Hedge Funds: What the Label Actually Covers

A hedge fund is not a way of investing. The words name a privately offered pooled vehicle and the arrangement by which its manager is paid. Money is subscribed rather than promised, so nothing is ever called; the management fee sits on net assets; and a performance fee is taken only above a high-water mark. Eight unrelated approaches sit under the one word.

Everything that reads as different about this kind of fund comes out of one structural fact, and it is worth holding that fact still for a moment before any arithmetic arrives. Nilgiri Absolute Return Fund, invented, is open-endedA fund that keeps issuing and cancelling units, so its size changes as investors come and go.. An investor hands over cash and receives unitsOne share of the fund, priced at its net asset value., and the fund puts that cash to work the day it lands. A closed-end private fund does the opposite: it takes a promise first and asks for the cash later, in pieces, over years. Change that one thing and the fee basis, the way out, the shape of the manager's reward and the very existence of a wind-up date all move with it. One structural fact is why this guide spends its time on the container rather than on strategy, and why the label at the top predicts so little about what any particular fund is actually doing.

What do the words hedge fund actually name?

Two things, and neither of them is an investment style. The first is a vehicle: a pooled fund offered privately rather than sold to the public. The second is a fee arrangement: a charge for running the money, plus a share of the gain. A vehicle and a fee arrangement are the whole content of the label. The words sit closer to the phrase private limited company than to the phrase equity investing. The label names the kind of container in view and how the person holding it is paid, and it says almost nothing about what is inside.

The word restaurant carries a comparable amount of information. The word promises tables, a kitchen and a bill at the end. The signboard does not say whether a thali or a bowl of noodles will arrive, and nobody would read a menu by staring at it. The word hedge fund works the same way: it describes the container and the bill, and the menu is a separate document entirely. A reader who treats the label as a description of the manager's actual holdings has read the signboard and skipped the menu.

Nilgiri Absolute Return Fund, invented, is the fund this guide uses throughout. The fund is managed by Nilgiri Alternatives Advisors Private Limited, invented, sponsored by Nilgiri Financial Holdings Private Limited, invented, and settled as a trust whose trustee is Nilgiri Trusteeship Services Private Limited, invented. The fund is registered as a Category III Alternative Investment Fund with the Securities and Exchange Board of India. At its record date it held net assetsWhat the fund holds less what it owes, on the day it is struck. of Rs 5,00,00,00,000, and 5,00,00,000 units were issued at Rs 100.00 each when it launched. Every figure in this guide belongs to that one fund.

Set it beside a closed-end private fund and six terms differ at once. The six differences are not six independent design choices; they are one choice showing up six times.

Where did the capital call go?

There is not one. Not a small one, not a rare one, not a different kind of one. Nilgiri Absolute Return Fund, invented, has no capital call at any point in its life, and that absence is the cleanest thing in the structure.

Here is what happens instead, in full. An investor pays cash to the fund. The fund issues units at the value a unit is worth on the dealingIssuing or cancelling units at a stated price on a stated date. date. That is it. There is no promise standing behind the payment, no notice that arrives later, no schedule of drawdowns, and no balance sitting unfunded on anybody's books. A subscriptionCash paid in to buy units, on the day it is paid rather than on a later call. is finished on the day it happens, and that is exactly what a commitmentA promise to pay cash when the manager asks for it, which this fund does not use at all. is not.

The difference is a familiar one from both sides. Paying the full price of a scooter at the showroom counter is a subscription: money moves, the thing belongs to the buyer, the matter is closed. Signing up for a chit fund that carries a monthly contribution for the next two years is a commitment: nothing has moved yet, and what has been handed over is an obligation, not cash. One of those leaves a balance hanging over the person and the other does not.

So what is a commitment, seen from the fund that does not have one?

A commitment is easiest to see in a fund that has none, so the definition is worth slowing down for. A commitment is not money. A commitment is a legally binding promise to hand over money when somebody else asks for it, on terms fixed in advance, at times the investor does not choose. Three separate things are bundled inside that sentence, and all three are absent here.

The first is an obligation that survives the day it was made. An investor with a commitment owes something tomorrow. An investor who has subscribed owes nothing tomorrow. The transaction finished on the day it was made. The second is somebody else holding the trigger. The manager decides when the cash is wanted and the investor pays on that timetable. A committed investor therefore has to keep money available for a call that has not arrived yet. The third is a consequence for failing. A promise nobody can enforce is not a promise, so closed-end documents carry a penalty for a missed payment. Take away the promise and all three vanish at once: no obligation carried forward, no trigger in the manager's hand, and no penalty clause needed. Nothing is left to fail to do.

