3.2.6. 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 a mutual fund 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 required to register under the Investment Company Act. Hedge funds avoid being called mutual funds by meeting one of two exemptions:
1. Limit the number of investors to no more than 100 investors (up to 35 may be non-accredited, but the rest need to be accredited investors). An accredited investor is someone the SEC regards as wealthy or sophisticated enough to be able to make good financial decisions and absorb substantial losses.
2. Sell to qualified purchasers only. Qualified purchasers are individuals with more than $5 million and institutions with more than $25 million.
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 may also invest in 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 large losses. Because of their increased risk and illiquid nature, hedge funds are usually available to accredited investors only.
Unlike mutual fund shares, which can be redeemed at any time, hedge funds often have limited periods when shares can be redeemed (monthly, quarterly, or annually). Additionally, hedge funds are usually subject to lock-up periods when investors cannot redeem their shares in the first one or more years of investment, and hedge fund shares cannot be traded on an exchange. For these reasons, hedge funds are suitable only for customers who are willing and able to lock up their money for a long period.
Hedge funds set high minimum investment amounts for investors.