Hedge Funds

Hedge funds are usually structured as private investment partnerships that (as of April 2009) are exempt from many SEC regulations (as long as they abide by the rules and stay within the safe harbor). This appears likely to change as a result of the financial crisis of 2008.

From a U.S. perspective, there are two classes of hedge funds: onshore funds, which are located domestically, and offshore funds, which are domiciled outside of the United States. Safe harbor refers to limitations that investment companies must abide by in order to be exempt from most SEC regulation. These include restrictions on publicity and strict guidelines about the number and kind of investors they accept.

Hedge Funds or Hedged Funds? A Tangle of Terminology

The term hedge fund comes from the early use of these funds for hedging against a downturn in the markets by engaging in short sales. Today, paradoxically, many hedge funds do not engage in any hedging, but the term seems to be here to stay. Some advocate using the term hedged fund to describe the original type of fund; others have introduced absolute return fund to refer to the broader class of offshore and onshore hedge funds, allowing “hedge fund” to retain its original definition. Regulatory, technological, and economic changes have further confused the issue by blurring the distinction between hedge funds and the wider universe of mutual funds. For example, so-called 130/30 funds may be offered in a mutual fund format, even though they use some leverage and short-selling strategies traditionally associated with hedge funds.

short sale

Sale of securities not owned by the seller; used by investors anticipating a decline in the value of a security, or as a hedge.

Many domestic money managers offer both onshore and offshore hedge funds. The onshore fund is for sophisticated investors who, as U.S. nationals, are prohibited from investing in offshore funds. The offshore funds are for non-U.S. citizens (and tax-exempt domestic entities like pension funds, foundations, and endowments). The world of hedge funds is growing in importance. Over the last decade, it has become easier for accredited investors to find out about hedge funds.

Are You an Accredited Investor?

The lower threshold is liquid net worth of $1 million or income exceeding $200,000 for at least two consecutive years with the expectation that it will continue. There is also a new, more stringent requirement for funds that wish to accept more than the previous limit of 99 investors. These 3c-7 funds require a minimum net worth of $5 million.

Increasing numbers of accredited investors have decided that hedge funds offer benefits that mutual funds don’t. Fighting back against this trend, mutual funds have become a bit more like hedge funds, striving for more flexibility in their investment strategies to counter the perception that hedge funds are simply better investment vehicles. This trend was facilitated by the end of a longstanding restriction on mutual funds, the short-short rule, which formerly prohibited mutual fund managers from engaging in aggressive short-term trading strategies without worrying about endangering the fund’s pass-through tax status. Nonetheless, hedge funds remain far more flexible as investment vehicles, and this is unlikely to change soon. A note of caution: As the much-publicized 2007-2008 collapse of many prominent hedge funds showed, the freedom that hedge funds have with regard to investment strategies often magnifies risk as well as return.

Over the last decade, hedge funds increased in size and number as banks, mutual fund groups, and others launched hedge funds, trying to capture a piece of a very profitable business. In the case of mutual fund groups, these hedge funds frequently had investment objectives similar to those of their existing mutual funds. This raised the concern that managers might favor the hedge fund over the mutual fund when making investment decisions. Why would they? In addition to the 1 to 2 percent management fee, hedge fund managers typically also receive 20 percent of the profits of the hedge fund, as long as the fund is above its (or the investor’s) high-water mark. In contrast, mutual funds generally do not charge performance fees.

This more lucrative fee structure could create a financial incentive to favor the hedge fund in executing investment strategies. It should be noted, however, that hedge funds are typically far smaller than their mutual fund brethren, not only in terms of legal limitations on the number of investors, but also because of capacity constraints on the strategies employed by many hedge fund managers.

Additional information about hedge funds is available from a number of sources:

• Alpha Magazine (212-224-3300, www.iimagazine.com/alpha) is published by Institutional Investor (“II”). II publishes a wide range of specialty newsletters for institutional investors, in addition to Alpha Magazine and its flagship publication, Institutional Investor Magazine. While many of these publications cost over $1,000 per year, a wide variety of free information is available on their website. www.iimagazine.com.

• The U.S. Offshore Funds Directory (212-371-5935, www.hedgefundnews.com) is an annual publication providing information on more than 1,200 offshore funds. Cost: $695.

• Lipper TASS Hedge Fund Data. (www.lipperweb.com) has data and research on hedge funds and related alternative investments. The company has a New York office (877-955-4773). The database includes information on more than 7,000 actively reporting hedge funds and CTAs and over 6,000 funds and CTAs that have either closed, liquidated, or just stopped reporting. Information on funds that have stopped reporting is important because it helps mitigate the problem of selection bias which arises when funds with better records report more frequently than do funds with poor records.

alternative investment

Investments intended to help diversify a traditional stock/bond portfolio, such as real estate, hedge funds, or commodities.