Hedge Fund Investment Structure

Today the term hedge fund is a generic label for all of the diverse strategies used by hedge fund managers. The term itself is said to have been coined to describe what Alfred Winslow Jones did in 1949 when he combined a leveraged long stock position with  a portfolio of short stocks in an investment fund with an incentive fee structure. Since then, the scope of the term hedge fund has expanded beyond this specific strategy (a leveraged long portfolio “hedged” by short stock sales) to describe funds engaging in a range of investment strategies.

The commonality of these funds is their commingled investment structure, typically a limited partnership or offshore corporation. Like the term mutual fund, which describes only the investment structure and does not indicate whether the fund invests in stocks or bonds or in the United States or abroad, the term hedge fund does not tell an investor anything about the underlying investment activities. Thus, a hedge fund acts as a vehicle within which one or more of the investment strategies.

It should be noted that hedge funds differ from traditional mutual funds in the range of allowable investment approaches, the goals of the strategies they use, their typically private nature (they do not have to be registered with a regulatory agency such as the Securities and Exchange Commission), methodology of manager compensation (management fee plus an incentive or performance fee), breadth of financial instruments traded, and range of investment techniques employed.

This distinction, however, is becoming blurred as mutual fund regulatory changes and investor demand have allowed certain hedge fund strategies to operate under the mutual fund structure. Since the term hedge fund describes an investment structure and has been applied to a range of strategies, in order to understand
particular hedge funds it is necessary to separate the structure of the investment (its legal form and method of operations) from its investment strategy (how it invests capital in the financial markets to achieve its goals).

The investment structure is the legal entity that allows investment assets to be pooled and permits the hedge fund manager to invest them. The investment approach the manager takes is known as the hedge fund strategy or alternative investment strategy. The structure establishes such things as how manager compensation is determined; how many investors he or she can accept; the type of Fund of Funds in the Hedge Fund Industry investor allowed to invest in the hedge fund; and what the investors’ rights are related to profits, taxes, and reports. The elements that make up the strategy include how the manager will invest, the markets and instruments that will be used, and the opportunity and return source that will be targeted.

Legal Structure
Hedge funds and funds of funds have very similar investment structures.These come in a variety of legal forms depending on where they are located and the type of investor the fund organizer wishes to attract. To avoid entity-level tax, in the United States they are usually formed as limited partnerships, or in some cases, limited liability companies or trusts.


Number of Investor and Minimum Investment Size
Hedge funds and funds of funds are usually private investment vehicles. In the United States this means that under one of the available exemptions the securities that hedge funds offer to investors (the limited partnership or limited liability company interests) need not be registered with the Securities and Exchange Commission (SEC) to be offered to the public. The exemptions specify certain requirements in order to avoid registration. These generally deal with the type of investor allowed to invest in the fund, the number of investors that
can invest (the previously mentioned “slots”), and how the investors can be solicited. Most U.S. state securities laws (blue sky laws) also contain exemptions from registration for limited or private offerings.


Reporting and Disclosure
Hedge funds and funds of funds have historically calculated and reported performance on a monthly or quarterly basis. The level of fund of funds reporting is dependent on the information provided by the underlying hedge funds. In response to increased investor demand, some funds now report weekly, and even daily, estimates, but the industry as a whole normally provides monthly performance results. Furthermore, there is no standard reporting format. Some hedge funds provide faxes of percentage profit or loss. Others send detailed statements to each investor with a letter describing the fund’s investment activities and results.


In a hedge fund context, liquidity refers to the timing and notice period required for investors to redeem their investment and have their money returned from the fund. For example, quarterly liquidity means that an investor can take money out of the funds at the end of each calendar quarter, while monthly liquidity means that an investor can get out at the end of each month. One mistake that many investors make is not factoring in the “notice period” they are required to give before they can redeem their investments. Some hedge funds cannot generate cash for investor redemptions on short notice and require notice periods that range from 30 to 90 days.


A lockup period is the length of time that investors must remain invested before their investment can be redeemed or becomes subject to the standard liquidity provision. The lockup period for hedge funds ranges from a few months to one or more years, but usually the lockup in U.S. funds is one year. It works like this: If the liquidity is quarterly and the lockup is one year, then an investor who invests on January 1 cannot redeem until December 31 of the same year. Once a year has passed, liquidity becomes quarterly, so the next date when a redemption would be allowed is March 31 of the following year.

The liquidity of underlying hedge funds will influence, if not determine, the liquidity provisions of a fund of funds. In order to meet its own redemptions, a fund of funds must redeem from the underlying funds in which it has invested in order to have cash available unless it arranges for borrowing to meet redemption demands.

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