An Introduction to Hedge Funds

In previous articles we discussed different financial instruments as well as strategies to trading equities. We discussed a value approach as well as an event driven catalyst approach.

In this article we will discuss the concept of hedge funds and apply the principles that we have learned in previous articles to see how hedge funds use these principals in applying their strategies.

What is a Hedge Fund?

A hedge fund is a loosely regulated private investment fund that charges a management and performance fee.

A hedge fund collects its funds from private wealthy individuals and large institutions and uses funds to trade securities with the hope of capital and income appreciation. Unlike other investment vehicles, hedge funds concentrate on making a consistent absolute return rather than a relative return to a benchmark index. One important distinguishing factor a hedge fund has compared to traditional mutual funds and asset management companies is that a hedge fund is allowed to use almost any structured product. This means that they are allowed to engage in leveraged derivative positions as well as shorting securities, a method usually forbidden at mutual funds. Hedge funds traditionally identify inefficiencies in the financial markets and trade to capture profits from them.

Growth of Hedge Funds

In the last 9 years hedge funds have grown in number by approximately 20% every year.

Currently there are an estimated 9000 hedge funds in the world managing over 1.1 trillion USD. The assets within each hedge fund are also growing every year. Performance is said to account for a third of this increase.

Hedge funds are said to account for around 50 billion USD of fees on Wall Street and City investment banks. They make up more than 50% of US bonds trading, 40% of equity trades and over three quarters of distressed debt trading (explanations of these terms come at a later section).

Laws Relating to Hedge Funds

Hedge funds by all reasonable definitions fall under the definition of an investment company

This means that according to the Investment Company Act of 1940 they need to be registered with the SEC as an investment advisor. There are two exemptions which hedge funds elect however. The first one is under Section 3(c) (1) and the other under Section 3 (c) (7). A 3 (c) 1 fund is simply one that has no more than 100 investors and is not making or planning to make a public offering of its securities. A 3(c) (7) fund is one where the investors of the fund are at the time of the acquisition “qualified purchasers”, meaning that they have more than 5 million USD of assets.

Given these two restrictions the hedge fund can sell its “shares” under what is called Regulation D. Regulation D allows companies to sell shares of the company under private placements. This is a direct private offering of securities to a limited number of sophisticated investors. This is unlike a public offering of stock which can be even sold to the retail. A company can issue shares and sell it as a private placement if it wants to avoid dealing with all the legal mess and financial costs of investment banking fees and registration. The drawback is however that they can only sell them to limited investors with a net worth of at least 1 million USD or minimum income of 200’000 USD in each year in the past two years and expecting it to continue in the future. Given these exemptions a hedge fund can sell itself to wealthy individuals and institutions without the need to register.