What is a Hedge Fund?

What is a hedge fund?

A hedge fund is a limited liability investment pool run by a separate manager, which is not widely available to the public. A hedge fund formed under Section 3(c)(1) of the 1940 Investment Company Act can have up to 100 investors, whereas a hedge fund formed under Section 3(c)(7) can have up to 500 investors who are “qualified purchasers.” See http://www.law.uc.edu/CCL/InvCoAct/index.html. A hedge fund can invest in a wide variety of financial products otherwise unavailable to mutual funds (also known as registered investment companies).

Who created the first hedge fund?

Alfred W. Jones is widely credited with having created the first hedge fund, in the 1940s. His first hedge fund consisted of long and short positions, the latter giving rise to the term “hedged fund,” which later evolved to “hedge fund.” However, it is rumored that Warren Buffett may have been the first person to create a hedge fund.

Must a hedge fund have under management a minimum amount of assets?

No. While the average hedge fund manages millions of dollars, hedge funds can manage anywhere from hundreds of thousands of dollars to billions of dollars.

Do larger hedge funds perform better than smaller hedge funds?

No. New research shows returns of larger hedge funds lag those of smaller hedge funds. See http://www.reuters.com/article/idUSN1117515220101111. Furthermore, research of returns from January 1996 through December 2010 indicates that smaller hedge funds have outperformed larger ones by 3.95% annually. See http://www.hedgeindex.com/hedgeindex/documents/2010%20Hedge%20Fund%20Ind…

Must a hedge fund manager be registered as an investment advisor?

No. Under the Investment Advisors Act of 1940, Section 203(b)(3), registration is not required for hedge fund managers with fewer than fifteen clients. Under this law, a hedge fund is deemed “one client.”

Must a hedge fund register with the Securities & Exchange Commission?

If a hedge fund’s assets under management exceed $150 million, then a hedge fund must register with the Securities & Exchange Commission. See The Private Fund Investment Advisers Registration Act of 2010 codified in Frank-Dodd Wall Street Reform and Consumer Protection Act (Pub. L. 111-203, H.R. 4173), http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf

Why are hedge funds not allowed to advertise?

Because Regulation D, Rule 502(c) of the Securities Act of 1933 states: “neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following…[a]ny advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio.” See http://www.law.uc.edu/CCL/33ActRls/rule502.html. This law was and remains predicated on the false theory that non-wealthy investors (i.e., those with a net worth less than $1 million) are unable to comprehend financial information and act in their best interests, and that wealthy investors can “afford” to lose their minimum $1 million investment in a hedge fund.

Who invests today in hedge funds?

Individuals, government pension funds (such as the New York State Common Fund and CALPERS), retirement funds, university endowments (such as Harvard and Yale), charitable foundations insurance companies, and other financial institutions.

Who can invest in a hedge fund?

Contrary to myths propagated by some media outlets, anyone of contract age (18 and over) can invest in a hedge fund that accepts non-accredited investors. An accredited investor has several definitions; the one most widely-cited is that s/he has a net worth exceeding $1 million. See http://www.sec.gov/answers/accred.htm

In what type of financial products do hedge funds invest?

This list is meant to be illustrative, not comprehensive: mutual funds, exchange traded funds, stocks, commodities, convertibles, corporate bonds, credit-default swaps, currencies, derivatives, futures, illiquid assets, initial public offerings, mortgage-backed securities, options, private equity, real estate, and venture capital.

How is a hedge fund different than a mutual fund?

A hedge fund can invest in a wide variety of financial products otherwise unavailable to mutual funds. A hedge fund is not required under federal and state securities laws to disclose its holdings to anyone (including its own hedge fund investors), whereas mutual funds are required to issue prospectuses, and semi-annual and annual reports.

Can a small hedge fund with fewer than $1 million in assets compete with a larger hedge fund with $50 million in assets?

Yes. Asset size does not cause low or high returns. While there are documented cases of extreme asset size (termed “asset bloat”) causing a fund’s returns to lag behind its peer funds, there are no documented cases of hedge funds with small asset size producing lower returns within their category on account of their size (excluding cases of gradual or pending liquidation which is a separate issue). While a lack of capital may prevent a hedge fund manager from implementing all of its investment and trading strategies at a particular moment in time, it does not follow that the particular investments and / or strategies the hedge fund manager is unable to implement due to dearth of capital would have produced higher returns for the hedge fund.

Is a hedge fund the riskiest investment vehicle available?

No. There is nothing inherently risky about hedge funds. Risk should be measured as a function of investment and trading strategy – not as a function of investment vehicle. Of course positions that have limited downside with exponential upside are the ultimate in the risk/reward tradeoff, and a manager who successfully executed such strategies could be working for any type of investment vehicle – hedge fund, privately managed account, mutual fund, and so forth. Hedge funds produced relatively better risk-adjusted returns than traditional asset classes in 2010 and they posted returns on par with global equities with nearly one quarter of the risk. See http://www.hedgeindex.com/hedgeindex/documents/2010%20Hedge%20Fund%20Ind…

For example, think of a hedge fund investing 100% of its assets in U.S. government bonds versus a mutual fund investing 100% of its assets in the riskiest companies in Russia and the Former Soviet Union. Which investment vehicle is riskier in this scenario?

What value is there in analyzing the past performance of a hedge fund?

In comparing the performance of one hedge fund to its category benchmark (i.e., compare a hedge fund with a long-short strategy to its peers), one can determine the rate of alpha generation, its standard deviation risk, and a multitude of other factors allowing one to determine whether a particular hedge fund produced higher returns with lesser risk than those in its peer category. One can also compare the hedge fund’s performance over time to that of other hedge funds on an individual basis. Although the past performance of a hedge fund is only one factor a potential investor should consider prior to investing in a hedge fund, it is an important factor nonetheless.

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