What is a Hedge Fund?

"What is a hedge fund?" There is an ongoing debate over the answer to this seemingly simple question. Various websites, books, articles, legal authorities and even the fund managers differ over the explanation or definition of exactly what is a hedge fund.

Federal and state securities regulations do not even use the term “hedge fund” but I instead use the term “investment company”. Section 3(a)(1)(C) of the Investment Company Act of 1940 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.”

Over the years following the 1940 Act, as more and more investment companies entered the field and started managing pools of money from wealthy investors, marketing of course became an important factor in attracting these wealthy investors.

Nobody remembers who started using the term first, but needless to say, it caught on like wild fire. The term was “hedging”. If an investment company could claim that it was “hedging” its investments it was making a claim that it could be as profitable in down markets as it was in up markets by hedging its investments.

Many investment companies today call themselves hedge funds but are not hedged at all. This is evidenced by all the hedge fund collapses that we hear about each year. The term hedge fund just stuck. It’s like when someone says “I need a Kleenex” instead of “I need a tissue.”

Anyway, with that background in mind, here is my simple attempt to explain “What is a hedge fund?”

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."

If you want to learn more on this subject click here: What is a Hedge Fund - How to Define a Hedge Fund.

Here's another section you might want to check out on Hedge Fund Formation.