7.3. 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 into securities. However, hedge funds typically try to avoid registering as investment companies and also try to avoid registering investments in the fund as securities. As a result of this desire to be exempt under both the Investment Company Act of 1940 and the Securities Act of 1933, hedge funds have complicated rules about who can invest in them.

See Chapter Twelve for more information about SEC Regulation D, Rule 506, which hedge funds typically use to gain exemption from registering their shares as securities. With regard to registering the fund itself as an investment company, hedge funds typically avoid this by meeting one of two standards:

• They limit the number of investors to under 100 investors (up to 35 may be non-accredited, but the rest need to be accredited investors).

• They sell only to qualified purchasers

Qualified purchasers are individuals with more than $5 million and institutions with more than $25 million. This is a stricter standard than the “accredited investor” standard discussed in Chapter Twelve. Anyone who meets the definition of a qualified purchaser will also meet the definition of an accredited investor.

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 also 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 face high returns and high 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