One sentence heard constantly about closed-end funds also collapses in a fund built this way. An investor in a closed-end vehicle can be fully committed and barely invested. The promise is large and the cash so far called is small. In Nilgiri Absolute Return Fund those two words describe one number. The amount paid is the amount invested, and no gap sits between them for anybody to talk about. The mechanics of a capital call, and what a closed-end document does about a missed one, are covered separately.

Why is the management fee charged on net assets here?

Because there is nothing else to charge it on. A fee needs a base, and the base has to be a number that exists. In a closed-end fund the promises exist from day one and can carry the fee. Here nobody promised anything, so the only number available is the fund's own net assets, Rs 5,00,00,00,000 at the record date.

Nilgiri Absolute Return Fund, invented, charges 2.00 per cent a year on net assets. On the Rs 5,00,00,00,000 it held at its record date, that is Rs 10,00,00,000 a year. Halve the net assets and the charge halves to Rs 5,00,00,000, without anybody renegotiating anything. A fee on net assets follows the fund down as faithfully as it follows the fund up, and that symmetry is the single most useful thing to know about this basis. A fee on promises does not do that: the promises are a fixed number written in a contract, and they sit still while the value of the investments moves.

A second charge sits beside the first and is a completely different animal, and the two are separated carefully below. The performance feeA share of the gain, charged annually here, and only above the high-water mark. is 20.0 per cent of the gain, charged once a year, and only above the high-water markThe highest value a unit has already been charged a fee at, which the value must clear before another fee is charged.. Metrick and Yasuda, in The Economics of Private Equity Funds in the Review of Financial Studies in 2010, showed that fee income and a share of the gain behave as two quite separate revenue streams for a manager, and that analysis is theirs. The reason the split matters to a reader is arithmetic rather than opinion. One charge arrives in every single year, including the years when nothing rose. The other arrives only in the years the mark is cleared. On this fund's record they landed in three years out of five.

What is a high-water mark actually for?

One job, and only one: it stops the manager being paid twice for the same rise. One job is the whole of it. Everything else people say about a high-water mark is a consequence of that one sentence.

Picture the water mark on a wall after a flood. The line stays where the water reached. Next monsoon, the water has to climb past that line before anybody says the flood was worse. Water rising three feet in a room whose old line is five feet high has not beaten anything. A high-water mark is exactly that line, drawn on the value of a unit, and the manager is paid only on the part of the rise that clears it.

Here is Nilgiri Absolute Return Fund over five years, worked to the paisa on the value of one unit issued at Rs 100.00 at launch. Every row is the record of that single unit and not of the fund.

Three details in that table are worth pulling out by hand. First, the new mark is set at the value after the fee and never at the value before it, so Year 4 leaves a mark of Rs 118.00 rather than Rs 120.00. Setting it at the higher figure would charge the investor a second time on rupees the manager has already taken. Second, the mark rose in three of the five years and fell in none, and that one-way movement makes it a ratchet rather than a rolling average. Third, the whole five years runs Rs 100.00 to Rs 122.00, being 22.0 per cent in total and 4.06 per cent a year compounded. A five-year record of one fund over one stated period says nothing about any other fund, any other period or anybody's expectations.

Year 3 is where the idea stops being abstract, so look at it on its own. The unit began the year at Rs 99.00 and finished at Rs 106.00. A move from Rs 99.00 to Rs 106.00 is a rise of 7.07 per cent, computed as Rs 7.00 over Rs 99.00, and it is a real gain in anybody's language. The performance fee for that year was nil. Not reduced, not deferred: nil. Rs 106.00 is below the Rs 110.00 mark, so every rupee of that rise sits inside ground the manager has already been paid for, and it carries no fee at all.

Why did a fee stated at a fifth take a quarter?

Where does the extra come from? From Year 1, and from the Rs 2.50 charged there. The fee of Rs 2.50 was charged on a rise from Rs 100.00 to Rs 112.50, and in Year 2 the unit fell to Rs 99.00, handing the whole of that rise back and a little more. Nothing hands a fee back. The mark then stopped the manager being paid again on the same ground in Years 2 and 3, and stopping that second payment is exactly its job. It did nothing whatsoever about the Rs 2.50 that had already gone. The mark ratchets up and never down, so a fee already taken on a rise that later reverses stays taken, and the more a fund zig-zags the wider the gap between the stated rate and the share of the round trip.

