THE STRUCTURE AND OPERATIONS
OF HEDGE FUNDS
First
Hedge Fund
 Formed by Alfred Winslow Jones in 1949
 Started with $100,000
 Between 1955-1965 had returns of 670%
 Primarily long positions, but also short
Black
Box Funds
 Esoteric Portfolio Theory
 Highly complex mathematical formulas
 Computer driven
 Quants
Hedge
Fund
 a private investment vehicle that engages in the active
trading of various types of securities and
commodities, employ sophisticated investment
techniques, such as arbitrage, leverage, and hedging
and whose structure and operations are designed to
promote the goal of absolute returns.
Pooled/Partnerships
of Investment advisors
registered with the Securities & Exchange
Commission
 Frequently invested in one or more upper tier
partnerships
 Low turn over of investments
 Low turn over of partners and partners are often
committed to additional contributions
 There are usually no distributions until investment in
upper tier is sold
Long
Term Capital
 When Genius Failed by
Roger Lowenstein
Players
 James Simons
 John Paulson
 Former
Math Professor
 Code Breaker for
Department of Defense
 Uses computer driven models to
detect pricing anomalies in stocks,
commodities, futures, and options
 Charges 5 and 44
 Earns over 20% for his partners over
a multi-year period

Worked in mergers & acquisitions at
Bear Stearns


Founded his own hedge fund
with $2 million and 2 employees
Under his direction, Paulson & Co.
capitalized on the problem in the
foreclosure and mortgage backed
securities market
 In 2007 alone his firm earned $15 billion! He personally made
$3.7 billion
 In 2008, his firm hired former Fed Chairman, Alan Greenspan
 Management
Fee
% of total assets in fund usually 2%
 Incentive
Fee
 % of net income – usually 20%
 High water mark –
Meaning no compensation for manager if he/she has net
income in year one but, falls behind in year 2, than no
more incentive until he gets back to where he was.
High water mark may only apply for 2 years
 Absolute
Return Strategy vs. Relative Return
Strategy
 Relative is relative to something else, i.e., Standard &
Poors
 You can’t eat relative returns!
 Absolute returns stand alone
 Alpha  producing returns not tied to an index
 Four
Primary Characteristics
 Organized as partnerships with the General Partner having
a significant investment
 Managers are compensated based on fund performance
 Investors purchase interest in fund for a % of a fund profit.
Interests are significant, restricted transferability and
limited redemption
 Provide liquidity and capital to the market place
• A role that has been vacated by the large brokerage firms as
they have shut down their proprietary trading desks
 Limited
Partnerships/LLC
 Fees typically are 2 and 20
 Normally utilize a high water mark or hurdle rate
 Claw back provision
 No
rules
 Unlimited types of investments
 Shorts permitted
 Margins permitted
 Limited
redemption opportunities
 Governed by the partnership agreement
 Approximately 8,000 hedge funds with more than $2.68
trillion currently
 Types
of Funds
 Fund of Funds
 Master Feeder Funds
• Assets are pooled into one account and managed as a single portfolio
• Profits and losses are allocated on where funds come from (capital
contributions/distributions)
 3(c)(7) Fund– under 500 investors, limited to only qualified
investors (investors with over $5 million in liquid, investable assets)
 3(c)(1) Fund– under 100 investors and limited to 35 non-accredited
sophisticated investors (accredited investors have excess of
$200,000 of annual income or a minimum of $1 million in net
worth exclusive of Primary residence
 Except for the exemption under Sec. 3(c)(1) or Sec. (c)(7) above,
hedge funds would fall under the regulations for regulated
investment companies
 Entry
normally limited to yearly, quarterly, or
monthly per partnership agreement
 Sold through a private placement memorandum
 Partnership Agreement
 Subscription Agreement
 Administration/Operations
 Prime Broker
• Execution of trades done monthly through trading
screens piped through the internet to a broker
• Provides portfolio reporting, securities lending, office
space, technology help, leverage, etc.
 Hedge Fund Hotels
• Could be the prime broker or a non-clearing broker
• Provides office space, computer, and the rest of build
out in the office quarters
 Administrator
 Provide general ledger accounting
 The allocation of income and expenses and gains
and losses to the partners
 Calculation of management and incentive fees, highwater-marks and hurdle rates
 There is an interface between what the prime broker
provides and what the administrator provides
• The prime broker often provides a special trade date
run that complies with U.S. GAAP
 Accounting
 Break Period
• Occurs as partners ownership percentages changes through
purchases and redemptions
 Aggregate Method vs. Layering Method
• The Aggregate Method does not take into account each
partners individual portion of unrealized gain or loss for
each security held by the fund
Allocations are based on the unrealized gain or loss of the
partnership’s securities as a whole
• The Layering Method accounts for each partner’s share of
unrealized gain or loss generated on each security over a
period of time

Rule 206(4), an investment advisor registered with the Sec and
acting as general partner to a pooled investment vehicle, such as a
hedge fund, and has custody of the client’s assets is subject to this
rule. 1
 Must maintain client’s funds and securities with a qualified custodian
 Must be audited annually
 Must distribute audited U.S. GAAP financial statements to all
investors within 120 days of the end of the fiscal year or 180 days for
Fund-of-Funds
 Must have a compliance officer
1 Hedge
funds must register with the Securities and Exchange
Commission when they have $100 million in assets.