A “Hedge Fund” is a way of pooling investments that dynamically uses numerous strategies domestically and globally to generate high investment returns. It is somewhat similar to a mutual fund in that it pools assets and is professionally managed; however, it is unlike a mutual fund in many ways.
First, Hedge Funds cater to ultra-rich private investors; they are not sold to the general public or to retail investors. That is probably why you and I do not readily recognize names such as “Appaloosa” and “Fortress Investment Group,” just 2 of the world’s many Hedge Funds. In the United States, the majority of investors in a Hedge Fund must be “accredited” – earning an annual minimum amount of money, having a net worth in excess of $1 million and possessing considerable knowledge about investments.
Secondly, Hedge Funds are frequently set up as partnerships with a general partner (often a limited liability company) responsible for the fund’s operation and one or more limited partners who invest money, initially large sums of money. SEC regulations limit the number of limited partners to 99 in order to avoid SEC registration.
Third, the investments tend to be “illiquid” in that investors are often restricted from subscribing to and redeeming from the fund for a minimum number of days and are sometimes even “locked up,” requiring a minimum commitment, usually 1 year.
Fourth, since Hedge Funds are not sold to the general public and can encompass the globe, they tend to have far fewer regulations than do mutual funds. The traditional notion of “hedging” against threats to the investment historically led to the naming of Hedge Funds but today that notion has a significantly modified application. Hedge Funds now may hedge against some risks but their managers may also employ some highly speculative investments in order to greatly increase the possibility of high returns. The aggressive nature of Hedge Funds was somewhat curtailed by the U. S. after the 2008 financial crisis. The crisis caused the government to seek greater control over these funds and to close regulatory gaps. Investors intent on circumventing at least some of those regulations rely on hedge funds “offshore,” with approximately 75% of all hedge funds being established and maintained in the Cayman Islands.
Fifth, the fee structure of a Hedge Fund is somewhat unique and attractive to money managers because the structure includes: a management fee, which is usually 2% or more of the managed assets; an incentive fee of typically 10 – 20% of the fund profits that are higher than the fund’s previous high (called the “high-water mark”), as a reward. Furthermore, depending on the hedge fund, the profits must exceed a “hurdle rate” when measured against some other types of investments.
Sixth, many Hedge Funds strategize to attain positive returns regardless of the market. This is called “absolute return” and it is characterized as “market neutral” – with less correspondence to market variations – or “directional” – using marking trends and fluctuations.
Seventh, despite the fact that Hedge Funds may sound somewhat financially exotic, investors are often attracted to them for diversification of their portfolios, particularly when the “absolute return” is “market neutral” providing returns even in bear markets.
Eighth, as you might imagine from the Hedge Fund’s nature as a “special mutual fund for the rich,” huge sums reside in hedge funds across the globe. As of summer 2013, nearly $2.5 trillion was invested in hedge funds worldwide. In sum, though you and I might live blissfully unaware of Hedge Funds, they wield considerable financial power throughout the world.
What investments attract hedge funds? Given their investment flexibility and low-to-no profile, the sky is the theoretical limit for hedge funds. They can invest in Far East “distressed equity” markets (reportedly a current favorite), or hotels, or fine art, or other companies, or rare toys, for just a few examples. The flexibility, variety and often-muted natures of hedge fund investments make them very popular with the very wealthy. Hedge Funds are quite popular in certain circles, for excellent reasons.
[Note from HandelontheLaw.com: This article is to be used as an educational guide only and should not be interpreted as a legal consultation. Readers of this article are advised to seek an attorney if a legal consultation is needed. Laws may vary by state and are subject to change, thus the accuracy of this information cannot be guaranteed. Readers act on this information solely at their own risk. Neither HandelontheLaw.com, or any of its affiliates, shall have any liability stemming from this article.]