The Mysterious Nature of Hedge Funds

The term hedge fund is enough to scare some investors off of an investment strategy. Few investors truly understand how hedge funds work, and this is likely because each hedge fund operates in its own unique way. One constant, though, is that they are investment pools with a very high capital base. Due to this capital base, hedge funds are not subject to the same investment regulation as other financial firms or investment banks assisting investors with a lower amount of capital investment. Because they lack this regulation, hedge funds are often viewed as controversial or mysterious.

How Hedge Funds Work

Hedge funds employ some of the greatest financial minds on Wall Street. These individuals use complicated mathematical modeling, called derivatives, to "hedge" their bets. This means they are investing in highly risky opportunities, including short selling, or borrowing stocks with the hope they will decrease in value. Hedge fund operators do not take a standard investment fee like many investment banks. Instead, these individuals are typically paid based on a percentage of earnings, giving them added incentive to make money, but also an added incentive to take risks. Many criticize hedge funds because they make high incomes if they succeed but do not pay back investors if they fail.

How Hedge Funds are Regulated

Nearly all financial investment firms need to be registered with, and therefore regulated by, the Securities Exchange Commission. Hedge funds capitalize on a loophole in securities law that allows a certain type of corporation with participants who have over $5M invested in the market or with fewer than 100 investors to remain unregulated. These are termed 3(c) 7 and 3(c) 1 funds. Hedge funds can fall into one or both of these categories to avoid registering with the SEC, which makes them exempt from certain disclosures, caps on income and other regulations.

Hedge Fund Benefits

Hedge funds present benefits to their investors and the market as a whole. To individual investors, they provide an avenue for sophisticated investors with high market capital to be free from regulation meant to protect novice investors. For example, certain tactics are not legal to push on investors who do not understand risk. Many hedge fund investors will fully understand the risk associated with these investments and choose to make them anyway. Hedge funds benefit the market as a whole because they often provide funding for projects that would otherwise be deemed too risky, or too costly. For example, some private equity hedge funds helped provide funding for eBay, Google and green energy technologies. 

Hedge Fund Risks

Some investors place their funds with hedge funds and do not recognize the lofty risk of the investment. These individuals, despite their high market capital, are relatively novice investors and could benefit from the regulation of the SEC. To the market as a whole, hedge funds can be damaging because they manipulate stock performance. In particular, hedge funds that short sell stock frequently can falsely inflate or deflate the value of the stock for their own benefit while ignoring the greater consequence this has to other investors.

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