Who makes this error? Almost everybody who reads a performance fee as a share of the period return. The cost of the error is easy to state. Readers who make it understate the fee on any record that is not a straight line, and they understate it by more the bumpier the record is. The fix is not suspicion of the manager. The fix is one division: the fee actually charged, over the gain actually kept, across the whole period rather than year by year.

And now the fair half of the sentence. An account that only prosecutes has not taught anything. Without the mark, the manager would have been paid 20.0 per cent on the Year 3 rise of Rs 7.00 as well, being another Rs 1.40 on ground it had already been paid for in Year 1. The mark is the reason that did not happen. The mark does exactly one job, does it properly, and was never designed to do the other one.

What do the eight approaches under this label actually share?

How Hedge Fund Strategies Work at a Structural Level

Eight approaches shelter under the one word, and they are not variations on a theme. The eight are separate jobs entirely. Global macro takes positions on currencies, interest rates and broad markets. Managed futures and systematic trend following run rules over price series and trade what the rules say. Equity market neutral holds long and short positions sized so the market itself is meant to drop out. Relative value works the gap between two things that ought to be priced together. Event-driven positions itself around a specific corporate event. Long-short equity holds shares it expects to gain and short positions alongside them. Short selling as a standalone approach does only the second half of that. Arbitrage in its precise sense takes the same asset in two places at two prices.

Read that list again and notice what it does not contain. No statement appears there about which approach works, about whom each one suits, about when one is used, or about what any of them returns. Each of the eight is named here and described separately, and the label at the top ranks none of them. Nilgiri Absolute Return Fund, invented, itself runs the sixth of them, long-short equity, and holds both long and short positions; what gross and net exposure mean and how that book is measured are covered separately.

So what do all eight actually have in common? Three permissions that the vehicle gives its manager, and nothing else. The first is the ability to sell short, meaning to take a position that gains when a price falls. The second is the ability to borrow, both cash and stock, so the fund can hold positions larger than the money in it. The third is the fee arrangement itself: a share of the gain, on top of a charge for running the money. The three permissions are the entire content of the shared label, and none of them says what the manager will do with them. A fund that can sell short and does not, and a fund that can sell short and does nothing else, carry the same three permissions and are not remotely the same object.

Each permission carries its own risk, and it is worth naming them plainly rather than leaving the reader to guess. A short position can lose more than it can gain. Sell at Rs 100 and the most a fall can give is Rs 100. A rise to Rs 400 takes Rs 300 away, and that asymmetry is arithmetic rather than opinion. Borrowing means somebody else sets the terms on which positions stay open. And a fee on the gain is charged on years. The risk carried to earn it may be spread across several. None of that makes any approach good or bad. Each approach is a mechanism with a cost, and naming the mechanism and the cost is the only useful description of any of them.

If there is no end date, how does anybody ever get out?

Through contracted liquidity terms, and this is the last structural consequence of being open-ended. A closed-end fund has a term: an investor waits for it, and on that date the fund sells what is left and pays everybody out. Nilgiri Absolute Return Fund, invented, has no term, no wind-up date and nothing to wait for. The fund has instead four terms written into its own documents, and each of the four governs when units may be cancelled and cash paid out.

Here they are, one sentence each. How the four interact, and in what order each of them bites, is covered separately and is a subject of its own. The first is a lock-up of twelve months from each subscription, during which no redemption is accepted at all. The second is a redemption window: dealing quarterly on the last business day of the quarter, on written notice, with payment after the dealing date and a holdback released later. The third is a gate. A gate caps how much may leave at any single dealing date and carries the excess forward. The fourth is a side pocket, into which a holding the manager designates as not reliably valuable can be moved, and in which no subscription or redemption is accepted until it is realised. All four are this invented fund's own contracted terms rather than anything standard, typical or required of anybody.

The structure has made a trade. A closed-end investor has certainty about the date and no way out before it. An investor here has a way out four times a year and no certainty about any particular one of them. Three of the four terms above can reduce or postpone what actually leaves. Neither is the better arrangement. The two are different shapes, and knowing which shape is on the table is the point. How the four terms interact is covered separately, as are the mechanics of the dealing calendar and the mechanics of the side pocket, each of which is a mechanism in its own right.

What happens to an investor who arrives after a bad year?

Something goes wrong, and it is the hardest idea in this guide, so it comes in two halves: the fault first, and then the machinery that removes the fault.

