Quick Answer
Hedge funds are private, illiquid, largely accredited-investor pools that skip registration, charge "2 and 20," and report on a Schedule K-1. Asset-backed securities (ABS) pool loans and slice them into tranches: collateralized mortgage obligations (CMOs) divide timing risk, collateralized debt obligations (CDOs) divide credit risk. Match the risk to the product.
The whole unit on one sheet: how hedge funds are structured, how ABS are tranched, and which investor bears which risk.
What Are the Core Facts About Hedge Funds?
- Two exemption layers stack together: a 1940 Act exemption keeps the fund from registering as an investment company; a Regulation D private placement keeps the offering from registering as a public securities offering.
- 100-beneficial-owner exemption: no more than 100 beneficial owners, cannot make a public offering. Does not itself require accredited-investor status.
- Qualified-purchaser exemption: no owner cap under the exemption itself, but owners must be qualified purchasers exclusively; qualified purchaser is a higher bar than accredited investor.
- Regulation D is the layer that requires accredited investors: unlimited accredited investors plus up to 35 sophisticated non-accredited investors under one path, or accredited investors only with mandatory verification under the other.
- Illiquid: no exchange trading, redemptions only at quarterly or annual windows, lock-ups commonly 1-2 years.
- "2 and 20" fees: 2% management fee on assets, 20% performance fee on profits above a high-water mark.
- Fund of funds (FOF): spreads capital across multiple hedge funds for diversification, but stacks its own fees on top of the underlying funds' fees.
What Are the Core Facts About Asset-Backed Securities?
- Securitization: originator makes loans, loans pooled into a trust, trust issues tranches, investors receive the cash flows.
- Call and put features: clean-up calls retire remaining securities when the pool balance falls below about 10%; a minority of ABS also carry a put (tender) feature letting the holder require redemption on specified dates.
- CMO tranches divide timing risk (prepayment and extension), not credit risk. Types: sequential-pay, Planned Amortization Class (PAC, lowest risk), Targeted Amortization Class (TAC), companion (highest risk), Z-tranche, interest-only (IO), principal-only (PO).
- CDO tranches divide credit risk: senior (paid first, loses last), mezzanine, equity/junior (paid last, loses first).
Which One-Liners Win Points?
- Hedge fund investors get a Schedule K-1, not a 1099, because the fund is a partnership.
- Phantom income: you can owe tax on allocated gains the fund reinvested and never paid out in cash.
- PAC tranche = lowest risk / lowest yield; companion tranche = highest risk / highest yield and the most prepayment risk.
- IO strips move inversely to most bonds: value rises when rates rise. PO strips act like typical bonds: value rises when rates fall.
- CDO cash flows run top-down (senior first); losses run bottom-up (equity first).
- Prepayment (contraction) risk = rates fall, borrowers refinance, principal comes back early. Extension risk = rates rise, borrowers hold, principal comes back late.
Which Numbers Matter Most?
| Item | Value |
|---|---|
| 100-beneficial-owner exemption owner cap | 100 beneficial owners |
| Qualified-purchaser exemption owner cap | no cap under the exemption itself |
| Reg D non-accredited-investor cap | 35 (under the unverified-accredited-status path) |
| Qualified purchaser threshold | $5 million+ investments (individuals), $25 million+ (institutions) |
| Typical lock-up period | 1-2 years |
| Hedge fund fee structure | "2 and 20" (2% management, 20% performance) |
| Clean-up call threshold | pool balance below about 10% |
| Mortgage-backed accrued interest | 30/360 day-count |
Which Gotchas Trip Students Up?
- The 100-beneficial-owner exemption caps beneficial owners at 100, not investors. A fund of funds can count as a single beneficial owner, subject to look-through rules.
- Don't confuse the two exemption layers. The 1940 Act exemption controls whether the fund registers as an investment company (based on who owns it); Regulation D controls whether the offering registers as a public securities offering (based on who is sold to, and it is the source of the accredited-investor requirement).
- A fund of funds may register under the 1940 Act (reaching non-accredited investors) even when the underlying hedge funds are not registered.
- Agency CMOs have minimal credit risk but still carry prepayment risk: the guarantee covers defaults, not timing.
- CMO tranches divide timing risk; CDO tranches divide credit risk. That single distinction answers many questions.
- Hedge fund liquidity risk has two sources: lock-up provisions AND the lack of an exchange-traded secondary market.
One-Breath Recap
Hedge funds are private, illiquid, largely accredited-investor partnerships that skip registration, charge two and twenty over a high-water mark, and hand you a Schedule K-1 with possible phantom income. Asset-backed securities pool loans into tranches, where collateralized mortgage obligations slice timing risk (planned-amortization-class safest, companion riskiest, interest-only and principal-only strips moving opposite ways) and collateralized debt obligations slice credit risk from senior down to equity. Match the risk to the product and these questions answer themselves.
Need more than the recap? Read the full Hedge Funds and Asset-Backed Securities unit.