A private investment pool, managed by a professional investment firm.

A hedge fund can be broadly defined as a privately offered fund that is administered by a professional investment management firm (or “hedge fund manager”). The word “hedge” refers to a hedge fund’s ability to hedge the value of the assets it holds (e.g., through the use of options or the simultaneous use of long positions and short sales). However, some hedge funds engage only in “buy and hold” strategies or other strategies that do not involve hedging in the traditional sense. In fact, the term “hedge fund” is used to refer to funds engaging in over 25 different types of investment strategies, that fall in five major groupings: global macro, directional, event driven, relative value and miscellaneous.

Unlike hedge funds, mutual funds are widely available to the general public and therefore must be registered under the Investment Company Act of 1940 and the U.S. Securities Act of 1933. As a result, mutual funds are subject to rigorous SEC oversight and regulation. Mutual funds are limited by regulation in the strategies they can employ (e.g., mutual funds are limited in their ability to engage in short sales and use leverage). Hedge funds, on the other hand, typically qualify for exemptions from registration under the securities laws and therefore generally are not constrained by regulatory limitations on their choice of investment strategies. Whereas mutual funds often seek to realize “relative” returns, that is, they measure their success by comparison to the performance of a benchmark like the S&P 500 stock index; hedge funds typically pursue “absolute returns”, which often are purposefully not correlated to a traditional investment index or measure. In this way, hedge funds can offer investors returns that offset the risks of more traditional stock and bond investments and therefore diversify and enhance the overall returns of their investment portfolios. In addition, hedge fund managers typically have a substantial amount of their own capital invested in the funds they manage – often more closely aligning the managers’ interests with those of their investors.

Many hedge fund strategies provide returns to investors that are not correlated to those of traditional stock or bond markets.

As noted above, hedge funds often are not restricted either contractually or by regulation in their choice of investment strategies. As a result, the hedge fund industry represents a widely varied universe of investment styles and strategies. The major strategies include “macro” or global directional investment strategies; “market-neutral” or arbitrage strategies; long only, short only or long/short strategies for trading in equities; eventdriven strategies, which seek to profit from anticipated events, such as mergers or restructurings; regional strategies, which concentrate on a particular geographic region (such as emerging markets), sector strategies, which focus on a particular industry; and specific asset class strategies (such as currencies). One of the reasons that regulators have restricted retail investors’ access to hedge funds is the more complex risk/reward ratio that these alternative investment strategies can present. A list of over 25 investment strategies and their definitions can be found at the web site for Hedge Fund Research, Inc. (http://www.hedgefundresearch.com/pdf/HFR_Strategy_Definitions.pdf).

Although many hedge fund strategies rely on leverage to achieve desired returns, many do not.

Hedge funds are in the business of seeking and assuming calculated risks in order to achieve the returns desired by their investors. Some hedge funds invest in generally lowrisk strategies, such as securities arbitrage, and leverage their positions in order to offer a reasonable expectation of return. Other hedge funds employ little leverage, particularly where the instruments in which they invest already have a high risk-return tradeoff.

Institutional investors and a restricted class of high net worth individuals.

Domestic and foreign insurance companies, university and charitable endowments, pension funds, banks and other investment funds are among the most significant investors in U.S. hedge funds. Because they are not registered for public sale, hedge funds are required by law to limit their U.S. investors to those that satisfy special qualifications under the U.S. securities laws (as described below). Specifically, hedge funds typically comply with one of the following two exclusions of the Investment Company Act of 1940 in order to avoid the need for fund registration:

• Section 3(c)(1): This exclusion provides that a fund that sells its shares privately to no more than 100 investors is not subject to regulation as an investment company. In order to offer the fund’s shares privately (i.e., without registering with the SEC), the fund sponsor must offer shares only to “accredited investors”, which include banks, business development companies, trusts and other institutional investors as well as natural persons with net worth of $1 million or individual income in excess of $200,000 or joint income in excess of $300,000 in each of the last two years.
• Section 3(c)(7): This exclusion provides that an investment pool is not subject to regulation under the Investment Company Act of 1940 if each investor in the pool is a “qualified purchaser”. The term qualified purchaser includes: natural persons who have at least $5 million in investments; persons who, acting for themselves or the accounts of other qualified purchasers, in the aggregate own and invest on a discretionary basis not less than $25 million in investments; certain qualifying trusts and institutional investors.
  

An increasing recognition that many hedge funds are a valuable diversification tool that can perform well in falling markets.

