DEFINITION OF HEDGE FUND

Definitions of hedge funds run into problems because it is exceedingly difficult
to describe what a hedge fund is without running into trouble with
funds that don’t fit into the rules. There are investment pools that closely
resemble hedge funds but are generally regarded as a different type of investment.
Still other types of investments may contain characteristics that
are generally associated with hedge funds.
As a starting point, begin with a rather typical definition of a hedge
fund:
A hedge fund is a loosely regulated investment company that charges
incentive fees and usually seeks to generate returns that are not highly
correlated to returns on stocks and bonds.
Many traits of hedge funds aren’t useful in defining what is and what is not
a hedge fund.


Regulation and Hedge Funds
Chapter 8 describes the laws and regulations that control hedge funds.
While hedge funds are not unregulated, as is sometimes asserted, they are
more loosely regulated than mutual funds and common trusts run by bank
trust departments. Other types of investments are also loosely regulated,
though, including private equity partnerships, venture capital funds, and
many real estate partnerships.
Investors may feel they will “know it (a hedge fund) when they see it,”
but there are no firm lines separating hedge funds from these other types of
investments. Hedge funds may invest part of their assets in private equity,
venture capital, or real estate.
To further blur the distinction between hedge funds and regulated investment
companies, there is increasing pressure from the Securities and
Exchange Commission (SEC), bank regulators, auditors, and exchanges
for hedge funds to disclose more information and to control permitted
activities. Hedge funds may soon be required to disclose much of the information
that mutual fund companies must report. The SEC has proposed
to require all hedge fund management companies to register as
investment advisers.

Limited Liability
Sometimes, the definition of hedge funds mentions that hedge funds are a
vehicle where investors have no liability for losses beyond their initial investment.
It certainly is true that most hedge funds in the United States are
organized as limited partnerships or limited liability corporations (see
Chapter 5) that protect the investor from liability. However, offshore funds
are usually organized as corporations and, despite this difference, also create
a limited liability investment.
Most other investments are also limited liability investments. Investors
can lose no more than 100 percent of the value of long positions in stocks
and bonds. Mutual funds also protect the investor from losses in excess of
the amount of money invested. While accurate for hedge funds, the characteristic
of limited liability does little to define hedge funds.

Flow-Through Tax Treatment
Hedge funds are not taxed like corporations. Instead, all the income, expenses,
gains, and losses are passed through to investors. This feature does
not define hedge funds because many other investment types are flowthrough
tax entities. Real estate investment trusts (REITs), mutual funds,
venture capital funds, and other private equity funds are regularly constructed
to receive flow-through tax treatment.
Hedge funds organized outside the United States are frequently organized
in locations that have little or no business tax. In these locations,
hedge funds are not organized to get flow-through tax treatment.
Instead, these funds are organized as corporations that do not require
investors to include the annual hedge fund income and expenses on investor
tax returns.

“intelligent” investor?

Now let’s answer a vitally important question. What exactly does Graham

mean by an “intelligent” investor? Back in the first edition of this

book, Graham defines the term—and he makes it clear that this kind of

intelligence has nothing to do with IQ or SAT scores. It simply means

being patient, disciplined, and eager to learn; you must also be able to

harness your emotions and think for yourself. This kind of intelligence,

explains Graham, “is a trait more of the character than of the brain.” 2

There’s proof that high IQ and higher education are not enough to

make an investor intelligent. In 1998, Long-Term Capital Management

L.P., a hedge fund run by a battalion of mathematicians, computer

scientists, and two Nobel Prize–winning economists, lost more than

$2 billion in a matter of weeks on a huge bet that the bond market

would return to “normal.” But the bond market kept right on becoming

more and more abnormal—and LTCM had borrowed so much money

that its collapse nearly capsized the global financial system.3

And back in the spring of 1720, Sir Isaac Newton owned shares in

the South Sea Company, the hottest stock in England. Sensing that

the market was getting out of hand, the great physicist muttered that

he “could calculate the motions of the heavenly bodies, but not the

madness of the people.” Newton dumped his South Sea shares, pocketing

a 100% profit totaling £7,000. But just months later, swept up in

the wild enthusiasm of the market, Newton jumped back in at a much

higher price—and lost £20,000 (or more than $3 million in today’s

money). For the rest of his life, he forbade anyone to speak the words

“South Sea” in his presence.

Sir Isaac Newton was one of the most intelligent people who ever

lived, as most of us would define intelligence. But, in Graham’s terms,

Newton was far from an intelligent investor. By letting the roar of the

crowd override his own judgment, the world’s greatest scientist acted

like a fool.

In short, if you’ve failed at investing so far, it’s not because you’re

stupid. It’s because, like Sir Isaac Newton, you haven’t developed the

emotional discipline that successful investing requires. In Chapter 8,

Graham describes how to enhance your intelligence by harnessing

your emotions and refusing to stoop to the market’s level of irrationality.

There you can master his lesson that being an intelligent investor is

more a matter of “character” than “brain.”

