THE TERM hedge fund has been used to describe both an investment structure—a commingled investment fund—and a strategy—a leveraged long portfolio “hedged” by stock short sales. However, because of the diverse range of investment approaches now employed, it more accurately describes the investment structure within which a hedge fund strategy is executed. For example, a convertible arbitrage hedge fund and a distressed securities hedge fund both operate in the same type of fund structure but follow two distinct strategies. Like the term mutual fund, which describes only the investment structure and does not indicate whether it invests in stocks or bonds or in the United States or abroad, the term hedge fund alone does not tell an investor anything about the underlying investment activities. A hedge fund acts as a vehicle, helping an investor get to the ultimate investment goal: to turn market opportunities into investment returns. In this respect, a hedge fund is no different from a mutual fund. Hedge funds differ from mutual funds in the range of allowable investment approaches, the goals of the strategies that they use, and in the breadth of tools and techniques available to investment managers to achieve those goals for investors. (It should be noted that this distinction is becoming blurred. Mutual fund regulatory changes have allowed certain hedge fund strategies to operate under the mutual fund structure.)

There is nothing mystical about the strategies that hedge fund managers use. These strategies can be described in the same terms as those for a traditional portfolio: return source, investment method, buy/sell process, market and instrument concentrations, and risk control. The alternative investment strategies that hedge fund managers tend to use produce returns by leveraging some kind of informational or strategic advantage. Essentially, although some hedge fund strategies are complex, hedge fund investing can be understood by anyone familiar with financial markets and instruments who also has a basic working knowledge of corporate structure and finance.

Hedge fund managers are more difficult to categorize than the various strategies of the funds they manage. Their diverse backgrounds often provide them with the specialized knowledge, expertise, and skills they use to implement unique variations of general strategies.

Hedge fund investors have traditionally been high-net-worth individuals. At times, more than half of these were from countries outside the United States. These non-U.S. investors sought to invest with the top investment talent, which in the early 1990s was almost exclusively based in the United States; today top hedge fund managers are located in financial centers around the globe. Recently, the increasing number of American and international high-net-worth individuals has been augmented by institutional investors, including pension funds, endowments, banks, and insurance companies. An infrastructure has emerged to process and make available information about hedge funds. In light of these developments, institutions have become more open to exploring allocations to alternative investment strategies. In response, many hedge funds have made changes, such as providing transparency, to accommodate the needs of institutional investors. It has been a self-reinforcing process: as funds make information about their operations available to institutions, infrastructure to support this body of information is created, and institutions are more likely to make allocations to hedge funds. These institutional investors represent a growing number of hedge fund investors that control significant assets and usually make much larger allocations than individuals; thus funds are willing to accommodate their needs.

As stated earlier, the hedge fund structure is an investment vehicle because it helps investors reach their ultimate goal: to turn market opportunities into investment returns. The investor brings investment capital to the industry. These assets are pooled in structures called hedge funds. The hedge fund structure gives the investor access to hedge fund managers who tap the return opportunities available from a variety of market inefficiencies. For investors, the hedge fund structure is both a method to pool their assets with those of other investors and a way to access talented hedge fund managers, the alternative investment strategies they use, and the exposures they provide. For managers, the structure enables them to pool the assets of wealthy and institutional investors, allows them to implement their particular strategies, and permits them to collect an asset-based and incentive-based fee from their investors. They combine their expertise with an alternative investment strategy to generate returns for their investors and for themselves, completing the dynamic (shown in FIGURE 1.1).

To understand the characteristics of the hedge fund industry, keep in mind that it is the aggregate of various strategies operating under the same general structure. The opportunities pursued by these strategies are created by market inefficiencies. The industry is dynamic in that the size, composition, and return opportunities for each strategy—and among strategies—fluctuate over time. Change also creates market inefficiencies, and the ongoing shifts in global markets and geopolitical activities continue to supply new investment opportunities to hedge fund managers.

Assets in the hedge fund industry have grown substantially over the past fifteen years, from around $39 billion in 1990 to $973 billion in 2004 (see FIGURE 1.2). This growth is a result of inflows (shown as a portion of the total assets, in FIGURE 1.3) and performance.

FIGURE 1.5 provides annual estimates of the number of hedge funds in the industry. Not surprisingly, this measure has increased along with asset growth. Since 1990, the number of funds has increased more than tenfold from 530 to 5,782 as of 2004. Over the period from 1990 through 2000, growth in the number of hedge funds was stable and averaged 280 funds each year. In 2001, however, 569 new funds entered the market and several large additions to the number of funds in the industry followed. An average of 612 new funds entered the industry each year between 2001 and 2004.

The pie chart in FIGURE 1.6 on the following page shows a grouping of hedge funds by the size of the assets they maintain under management. Nearly one-third of all funds in the industry manage between $25 million and $100 million. Funds with less than $10 million under management (22 percent) together with funds holding between $10 and $25 million (16 percent) represent more than one-third of funds as well. The remainder of the hedge fund industry is split among funds with over $100 million under management. Funds with between $100 million and $200 million and funds with between $200 million and $500 million each represent about 11 percent of the industry. Funds larger than this are still in the minority, with about 4 percent between $500 million and $1 billion, and just 3 percent with more than $1 billion under management.

The chart in FIGURE 1.7 categorizes currently active hedge funds by age. As shown, veteran funds that have existed for more than seven years represent nearly a quarter of the funds in the industry. Interestingly, nearly a third of the hedge funds are emerging funds that were launched within the past two years. Funds between 2 and 7 years of age are spread almost evenly across the remaining categories shown in the chart; an estimated 15 percent of funds have been active for between 2 and 3 three years, and 18 percent and 13 percent of funds fall into the 3 to 5 and 5 to 7 year intervals, respectively.

The hedge fund industry has provided attractive, stable returns for the past fifteen years. This is illustrated in FIGURE 1.8, which plots the growth of $1,000 invested in the HFRI Fund Weighted Composite Index, the MSCI World Index, and the S&P 500 index on a monthly basis from January 1990 through December 2004. Hedge funds have outperformed equities as measured by the 14.43 percent annualized return of the HFRI compared to 4.93 percent for the MSCI World and 10.92 percent for the S&P 500. During the period shown, the HFRI had less than half the volatility of each of these equity indexes at 6.93 percent compared to more than 14 percent for the MSCI World and 15 percent for the S&P 500.

Figures 1.8 and 1.9 highlight the value of hedge funds as a wealth preserving investment. Following an upward trend for all three indexes through August 2000, the MSCI World and S&P 500 indexes lost 24 percent and 22 percent, respectively, as of September 2002. Meanwhile the HFRI Fund Weighted Composite index lost only 10 basis points for the same period.

As we have seen, hedge funds have delivered attractive long-term returns with low volatility. As a group, they preserve wealth by mitigating losses. However, they do experience losing periods. FIGURE 1.12 shows multi-month losing periods, known as drawdowns, since 1990. A drawdown begins with a losing period and continues until the losses are earned back and new positive returns are achieved.

The hedge fund industry consists of multiple strategies. Depending on market cycles and changes, performance leadership shifts among the strategies relative to each other. FIGURE 1.13 on the following two pages demonstrates the changing performance relationship among the strategies for each year from 1993 to 2004, ranking best to worst performing strategies as well as general market indexes. Note how the ranking changes from year to year.