!44: The Four Common Characteristics Of Hedge Funds

!±8± The Four Common Characteristics Of Hedge Funds

I. CENTRALIZED MANAGEMENT

Hedge funds are managed by a hedge fund advisory firm, which may be run by an individual portfolio manager or a team of managers, but the firm makes all decisions regarding the fund's investment activities. The fund itself is organized as a limited liability entity whose partners, members, or shareholders are passive investors with little or no voting rights.

II. CO-INVESTMENT

Fund managers usually invest a significant portion of their own liquid net worth in their funds alongside of the fund's other investors. This if often a major distinction from mutual fund managers, and provides investors some measure of comfort in that the manager "has his own skin in the game," thereby helping to align the interest of the manager with that of the investor. Indeed, most sophisticated investors in such funds will insist upon such co-investment as a prerequisite to investing their own money with the manager.

III. PERFORMANCE-BASED COMPENSATION

While fund managers generally receive a periodic asset based management fee of 1% to 2% per annum, and may also pass through to investors certain other costs, it is the assessment of performance based fees or profit allocations, pursuant to which the manager receives a percentage (often but not exclusively 20%) of the annual profits generated for the hedge fund, that has been a significant distinguishing factor from traditional money management. This is a major factor behind the ability of hedge funds to attract a steady stream of talented traders and portfolio managers.

IV. LIMITED LIQUIDITY

The fourth and final defining characteristic is the limited liquidity of hedge funds. This does not mean that the underlying investment portfolios of hedge funds are necessarily illiquid. Most funds carry out their strategies in securities that are traded in broad liquid markets. The limited liquidity in question relates instead to the ability of investors to either add to or withdraw from the funds in which they invest. Hedge funds often accept capital only at the beginning of calendar months and, if they determine that they may be reaching levels of assets under management that exceed their ability to effectively deploy such capital, may temporarily close themselves to new investor contributions. Conversely, funds typically limit the ability of investors to withdraw capital or redeem from a fund, so that investors may only be able to exit annually, semi-annually, quarterly or monthly, upon tendering a certain amount of advance notice to the fund. This differs markedly from mutual funds, which are required to offer daily liquidity to their investors.