Hedge Fund

What is a hedge fund?

A hedge fund is a private investment fund or pool that trades and invests in various assets such as securities, commodities, currency, and derivatives on behalf of its clients, typically wealthy individuals. (Source: CFTC)

Like mutual funds, hedge funds pool investors' money and invest those funds in financial instruments in an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.

Unlike mutual funds, however, hedge funds are not required to register with the SEC. Hedge funds typically issue securities in “private offerings” that are not registered with the SEC under the Securities Act of 1933. In addition, hedge funds are not required to make period reports under the Securities Exchange Act of 1934. But hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary duties as other investment advisers.

What are "funds of hedge funds?"

A fund of hedge funds is an investment company that invests in hedge funds -- rather than investing in individual securities. Many registered funds of hedge funds have much lower investment minimums (e.g., $25,000) than individual hedge funds. Thus, some investors that would be unable to invest in a hedge fund directly may be able to purchase shares of registered funds of hedge funds.

Before investing in a hedge fund or a fund of hedge funds, be sure to:

1. Read the fund's prospectus or offering memorandum and related materials. Make sure you understand the level of risk involved in the fund's investment strategies and ensure that they are suitable to your personal investing goals, time horizons, and risk tolerance. As with any investment, the higher the potential returns, the higher the risks you must assume.

2. Understand how a fund's assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources.

3. Ask questions about fees. Fees impact your return on investment. Hedge funds typically charge an asset management fee of 1-2% of assets, plus a "performance fee" of 20% of a hedge fund's profits. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return. Funds of hedge funds typically charge a fee for managing your assets, and some may also include a performance fee based on profits. These fees are charged in addition to any fees paid to the underlying hedge funds.

4. If you invest in hedge funds through a fund of hedge funds, you will pay two layers of fees: the fees of the fund of hedge funds and the fees charged by the underlying hedge funds.

5. Understand any limitations on your right to redeem your shares. Hedge funds typically limit opportunities to redeem, or cash in, your shares (e.g., to four times a year), and often impose a "lock-up" period of one year or more, during which you cannot cash in your shares.

6. Research the backgrounds of hedge fund managers. Know with whom you are investing. Make sure hedge fund managers are qualified to manage your money, and find out whether they have a disciplinary history within the securities industry. You can get this information (and more) by reviewing the adviser’s Form ADV. You can search for and view a firm’s Form ADV using the SEC’s Investment Adviser Public Disclosure (IAPD) website. You also can get copies of Form ADV for individual advisers and firms from the investment adviser, the SEC’s Public Reference Room, or (for advisers with less than $25 million in assets under management) the state securities regulator where the adviser's principal place of business is located. If you don’t find the investment adviser firm in the SEC’s IAPD database, be sure to call your state securities regulator or search the NASD's BrokerCheck database for any information they may have.

7. Don't be afraid to ask questions. You are entrusting your money to someone else. You should know where your money is going, who is managing it, how it is being invested, how you can get it back, what protections are placed on your investment and what your rights are as an investor. In addition, you may wish to read NASD’s investor alert, which describes some of the high costs and risks of investing in funds of hedge funds. (Source: SEC)

A hedge fund is a private investment fund charging a performance fee and typically open to only a limited number of investors. Hedge Funds have grown in size and influence on the public securities and private investment markets. Hedge Funds are not currently subject to any direct regulation, unlike mutual funds, pension funds, and insurance companies.

The term is not tightly defined, but is used to distinguish such funds from retail investment funds that are available to the general public. An example of such retail funds in the US are Mutual Funds. Retail funds tend to be highly regulated, limited to holding -- being long of -- a specific range of financial assets such as bonds, equities or money market instruments. Retail funds tend to have a restricted ability to borrow, leverage or hedge their investments, though they may have a limited ability to hedge via derivative contracts.

Hedge funds are limited only by the terms of the contracts governing the particular fund. Hedge funds may be either long or short assets and may enter into futures, swaps and other derivative contracts. In this way, hedge funds are able to follow more complex investment strategies intended to profit from market volatility or from falling market.

Because of the substantial risks involved in unregulated, complex and leveraged investments, hedge funds are normally open only to professional, institutional or otherwise accredited investors. This restriction is often implemented though limits on investor numbers or minimum investment amounts. (Source: Wikipedia)

See also:
Hedging
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