A hedge fund is a private investment fund open only to sophisticated investors. Depending on the type of fund, the investor may need to fulfill the requirement of “accredited investor” or “qualified client.” In most states, hedge funds are not required to register with the Securities and Exchange Commission and are therefore often regarded as “secretive” or “unregulated.” In actuality, there have been limited regulations placed upon the hedge fund industry and there is a push to have more regulations enacted.
There are an estimated 10,000+ hedge funds in the U.S. today. Hedge Funds are estimated to manage approximately $3 trillion in assets, but because all hedge fund data is self-reported, the exact number is unknown. Estimates of new assets flowing into hedge funds exceed $60 billion on average for the last few years.
The term “hedge” is used loosely and does not always mean that a hedging technique is being used. In fact, hedge funds use a wide array of strategies, and sometimes they are not “hedged” against the market at all.
Hedge funds are usually structured as partnerships, with the general partner being the portfolio manager, making the investment decisions, and the limited partners are the investors. Hedge fund managers aim to produce much higher returns than mutual funds or other investment vehicles and try not to be dependent upon the market. Many times, markets with high volatility are even preferred, since this sometimes yields the highest returns.
While hedge funds themselves have few regulations, hedge fund managers and traders are subject to the same market rules and regulations as any other trader. The beauty of hedge funds is that they can employ a multitude of strategies and they can invest in more asset classes than mutual funds can. This may include real estate, art, PIPEs, soybeans, even website domain names.
The hedge fund manager may also use more sophisticated and riskier techniques such as leverage, short-selling, asset-backed lending, arbitrage, or a variety of other techniques in order to garner maximum returns for investors. Hedge fund managers may also engage in derivatives trading. As the name implies, derivatives derive their price from an underlying security. Options and futures are forms of derivatives and there is a certain amount of leverage inherent in derivatives trading.
While investors may reap the benefits with above average returns, hedge funds do have the reputation of being riskier for a reason. This is why only a handful of investors are allowed to invest in a hedge fund; the SEC does not want the average, middle-class person to lose his life savings in a risky bet. Since hedge funds generally have very little transparency in comparison to mutual funds, the investor really has to do his homework. Conversely, the hedge fund manager must prove himself in order to gain the investors trust, and his money.
Another potential issue with hedge funds is liquidity. Mutual funds have a net asset value that is calculated each and every trading day and can thus be sold at the end of any trading day. Contrarily, most hedge funds have a “lockup period”. During the lockup period, investors are not allowed to sell their shares.