DEFINITION OF HEDGE FUND

Definitions of hedge funds run into problems because it is exceedingly difficult
to describe what a hedge fund is without running into trouble with
funds that don’t fit into the rules. There are investment pools that closely
resemble hedge funds but are generally regarded as a different type of investment.
Still other types of investments may contain characteristics that
are generally associated with hedge funds.
As a starting point, begin with a rather typical definition of a hedge
fund:
A hedge fund is a loosely regulated investment company that charges
incentive fees and usually seeks to generate returns that are not highly
correlated to returns on stocks and bonds.
Many traits of hedge funds aren’t useful in defining what is and what is not
a hedge fund.


Regulation and Hedge Funds
Chapter 8 describes the laws and regulations that control hedge funds.
While hedge funds are not unregulated, as is sometimes asserted, they are
more loosely regulated than mutual funds and common trusts run by bank
trust departments. Other types of investments are also loosely regulated,
though, including private equity partnerships, venture capital funds, and
many real estate partnerships.
Investors may feel they will “know it (a hedge fund) when they see it,”
but there are no firm lines separating hedge funds from these other types of
investments. Hedge funds may invest part of their assets in private equity,
venture capital, or real estate.
To further blur the distinction between hedge funds and regulated investment
companies, there is increasing pressure from the Securities and
Exchange Commission (SEC), bank regulators, auditors, and exchanges
for hedge funds to disclose more information and to control permitted
activities. Hedge funds may soon be required to disclose much of the information
that mutual fund companies must report. The SEC has proposed
to require all hedge fund management companies to register as
investment advisers.

Limited Liability
Sometimes, the definition of hedge funds mentions that hedge funds are a
vehicle where investors have no liability for losses beyond their initial investment.
It certainly is true that most hedge funds in the United States are
organized as limited partnerships or limited liability corporations (see
Chapter 5) that protect the investor from liability. However, offshore funds
are usually organized as corporations and, despite this difference, also create
a limited liability investment.
Most other investments are also limited liability investments. Investors
can lose no more than 100 percent of the value of long positions in stocks
and bonds. Mutual funds also protect the investor from losses in excess of
the amount of money invested. While accurate for hedge funds, the characteristic
of limited liability does little to define hedge funds.

Flow-Through Tax Treatment
Hedge funds are not taxed like corporations. Instead, all the income, expenses,
gains, and losses are passed through to investors. This feature does
not define hedge funds because many other investment types are flowthrough
tax entities. Real estate investment trusts (REITs), mutual funds,
venture capital funds, and other private equity funds are regularly constructed
to receive flow-through tax treatment.
Hedge funds organized outside the United States are frequently organized
in locations that have little or no business tax. In these locations,
hedge funds are not organized to get flow-through tax treatment.
Instead, these funds are organized as corporations that do not require
investors to include the annual hedge fund income and expenses on investor
tax returns.