What is A Hedge Fund: Part 1

A hedge fund offers a wide variety of opportunities for the sophisticated, well-off investor. A key feature is the ability of the hedge fund to ratchet its risk profile up and down by taking offsetting short positions within and across different asset classes.

Hedge Fund Strategies

Generally speaking, a hedge fund is a private, open-ended company formed for the purpose of investing. It is differentiated from other types of hedge fund strategies by its organization, its membership, its activities and its compensation scheme.

Hedge Funds Are Privately Organized Companies

Most commonly, hedge funds are organized privately, though there are jurisdictions in which investment companies that resemble hedge funds in form or function may be accessible to the general public. These more readily accessible structures include UCITS in the European Union, structured notes or various forms of insurance participation.

Organizing Hedge Funds

Organizing as a private company gives the sponsor of the hedge fund flexibility in terms of the investment strategies the fund can employ. In addition, in targeting sophisticated, wealthy investors and institutions by raising funds via a private placement, the hedge fund qualifies for exemption from securities and mutual fund registration with the local jurisdiction.

In the United States, there are two types of safe harbour from prospectus registration requirements for the securities offerings of interests in the hedge fund under the Investment Company Act of 1940: Section 3(c)(1) and Section 3(c)(7). To merit the benefit of these legal carve-outs, the hedge fund must restrict itself to soliciting only a particular type of investor and there are limits to the number of investors in the fund under each proviso.

In the case of a 3(c)(1) fund, the interests may be offered only to “accredited investors” and the fund cannot have more than 100 of these accredited investors. An accredited investor is defined in the US Investment Company Act of ’40 as someone, individually or jointly with their spouse, having a net worth or annual income above a defined threshold. The minimum net worth for accredited investors is $1 million, individually or jointly. The minimum annual income is $200,000 ($300,000 for married couples) in each of the past two years with the expectation of earning at least that amount in the next year. There are also other types of institutional accredited investors.

For a 3(C) (7) fund, the hedge fund may offer its interests under a private placement to so-called “qualified purchasers”, defined (again, in the US Investment Company Act of ’40) as a natural person who owns at least $5 million in investments (securities and other permitted assets held for investment purposes). Again, there is a restriction on the number of qualified purchasers in a 3(c)(7) fund, with the limit imposed at 500 investors.

Hedge Funds Have Greater Flexibility With Respect To Investment Strategy

Restrictions and Regulations

There are a number of restrictions imposed on traditional, regulated investment vehicles such as mutual funds. These include limits on financial leverage, on the types of investments the fund can make, and the way in which the fund manages risk. Hedge funds are permitted greater freedom than these traditional investments, in part because the investors who are allowed to invest in hedge funds are deemed to be sophisticated enough to understand the more complex risks the manager undertakes. For example, a hedge fund can lever his positions (with an additional turn of leverage for equity).

Hedge Funds in an American Context

This article describes things with an American context, given the prevalence of hedge funds in the U.S. There are important differences with other regimes that merit specific attention.
A hedge fund investor can invest in private securities or directly in real assets, such as physical gold. A hedge fund may have much less liquidity than the typical requirements for daily liquidity in an open-ended mutual fund, permitting the hedge fund’s general partner to invest in such strategies as distressed debt or derivative products (including structured products). A hedge fund is not subject to the reasonable requirement of diversification, substituting active management of a concentrated portfolio in order to generate excess returns above what the Capital Asset Pricing Model (CAPM) would suggest for a portfolio with a given beta. And a hedge fund is able to invest in a dizzying array of instruments, limited only by the contractual restrictions to which it agrees to abide contractually in the fund’s offering documentation.

Hedge Funds and Risk Profile

Most important, as a differentiating factor, is the ability of the hedge fund to ratchet its risk profile up and down by taking offsetting short positions within and across different asset classes, in addition to managing its use of leverage dynamically with a view to increasing leverage in less volatile markets and reducing leverage in more volatile markets.

Cost Effectiveness

This speaks to the purpose of the hedge fund. It may be more cost-effective for the end investor to be a limited partner in an investing partnership managed by an experienced, highly talented manager with immediate presence in a specific market than for the investor to replicate this strategy herself. A subsequent article will discuss other contractual provisions such as redemption terms.

-Article By Chand Sooran, Point Frederick Capital Management, LLC. Disclaimer

6 years ago