NEW YORK (TheStreet) -- Hedge funds have been one of the fastest growing investment vehicles over the course of the last two decades. However, for many individual investors who cannot invest in hedge funds, these funds appear to operate in a cloak-and-dagger manner, and remain an enigma.Nonetheless, hedge funds do have an impact on the individual investor -- both directly and indirectly. So let's peel back the hedge fund onion and expose what makes hedge funds unique and how those funds' activities can affect the market and you.
First, What Are Hedge Funds?Originally, hedge funds were designed to enter into long/short transactional strategies like the ones I described in " Five Arbitrage Techniques Every Investor Needs to Know." Over time, hedge funds have perverted the original concept of arbitrage and are now just very highly leveragedprivate investment vehicles. Hedge funds have several characteristics that distinguish them from separately managed investment accounts (like the ones I manage) or mutual funds. Here are some of those distinctions that individual investors should be concerned with:
Hedge funds are structured as limited partnerships.A limited partnership has two types of owners: a general partner (typically, the hedge fund manager) and the limited partners (the investors). The limited partners/investors have no say in the day-to-day management of the hedge fund. Limited partnerships are a "pass-through" entity, which is to say that the entity itself is not taxed but the income and expense is passed onto the general and limited partners.
Hedge funds charge investors not only an asset management fee but an incentive fee.Sometimes this is referred to as the "1&20" fee structure. The asset fee, say it is 1%, is a flat charge on the assets of the hedge fund. The incentive (or performance) fee is earned by the hedge fund manager if the hedge fund makes money. This is a very important aspect of the hedge fund and one that I will discuss later in greater detail.
Hedge funds can operate in a domestic (U.S.) environment or an offshore environment.
- The hedge fund and its manager are not required to register with the SEC or a state regulatory body.
- Reporting to investors is sporadic, delayed and limited in nature.
- Hedge funds can obtain favorable leverage, financing and brokerage rates.
- In order to invest in a domestic hedge fund you must be an accredited investor