Investment funds terminology
Mutual funds
A mutual fund (also
known as an open-end fund) is a pool of money managed and invested by
professional managers. Mutual funds can include equities like stocks, bonds,
cash or cash equivalents like treasury bills. The value of the mutual funds
changes daily, depending on economic conditions, market or company news,
interest rates, etc. There are many types of mutual fund: ranging from
balanced mutual funds, bond mutual funds, small cap mutual funds, blue chip
mutual funds, energy mutual funds, and so on. Each fund will vary in content
and therefore risk.
The Net Asset Value (NAV) of
a fund is the investment company’s total assets minus its total liabilities.
Because the valuation of the assets and liabilities changes daily, the NAV
will also vary accordingly. Mutual funds generally must calculate their NAV
at least once every business day, typically after the major US exchanges
close. An investment company calculates the NAV of a single share (or the
"per share NAV") by dividing its NAV by the number of shares that are
outstanding. The price that investors receive on redemptions is the
approximate per share NAV at redemption, minus any redemption fees that the
fund deducts at that time.
Closed-end funds
differ in that they generally do not continuously offer their shares for sale. Rather, they sell
a fixed number of shares at one time (in the initial public offering), after
which the shares typically trade on a secondary market. A closed-end fund is
not required to buy its shares back from investors upon request. Closed-end
funds also are permitted to invest in a greater amount of less liquid
securities than mutual funds. They do not have to report their NAVs daily
since their shares do not have to be bought back.
Hedge
funds
The term
hedge fund is an expression used to describe a type of private and
unregistered investment partnership that trades in a variety of securities.
There are two types of partners in a hedge fund: a general partner and
limited partners.
The general partner is the entity who started the hedge fund.
They handle all of the trading activity and day-to-day operations of running
the hedge fund. The limited partners supply most of the capital but do not
participate in the trading or day-to-day activities of running the hedge
fund.
Hedge
funds have traditionally been limited to sophisticated, wealthy investors.
Over time, the activities of hedge funds broadened into other financial
instruments and activities. Today, the term refers not so much to hedging
techniques, which hedge funds may or may not employ, as it does to their
status as private and unregistered investment pools.
Hedge funds vs Mutual funds
Hedge funds are
similar to mutual funds in that they both are pooled investment vehicles
that accept investors’ money and generally invest it on a collective basis.
Hedge funds differ significantly from mutual funds, however, because hedge
funds are not required to register under the federal securities laws. This
is because they generally only accept financially
sophisticated investors and do not publicly offer their securities. In
addition, some, but not all, types of hedge funds are limited to no more
than 100 investors.
Hedge funds also are not
subject to the numerous regulations that apply to mutual funds for the
protection of investors—such as regulations requiring a certain degree of
liquidity, regulations requiring that mutual fund shares be redeemable at
any time, regulations protecting against conflicts of interest, regulations
to assure fairness in the pricing of fund shares, disclosure regulations,
regulations limiting the use of leverage, and more. This freedom from
regulation permits hedge funds to engage in leverage and other sophisticated
investment techniques to a much greater extent than mutual funds. Although
hedge funds are not subject to registration and all of the regulations that
apply to mutual funds, hedge funds remain subject to the anti-fraud provisions
of the federal securities laws.
How are hedge funds profits allocated between the
partners?
For all the services that the
general partner provides, he will normally receive an incentive fee, often
20% of the net profits of the partnership. The incentive fee is dictated by
the partnership agreement. The general partner will also charge an
administrative fee - usually 1% of the year's Net Asset Value. This fee is
also dictated by the partnership agreement.
Hedge fund managers are only
rewarded for performance so if they make money they do well, but if they are
flat or lose money then they receive little or no money. The management fee
will usually not cover the expenses of operating a hedge fund. The remainder
of the profits/losses are allocated to all the partners in the partnership
based on their percentage ownership.
Accounting for
hedge funds
Partnership allocations form
the heart of hedge fund accounting. The allocations are then broken into
sections called break periods. Break periods will always occur when a
partner withdraws fully or partially, contributes more capital or a new
partner is admitted. The partnership then needs to be valued on that date
and the new capital activity and percentages will become effective on the
following day (basically, anything that affects the partnership percentages
is going to result in a break period).
Other aspects of hedge fund
accounting include: management fees, realised gains and losses on disposals,
incentive fees, interest due to a withdrawing partner*, loss carry-forwards
and high-water marks (these look at cumulative positions), professional
fees, interest income/expense, and tax allocations.
Hedge funds frequently trade
in initial public offerings (IPOs), which are known in the industry as
hot issues. Such activity must be separated from regular trading
activity and a separate brokerage account maintained.
Fund of funds
Simply
put, a fund of funds is a one that invests in other hedge funds. By its very
nature it does not make direct investments, and it is therefore known as a
look through vehicle. Ordinarily, a fund of funds is structured as a
limited partnership. This can afford the investor in a fund of funds certain
advantages. One such advantage is due diligence. Moreover, the fund of funds
can control risk by achieving manager diversity. They accomplish this by
diversifying in the strategies those managers employ. To the investor, this
allows them to participate in a unique asset allocation mechanism while
hopefully limiting downside risk.
Fund of funds are not without
disadvantages, however. The most notable of these is that an investor in a
fund of funds is required to pay an additional layer of fees. Usually, these
fees range from 1-2% percent of assets, but some fund of funds also charge a
performance fee.
HSBC Bank of Bermuda
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*When a partner fully
withdraws from a hedge fund, the hedge fund manager will usually pay the
limited partner that is leaving 90-95% of the amount due to him within 10-15
days of the break period. The remaining balance will be paid pending a
verification of capital amounts on the date the partner decides to leave.
This remaining balance attracts interest until paid to the withdrawing
limited partner.
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