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What’s a Hedge Fund? Part I

BLOG, EDUCATION  |  2 Mar 2010

We hear about these things all the time, usually in the context of someone talking about a “billionaire hedge fund manager”. Most people who don’t really know what hedge funds are have nevertheless formed impressions that they are risky and only available to the ultra-wealthy. Is there any truth behind these impressions? Let’s talk.

What’s behind the term “hedge fund”?

Interestingly enough, hedging actually means reducing risk. The first hedge funds were created to do just that, reduce the effects of market downturns. Today, the term applies to a variety of investment strategies, many of which have nothing to do with hedging. What all hedge funds have in common is that they are all pooled private investment vehicles that are largely unregulated, and which are only open to a select class of investors. Like actively managed mutual funds, hedge fund performance depends on the talents of the fund’s managers.

Are hedge funds risky?

All investments carry risk, so the better question is how do they compare with other common investments like stocks, bonds and mutual funds? Okay, I said that was a better question, but I didn’t say that it was a good one. The thing is, hedge fund strategies and objectives are all over the map. Some use strategies that are relatively safe, while others employ strategies that are very speculative.

What are some common hedge fund strategies?

Because hedge funds are subject to relatively little regulation, they have much greater flexibility than mutual funds in the strategies they employ. Some strategies include using leverage to enhance returns (and risk), long/short investing, arbitrage, buying distressed debt, using options and derivatives, and market neutral equity investing.

Who can invest in Hedge funds?

Unlike mutual funds, hedge funds are largely unregulated because they are only available to investors who are considered to be “sophisticated”. Not sophisticated as in rare wine and opera, rather hedge fund investors are thought to have investment savvy. How does one acquire this financial acumen? By having lots of money, of course! Most hedge funds require investors to be what is known as “accredited”. These are people whose net worth is over a million dollars, or whose income has been $200,000 a year ($300,000 for married couples) for the last two years and is expected to stay at that level. The fact that the SEC has determined that the mere status of being a millionaire somehow implies financial acumen is somewhat strange. (Think lottery winners, teenage heirs, and young professional athletes.) In any event, the SEC takes the position that accredited investors, by virtue of their sophistication, do not require the level of regulatory protection that is afforded to the less well-heeled.

In Part II, I’ll cover more on the differences between hedge funds and mutual funds, and some of the legal protections that are available to hedge fund investors.