Hedge Funds

There is no exact definition to the term "hedge fund", it is undefined in federal or state securities laws. There is neither an industry-wide definition nor a universal meaning for "hedge fund" according to the SEC. Since hedge funds do not register with SEC, their actual data cannot be independently followed; therefore hedge fund data is self-reported. There are over 9,000 hedge funds in the U.S. today. Hedge Fund assets are estimated to manage $2.0 trillion in assets. Estimates of new assets flowing into hedge funds exceed $25 billion on average for the last few years.

The term "hedge fund" is loosely defined and does not always imply a hedging technique is being used. Hedge funds today employ all different types of strategies, and the appropriate description could simply be conveyed as “any unregistered, privately-offered, managed pool of capital for wealthy, financially sophisticated investors.” Hedge funds are usually structured as partnerships, with the general partner being the portfolio manager, making the investment decisions, and the limited partners as the investors. Hedge fund managers attempt to produce targeted returns or absolute performance, regardless of the underlying trends in the financial markets. They implement a wide array of trading strategies, from equity, fixed-income, CTA portfolios, or mathematical algorithms, however they each strive to capture market inefficiencies.

Hedge funds are subject to the same market rules and regulations as any trader. The strategies they utilize are not as easily accessible, especially for other regulated entities, such as mutual funds. To achieve this "absolute return", hedge fund managers have the flexibility to incorporate different strategies and techniques that may include:

• Short-selling: Sale of a security that you do not own, with the anticipation of purchasing it in the future, at a reduced cost.

• Arbitrage: Simultaneous buying and selling of a financial instrument in different markets to profit from the difference between the prices

• Hedging: Buying/selling a security to offset a potential loss on an investment.

• Leverage: Borrowing money for investment purposes.

Hedge funds do not afford protection for the investor, which typically applies to most registered investment products. This includes the full set of protections applicable under federal and state securities laws. Simply, you will not get the same disclosure and transparency from a hedge fund than you would from a registered product, like a mutual fund.

Legal Definition

Hedge funds normally do not register with the SEC. Hedge Funds are designed as partnerships, with the general partner typically being the hedge fund's manager. The hedge fund manager usually makes investment decisions, and has a portion of his/her wealth within the fund. Under the Investment Company Act of 1940, there are two exemptions in which hedge fund managers rely upon:

Under Section 3(c) 1:

• For a hedge fund relying on the Section 3(c)(1) exemption, interests in the fund are typically offered to prospective investors pursuant to an exemption from the public registration requirements for securities offerings under Rule 506 of Regulation D of the Securities Act of 1933. Securities offered under Rule 506 may be sold solely to "accredited investors" and up to 35 "sophisticated investors".

An "accredited investor" is deemed to include, in part:

• A natural person with an individual net worth, or joint net worth with his or her spouse, at the time of purchase in excess of $1,000,000;

• A natural person with an individual income in excess of $200,000, or in excess of $300,000 with his or her spouse, in each of the two most recent years and who has a reasonable expectation of an income in excess of $200,000 individually, or in excess of $300,000 with his or her spouse, in the current year;

• Any executive officer, director or general partner of the issuer of the securities offered;

• An employee benefit plan within the meaning of Title I of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), (a) whose investment decisions are made by a plan fiduciary, as defined in Section 3(21) of ERISA, which is either a bank, insurance company or registered investment adviser; or (b) having total assets in excess of $5,000,000; or (c) if self-directed, the investment decisions are made solely by persons that are accredited investors;

• A trust, with total assets in excess of $5,000,000 which was not formed for the specific purpose of acquiring an interest in the hedge fund, whose purchase is directed by a sophisticated investor; and

• An entity in which each of the equity owners are accredited investors.

Under Section 3(c) 7:

• This exclusion, which was added to the Investment Company Act of 1996, stipulates there is no numerical limit on the number of investors. The size and nature of the investments of the individual are in question, and investors in funds that utilize the section 3(c) 7 exemption under most circumstances must be a "qualified purchaser." Qualified purchasers are by definition, high net worth individuals with certain specified investments in excess of $5 million, as well as qualified institutional investors. The premise behind 3(c) 7 is that affluent investors inherently should understand the risk and do not need the full protection of the federal and state securities laws.

Qualified Clients:

The SEC has stated that because the assets under management and net worth thresholds have been affected by inflation since 1985, it is increasing the amount of the assets under management standard for Qualified Clients from $500,000 to $750,000 and the net worth standard from $1,000,000 to $1,500,000.

However, the amended Rule adds additional categories of investors as Qualified Clients. As amended, the Rule permits investment advisers to enter into Performance Fee Contracts with clients who are "qualified purchasers" under Section 2(a)(51)(A) of the Investment Company Act. In general there are five categories of qualified purchasers:

• Natural persons owning "investments" of at least $5 million;

• Family owned companies owning not less than $5 million in investments;

• Trusts whose trustees or equivalent decision makers and whose settlors or other asset contributors are all qualified purchasers described in (1) and (2) above;

• Institutional investors, acting for their own accounts or for other qualified purchasers, that own and invest on a discretionary basis "investments" of at least $25 million, including employee benefit plans that are not participant-directed; and

• Certain qualified institutional buyers ("QIBs") acting for their own accounts or for other QIBs or qualified purchasers.

Specifically excluded from the definition of qualified purchasers are (i) participant-directed employee benefit plans and (ii) with respect to any particular Section 3(c)(7) Fund, any entity formed for the specific purpose of investing in that Fund unless all of the entity's beneficial owners are themselves qualified purchasers.

The SEC will now also permit certain "knowledgeable employees" of the investment adviser to be considered Qualified Clients. The new category is similar to the definition of knowledgeable employee in Rule 3c-5 under the Investment Company Act, and includes executive officers, directors, trustees, and general partners of the investment adviser, and other persons serving in similar capacities, as well as certain other employees of the adviser who participate in investment activities and have performed such functions for at least 12 months.