Tuesday, February 4, 2014

Understanding Hedge Funds terms

Absolute returns 
Unlike long only funds, hedge funds use absolute returns instead of relative returns.  In reality the only index to beat is cash, and the relevant view is from the beginning of your Investing life until the end.

Alternative investment managers
By investing in alternative investment managers, you can benefit from potentially greater asset inflows as more investors become comfortable with the idea od directing their capital into their funds.  The funds do not share in Client losses, winning fees go straight to bonuses and shareholders. 

Assets under management (AUM) comes from inward capital cash flows, as well as retained investment returns. There are trillions of dollars of global money looking for a RELIABLE return higher than government bonds but with LESS risk than long only equity. It takes a certain amount of back office to run a fund. You have regulatory costs, staff, research and computers. On a small firm the 2% won’t cover it, which is where the performance fees came in. But when the fund gets really big, the 2% will cover the costs for additional offices to bring in more Clients.

Benjamin Graham
Early Hedge Fund operator. It involved a partnership structure, a percentage-of-profits compensation arrangement for Ben Graham as general partner, a number of limited partners and a variety of long and short positions.

Carried interests
Partners are taxed on their share of partnership income only when a partnership-level realization event occurs, regardless of how long it takes for such an event to transpire or how many years go by before realized funds are distributed.  It happens when the income comes in short term and is deferred or carried until it is long term for tax purposes. - Carry

Distributable earnings
Measure profit minus adjusted income taxes. Och-Ziff reckons this distributable-earnings figure is a more accurate gauge of its performance than Earnings per share.  Market watch

40 Act
The “40 Act,” as investment professionals often refer to it, are Hedged mutual funds which comply with the Investment Company Act of 1940. 40 Act funds, can be owned by small investors and must have daily mutual fund redemption, whereas real Hedge Funds are not regulated, not liquid and require Millionaire investors.

Fee based
The fee based part of the dividend is more predictable than the performance fees. A Hedge Fund may have fees that barely cover expenses in years with low incentive fees, and receive relatively gigantic payouts during periods when the performance fees apply.

Hedge fund
An expression believed to have been first applied in 1949 to a fund managed by Alfred Winslow Jones. His private investment fund combined both long and short equity positions to “hedge” the portfolio’s exposure to movements in the market.  Hedge funds are largely unregulated and therefore are free of the restrictions that keep most mutual funds from pursuing untraditional investment strategies like selling short and investing in complex derivatives.

Hedge fund managers 

Have their own money on the line usually seeking absolute returns.  The 20% of profits is particularly beneficial since that income generally receives favorable capital gains tax rates.  Being allowed to own the management company sidesteps those charges and the stringent income and net worth requirements attached to hedge fund investing. 

Investment banks 
The core activities of investment banks are subject to regulation and monitoring by central banks and other government institutions - but it has been common practice for investment banks to conduct many of their transactions in ways that don’t show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investors.

Unlike many hedge funds, Och-Ziff uses very limited leverage, the practice of borrowing multiples of the firm's assets under management to enhance returns.  Management gets 20% of the profits on other peoples money when it goes up, none of the losses when it goes down. 

The loophole is that the limited partnership is being taxed as a partnership.  The lawmakers say it is compensation for work and should be taxed as such.  If it should be abolished  the profits for the asset managers will be significantly curtailed by increased taxes.

Och-Ziff Capital Management Group LLC - Prospectus 

Private equity
Multi-million-dollar blocks of “private” capital from a limited number of wealthy investors or institutions, as opposed to the “public” money from unlimited numbers of investors holding exchange-traded, SEC-regulated securities.  Investors in private equity funds contractually limit their ability to withdraw their capital. 

OZM revenue is primarily derived from its management fees and incentive income.  Management fees equal between 1.5-2.5% annually of the assets under management, and are set and charged at the beginning of each quarter, based upon the amount of assets under management.  Performance fees, also known as incentive income, generally equal 20%, of the net returns earned by the funds, and form the majority of the firm’s revenues. This poses a problem in bad markets, as the funds have high-water marks that prevent the manager from receiving performance fees unless the fund is above its previous greatest value.

Risk is not the relative risk of beating some made-up average on retirement day. Risk is not having enough to make partial withdrawals for thirty plus years. It is always a blend of how much to keep earning and how much to spend.

One of the things that you might notice. Instead of offering a product and trying to sell it like a mutual fund salesmen.  Instead he acts as Investment Counsel which earns higher fees.  Emphasis is on finding out what the client needs and providing it on a three year agreement with 2% and 20% fees.  Then getting them to bring him more problems to solve, so that they re-up with more funds later on.  Instead of offering one strategy to all, they try to mold a strategy to meet the pension fund or Investment banks clients needs.

Two and Twenty
Investment Counsel use to get 2% annually of assets under management, Hedge funds enjoy the “two and 20" fee structure, in which asset managers are paid 2% of assets and 20% of profits.

The French word for “slice." A piece, portion or slice of a deal.

Volatility of expected return
 This is what Wall Street calls this risk.  Volatility is not risk when it is anticipated.

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