The Securities Act does not provide a definition of a pool of investment funds run by asset managers known as hedge funds.

The following are definitions of hedge funds offered by the Financial Services Authority of the United Kingdom, the regulatory body for all financial services providers in that country.

The term can also be defined by considering characteristics commonly associated with hedge funds.

  • Private investments are organized as partnerships or offshore investment corporations.
  • Use a variety of trading strategies that involve taking positions in different markets.
  • Using an assortment of trading techniques and instruments that usually include short selling, derivatives, and leverage.
  • Paying performance fees to their managers.
  • An investor base comprised of wealthy individuals and institutions and a relatively high minimum investment limit should have been set at US$100,000 or more for most funds.

This definition helps to understand many characteristics of a hedge fund. First of all, the term hedge in hedge fund is misleading because it is not a feature of today's hedge funds. Second, hedge funds use a variety of trading strategies and techniques to not only generate abnormal returns, but also to try to generate stellar returns regardless of market movements. Strategies used by hedge funds may include one or more of the following.

  • Leverage is the use of borrowed funds.
  • Short selling is the sale of a financial instrument that one does not own in anticipation of a decline in the price of that financial instrument.
  • Derivatives are a great way to leverage and control risk.
  • Simultaneous buying and selling of related financial instruments to profit from temporary misalignment of their prices.

Hedge funds operate in financial market sectors in the cash market as well as derivative markets for bonds, stocks and currencies.

Third, when evaluating a hedge fund, investors are interested in the absolute return generated by the asset manager, not the relative return. Absolute return is the realized return rather than the relative return, which is the difference between the realized return and the return on some benchmark or index, which is quite different from the criteria used in evaluating the asset manager's performance.

Fourth, the management fee structure for hedge funds is a combination of a fixed fee based on the market value of assets managed and a share of positive returns. The latter is performance based compensation referred to as incentive pay. Hedge funds are available to accredited investors. Accredited investors, as defined by the SEC, include banks, individuals, insurance companies and registered investment firms with assets in excess of $1 million.

The term hedge fund was first used by Fortune in 1966 to describe Alfred Winslow Jones' private investment fund. In managing the portfolio, Jones tried to hedge the fund's market risk by creating a portfolio that was equally long and short the stock market.

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