Domestic Hedge Funds

Traders and money managers often dream about one day running their own hedge fund, managing large sums of money, and competing toe-to-toe with the world’s top traders. For the uninitiated, the first step toward setting up a hedge fund is getting a better grasp on what exactly a hedge fund is and what it is not.

A hedge fund is not a mutual fund. Unlike a mutual fund, a hedge fund is not open to any and all investors and cannot advertise for investors. A hedge fund can use any means necessary to make money. The SEC prohibits a mutual fund manager to use derivatives or employ shorting strategies to make money.

A mutual fund manger is limited to taking long positions in stocks and in bonds, there is more risk to investing in the typical mutual fund than investing in the typical hedge fund. A hedge fund manager can employ long and short positions to make money in good and bad markets. A mutual fund manager is paid on the basis of the amount of assets under management and makes money even when he or she loses money for investors. Unlike a mutual fund manager, a hedge fund manager is paid primarily for results. A hedge fund manager often invests significant amounts of his or her own money into the funds that they manage. Unlike a mutual fund manager, a hedge fund manager must aggressively preserve capital and make money for investors. Hedge fund managers cannot afford to take uncalculated risks since, as the old adage states, “it takes money to make money.” For these reasons, hedge funds are far more attractive to investors than mutual funds. It is widely agreed that the best minds in the money management business have moved from mutual funds and brokerages to the world of hedge funds.

Hedge or Hedged Fund? The term “hedge fund” was reportedly coined by Alfred Winslow Jones in the 1940s. Hedge funds are private investment pools of money and originally a hedge fund invested in equities, used leverage, and actually had to “hedge” and protect itself against market swings by taking long and short positions. Only a hedging fund was actually called a “hedged fund.”

A hedge fund is usually structured as a limited partnership or limited liability company to give the general partner (the fund manager) a share of the profits earned on the limited partners or members (the investors) money. The profit sharing (referred to as a “performance fee” or an “incentive allocation” if referring to an onshore fund) is typically 20 to 30 percent of the fund’s profits. Management fees are typically 1 to 2 percent of assets under management and are paid to support the cost of day-to-day fund operations. The best hedge funds are those that actually engage in arbitrage and employ hedging strategies and duck or minimize management fees. As noted, a genuine hedge fund has a manager that engages in arbitrage and employs hedging strategies.

So-called “hedge fund managers” that use traditional, long-only equity strategies and do not hedge in fact operate a type of mutual fund, and an expensive one at that. A hedge fund manager that uses large amounts of leverage to take long positions but fails to use short positions to protect against market bottoms will most likely fail.

Offshore Hedge funds are set up as offshore or onshore funds to allow for different groups of investors. U.S. based hedge fund managers who have significant potential investors outside the United States and/or U.S. tax-exempt investors typically create offshore funds. Many hedge fund managers use offshore hedge funds to provide privacy to investors. In those cases where complete investor confidentiality and privacy are necessary, an offshore fund should not accept U.S. investors and the fund manager should not be based in the United States.

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