By Julius J. Brecht[1] For The AlaskaJournal of Commerce Hedge funds have garnered considerable attention recently. But, exactly what is a hedge fund? Is it your next trim adventure or something steadfastly to avoid?

A hedge fund is an investment vehicle. Investment and other activities are limited, in part, by the terms of organizing documents and state law governing the fund. However, a hedge fund is extremely flexible in that it can be fashioned to pursue widely differing investment strategies.

The hedge fund concept has its origins in investment vehicles which were first developed mid-last century to sell short some stocks (selling interests without owning them with the expectation of buying them back at a lower price in the future), while buying others. In this way, some of the market risk was hedged or offset.

From these origins, hedge funds have evolved with a variety of strategies, each possessing an attendant risk exposure in the market place. They include, in addition to short sales, investing in assets mispriced relative to global alternative investments, investing in anticipation of a specific event (a merger of companies), or investing in emerging markets.

Today a typical hedge fund uses leverage or debt to invest positions taken in financial markets. Therefore, the success of the fund relies critically on continued, stable access to credit.

A hedge fund's primary goal is reduction of volatility and risk while at the same time preservation of capital and delivery of positive returns under different market conditions. However, the level of risk varies with the strategy pursued.

A hedge fund which focuses on aggressive growth companies in technology, or which seeks to profit from changes in global economies, may have high volatility. In contrast, a hedge fund which focuses on purchases of deeply discounted securities of distressed companies facing reorganization or bankruptcy, or which seeks investments emphasizing yield or current income rather than capital gains, may have low to moderate volatility.

A hedge fund can be less constrained than many other investment vehicles. Such vehicles include offer and sale of individual stocks and mutual funds.

A purchase of any one of these alternative investments is subject to attendant rules that must be followed in the offer, sale and retention of the securities involved. For example, offer and sale of individual stocks to the public is subject to various state and federal securities laws.

These laws require, in the context of a public offering and sale, that the securities offered must first be registered or satisfy specific registration exemptions under state securities laws and the federal Securities Act of 1933.

The company issuing these securities may be further subject to requirements of the federal Securities Exchange Act of 1934. These requirements include distribution of detailed periodic and other reports to investors on company status.

A mutual fund public offering is subject to registration and other requirements under the federal Investment Company Act of 1940. These requirements include distribution of detailed periodic reports to investors on fund status.

A hedge fund may be excluded from the Investment Company Act. That is, although the fund may appear to fall within the definition of an investment company, it may satisfy one or more exclusions from that definition under the act. Two of them are of particular interest.

The first exclusion applies to a company having fewer than 100 investors. The second exclusion applies to a fund where each investor is a qualified purchaser (defined as an individual with over $5 million in investment assets).

While the first exclusion limits the number of investors, the second one does not.

A hedge fund offering is also subject to the securities registration and registration exemption provisions of the Securities Act. In addition, the offering must comply with state securities laws.

A hedge fund may reward its manager through a management fee and a performance fee. The management fee is usually calculated as a percentage of assets under management. It may be in the range of 2%.

The purpose of a performance fee asserted by some is to provide incentive to the manager to strive for higher performance of the fund. Others state that such fees encourage excessive risk as opposed to long term gains.

Limitations on performance fees are sometimes used by a hedge fund. Nevertheless, performance fees can vary widely from fund to fund, ranging from 20% of gross returns to well in excess of double that amount.

Popularity of hedge funds has grown dramatically over the past few years. In addition, some mutual funds now include strategies which evolved in hedge funds. These hybrid funds hold themselves out as public hedge funds.

A clear distinction between a hybrid fund and a hedge fund is that the former is regulated as an investment company, including the amount of manager performance fees that may be paid. However, a hedge fund, in being excluded from the investment company definition under the act, is not subject to such regulatory restrictions.

For purposes of this article, the term "hedge" is used in the context of a private offering by a fund excluded from the definition of an investment company under the Investment Company Act.

A hedge fund is typically offered in reliance upon the registration exemption provisions of Regulation D adopted pursuant to the Securities Act. It is also offered in reliance upon corresponding provisions of state securities laws accommodating that exemption.

One provision of Regulation D limits the number of allowed purchasers, with limited exception. The exception consists of what are termed "accredited investors."

The term "accredited investor" is defined in Regulation D to include, at the time of the offer, an individual with a net worth (or joint net worth with that individual's spouse) of $1 million. The term further includes an individual who, at that time, had income in excess of $200,000 in each of the then two most recent years (or joint income with the individual's spouse in excess of $300,000 in each of those years) and had a reasonable expectation of reaching the same income level in the then current year.

Success of a hedge fund also depends upon a stable base of investors. With a hedge fund being private in nature, there typically is no market for investor interests in the fund. The investor must have the ability to hold an illiquid investment for a period of time commensurate with the fund's investment strategy and the terms of its organizing documents.

A variation on a hedge fund is a fund of hedge funds. This structure allows the manager to select from a diversified portfolio of uncorrelated hedge funds.

The fund of hedge funds structure also allows selection of different funds that might be expected to react differently to events in the market place. Therefore, this structure supposedly hedges risk even further than can be accomplished with a single fund.

Interests in a hedge fund must not be offered, sold, or advertised to the public. To do otherwise causes loss of the registration exemption and places the organizers in the vulnerable position of making an unregistered offer and sale of securities in violation of state securities laws and the Securities Act.

As a result, unlike mutual funds, little public information is available on hedge funds. Yet, some hedge funds have become significant investors in public companies.

The prudent prospective investor carefully considers risk factors associated with hedge funds and consults with his or her investment adviser as to whether an investment in those funds makes sense.

Get informed before you invest!

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