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Offshore funds primer

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. The NAV of a fund is therefore a key concept relevant to all funds.

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

Click here for specific information on the Bank of Bermuda's Global Fund Services operations.
 

*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.

Article: Bermuda hedge funds hold US$107 billion (click link to read) 
Article: Cayman hedge funds (click to read)

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