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What Is A Hedge Fund?

Hedge funds sound exclusive, profitable, risky, and complex. Some are hedged; others aren't. It's confusing.

But what exactly is a hedge fund? And why is it so hard to get a straight answer about it?

Hedge Funds Are a Residual Regulatory Category

More than anything else, a hedge fund is a regulatory category of investment fund. In exchange for greater restrictions on the type and number of permitted investors, as well as restrictions on advertising to the general public, a hedge fund faces fewer constraints on the types of investments it can make and the trading tools it can use. This allows the fund to pursue a variety of investment strategies not possible with ordinary investment funds.

Making the matter more slippery, hedge funds are not even an official regulatory category; they are simply a residual group: a term applied to a set of investment companies that―due to their size and legal structure―are not covered by regulations such as the Investment Fund Acts of 1934 and 1940. In the United States, the Dodd-Frank Act of 2010 changes this somewhat, and regulations on hedge funds can be expected to evolve both in response to the 2008-2009 financial crisis and the availability of new technologies.

The regulations that hedge funds are structured to avoid have traditionally been to protect "unsophisticated" retail investors from securities fraud and hidden risks. This is why hedge funds can only receive investments from "accredited" investors and why they cannot overtly advertise to the general public.

In practice, "accredited" simply means an investor who has a minimum level of investible assets and/or income to be considered "sophisticated." The regulations assume that accredited investors have enough experience managing their assets that they do not require the same level of protection and can therefore make investment decisions based on their own more intense due diligence, although the Madoff scandal and other fund failures can make one question that assumption.

Hedge funds are called "hedge funds" for historical reasons more than anything else. The very first funds used short positions to hedge the market (or other) risks of long positions. Not all modern hedge funds do this, although many do. The term "hedge funds" most likely comes from the original "hedged fund," morphed into a phrase that rolls off the tongue more easily. In practice, it is probably easier to understand the hedge fund landscape if one simply avoids placing any meaning on the "hedge" in "hedge fund."

Tools Available to Hedge Funds

Escaping regulation sounds like a recipe for high risks, and it does place a higher due diligence burden on the investor. But it also opens up new trading possibilities and strategies. In particular, hedge funds can:

• Buy securities on margin: This means that hedge funds can use leverage to magnify small-but-identifiable mispricings and make them profitable enough to exploit. This is particularly true in fixed income strategies. The ability to use margin also allows hedge funds to profit from shorting opportunities and overpricings more fully than ordinary funds.

• Use derivatives for speculation as well as hedging: Traditional funds are restricted in their use of futures and options for hedging-only purposes. Hedge funds not only can use derivatives and futures for leverage, cash management, risk management, and speculation, they can also profit directly from mispricings in derivatives markets.

• Invest in illiquid/difficult-to-value assets: Mutual funds must offer the option to invest and/or redeem on a daily basis, based on Net Asset Value (NYSE:NAV) per share. This requires daily pricing and makes it difficult for those funds to invest effectively in illiquid and difficult-to-price assets.

Not only do these tools individually permit new investment strategies, but they can also be combined with traditional strategies and each other to produce a wide array of strategies that previously were not implementable as a fund.

A future post will describe some of the hedge fund strategies in use and how they might fit into an investor's portfolio decisions.

Dividing New Return Sources Among Fewer Investors Improves Returns Too

Recognizing that "hedge fund" is a leftover regulatory category, and that the category enables investment types and trading instruments not traditionally allowed under ordinary regulations, it is now easier to see why so many different assets and investment strategies are included under the umbrella of hedge funds. Over time, more and more investment techniques that were not feasible under traditional rules began to adopt the form and legal structure of hedge funds in order to operate. And not all of them require hedging.

This also helps explain why many hedge fund strategies have been so profitable, particularly early ones. To the extent that a hedge fund strategy actually uncovers something of value (remembering that legal structure alone is no guarantee that things are being managed profitably), the rules on the number and types of investors limit the total capital available to exploit it. This means that―compared to a mutual fund strategy that can be accessed by everyone―the gains that a hedge fund strategy can produce are accessible by and divided among a smaller segment of the total investing population.

Ultimately, dividing a new or unusual return source amongst a smaller community of eligible investors means that some of hedge funds' high-sounding returns are simply a result of regulations restricting the number of investors. It also means that as a hedge fund strategy demonstrates effectiveness and gains acceptance, its advantage may be harder to "compete away" because there are fewer resources for competition to tap. To the extent that a hedge fund's management is responsible, reasonably intelligent, and ethical, many hedge fund investors gain simply from being part of a smaller, elite group that can access opportunities others cannot. This advantage sits on top of any intrinsic merit to the underlying strategy.

Within the universe of hedge funds, however, choice can still matter. Due diligence and effective manager selection is still very important, as investors in Long-Term Capital Management and Bernard Madoff's funds discovered. It is true that hedge funds generally want to protect the intellectual capital unique to their investment process, but much of their publicly perceived secretiveness is simply required in order to maintain their regulatory status.


Disclosures & Disclaimers

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