Hedge Fund. Course STUART A. MCCRARY. John Wiley & Sons, Inc.

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1 Hedge Fund Course STUART A. MCCRARY John Wiley & Sons, Inc.

3 Hedge Fund Course

4 Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, 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 financial instrument analysis, as well as much more. For a list of available titles, visit our Web site at

5 Hedge Fund Course STUART A. MCCRARY John Wiley & Sons, Inc.

6 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, , fax , or on the web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, , fax 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 Material may be outdated.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 , outside the United States at or fax 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 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 (pbk.) 1. Hedge funds. I. Title. II. Series. HG4530.M '524 dc Printed in the United States of America

7 To my loving wife, Nancy

9 Contents Preface Acknowledgments About the Author ix xiii 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

10 viii CONTENTS 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

11 Preface Business 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 alternative. 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 advisers, 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 because 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 information needed by hedge fund venture capitalists. This book serves to bridge another gap. It provides an extensive survey ix

12 x PREFACE of the hedge fund management business. The course book format is written at a more technical level than most books. Although no specific prior knowledge of statistics, accounting, or finance is required, the reader will find that a background in these fields will be helpful. This book is written for students in a classroom or students in their own self-study program. It could be the basis for a class in a graduate business school or the curriculum of training programs created for new employees in banks and brokerage firms. This book is also perfect for someone who works for a hedge fund or hopes to get a job with a hedge fund and needs to learn the essential facts about this important industry. Finally, lawyers and accountants who serve the hedge fund industry can learn about the business of their hedge fund customers. The course book format is designed to let readers quickly learn as much or as little as they require. Readers can read chapters in any order and may skip chapters or parts of chapters. Short chapters describe the essential facts on a particular topic. Questions follow each chapter, and answers are at the back of the book. The questions are not designed to test the reader s understanding of the reading. Instead, the questions and answers delve more deeply into the topics reviewed in the text. The question sections contain most of the quantitative material of the book, so readers comfortable with the mathematics should be careful not to skip this valuable bonus material. TOPICS INCLUDED Chapter 1 Introduction The first chapter provides a primer on the hedge fund industry. It explains how a hedge fund differs from other investment products, the growth of the industry, and basic vocabulary and operation of hedge funds. Chapter 2 Types of Hedge Funds Most of the thousands of hedge funds resemble one of a handful of strategies. This chapter describes the most popular strategies that comprise most of the hedge fund assets under management. Chapter 3 Types of Hedge Fund Investors Although individuals began investing in hedge funds before most types of institutional investors, today nearly all types of investors invest in hedge funds. The needs and wants of individual investors differ greatly from

13 Preface xi those of pension funds and endowments. This chapter describes the most important groups of hedge fund investors. Chapter 4 Hedge Fund Investment Techniques Certain investment techniques have been developed in broker-dealers or private equity funds and fit well into hedge funds. This chapter describes investment techniques outside the domain of the traditional portfolio manager. Chapter 5 Hedge Fund Business Models Hedge funds and hedge fund managers are organized as corporations, partnerships, and limited liability corporations to get maximum tax advantages and limited liability for investors. Offshore funds combine several structures to comply with U.S. and offshore regulations. Chapter 6 Hedge Fund Leverage This chapter describes the many techniques used by hedge funds that allow a hedge fund to carry positions larger than the hedge fund capital. The chapter also describes how hedge funds can create short positions to implement trading strategies and control risk. Chapter 7 Performance Measurement Hedge fund investors closely monitor hedge fund performance. Investors have developed a collection of tools to measure performance and risk. Hedge funds share some of these tools with traditional asset managers, but they also have methods designed for leveraged portfolios. Chapter 8 Hedge Fund Legislation and Regulation Anyone who thinks a hedge fund is not affected by rules and regulations hasn t read a risk disclosure document. Although most securities laws contain exemptions that allow hedge funds to escape some of the burdens of regulation, the exemptions create complications as well. Chapter 9 Accounting This chapter describes the accounting requirements unique to hedge funds. Hedge funds pose all the challenges typical of portfolio accounting. Hedge

14 xii PREFACE funds create additional challenges because they carry short positions, may finance their long positions, and may turn over their positions rapidly. 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 take more risks than traditional portfolio managers and hedge funds almost always take different risks than traditional portfolio managers. Risk measurements provide managers, investors, and creditors with valuable insights into the nature of hedge fund positions. Chapter 12 Marketing Hedge Funds Regulations define how hedge fund managers can market their funds. A specialized industry has evolved to help managers raise money. Chapter 13 Derivatives and Hedge Funds One of the latest developments in hedge fund investing involves investing indirectly into hedge funds through derivative products. These new structures offer several potential advantages over direct hedge fund investing. Chapter 14 Conclusions This chapter provides a review of the state of the hedge fund industry and provides insight into the future of the hedge fund marketplace.

15 Acknowledgments Iwant to thank everyone who assisted me in writing this text. I received invaluable comments from Ricardo Cossa and John Szobocsan, who spent many hours reviewing drafts and offering suggestions. I must also thank my wife Nancy and children Kate, Lauren, and Douglas, who endured my absence while writing and revising this text. SMc xiii

The Fundamentals of Hedge Fund Management

The Fundamentals of Hedge Fund Management Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia,