAPTER

1

Hedge Fund Fundamentals
Training is everything. The peach was once a bitter almond;
cauliflower is nothing but cabbage with a college education.
—Mark Twain

his chapter provides a brief 20,000-foot-view introduction to hedge funds
and provides a context for the content of this book. In this chapter I briefly
cover the history of hedge funds, important definitions, the hedge fund
ecosystem, media portrayal of hedge funds, five industry trends, regulations,
and the future of hedge funds.
Why important: This chapter is the foundation for the rest of this book.
If you have more than five years of industry experience, you may want to
skim this chapter and skip to the chapter review questions to check your
level of industry knowledge.
What this chapter is not: This book is not a thorough review of hedge
fund investment strategies or analytics; those topics are already covered in
dozens of other texts, including two that are required in the Certified Hedge

Fund Professional (CHP) Designation Program. See these required books
and other recommendations at HedgeFundBookstore.com.
What is a hedge fund? The one-sentence definition of a hedge fund is
“a private investment vehicle that charges its investors two types of fees: a
management fee and a performance fee.” Any more specific definition will
lead to conflicts in the industry today, as it has grown in many directions.
The management fee is a standard fee based on total assets under management and it typically runs between 1 and 2 percent. The second type of fee
typically charged by hedge funds is a performance fee; typically this is 10 to
20 percent and is charged based on the performance achieved by the fund.
If a hedge fund has 10 percent positive performance for a single year and its
performance fee is 20 percent, the hedge fund’s management would get to

T

5


6

THE HEDGE FUND BOOK

keep 2 percent of that 10 percent gain as part of their profits, a reward for
achieving these positive returns for their investors.

BONUS VIDEO MODULE
Watch a video explaining what a hedge fund is and is not, here:
HedgeFundTraining.com/What-is-a-Hedge-Fund?

HEDGE FUND MECHANICS AND STATISTICS
It is important to know that while these fee figures just mentioned are typical,

the hedge fund industry has become competitive and diverse. There are now
hedge funds operating that charge a 0 percent management fee while others
charge 3 percent. Wide variations in performance fee levels may also be
seen. One important aspect of this dual-level fee structure is the incentive
it sets in place for hedge fund managers. While many hedge fund managers
have already invested their own assets in the portfolio they are managing,
remunerating the managers based on positive performance and not just total
assets under management rewards those who can achieve consistent yearafter-year gains. This in turn leads to rich compensation for those who can
outperform the majority, and it attracts the best of talent to the industry. A
portfolio manager can potentially earn two to three times as much working
for a hedge fund as he could working for a similar size mutual fund or
long-only optimization firm.
Investments made in hedge funds are typically seen as medium to long
term for several reasons. The main reason is liquidity. Most hedge funds
have lock-up periods of one to two years, and many restrict redemptions
for as long as three years after the initial investment is made. A lock-up
period simply means that the investor may not redeem his invested funds
until this period has expired. These lock-up periods are put into place so
that the hedge fund may invest in various assets and will have more control
and flexibility in the timing of its purchasing and selling of these assets over
time. Without lock-up periods, a manager may make a long-term investment
in a security, for example, and a new investor could come and request his
assets back during a weak point in the markets, forcing the manager to sell
the security at a loss to meet that redemption request. While lock-up periods
help managers in running their funds, they are seen as a major concern and
drawback by institutions and high net worth (HNW) investors. While this


Hedge Fund Fundamentals

7

book does not cover hedge fund replication or publicly traded hedge funds,
these are two areas worth additional research if this topic is of interest to
the reader.
There are between 100,000 and 150,000 professionals who work
directly within the hedge fund industry and another 1,000,000-plus professionals who work with hedge funds in some way, indirectly or as part of
a broader platform of services. There are between 10,000 and 25,000 hedge
funds in existence today, depending on whose statistics and databases you
trust most, and new funds are launched daily. The average hedge fund has
just around $40 million in assets under management (AUM), while many
start with just $500,000 to $5 million, and a larger group runs over $1 billion
in assets.

BONUS VIDEO MODULE
To watch a video on hedge fund liquidity and lock-up periods, please
type this URL into your Web browser: />Liquidity

Additional Common Hedge Fund Terms
Hurdle rate: A hurdle rate is a set performance figure that must
be achieved before any performance fees will be calculated or paid
to the hedge fund manager. For example, a hedge fund may have its
hurdle rate set at 3 percent so that any performance above 3 percent
will be considered outperformance. Hurdle rates avoid having investors
pay high fees for low-single-digit portfolio performance.

