Definition of a Hedge Fund and Hedge Fund Background Information

Oftentimes government sources of information provide us with good, comprehensive definitions like the discussion below on hedge funds.  The Government Accountability Office released a report on Defined Benefit Plans Investing in Hedge Funds that detailed pension plan investments in hedge funds (for our account of the complete article, please see Hedge Fund Report by GAO).  Below is an except from that report which provides a good overview of the hedge fund industry and regulatory environment.  The full report can be found here.

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Although there is no statutory or universally accepted definition of hedge funds, the term is commonly used to describe pooled investment vehicles that are privately organized and administered by professional managers and that often engage in active trading of various types of securities, commodity futures, options contracts, and other investment vehicles. In recent years, hedge funds have grown rapidly. As we reported in January 2008, according to industry estimates, from 1998 to early 2007, the number of funds grew from more than 3,000 to more than 9,000 and assets under management from more than $200 billion to more than $2 trillion globally.

Hedge funds also have received considerable media attention as a result of the high-profile collapse of several hedge funds, and consequent losses suffered by investors in these funds. Although hedge funds have the reputation of being risky investment vehicles that seek exceptional returns on investment, this was not their original purpose, and is not true of all hedge funds today. Founded in the 1940s, one of the first hedge funds invested in equities and used leverage and short selling to protect or “hedge” the portfolio from its exposure to movements in the stockmarket.* Over time, hedge funds diversified their investment portfolios and engaged in a wider variety of investment strategies. Because hedge funds are typically exempt from registration under the Investment Company Act of 1940, they are generally not subject to the same federal securities regulations as mutual funds. They may invest in a wide variety of financial instruments, including stocks and bonds, currencies, futures contracts, and other assets. Hedge funds tend to be opportunistic in seeking positive returns while avoiding loss of principal, and retaining considerable strategic flexibility. Unlike a mutual fund, which must strictly abide by the detailed investment policy and other limitations specified in its prospectus, most hedge funds specify broad objectives and authorize multiple strategies. As a result, most hedge fund trading strategies are dynamic, often changing rapidly to adjust to market conditions.

Hedge funds are typically structured and operated as limited partnerships or limited liability companies exempt from certain registration, disclosure and other requirements under the Securities Act of 1933, Securities Exchange Act of 1934, Investment Company Act of 1940, and Investment Advisers Act of 1940 that apply in connection to other investment pools, such as mutual funds. For example, to allow them to qualify for various exemptions under such laws, hedge funds usually limit the number of investors, refrain from advertising to the general public, and solicit fund participation only from large institutions and wealthy individuals. The presumption is that investors in hedge funds have the sophistication to understand the risks involved in investing in them and the resources to absorb any losses they may suffer. Although many workers may be impacted by any losses resulting from pension fund investment in hedge funds, a pension plan counts as a single investor that does not prevent a hedge fund from qualifying for the various statutory exemptions.

Individuals and institutions may also invest in hedge funds through funds of hedge funds, which are investment funds that buy shares of multiple underlying hedge funds. Fund of funds managers invest in other hedge funds rather than trade directly in the financial markets, and thus offer investors broader exposure to different hedge fund managers and strategies. Like hedge funds, funds of funds may be exempt from various aspects of federal securities and investment law and regulation.

* Leverage involves the use of borrowed money or other techniques to potentially increase an investment’s value or return without increasing the amount invested. A short sale is the sale of a security that the seller does not own or a sale that is consummated by the delivery of a security borrowed by, or for, the account of the seller. Short selling is used to profit by a decline in the price of the security.

Other HFLB articles which relate to items in this article include:

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  1. Pingback: Overview of Hedge Fund Investment Strategies | Hedge Fund Law Blog

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