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What is a hedge fund? (Part 2)

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Another Hedge Fund Definition

The term “hedge fund” has been defined numerous times in various government reports and in other financial publications.  We have provided a previous Hedge Fund Definition.  The definition provided below comes from the President’s Working Group report on Hedge Fund Best Practices.

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By “hedge fund” we mean a pooled investment vehicle that generally meets most, if not all, of the following criteria:  (i) it is not marketed to the general public (i.e., it is privately offered), (ii) its investors are limited to high net worth individuals and institutions, (iii) it is not registered as an investment company under relevant laws (e.g., U.S. Investment Company Act of 1940), (iv) its assets are managed by a professional investment management firm that is compensated in part based upon investment performance of the vehicle, (v) its primary investment objective is investing in a liquid portfolio of securities and other investment assets, and (vi) it has periodic but restricted or limited investor redemption rights. (This description is based in part on the definition in the Managed Funds Association’s 2007 Sound Practices for Hedge Fund Managers.) Although hedge funds may invest in private equity and real estate, this Report is not addressed to the specific considerations of private equity or real estate funds.  We use the terms “alternative asset manager” and “manager” to refer to the entity that establishes the investment profile and strategies for the hedge fund and makes the investment decisions on its behalf.

What is a hedge fund?

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In short, hedge funds are pooled investment vehicles. That is, a hedge fund is a company which pools money from its investors (owners) and makes investments pursuant to the fund’s stated investment objective. There are many different types of hedge funds, which can invest in everything from stocks and bonds to more esoteric investments like derivatives, commodities and real estate. In addition to investments in a wide variety of financial or other instruments, hedge funds can “short” certain financial instruments and can also borrow to “leverage” their investments.

Unlike mutual funds, hedge funds are not registered with the U.S. Securities and Exchange Commission. While this means that hedge funds are not subject to the same level of government scrutiny as mutual funds, it does not mean that the SEC and the states cannot bring enforcement actions against hedge fund managers who break the law or make misrepresentations to investors.

While hedge funds are not subject to the more rigorous standards of mutual funds, they will need to comply with the U.S. securities laws regarding “private placements.” Hedge funds are generally sold to investors in “private placements” which means that hedge fund managers cannot advertise and that, generally, investors will need to be “accredited investors” that is they must have either (i) a one million dollar net worth or (ii). The investment managers will also need to adhere to certain filings within each state in which an investor resides. This will generally mean that they must file a “Form D” notice with each state within 15 days of the date in which each investor invests in the fund. The “Form D” must also be filed with the SEC within this time period.