Hedge fund
Also known as: private investment fund
A hedge fund is a private, loosely regulated investment pool that uses aggressive strategies — leverage, short selling, derivatives — to seek high returns for wealthy, accredited investors.
A hedge fund is a private pooled investment vehicle open only to accredited investors and institutions. Unlike mutual funds, hedge funds avoid registering their shares under the Securities Act of 1933 by selling through private placements, and they avoid registering as investment companies under the Investment Company Act of 1940 by limiting the number or type of investors they accept. Together those exemptions free them from many of the disclosure and investment restrictions that apply to registered investment companies.
That regulatory freedom lets hedge fund managers pursue strategies mutual funds generally cannot: heavy use of leverage, short selling, concentrated positions, derivatives, and illiquid assets. Most are organized as limited partnerships, with the fund manager serving as general partner and investors as limited partners. A typical fee arrangement is "2 and 20" — a 2% annual management fee plus 20% of profits — often paired with a high-water mark so the manager only earns the performance fee on new gains.
Hedge funds are considered high-risk, illiquid investments. Many impose lock-up periods that prevent investors from withdrawing money for months or years, and their performance fees can encourage aggressive risk-taking. Because of these features, they are suitable only for sophisticated investors who can afford to lose their entire investment and do not need quick access to their capital.
The SIE, Series 7, and Series 65 exams all test hedge funds as a category of alternative pooled investment. Know the key contrasts with mutual funds: private placement instead of public offering, accredited investors only, limited liquidity, performance-based fees, and minimal regulatory oversight — plus the suitability implications that follow from each.
Key takeaways
- Hedge funds are private investment pools sold through private placements to accredited investors, not to the general public.
- They can use leverage, short selling, and derivatives freely because they are exempt from registration as investment companies.
- Typical fees are "2 and 20" — a 2% management fee plus 20% of profits, often subject to a high-water mark.
- Lock-up periods and illiquid holdings make hedge funds unsuitable for investors who need ready access to their money.
- Securities exams test hedge funds as high-risk alternative investments and contrast them with mutual funds.