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What Are Hedge Funds?

A hedge fund is an investment vehicle that is most often structured as an offshore corporation, limited partnership or limited liability company. The fund is managed by an investment manager in the form of an organization or company that is legally and financially distinct from the hedge fund and its portfolio of assets. Many investment managers utilize service providers for operational support. Service providers include prime brokers, banks, administrators, distributors and accounting firms.

Prime brokers clear trades, and provide leverage and short-term financing. They are usually divisions of large investment banks. The prime broker acts as a counterparty to derivative contracts, and lends securities for particular investment strategies, such as long/short equities and convertible bond arbitrage. It can provide custodial services for the fund’s assets, and execution and clearing services for the hedge fund manager.

Hedge fund administrators are responsible for operations, accounting, and valuation services. This back office support allows fund managers to concentrate on trades. Administrators also process subscriptions and redemptions, and perform various shareholder services. Hedge funds in the United States are not required to appoint an administrator, and all of these functions can be performed by an investment manager. A number of conflict of interest situations may arise in this arrangement, particularly in the calculation of a fund’s net asset value (NAV). Some US funds voluntarily employ external auditors, thereby offering a greater degree of transparency.

A distributor is an underwriter, broker, dealer, or other person who participates in the distribution of securities. The distributor is also responsible for marketing the fund to potential investors. Many hedge funds do not have distributors, and in such cases the investment manager will be responsible for distribution of securities and marketing, though many funds also use placement agents and broker-dealers for distribution.

Most funds use an independent accounting firm to audit the assets of the fund, provide tax services and perform a complete audit of the fund’s financial statements. The year-end audit is often performed in accordance with either US generally accepted accounting principles (US GAAP) or international financial reporting standards (IFRS), depending on where the fund is established.[100] The auditor may verify the fund’s NAV and assets under management (AUM). Some auditors only provide “NAV lite” services, meaning that the valuation is based on prices received from the manager rather than independent assessment.

Understanding Hedge Funds

 

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