3.8.6 Hedge Funds
A hedge fund is a fund that tries to achieve a positive return for its investors, even when market returns are negative. Hedge funds are similar to mutual funds in that they pool investors’ money and invest it in securities, but they usually try to avoid classification as a mutual fund so that they are not subject to the restrictions placed on mutual funds. Hedge funds avoid being called mutual funds by meeting one of two exemptions:
• They limit the number of investors to under 100 (up to 35 may be non-accredited, but the rest must be accredited investors).
• They sell to only qualified purchasers. Qualified purchasers are individuals with more than $5 million in investments and institutions with more than $25 million in investments.
Hedge funds also differ from mutual funds in that they usually rely on broader investment strategies, such as investing in derivatives to hedge risk and increase leverage. Hedge funds often invest in more long-term, less-liquid investments than mutual funds. For all these reasons, hedge funds tend to be riskier than other investment vehicles and, thus, may yield large gains or incur large losses. Because of their increased risk and illiquid nature, hedge funds are usually available to accredited investors only.
Unlike most mutual funds that can be redeemed at any time, hedge funds often have limited periods when they can be redeemed (monthly, quarterly, or annually). Additionally, hedge funds are usually subject to lock-up periods: investors cannot redeem their shares in the first one or more years of investment. For these reasons, hedge funds are suitable for only those clients who can lock up their money for a long period.
Hedge funds set high minimum investment amounts for their investors. High risk coupled with high minimum investments make hedge funds a tool for wealthy individuals and institutions seeking high returns. Typical investors tend to be insurance companies and pension fun