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A hedge fund is a private investment fund open to a limited range of investors which is permitted by regulators to undertake a wider range of activities than other investment funds and which pays a performance fee to its investment manager. Although each hedge fund will have its own strategy which determines the type of investments and the methods of investment it undertakes, hedge funds as a class invest in a broad range of investments, from shares, debt and commodities to works of art.
As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term hedge fund has come to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other hedging methods to increase rather than reduce risk, with the expectation of increasing return.
Hedge funds are typically open only to a limited range of professional or wealthy investors. This provides them with an exemption in many jurisdictions from regulations governing short selling, derivative contracts, leverage, fee structures and the liquidity of investments in the fund. A hedge fund will nevertheless voluntarily limit the scope of its activities via its contractual arrangements with its investors, in order to give the investors some certainty over what they are investing into.
The assets under management of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage, meaning that their influence over markets is substantial. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt.
Comparison to Private Equity Funds
Hedge funds are similar to private equity funds in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in relatively liquid assets, and permit investors to enter or leave the fund, perhaps requiring some months notice. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition funds.
Between 2004 and February 2006 some hedge funds adopted 25 month lock-up rules expressly to exempt themselves from the SEC's new registration requirements and cause them to fall under the registration exemption that had been intended to exempt private equity funds.
Comparison to Mutual Funds
Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to invest). However, there are many differences between the two, including:
Mutual funds are regulated by the SEC, while hedge funds are not
A hedge fund investor must be an accredited investor with certain exceptions (employees, etc.)
Mutual funds must price and be liquid on a daily basis
Some hedge funds that are based offshore report their prices to the Financial Times, but for most there is no method of ascertaining pricing on a regular basis. Additionally, mutual funds must have a prospectus available to anyone that requests one (either electronically or via US postal mail), and must disclose their asset allocation quarterly, while hedge funds do not have to abide by these terms.
Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time where the total returns are generated (net of fees) for their investors and then returned when the term ends, through a pass through requiring CPAs and US Tax W-forms. Hedge fund investors tolerate these policies because hedge funds are expected to generate higher total returns for their investors versus mutual funds. Recently, however, the mutual fund industry has created products with features that have traditionally only been found in hedge funds.