Credit Risk Management

Assume a major building
company is asking its house bank for a loan in the size of ten billion
Euro. Somewhere in the bank’s credit department a senior analyst has
the difficult job to decide if the loan will be given to the customer or
if the credit request will be rejected. Let us further assume that the
analyst knows that the bank’s chief credit officer has known the chief
executive officer of the building company for many years, and to make
things even worse, the credit analyst knows from recent default studies
that the building industry is under hard pressure and that the bankinternal
rating1 of this particular building company is just on the way
down to a low subinvestment grade.
What should the analyst do? Well, the most natural answer would
be that the analyst should reject the deal based on the information
she or he has about the company and the current market situation. An
alternative would be to grant the loan to the customer but to insure the
loss potentially arising from the engagement by means of some credit
risk management instrument (e.g., a so-called credit derivative).
Admittedly, we intentionally exaggerated in our description, but situations
like the one just constructed happen from time to time and it
is never easy for a credit officer to make a decision under such difficult
circumstances. A brief look at any typical banking portfolio will be sufficient
to convince people that defaulting obligors belong to the daily
business of banking the same way as credit applications or ATM machines.
Banks therefore started to think about ways of loan insurance
many years ago, and the insurance paradigm will now directly lead us
to the first central building block credit risk management.


Situations as the one described in the introduction suggest the need
of a loss protection in terms of an insurance, as one knows it from car or
health insurances. Moreover, history shows that even good customers
have a potential to default on their financial obligations, such that an
insurance for not only the critical but all loans in the bank’s credit
portfolio makes much sense.

Trade can help the poor

If South Asia, Africa, East Asia, and Latin America increased their share of world exports by 1 per cent each, the resulting gains in income could lift 128 million people out of poverty, says a report by development agency Oxfam. Barbara Stocking, director, Oxfam, was in India recently to promote its 'Make Trade Fair' campaign. She explained to Vikas Singh and Rahul Shivshankar why it is vital that developing countries continue to seek greater market access:

Why has an agency better known for humanitarian work taken up the issue of fair trade?

Oxfam has a long history of campaigning and advocacy. Remember, it was set up during World War II to ensure that ordinary people did not suffer from famine in a war situation. We're also a development agency. Almost half our funding goes into tackling development issues in 80 poor countries. The reason for this trade campaign is that you can't just work on the ground, you also have to change policy at the national and international level, to really make a difference to the lives of poor people.

Aren't you worried that your report may end up encouraging anti-trade campaigners?

Let me make it clear, we believe trade can help poor people. Unfair trading rules may be hindering that right now, but that doesn't mean there's anything wrong with trade. Equally, globalisation is a reality. There may be some people who talk about opting out, but that's unrealistic. You really have to see how to make the system work better.It would be nice if everything was open and fair, but it's not like that in the real world. There are imbalances in all sorts of power relations and rules and regulations, and we have to try and switch those a bit.

What kind of reforms would you like to see at the World Trade Organisation?

We are really concerned that the processes at the WTO become much more transparent. Developing countries are working on capacity-building, but we are not sure they understand the implications of everything they are signing up for. We will work right through the next round of negotiations to ensure that it lives up to its billing of being a 'development round'. For example, we will be pushing for scrapping - or at least reduction - of agricultural subsidies in the north, and the issue of compulsory licensing in countries where people can't produce their own generic drugs.Activists favour labour standards; developing countries see them as a trade barrier.

Where does Oxfam stand?

We are pressing companies to do the right thing. A number of big companies say they don't allow poor working conditions or sexual harassment at their own workplaces, but can't check what's happening down the supply chain. We tell them that if corporates press down very hard on the prices they pay suppliers, the local factory owners in turn will squeeze their employees, making it worse for the workers. So, it's really up to corporates to pay a fair price for what they are getting. It's in their own interest to do so. Because internationally, it's not considered very respectable to be associated with such practices. Above all else, consumer pressure works. More and more consumers across the world don't want to be associated with firms that use sweatshops, and we're going to keep adding to that pressure.

Aren't you preaching to the converted in India about fair trade? What is Oxfam doing in the United States, where steel import curbs have been imposed?

I agree we've really got to get some movement in the US and the European Union, and we need to work on them to change their position. But we can only get change if, around the world, a lot of people show that they are really concerned about the way trade rules work. We've got to get people mobilised, which is why we've put the campaign on the Web. We have some confidence that we can actually achieve change, because we saw it in the case of the campaign to reduce debt for developing countries. We saw mass mobilisation, and governments recognised that their people didn't like what was going on. Of course, it doesn't happen overnight. We have to keep pushing.This particular campaign is aimed for the next three years, and we'll be focusing on specific issues like commodity prices and labour rights, particularly female labour rights. But that doesn't mean we haven't been campaigning on such issues before. For example, our campaign on the cost of drugs was obviously linked up to the patents issue, and came well before the free trade campaign. You're urging governments to embrace free trade.

But how about also telling them to simultaneously create social safety nets and improve infrastructure?

