Hedge Fund Definition

Hedge Fund Definition - During the 1940's and 1950's when limited partnerships were set up with investors they came under certain exemptions and did not have to register with the U.S. Securities and Exchange Commission (“SEC”) under the Investment Company Act of 1940 (the “1940 Act”). All mutual funds had to register, but certain investment companies did not have to register if they were exempt under certain provisions of the 1940 Act and the state laws of the state in which they had offices.

Some early funds went long on undervalued stocks and short on overvalued stocks in a way "hedging" their investment portfolio. The term market-neutral strategy also became popular and is a very popular strategy used my hedge funds today.

Many funds today, however, are not really hedged at all. It’s just that the term became so popular that it stuck and now everyone uses it and hardly anyone uses the term "investment company".

If you look up the term “Hedge Fund” in either

the Securities Act of 1933;
the Securities Exchange Act of 1934;
the Investment Company Act of 1940; or
the Investment Advisers Act of 1940

you won't find anything, because they don’t define or discuss the term "hedge fund" so there is no hedge fund definition in those regulations. The various states eventually started adopting their own securities regulations over the years and based most of their regulations on the SEC regulations to keep uniformity, but in some cases the states laws are more restrictive.

For instance, a hedge fund exempt under the SEC federal regulations is also exempt in the state of New York, because New York pretty much mirrors the 1940 Act. That is not the case in all states so each state law has to be reviewed based on where the fund has its principle, as well as satellite offices.

Based on the above explanation, the same holds true for the term "Hedge Fund Manager" which really is the same as an "Investment Adviser", since none of the regulations talk about Hedge Fund Managers. If you look at the various state securities regulations, you aren't going to find anything under the term “Hedge Fund” or “Hedge Fund Manager” since most of the state regulations somewhat mirror the federal regulations.

Here is my Hedge Fund Definition which is based on experience, review of federal and state regulations, forming several hedge funds for clients and advising those clients over the years.

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" or “investment company.”

There are numerous strategies used by hedge funds. They include: long-short, long-short market neutral, long only, contrarian, futures, convertible arbitrage, bonds, opportunistic, distressed equity, emerging markets, macroeconomic, special situations, multi-strategy, fund of funds and many more.

There are sub categories within each of the strategies that can be based on a particular industry, like energy, pharmaceutical, biotech or manufacturing. There are no regulations or hard and fast rules as to what category a fund actually fits into. Websites and data reporting sources tend to have their own categories that don't exactly match with one another although they are fairly close.

One interesting strategy that is relatively new to the hedge fund definition is the "activist" strategy. Bulldog Investors is quite popular and has built a reputation around this strategy. An activist fund basically examines a public company that is mismanaged for one reason or another. It could be mismanaged because it is carrying too much debt and paying too much interest, or it has cash that could be used for a share buy-back to improve the share price, or it could even been that management is paying itself way too much in salaries and bonuses to the detriment of its share price and shareholders. The activist fund will then push the company to make changes to improve its share price. It may even call for a shareholder's meeting to air these matters publicly and get the shareholders to push for such changes.

If you need more on this hedge fund definition, check out What is a Hedge Fund?

If you are more interested in hedge fund definition as it relates to formation then click Hedge Fund Formation