BONUS VIDEO MODULE
To watch a video on the definition of a hurdle rate, please type this
URL into your Web browser: />
High-water mark: A high-water mark is a tool by which hedge fund

managers can assure investors that they will not be charged performance


8

THE HEDGE FUND BOOK

fees after portfolio losses until the fund has made up those past losses.
In other words, if a hedge fund manager has a loss of 5 percent in
one year, he may not be paid any performance fees in the following
year until he has first regained that loss, restoring the fund to the highwater mark point. Again, the high-water mark protects investors from
paying the performance fee until the manager has made up the ground
he previously lost in the portfolio.

BONUS VIDEO MODULE
To watch a video on the definition of a high-water mark, please
type this URL into your Web browser: />High

Gating clause: A gating clause allows a hedge fund manager, under
certain circumstances, to restrict or completely cut off redemptions from
the portfolio due to market illiquidity or specific sets of circumstances
set forth in the contract. This term has been highly debated recently due
to hundreds of funds “closing the gate” or enacting this clause in their
agreements with investors.
For more definitions, please see the Glossary at the back of this book.

HISTORY OF HEDGE FUNDS
Financial journalist, author, and sociologist Alfred W. Jones started the first
hedge fund in 1949 while working for Fortune. The fund was started on the
belief that the movements of individual securities were due to both the performance of that specific security and the performance of the broader markets. His strategy was to address this by investing in securities that seemed

to be positioned to outperform the market, while shorting (see Glossary) or
selling those securities that seemed likely to underperform the market. The
goal was to neutralize or cancel out market risk by allowing the portfolio
to hedge against negative market movements. This is how the first hedge
fund was created. This idea was unique in that it was designed to do well,
or at least relatively well, during volatile or even bear market conditions.
This new method of managing portfolios of equities started becoming
popular in the 1960s, and by the 1970s there were over 150 hedge funds


Hedge Fund Fundamentals

9

in existence managing close to $1 billion in assets. Some early hedge fund
managers were Warren Buffett, Michael Steinhardt, and George Soros. Since
then hedge funds have evolved to include commodities, bonds, real estate,
and other types of assets.
Over time, the term hedge fund took on the broader definition of a general private investment partnership, which typically includes management
and performance fees as the only common denominator. Even this definition is now becoming dated as more hedge funds and firms that run hedge
funds become publicly traded companies. Hedge funds are hard to understand as a whole because they are diverse and somewhat secretive. Hedge
funds are secretive because of strict advertising and public offering rules
as well as to keep their investment process, trading strategy, and positions
from their competition. The hedge fund industry is very competitive and
entrepreneurial.

BONUS VIDEO MODULE
To watch a video on the history of the hedge fund industry, please
type this URL into your Web browser: />History

MEDIA PORTRAYAL OF HEDGE FUNDS
Along the way there have been hedge fund blowups (that have had performance dives and made public headlines), fraud cases, insider trading, and
misreporting. While the whole idea of what a hedge fund does has been
growing, public knowledge of these vehicles is still relatively limited and
misunderstood, and hedge funds are often in the bottom 1 percent of the industry in terms of ethics or performance that makes the headlines each day.
Hedge funds are now mentioned in thousands of magazines and newspapers
each month.
There are often misconceptions formed about hedge funds, which are
largely caused by reading mainstream news sources on the topic. Here are
the top three misconceptions caused by the media:
1. Hedge funds are large multibillion-dollar investment vehicles that can
destroy companies. Reality: While the largest of hedge funds do control


10

THE HEDGE FUND BOOK

a large share of total assets under management, the industry is actually
made up of mostly $1 million to $200 million size hedge fund managers.
2. Hedge funds are not regulated. Reality: Many hedge funds are already
regulated at the asset level based on what they are investing in.
3. Hedge funds are always committing fraud and blowing up their funds.
Reality: Less than 0.1 percent of the industry is ever accused of any
fraud claims, and a 2006 study by Capco shows that over half of all
hedge fund failures are actually due to operational business reasons and
not performance-related issues.

BONUS VIDEO MODULE
To watch a video called “Media Portrayal of Hedge Funds:

Misconceptions and Myths,” please type this URL into your Web
browser: />
HEDGE FUND ECOSYSTEM
Hedge fund managers do not work in a vacuum where they coordinate
directly with investors and receive no assistance from outside parties. Most
hedge fund managers work with at least three of the five types of service
providers shown in Figure 1.1.
It is important to know the function of each of these parties to understand how hedge funds operate, and how they invest and control their
assets. Here are definitions and explanations for each of these service
provider types:
1. Prime brokerage. Prime brokers provide a package of services typically within the largest business of an investment bank. The following
services are sometimes offered by prime brokers: custody, securities
lending, financing, customized technology, operational support, capital
introduction, and other trading-related services.
2. Fund administration. Fund administration firms provide support and
operational services to hedge fund managers. These services may include accounting services, operational/finance services, settlement of
daily trades, calculation and payment of distributions, and payment
of fund expenses.


