What is a Hedge Fund?

So what is a Hedge Fund and why does everyone hate them? A Hedge Fund, in its simplest form, is just a limited partnership. A legal document drafted by an attorney sets up the legal structure into which accredited investors invest money. The media and the non investment world loves to use various terms to describe Hedge Funds. The definition in the American Heritage Dictionary is this:

"An investment company that uses high-risk techniques, such as borrowing money and selling short, in an effort to make extraordinary capital gains."

Well, actually no. In theory if you sell short along with going long equities, then you have less risk and there is no law that says you have to borrow money when you run a hedge fund.

So here is my definition of a "hedge fund." I will give the characteristics of a Hedge Fund and then an explanation of why I am including it. A Hedge Fund is a:

Lightly Regulated - Most Hedge Funds offerings are exempt from registration under the appropriate U.S. Securities Laws. I use the word "lightly" because some Hedge Funds do register as investment advisers

Private Pool of Capital - An obvious one that is simply descriptive. It is private because it is only available to accredited investors and not the general public.

Focused on Absolute Returns - I don't care who you are or what your strategy is, but you damn well better be up every year. I don't give a rats ass what "the market" does. If I want a closet indexer I'll go to a mutual fund company and invest in a fund with an R squared of .99 that holds 400 positions.

Performance Based Compensation - Hedge Fund Managers earn most of their compensation from a percentage of the excess gains above a hurdle rate, and subject to a high water mark. This percentage is usually 20% but can go as high as 50%.

So there it is then - a Hedge Fund is a lightly regulated, private pool of capital that is focused on achieving absolute positive returns in any market where the manager is compensated mostly on performance.