A hedge fund is a professionally managed portfolio of investments that is typically open to a limited range of sophisticated or wealthy investors. As the name suggests, these funds hedge their risks by offsetting potential losses by hedging their investments using different approaches, the most popular one being short selling. Nowadays, the term hedge fund is applied to funds that do not actually ‘hedge’ their risks but rather increase it because they expect to generate a higher return.
Mutual funds invest in a certain sector (e.g. technology) or use a specific approach (e.g. small cap growth). To determine whether a mutual fund has been performing well, its returns are usually compared to a the market benchmarks e.g. Russell Financials 1000 index. On the other hand, hedge funds seek positive absolute returns, irrespective of the sector performance or the market benchmark.
A constant complaint against hedge funds is that they are lightly regulated or largely unregulated. This is in comparison to mutual funds which are regulated under the Investment Company Act of 1940. Hedge funds do not fall under the 1940 Act because they participate in ‘private offerings’ to sophisticated investors alone unlike ‘public offerings’ of mutual funds. This is also why hedge funds are not required to register with the SEC under the Securities Exchange Act of 1934. Due to the rapid growth of hedge funds, the SEC was prompted to study the operations of these entities in greater detail. In 2004, the Securities and Exchange Commission adopted new rules that required hedge funds with more than $25 million in assets to register under the Act of 1940 unless the the fund held onto the investors funds for at least two years.
In the financial crisis of 2008-2009, the short-selling of the financial stocks by the hedge funds were blamed by the financial media to be one reason why the crisis deepened as quickly as it did. The fall of Lehman Brothers in 2008 was also attributed to the continuous short-selling of Lehman stock even though there were not enough shares to cover for those short positions. This is most definitely not the end of regulation of hedge funds as this crisis highlighted how little we know about the practices of hedge funds and how the actions of the money managers of these funds can move markets.