A simple hedge fund definition is: a hedge fund is an alternative investment that is designed to protect investment portfolios from market uncertainty, while generating positive returns in both up and down markets.
Throughout time investors have looked for ways to maximize profits while minimizing risk. The issue of shielding an investment from market risk is attempted (although not always successful) with alternative investments that try to mitigate loss and preserve capital. These alternative investments are called hedge funds.
To simplify the definition of a hedge fund, you have to look at the investor’s objectives, classification and look at hedge fund strategies typically used by the fund manager.
Perhaps the widest definition of a hedge fund is an alternative investment portfolio used by a group looking for above market returns. You may hear the term “absolute return” used in conjunction with hedge funds, this describes how investment strategies are designed to generate returns in both good markets and bad. That is, “hedging” the markets.
Who Invests in a Hedge Fund?
“Sophisticated investors” do – those who do not need the protection provided by the regulations that apply to mutual funds. These are entities, or wealthy individuals that must pass either an “accredited investor” test or a “qualified purchaser” test. An accredited investor is an individual whose net worth exceeds $1 million, or whose income in the last 2 calendar years exceeds $200,000/yr, and who expects more of the same. It can also be an entity with assets exceeding $5 million.
A qualified purchaser is someone with over $5 million who invests in total assets, or one of a number of entities. Many hedge funds rely on sections 3 (c) (1) or 3 (c) (7) of the Investment Company Act of 1940 to avoid registration and regulation as investment companies. That is why a hedge fund partnership may often be referred to as a “3 c 1” or a “3 c 7” fund.
Hedge funds are prohibited from advertising their funds to the public. However, some hedge funds choose to register with the SEC. This enables them to have a lower minimum investment, and an unlimited number of investors (3c1/3c7 funds have limits).
Why Invest in a Hedge Fund?
Hedge funds can make sense in an overall portfolio context, for a number of reasons. Here are a few:
- Diversification – hedge funds add a level of diversification to an investment portfolio, since their returns are often not correlated with those of other asset classes.
- Downside Protection – since hedge funds can hold both long and short positions, they usually are less volatile than typical long-only portfolios, and some funds can provide a layer of protection in a declining market.
- Absolute Return Focus – hedge funds concentrate on making positive returns in all kinds of markets–achieving an absolute return.
- Active Management Focus – hedge fund managers are applying strategies they believe will add alpha. They are using their skill at interpreting information to actively exploit an inefficiency in the market.
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