The fault comes from a mismatch. The mark of Rs 110.00 is one number for the whole fund, and it was set by a history the newest investor was not present for. Everybody in the fund is charged as though they arrived at the mark. Almost nobody did. The mismatch has a name, equalisationThe problem of charging each investor a performance fee on its own gain rather than on the gain of the fund., and equalisation is a problem before it is ever a solution.

Work it on this fund's own record, with a single fund-level mark and no other machinery. Three investors, one unit each, all held to the end of Year 5 when the unit stood at Rs 122.00. The first subscribed at launch at Rs 100.00, paid Rs 2.50, Rs 2.00 and Rs 1.00 across Years 1, 4 and 5, and kept a gain of Rs 22.00; its fee is 25.0 per cent of what it kept. The second subscribed at the Year 2 close at Rs 99.00, paid nothing in Year 3, Rs 2.00 in Year 4 and Rs 1.00 in Year 5, being Rs 3.00 in all, and kept a gain of Rs 23.00; its fee is Rs 3.00 over Rs 23.00, being 13.04 per cent of what it kept. The third subscribed at the Year 4 close at Rs 118.00, exactly the mark that day, paid Rs 1.00 in Year 5 and kept Rs 4.00; its fee is 25.0 per cent again.

Same fund, same terms, same five-year record, and one investor was charged 13.04 per cent of its own gain while the other two were charged 25.0 per cent of theirs. The second investor rode the whole recovery from Rs 99.00 up to the Rs 110.00 mark without paying a paisa on it. The fund had already been charged on that ground before that investor arrived. The gap between those percentages is not a scandal and nobody was cheated; it is a single mark being asked to describe three different histories. Notice which investor it happens to describe correctly: the third, whose entry price was exactly the mark. One mark is right for exactly one entry price, and everybody else is somewhere either side of it.

The mismatch runs the other way too, and that direction can be named without a number attached to it. An investor who subscribes at a moment when the unit stands above the mark carries, at the year end, a fee charged on a rise that happened before it arrived. The record of this fund holds a value at each year end and no value in between, so no moment inside it can carry such a subscription. The direction is the teaching: one fund-level mark charges nobody 20.0 per cent of their own gain except the holder who happened to enter at the mark.

How does this fund answer that?

With series accountingIssuing a separate series of units at each subscription date so each holding carries its own mark., a device less clever than it sounds that works entirely by refusing to average. Instead of issuing one kind of unit, the fund issues a separate series at each subscription date. Each series carries the mark it started at. The performance fee on each series is worked on that series alone, against its own mark, and never against anybody else's.

The everyday version is a shared electricity meter in a building where tenants move in at different times. One meter and one bill split by heads charges the tenant who arrived last month for six months of somebody else's usage. Put a meter on each flat and the argument disappears; nothing about the tariff changed, only what each reading is measured against. Series accounting is the separate meter: same fee terms, same rate, different starting reading for each subscription date.

The cost of series accounting is bookkeeping. A fund that has dealt quarterly for several years carries many series, each with its own mark and its own unit value, and somebody has to strike all of them at every dealing date. Striking them all sits with the administrator, Kolar Fund Services Private Limited, invented, alongside the manager. The trade is plain: the fault is removed and the register gets longer. The contents of an investor's own statement, and how each series is struck and reported, are covered separately.

Who actually has to hold all this in their head?

More people than might be guessed, and none of them are picking funds. Three cases follow.

Somebody in an operations or finance team reconciling a statement from a vehicle like this one meets two fee charges under one heading, sitting on two different bases, one of which appears in every period and one of which does not. A reconciliation that treats them as one line will not tie out in a year like Year 2, when a fee on net assets was still charged and a fee on the gain was not. Knowing that the two charges have different bases is the difference between a break that can be explained in one sentence and a break chased for a day.

Somebody analysing an institution that holds units in such a fund has a different problem. The institution reports a holding in rupees, and behind that number the fund itself carries no wind-up date, four liquidity terms and a fee that accrues on net assets rather than on anything fixed. An analyst who reads that holding as though it converts to cash on demand has read it wrong, and one who reads it as locked until a maturity date has read it wrong the other way. Neither is true and the documents say which of the four terms applies.

And somebody who simply reads offering documents for a living, an auditor, a compliance officer, a student on their way into one of those seats, meets a vocabulary switch. Where a closed-end document says commitment, drawdown and unfunded, this one says subscription, dealing and units. The two sets of words are not synonyms and the substitution is not cosmetic. One set of words describes an obligation that continues; the other describes a transaction that closed. Reading either document with the other set of words in mind produces confident, specific errors, and those are the expensive kind.