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The SEC’s Definition of a Hedge Fund

January 30, 2008 | Leave a Comment

Hedge fund is a general, non-legal term that was originally used to describe a type of private and unregistered investment pool that employed sophisticated hedging and arbitrage techniques to trade in the corporate equity markets. Hedge funds have traditionally been limited to sophisticated, wealthy investors. Over time, the activities of hedge funds broadened into other financial instruments and activities. Today, the term “hedge fund” refers not so much to hedging techniques, which hedge funds may or may not employ, as it does to their status as private and unregistered investment pools.   

Hedge funds are similar to mutual funds in that they both are pooled investment vehicles that accept investors’ money and generally invest it on a collective basis. Hedge funds differ significantly from mutual funds, however, because hedge funds are not required to register under the federal securities laws. They are not required to register because they generally only accept financially sophisticated investors and do not publicly offer their securities. In addition, some, but not all, types of hedge funds are limited to no more than 100 investors.   

Hedge funds also are not subject to the numerous regulations that apply to mutual funds for the protection of investors—such as regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, regulations limiting the use of leverage, and more. This freedom from regulation permits hedge funds to engage in leverage and other sophisticated investment techniques to a much greater extent than mutual funds. Although hedge funds are not subject to registration and all of the regulations that apply to mutual funds, hedge funds are subject to the antifraud provisions of the federal securities laws.   

Hedge funds generally rely on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 to avoid registration and regulation as investment companies. To avoid having to register with the SEC the securities they offer, hedge funds often rely on Section 4(2) and Rule 506 of Regulation D of the Securities Act of 1933.


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