Many hedge funds provide attractive mechanisms for portfolio diversification because their returns have little or no correlation to those of more traditional stock and bond investments. As a result, many hedge fund categories tend to outperform these investments during periods of poor market returns. Much of the growth in hedge funds since the 1980s can be attributed to the increasing recognition by institutional investors, confirmed by a growing body of academic research, that hedge funds are an attractive alternative asset class that can help diversify returns and, in doing so, reduce the overall risk of an investment portfolio. Other reasons that account for increased interest in hedge funds include the decline in mutual fund returns and the movement of talented investment professionals to trading on behalf of hedge funds.

The term “retail” hedge funds refers to registered mutual funds that invest in hedge funds.

Due to increased investor interest in hedge funds, certain fund sponsors have recently registered mutual funds that invest in hedge funds, or “funds of hedge funds”, with the SEC in order to offer these products to the public. Because these funds are registered for public offering, they can be made available to investors that meet lower financial net worth and sophistication standards than those required of direct hedge fund investors. Although these investors may have legitimate interests in gaining exposure to hedge fund investment strategies and returns, it is important that these investors be capable of assessing and understanding the risks associated with such investments. In response to concerns raised regarding these retail funds of hedge funds, the SEC has included investor advice regarding these products on its web site at www.sec.gov/answers/hedge.htm. The NASD also published a Notice to Members in February 2003 reminding its members of their obligations when selling funds of hedge funds to retail customers.

Although the hedge fund industry has grown in recent years, hedge funds represent only a small fraction of the investment industry as a whole.

According to PerTrac’s (www.pertrac.com) February 2009 data there are in excess of 18,000 hedge funds and fund of funds in existence worldwide, with total assets under management of approximately $1.5 trillion. It is estimated that 75% of all hedge fund assets are managed by just over 200 firms, each with over $1 billion in assets under management. While these figures reflect strong growth in recent years, the hedge fund industry remains small relative to the estimated $16.2 trillion mutual fund industry.

Hedge fund fees generally differ from those charged by retail mutual funds in that they are in large part tied to performance, while mutual fund fees tend to be simply a fixed percentage of assets (regardless of performance). A typical hedge fund manager may charge a 1% fee based on assets under management and be entitled to 20% of any trading profits as a “performance fee”. This means that the fund manager must make a profit for investors in order to receive a performance fee. Mutual funds fees – which include sales loads, asset management, administrative and distribution fees – are generally a fixed percentage of assets under management. Performance fees are essential to a hedge fund manager’s ability to attract and retain the most talented and sophisticated investment professionals because they allow the manager to compensate them based on the returns they earn. Many investors believe that a performance-fee arrangement causes the interests of a fund manager to be better aligned with those of the fund’s investors.

Because hedge fund managers often engage in complex trading strategies that involve risks of varying types and degrees, a sophisticated and rigorous approach to risk management is essential to their success. As a result, many hedge funds have been actively investing in and building risk management systems that rival those of the largest global financial institutions and hiring the best available risk managers. Since 2000, the hedge fund industry has published a series of detailed recommendations on sound risk management practices, most recently by MFA in 2009 (see MFA’s 2005 Sound Practices for Hedge Fund Managers). These recommended practices have been adopted by the larger hedge fund managers in recent years, as their growth has resulted in the implementation of more formalized and sophisticated management policies and structures. These risk management recommendations address the establishment of an independent risk monitoring function, the use of “value-at-risk”, or VAR, models for managing market risk, the performance of stress tests and back-testing, the management of liquidity and counterparty credit risk and measuring leverage and its impact on other types of risk, among other risk management practices.

“Private” does not mean “unregulated”: hedge funds are regulated in a variety of ways.