11

Hedge Fund Fundamentals

Prime
Brokerage

Fund
Administration

Auditing

Hedge Fund
Manager

Legal and
Compliance

Third Party
Marketing

FIGURE 1.1 Types of Service Providers Used by Hedge Funds
3. Third Party marketing. Third party marketing firms are independent
hedge fund marketing consultants who work to raise capital for two to
five or more hedge funds at any one point in time for a single source of
investors, or for multiple distribution channels. They typically require
some sort of retainer along with sharing of 20 percent of both the
management and performance fees while the funds raised stay invested.
4. Legal and compliance. Legal and compliance firms become more important every year within the hedge fund industry. Hedge funds use
law firms for complicated formation processes, ongoing business legal
considerations, and ongoing compliance work as well.
5. Auditing. Auditing firms are used by hedge funds on a quarterly and
annual basis to verify their performance and accounting figures. Some
hedge funds use auditing firms for monthly checks or to prepare for an
annual audit as well.

BONUS VIDEO MODULE
To watch a video on the hedge fund ecosystem, please type this URL
into your Web browser: />

12

THE HEDGE FUND BOOK

Top Four Hedge Fund Industry Trends
Understanding the hedge fund industry requires knowing what is going on
now and also identifying current trends affecting how hedge funds operate,
invest, form, and trade. Following are the top four hedge fund industry
trends:
1. Recent poor absolute hedge fund performance and fraud has led to increasing pressure from investors for additional transparency and levels
of governance. This is being done to ensure that managers adhere to
their investment mandates, only restrict investor liquidity when necessary, and ensure that internal controls, checks, and responsibilities are
properly carried out. Independent administration firms and directors are
now required by many investors and boards of advisers.
2. The collapse of Lehman Brothers left some hedge funds in London without access to their assets, causing poor performance and in some cases
fund failures. Since this event, hedge funds with over $30 million in
assets have been investigating and implementing multi–prime brokerage models, rather than invite risk by working with one single prime
broker. In the past, prime brokerage firms would conduct due diligence on the soundness of their potential hedge fund clients. Now the
research is done in both directions, with hedge funds screening prime
brokers and vice versa. Some newcomers to the industry are now gaining strong market share because they are seen as a safe place to do
business.
3. The use of outside capital-raising resources, investor databases, and
third-party marketing firms is on the rise. The capital-raising environment is more competitive, and hedge fund managers are forced to evolve
their investor relationship cultivation systems, capital introduction resources, and investor contacts in order to compete.
4. Investors increasingly want to work with more institutional hedge fund
managers. This typically means hedge funds with over $100 million to
$250 million in assets under management. More specifically, it refers
to the types of operational processes, technology, risk management,
trading, and governance features that tend to be in place with funds
that have $1 billion in assets under management. This has always

been a challenge for emerging managers, who have limited access to
high-pedigree (well respected and accomplished) team members, investors comfortable with small fund managers, and many times even
the knowledge needed to create a more institutional-quality hedge fund
operation.


Hedge Fund Fundamentals

13

BONUS VIDEO MODULE
To watch a video on the top four hedge fund trends, please type this
URL into your Web browser: />
FUTURE OF THE HEDGE FUND INDUSTRY
During the financial crisis of 2008, many journalists wrote about the death
of hedge funds and how the industry was about to burn to the ground. This
was taken seriously by only a handful of professionals who actually worked
in the industry. The future of the hedge fund industry is actually bright due
to several short- and long-term factors.
The strongest argument for the strength of the hedge fund industry is the
constant innovation that occurs in this industry. Hedge funds are constantly
using new trading techniques, incorporating new asset classes, including
additional equity markets in their scope, and taking on new financing and
investing roles to expand their total market share. Most hedge funds on
the edge of innovation are small, hungry teams that are driven to succeed,
and they know that they will be rewarded handsomely for doing so. The
combination of relatively low barriers of entry and direct financial rewards
are a formula for continued growth and natural positive evolution of the
industry as a whole.

BONUS VIDEO MODULE
To watch a video on the future of the hedge fund industry, please see
/>
CHAPTER SUMMARY
Hedge funds have been growing rapidly over the past 20 years, and while
their growth is now slowing down, they are becoming more diverse and