The last few years have seen a US down market, and one of the results of this has been that new traditional equity funds have diminished in number, with a corresponding increase in the number of new hedge funds being initiated.  Many are start-ups as money managers leave large institutions and see an opportunity to capitalize on non-traditional investment techniques.

What are Hedge Funds?

Hedge funds use both long and short positions in various types of instruments, often using derivatives such as futures, options and warrants.  They engage in highly specialized investment strategies and often seek to exploit arbitrage opportunities.  Some hedge funds make extensive use of leverage.  Hedge funds often have a very low correlation to the major indices and are more concerned with absolute returns.

If a hedge fund is well-run and properly administered, it can achieve a level of growth even in a down market. Unlike private equity funds which are subject to the ups and downs of the market, a hedge fund is designed to be market neutral with a low level of correlation with the major world equity markets.

Traditional equity funds are long-only stock pickers.  They allocate most of their assets to equity holdings, although they sometimes also invest in fixed income or cash investments.  Hedge funds usually have both long and short positions in the market.  Hedge funds typically invest in derivative instruments and also engage in highly specialized investment strategies to exploit arbitrage opportunities.  Some hedge funds make extensive use of leverage and borrow money to invest in the markets.

Traditional equity funds measure their performance relative to a stock index such as the Dow Jones Industrial Index.  Hedge funds seek absolute rather than relative target levels of return, and some advertise an explicit level of target return.

Since hedge funds use a variety of different investment techniques, any two given funds will not normally have a high degree of correlation to each other.  Therefore, by investing in a variety of hedge funds (often accomplished through a fund of funds structure), investors can diversify their risks.

Hedge funds pursue strategies that do not depend on rising equity markets so they are called market neutral.  Many hedge funds are able to achieve positive returns even when major equity markets are falling.  Accordingly there is little correlation with the performance of major stock indices.  A hedge fund that has an investment strategy of primarily short selling instruments on the markets will have a negative correlation with the major stock markets.

Hedge Fund Administration Offshore

Hedge funds are normally open-ended pooled investment vehicles which are normally registered in offshore11 centers such as the Cayman Islands.  Management of the investment portfolios is normally done by investment managers located in the major financial centers mainly because that is where the leading investment managers choose to live and work.  The administrator of most, but not all, Cayman hedge funds is located in the Cayman Islands.  It is possible for hedge funds with minimum investment levels in excess of UD$50,000 to have the administrators located in other jurisdictions if the managers so prefer, but many managers find that the high quality level of administrators in the Cayman Islands convinces them to locate administration here.

Subscriptions and redemptions of shares in the hedge fund are normally only allowed monthly or quarterly, at the net asset value per share.  The net asset value per share is calculated by the administrator on the relevant trading dates.  Most hedge funds require a period of notice for redemption of shares, normally in the 30 to 50 day range.  It is very rare for a hedge fund to pay dividends, and earnings within the fund normally increase the net asset value so that earnings are realized upon redemption of the shares.

Investment Techniques

While hedge funds use a variety of strategies, they tend to focus on non-traditional investments and use techniques such as gearing and short selling.  They use these strategies to attempt to generate consistently high returns no matter what the markets are doing.

Gearing is the practice of investing more than the capital of the fund.  Gearing tends to be used in two situations.  First, where investment opportunities are identified but the fund does not have sufficient capital to take advantage of the opportunity and does not want to unwind its existing portfolio in order to do so.  Second, the fund may identify an attractive low risk arbitrage possibility with relatively low returns so the fund will gear the position to multiply the returns from the arbitrage trade.

Short selling is accomplished by borrowing securities from an owner and then selling the borrowed shares into the market.  When the timing is considered appropriate, the short seller purchases the shares which were borrowed in order to return the shares to the person they were borrowed from.  For the short seller, the sale price is agreed at the beginning of the period and the purchase price at the end of the period determines the profit or loss on the transaction.  A profit is made if the price of the securities falls during the period and a loss is made if the price of the securities rises during the period.

Funds which hold both long and short positions are hedging market movements by taking positions which do not all move in the same direction.  In addition, the downside on adverse movements can be capped by using equity options.  Hedge funds run long-short equity positions with or without caps in order to enhance return and at the same time to limit downside risk.

Hedge funds are attractive to non-traditional investors which exploit markets and instruments not generally available to traditional equity funds.  Hedge funds seek to attain absolute returns no matter what is happening in the world markets.  They succeed because they are market neutral with a low level of correlation with the world equity markets.  When various hedge funds are included in one package through a fund of funds, greater consistency of results can be achieved.  Hedge funds normally apply sophisticated, analytical methodology which integrates risk and return.

We anticipate that increasing numbers of hedge funds will be locating in the Cayman Islands given their ability to perform in all types of markets.  The Cayman Islands is a highly sophisticated and professional venue for the location of funds, with flexible legislation and numerous capable professionals available for the set-up and administration of funds.

________________________________________________________________________

International Management Services Ltd
P.O. Box 61, 
Harbour Centre
George Town, 
Grand Cayman, 
Cayman Islands 

Phone:  345 949 4244 
Fax:  345 949 8635 
Email: ims@candw.ky

________________________________________________________________________