What is a Hedge Fund

Hedge funds and other alternative investment funds developed on the basis of exceptions from the securities legislation enacted in the U.S. in the 1940s to regulate collective investment undertakings. The purpose of the exceptions was to exclude “private investment companies” and personal and family holding companies from the scope of legislation, but the SEC “knowingly permitted any group of up to 100 people to create a private investment pool.” The first hedge fund (A.W. Jones & Co.) and Venture Capitalist funds appeared, but it took almost two decades until they were named. Private equity funds appeared in 1970s on the basis of the same statutory safe harbor.

It is a simple process to enter the hedge fund industry; practically anyone with $15k to $20k can start a hedge fund and forming a hedge fund gets easier every year. It has become common for brokerages, attorneys, accountants and other financial professionals to team up in order to provide a one-stop-shop approach to developing and launching a hedge fund. Much of the consultation work is conducted over the phone, email and the internet. Key items needed to start a hedge fund are: money, a hedge fund consultant, an attorney, a prime broker, office space (or a home office), and eventually, an accountant and auditor.

A hedge fund is usually structured as a limited partnership or limited liability company to give the general partner (the fund manager) a share of the profits earned on the limited partners or members (the investors) money. The profit sharing (referred to as a “performance fee” or an “incentive allocation” if referring to an onshore fund) is typically 20 to 30 percent of the fund’s profits. Management fees are typically 1 to 2 percent of assets under management and are paid to support the cost of day-to-day fund operations. The best hedge funds are those that actually engage in arbitrage and employ hedging strategies and duck or minimize management fees. As noted, a genuine hedge fund has a manager that engages in arbitrage and employs hedging strategies.

So-called “hedge fund managers” that use traditional, long-only equity strategies and do not hedge in fact operate a type of mutual fund, and an expensive one at that. A hedge fund manager that uses large amounts of leverage to take long positions but fails to use short positions to protect against market bottoms will most likely fail.

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