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Types of Hedge Funds
June 07 , 2012

Hedge funds have been classified below in three ways.

1. Classification by organization structure

Domestic Hedge Fund

Domestic hedge funds are usually organized (in USA) as limited partnerships to accommodate investors that are subject to U.S. income taxation.  The fund's sponsor typically is the general partner and investment adviser. Hedge funds may also take the form of limited liability companies (LLC) or business trusts. LLPs, LLCs and business trusts are generally not separately taxed and, as a result, income is taxed only at the level of the individual investors. Each of three firms also limits investor's liability; LLCs offer the additional benefit of limited liability for fund advisors (general partners).

Offshore Hedge Fund 

Offshore hedge funds are typically organized as corporations in countries such as the Cayman Islands, British Virgin Islands, the Bahamas, Panama, The Netherlands Antilles or Bermuda. Offshore funds generally attract investments of US. tax exempt entities, such as pension funds, charitable trusts, foundations and endowments, as well as non-U.S. residents.  U.S. tax-exempt investors favor investments in offshore hedge funds because they may be subject to taxation if they invest in domestic limited partnership hedge funds.

2. Classification by strategy type

Hedge Fund Investment strategies tend to be quite different from those followed by traditional asset managers. Moreover, each fund usually follows its own proprietary strategies which do not always fit within neat definitional categories.  However hedge funds could be distinguished by the following three broad types:

Event driven- funds investing in securities to take advantage of price movements generated by corporate events. This group includes merger arbitrage funds and distressed asset funds.

Global macro- funds that take long and short positions in major financial markets based on views influenced by economic trends and events.

Market neutral- funds where the manager attempts to minimize (or significantly reduce) market risk.  This category includes long/short equity funds, convertible bonds arbitrage funds, and fixed income arbitrage. 

3. Fund of funds

Rather than investing in individual securities, a Fund of Funds invests in other hedge funds. Technically any fund that pools capital together, while utilizing two or more sub managers to invest money in equity, commodities, or currencies, is considered a Fund of Funds. Investors are allocating assets to Fund of Funds products mainly for diversification amongst the different managers' styles, while keeping an eye on risk exposure.  Fund of Funds are structured as limited partnerships, which afford advantages to the investor. One of the advantages is due diligence. Due diligence is a primary advantage because the fund of funds manager may spend his whole day evaluating strategies and speaking with individual fund managers. This would be an extremely hard task for an individual. The fund of fund also may combat risk by achieving manager diversity, because of the different strategies employed by the underlying managers. For example, some fund of funds may have exposure to a long/short fund, a distressed fund, and a private equity fund. By investing within the fund of funds, the investor is given the opportunity to have a unique asset allocation product, while trying to limit the risk on the downside.

Fund of funds have some drawbacks however. The first to come to mind is the double layer of fees. When dealing with fund of funds, an investor must understand that the underlying funds charge a fee, as well as the fund of funds manager. This translates to "layers" of fees before the investor receives his first rupee return. Transparency issues are also important. 

Research such as the individual manager's background and reputation, not to mention the nature of the investments that they are utilizing, are all issues a fund of fund manager must investigate. Therefore, investors have to rely on the fund of funds manager's talent and expertise in choosing managers, when investing in a fund of funds. Investors look for fund of funds because hopefully, they provide more stable returns while reducing risk.

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