Prime Brokerage

Prime Brokerage is the generic name for a bundled package of services offered by investment banks to hedge funds. The business advantage to a hedge fund for using a Prime Broker (PB) is that a PB provides a centralized securities clearing facility for the hedge fund. The result of having a centralized facility is it allows all the hedge fund's expenses and transactions to be more easily tracked. The Prime Broker benefits by earning fees ("spreads") on financing the client's long and short cash and security positions. The PB also charges, in many cases, fees for clearing and/or other services.
The following core services are typically bundled into the Prime Brokerage package:
• Global custody (including clearing, custody, and asset servicing)
• Securities lending – An exchange of stock or securities for some sort of collateral, usually cash equal or greater to the cost of the amount being borrowed.
• Financing - to facilitate leverage of client assets
• Customized Technology - provides hedge fund managers with portfolio reporting needed to effectively manage money
• Operational Support -prime brokers act as a hedge fund's primary operations contact with all other broker dealers.

Hedge Fund Structure

Many hedge funds are structured as master/feeder funds. In such a structure the investors will invest into a feeder fund which will in turn invest all of its assets into the master fund. The assets of the master fund will then be managed by the investment manager in the usual way. This allows several feeder funds (e.g. an offshore corporate fund, a US limited partnership and a unit trust) to invest into the same master fund, allowing an investment manager the benefit of managing the assets of a single entity while giving all investors the best possible tax treatment.

Hedge Fund Overview

Hedge Funds have become a fundamental aspect of the American stock market. From auspicious beginnings, they have grown into a force to be reckoned with. There currently exists over 200 hedge funds in the United States alone managing close to 1 trillion dollars! While they are a risky investment, the tantalizing rate of return continues to bring in investors. Will Hedge Funds rapid growth ever be clipped? It’s too hard to say but one thing is certain, as long as they remain largely unregulated, the veil of secrecy concerning their success and failures will remain largely unpierced.

US Regulation

Since Hedge Funds are unregulated, they can make investments without scrutiny by the SEC. Unlike mutual funds, they don’t have to report quarterly on their holdings. This means no one really knows what they are invested in. Their use of derivatives (complicated financial instruments, like options and futures contracts, that derive their value by reference to an underlying asset or index) means that, with little actual money invested, they have the capability to create large swings in the market. For example, many experts have said that the run-up in oil prices in July of 2006 was caused, in part, by hedge funds.

Hedge Fund Technology

A major reason for Hedge Fund’s increasing popularity and success is in large part due to the emergence of new technologies. What used to be an arduous search and investment process that was performed in person and through word of mouth has now been transformed into a seamless process easily monitored from the comfort of one’s home or office. The introduction and expansion of hedge fund database and analysis platforms, web sites, web meetings and teleconferencing, the process of marketing, finding, analyzing and monitoring hedge funds has completely revolutionized the industry. Not too long ago, finding hedge fund managers was a blend of skill, luck and networking. The primary method for discovering new hedge fund talent was word of mouth and extensive legwork, a common anecdote involved one company even going so far as to go door to door in New York’s financial district looking at nameplates to discover new talent.

How do Hedge Funds Work

Since they are unregulated, they can make investments without scrutiny by the SEC. Unlike mutual funds, they don’t have to report quarterly on their holdings. This means no one really knows what they are invested in. Their use of derivatives (complicated financial instruments, like options and futures contracts, that derive their value by reference to an underlying asset or index) means that, with little actual money invested, they have the capability to create large swings in the market. For example, many experts have said that the run-up in oil prices in July of 2006 was caused, in part, by hedge funds.

Offshore Hedge Funds

A lucrative reason for being offshore is that gains are either untaxed or very lightly taxed in the country where they were originated. While most investors set up offshore funds in the Caribbean and British Virgin Islands, a high number of new hedge funds are springing up all over the globe. This includes places like Hong Kong, Isle of Man, Switzerland, Luxembourg and many other places. Offshore financial centers are attractive to U.S. investors since they adhere to the privacy of their clients, and anonymous transactions can be made easily. Though the number of U.S. hedge funds far exceed the number of offshore funds, the money tied up in offshore funds is of far greater magnitude. Because voluntary information is scarce, it’s hard to estimate how much money is invested in these hedge funds but some have speculated it being over one trillion dollars!
Due to the nature of the U.S. tax and securities laws, it is easy to see why non-U.S. investors typically will not invest in hedge funds that are based in the United States. Many hedge fund managers do maintain both U.S. and non-U.S. components. The laws and regulations of the United States are directed not just to limiting the behavior of its citizens, but also to preventing money-laundering and other improper uses of offshore investment vehicles. Given the global complexity of the investment community, hedge fund managers want to keep their options open and attract investment money from both sides of the ocean.

Hedge Fund History

Hedge funds were created by Alfred Winslow Jones in 1949. Jones brought together two economic concepts to create what he considered a conservative investment scheme. He used leverage to buy more shares, and used short selling to avoid market risk. This approach has become a hallmark strategy of many hedge funds known today. He bought as many stocks as he sold, so regardless of whether the market was up or down, Alfred tried to maneuver himself into a good position. To Alfred this meant the crucial question, then, would not be the direction of the market but whether the manager had picked the right stocks to buy and sell. The fund avoided requirements of the Investment Company Act of 1940 by limiting itself to 99 investors in a limited partnership.
Alfred took a very proactive approach to this hedge fund. He chose to take 20 percent of profits as compensation and he charged no fee unless he made a profit. In summary, these three elements: a partnership structure where a percentage of profits is paid as compensation to the general partner/fund manager, a small number of limited partners as investors, and a variety of long and short positions, have now become the core elements of hedge funds today.