• Restrictions on Offerings to the Public, Advertising. As noted above, hedge funds are offered privately and thus are required to comply with well-established statutory and regulatory exemptive provisions related to private offerings. These “private placement” exemptions require hedge funds to limit their offerings to certain sophisticated investors and to file notices with the SEC and with State securities regulators of sales made in reliance thereon. In addition, hedge fund managers are generally prohibited from advertising, engaging in general solicitation or holding themselves out to the public as investment advisers. This prohibition on publicity may account for some of the “mystique” attributed to hedge funds and the limited public understanding of hedge fund investments.
• Compliance Requirements for Registration Exemptions. As noted above, in order to operate free of Investment Company Act of 1940 restrictions, hedge funds must either be restricted to investors that are “qualified purchasers” or have no more than 100 investors.
• Registration Requirements for Investment Advisers. A hedge fund manager with more than 14 clients (including other hedge funds) is required to register as an investment adviser with the SEC under the Investment Advisers Act of 1940, and consequently many hedge fund managers are so registered. In addition many states have their own investment adviser regulatory requirements that require hedge fund managers to be registered with the state despite their exemption from federal SEC registration.
• Anti-Fraud Provisions, Insider Trading Prohibitions under the U.S. Securities Laws. All hedge funds and their managers and advisors are subject to the broad anti- fraud and anti-manipulation provisions of the Securities Act, the Exchange Act and the Advisers Act which prohibit fraud in connection with the offer, sale and purchase of securities and in connection with the advisory relationship. In addition hedge fund managers are subject to the U.S. securities laws’ prohibitions on insider trading.
• CFTC Regulation. Many hedge funds are subject to the futures regulatory framework administered by the Commodity Futures Trading Commission (“CFTC”) because they are managed by commodity pool operators (“CPOs”) registered with the CFTC and invest in futures contracts and commodity options. In addition, if a fund manager is providing commodity trading advice to other accounts, it may be required to register as a Commodity Trading Advisor (“CTA”) with the CFTC unless an exemption applies. CPOs and CTAs must be members of the National Futures Association (“NFA”), the self-regulatory organization for the futures industry, and are required to comply with applicable NFA rules and requirements, including periodic audit by NFA. In addition, CPOs, CTAs and the pools they manage or advise are subject to various recordkeeping and reporting requirements under the Commodity Exchange Act and CFTC regulations depending on the status of the funds’ investors. In addition, a number of larger hedge funds have broker-dealer affiliates that are heavily regulated by the SEC and the NASD.
• Reporting Requirements. As with other market participants, hedge funds are required to comply with certain reporting requirements designed to increase market transparency, including:
• SEC Portfolio Reporting. Any institutional investment manager with investment discretion over $100 million or more in equity securities at the end of a calendar year must file quarterly reports with the SEC containing position information about the equity securities under the discretion of the fund manager, and the type of voting authority exercised by the fund manager.
• SEC Reporting on Ownership of Equity Securities. The Securities Exchange Act requires any person, who directly or indirectly, acquires more than 5% of any class of shares of a domestic public company to file a report with the SEC within 10 days of such acquisitions. Additional reporting is required if a person acquires more than 10% of the shares of a domestic public company.
• Treasury Large Position Reporting on Government Securities, Auctions. The U.S. Treasury imposes reporting and recordkeeping requirements on entities, including hedge funds, holding large positions in tobe- issued or recently issued Treasury securities. It also requires any customer awarded more than $500 million of government securities in a Treasury auction to file a confirmation which includes its reportable net long position (if any).
• Treasury Large Position Reporting on Foreign Exchange. The U.S. Treasury requires weekly, monthly and quarterly reports of data on foreign exchange contracts and positions of major market participants.
• CFTC Large Trader Reporting System. Hedge funds that trade in U.S. futures markets (even if not subject to commodity pool regulation) may become subject to the CFTC’s large trader reporting system, under which futures traders with positions that exceed specified reporting levels must provide certain information to the CFTC. CFTC Speculative Position Limits. Hedge funds, as with all traders in U.S. futures markets, are subject to position accountability or speculative position limit rules.
• Anti-Money Laundering Regulations. U.S. hedge funds (and hedge funds with a U.S. nexus) will likely be required to comply with certain key provisions of the USA PATRIOT Act once final rules are promulgated with respect to hedge funds. Hedge funds have actively worked with Treasury and other regulators in developing anti-money laundering regulations for this industry. MFA has published preliminary guidance on developing anti-money laundering programs in order to prepare hedge funds for complying with these requirements, notably:
  • Anti-Money Laundering Program Requirement. Section 352 requires financial institutions to establish an anti-money laundering (AML) program that includes at a minimum: the development of internal policies, procedures and controls; the designation of a compliance officer; an ongoing employee training program; and an audit function to test AML programs.
  • Customer Identification Program Requirement. Section 326 requires financial institutions to establish customer identification programs.
• Indirect Regulation by Banks and Brokers. The relationships of hedge funds with commercial banks and broker-dealers that lend or provide brokerage services to or transact with hedge funds are subject to regulation by securities and banking regulators. Specifically, banks are required to perform regular credit assessments of their hedge fund borrowers and counterparties, and similarly brokers are subject to net capital and margin rules that require them to actively monitor the positions of and manage their exposures to hedge fund customers.

Public and private sector experts have recognized that hedge funds provide significant market as well as investor benefits. Hedge funds enhance market liquidity, helping to absorb shocks in volatile markets, reducing the severity of price fluctuations and fostering smaller bid-ask spreads and lower transaction costs. Banking supervisors have acknowledged that hedge funds can provide systemic benefits to financial markets by increasing liquidity and efficiency, and fostering financial innovation and the allocation of financial risk; in short, they may add depth and liquidity to financial markets and can be stabilizing influences. Hedge funds also provide a critical source of liquidity to relatively illiquid markets and structured investments, such as the mortgage derivatives, distressed securities and risk arbitrage markets, which depend upon access to sizeable pools of investment capital.