How to Define a Hedge Fund

"How to define a hedge fund?" There is some controversy among various legal authorities, websites and even hedge fund managers themselves over this simple question.

Originally hedge funds were simply private investment vehicles for the wealthy. An experience money manager would invest the money on behalf on the investors in the fund. The key was diversification so that the investments could hold up in harsh economic times such as a recession, inflationary periods, stagflation and even a depression.

To define a hedge fund one must look at the background and history of hedge funds, which I attempt to cover briefly below, but here is my attempt at a definition.

A hedge fund operating in the United States is an investment vehicle, usually formed as a limited partnership, with a separate entity acting as the manager or adviser. The manager or adviser usually receives a 2% management fee based on a percentage of the assets under management, as well as some form of performance fee usually 20% of the increased value in the assets based on the investments being made. The hedge fund can either use one style or investment strategy or can use a multi-strategy approach. To truly "hedge" its positions, however, it must use some technique such as derivative instruments, shorting, convertible securities or reset provisions otherwise it is not really a hedge fund it is just an "investment fund."

An interesting observation that most people don't realize is that even though hedge funds and hedge fund managers are regulated at the federal and state level if you look at those regulations there is no reference to the term "hedge fund".

At the federal level the body of law that regulates hedge funds is called "The Investment Company Act of 1940".

Section 3(a)(1)(A) of the Investment Company Act defines an investment company as an issuer which is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in “securities.”

Section 3(a)(1)(C) of the Investment Company Act defines an investment company as an issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire “investment securities” having a value exceeding 40 percent of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis.

If you want to learn about how to define a hedge fund and Hedge Fund Formation click here:Hedge Fund Formation - How to Define a Hedge Fund