Overlay Structure of a Hedge Fund

by John Kibilko

Hedge funds typically are structured in a two-tier system in which an overlay manager — if one is employed — serves as the general partner and investors are limited partners, with the nexus of the entire structure being a hedge fund limited liability partnership, or LLP. Hedge funds traditionally have been structured similarly to mutual funds in that hedge funds are pooled investments dealing in stocks, options, bonds and other securities.

What is a Hedge Fund?

Alfred Winslow Jones generally is credited with creating the first true hedge fund in 1949 as a means of creating a conservative investment portfolio by buying stocks with highly speculative means, such as leverage or margin, and selling other stocks short. Jones also created organizational and fee structures still in use today, including overlay manager asset-management and performance fees based on Jones’s “2/20” ratio — 2 percent for assets under management fees and 20 percent of profits earned through the fund. Originally designed to invest in equity securities and employ leverage and short selling to “hedge” or protect an investment portfolio’s exposure to movements in equity markets, hedge funds today utilize myriad investment techniques and strategies intended to maximize investor returns, according to the Securities and Exchange Commission.

Hedge Fund Tactics

Hedge funds are designed to pursue “absolute returns on their underlying investments,” according to Eurekahedge Global Alternatives. The term "hedge fund" has evolved to describe any absolute-return fund within the financial markets of stocks, bonds, currencies, commodities and derivatives by applying unconventional portfolio management techniques such as shorting, leveraging, arbitrage and swaps. Advances in technology and communications have made the job of overlay managers much easier to accomplish, and allows for the oversight of individual account managers by the overlay manager to ensure that a client’s investment goals are coordinated.

Overlay Management

An overlay manager in a hedge fund coordinates multiple investment products that are customized to the needs of institutional and individual investors. Overlay managers can be individuals or companies that provide overlay management services for a hedge fund. Historically, the coordination of various accounts among separate account managers — stock advisers, mutual funds and other investment vehicles — has been left up to institutional advisers and individual investors. Overlay managers integrate administrative tasks and investment strategies across numerous products and accounts into a single account. The overlay manager serves as a client’s central discretionary authority by weighing, balancing and implementing a client’s investment needs and wishes into a comprehensive strategy and action plan. Overlay management offers more flexibility than traditional multiple-manager scenarios through the use of rebalancing, cash equitization and portable alpha, which is the measure of an investment’s performance on a risk-adjusted basis. When investors find that liquid assets — such as real estate — have become illiquid, overlay managers can use derivative instruments to liberate cash without altering the investment goals.

Hedge Fund Investors

Hedge funds traditionally were investment vehicles for very wealthy individuals, slowly evolving into investment opportunities for institutional investors such as pensions. Many hedge funds still require very large sums of money, although “funds of hedge funds” now make it possible for smaller investors to invest in hedge funds, typically for minimum amounts of $10,000 to $25,000. Overlay managers perform administrative duties for investors such as asset class rebalancing, cash-flow management and tax-loss harvesting — a strategy utilized to reduce tax liabilities by balancing capital gains and losses. Although overlay management can pertain to very specific disciplines such as currency and option-writing overlays, such specialty overlay implementation normally is employed by large institutions as a portion of enormous portfolios. Most overlay managers coordinate multi-discipline portfolios to achieve a client’s established and stated investment goals.

About the Author

John Kibilko has been writing professionally since 1979. He landed his first professional job with "The Dearborn Press" while still in college. He has since worked as a journalist for several Wayne County newspapers and in corporate communications. He has covered politics, health care, automotive news and police and sports beats. Kibilko earned a Bachelor of Arts in journalism from Wayne State University.

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