A hedge fund is a private partnership investment fund that uses complex investment strategies with the goal of maximizing returns on the funds’ underlying investments. Accredited investors run hedge funds and pool money in order to make risky, yet profitable investments. Therefore, despite the fact that “hedging” implies risk reduction, hedge funds tend to be associated with levels of risk higher than conventional investment channels.
Hedge funds were first established in the 1940’s and have developed to include many more complex methods and tools to reap profits. Still, the challenge for a hedge fund manager is to obtain the highest return on an investment while maintaining low levels of risk.
As hedge funds are private partnerships and limited to select investors, they generally require a large initial endowment. Hedge funds also tend to be fairly illiquid because investors are typically required to keep their money in the fund for about a year.
In order to achieve high levels of returns, a hedge fund can use a variety of techniques such as long, short, leveraged, and derivative positions. Hedge funds can also use arbitrage strategies, buy and sell undervalued securities, trade options or bonds, or invest in other various market opportunities.
Some examples of hedge funds include macro hedge funds, equity hedge funds and relative value hedge funds. A macro hedge fund invests in bond and stock markets, as well as other opportunities such as currency markets.
Until recently, hedge funds were mostly unregulated by the U.S. Securities and Exchange Commission (SEC) as most of the investors in a hedge fund had to be accredited. However, a key component of the Great Recession—the credit crisis of 2008—caused the creation of many regulations to provide investors with more oversight and prevent a similar crisis in the future.
As a result, many advisers to hedge funds and other private funds are required to register with the SEC, according to the Dodd-Frank Act. There are exceptions. Those private fund advisers with less than $150 million of assets under management (AUM) in the U.S. and that advise exclusively private funds are exempt from the registration requirements. Investment advisers with less than $100 million in AUM can also sidestep registration.