Certainly, trade on its own will not get rid of poverty completely. You have to work on education and basic infrastructure like electricity, water and roads. One of the problems I've been hearing about during my visit here is the high amount of taxation at state borders. If you're trying to encourage producers, then you could at least open your own markets a little more.One of my reasons for coming here was to talk with some ministers. I had a very good dialogue with your commerce minister, Murasoli Maran, and health minister C P Thakur. From my perspective, it was very helpful to talk about the WTO processes as the Indian government saw them. We didn't have deep conversations about internal Indian policies, because I don't know enough, and it would be very arrogant of me to come in for a few days and get into this area. But it could be something we could take up with our staff in India, and they can discuss some of the areas we might like to focus on.

What's Oxfam's reaction to Gujarat?

Oxfam stands for all people being equal and having basic human, economic and social rights. It's dreadfully sad to see a country that has historically had a good experience over thousands of years, of different communities and religions living together, starting to come apart. Did you raise the issue with the Indian government?No, I don't feel I know enough details. We are doing relief work in the refugee camps in Gujarat. But we are not going to get into who is right or wrong. What we are looking at is how ordinary people are affected. As I understand it, the UK government is very concerned about the situation. But we are not going to get into the middle of a debate between two governments. That is really not our business. We will do humanitarian work on the ground in Gujarat, and we will look at long-term peace-building there

Managing a Company in Today’s Business Environment

As business gets more competitive, more global, more technologically
driven, it gets easier for others to compete with you. It
gets harder to be successful by just doing OK. It gets harder to
launch a good product and enjoy the benefits of your innovation
for a long time without serious competition. And, yes, it does get
tougher to make a living. So what was good enough for our parents
to be able to get by and make a “good living” isn’t good
enough today. You may have read that many of us will fail to
achieve the relative standard of living that our parents did
because of that tougher world out there. Of course, if you’vebeen alive for the past 10 or 15 years, you also know that there
are unprecedented opportunities to create new wealth, new
products, new companies, and new fortunes that never before
existed. It’s unlikely that our forefathers could have imagined fortunes
being made, and lost, as quickly as they were in the ’90s.
So it’s hard to argue that times are more challenging now.
The question is: what can you do about it? The answer: not
much about the times, but a lot about how you prepare for
them. And that’s what this book is all about.
When I was a young boy, my father owned and ran a small
grocery store that supplied the neighbors with their daily household
needs, long before supermarkets killed the mom-and-pops
that then existed in every neighborhood. When school was over,
I went to the store to help out, because mom and dad were both
working there. My first job was opening cases of packaged
goods, pricing the packages, and stocking the shelves. Then I
packed groceries and delivered them to customers, sometimes
after taking their order over the phone and personally filling it.
(Yes, that was how many small stores did business back then.)
Then I graduated to cutting meat in the fresh meat department.
By the time I was in junior high school, I was checking out customers,
opening the store in the morning, and finally running
the store when my parents went on a rare vacation. By the time
I was in high school, I had run every aspect of a small business,
including opening and closing the cash register and doing the
bookkeeping at the end of the day.
In today’s business terms, I had worked in shipping/receiving,
warehousing and inventory control, production, sales, delivery,
billing and collection, accounting, and management.
Uncommon today? Yes, and yet that diverse background is
exactly what is being demanded more and more of today’s upand-
coming professionals. Managers in companies large and
small, including directors, vice presidents, and general managers,
are finding their particular specialties aren’t going to
carry them to the finish line as they might once have.
Their first clue might have been the arrival of the personal

computer. Senior managers and company executives a generation
ago were challenged by their lack of knowledge of this new
tool, no matter how firmly they knew their own particular areas
of expertise. The young professionals coming into the business
often made their bosses look old-fashioned with their mastery of
this impressive and intimidating technology. Soon, as we discovered,
those young professionals had children, whose computer
acumen after being on the planet for only a few years made
even their savvy parents sit up and take notice. And so it goes.
Now, as we are learning, finance and accounting are having
an impact on many companies in ways never before thought of
by managers outside the financial department. The accounting
scandals of 2002 showed that financial incompetence, or carelessness,
or simply lack of integrity, could wipe out the efforts of
thousands of loyal, hard-working employees. The report card, it
seems, has become more important than it ever was when we
were in school.
Today we’re finding out that we need to know how to read a
report card so we can just keep our jobs, let alone advance in our
careers. Boards of directors now need to delve into the reports
they have routinely received for years to a degree never before
contemplated. They need to understand financial terminology and
accounting methods they might previously have taken for granted.
CEOs now need to be completely aware of what their people
are doing and the financial ramifications, because they will no
longer be able to credibly say they didn’t know. And finally, managers
within a company, whether large or small, are going to
need to understand the rules of accounting and the boundaries of
proper finance well enough to avoid getting into trouble just
because they were aggressively trying to make their goals. As for
those who aspire to become managers, they might not even get
started up the ladder until they can demonstrate this kind of
knowledge. So you see, it touches everyone.
Now, it’s all well and good to say that accounting scandals
will make everyone learn more about finance and accounting,
but is that the only reason to know this stuff? Of course not!