Quick Answer
Hedge funds are private, illiquid, accredited-only 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.
Hedge Funds: The Core Facts
- Private placements under Regulation D; rely on exemptions from the Investment Company Act of 1940, so no SEC registration as an investment company.
- Accredited-investor exemption: no more than 100 beneficial owners, cannot make a public offering.
- Qualified-purchaser exemption: up to 2,000 beneficial owners; qualified purchasers are a higher bar than accredited investors.
- 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.
Asset-Backed Securities: The Core Facts
- Securitization: originator makes loans, loans pooled into a trust, trust issues tranches, investors receive the cash flows.
- 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).
The One-Liners That 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.
Numbers to Lock In
| Item | Value |
|---|---|
| Accredited-investor exemption owner cap | 100 beneficial owners |
| Qualified-purchaser exemption owner cap | up to 2,000 beneficial owners |
| 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 |
Top Gotchas
- The accredited-investor exemption caps beneficial owners at 100, not investors. A fund of funds can count as a single beneficial owner, subject to look-through rules.
- 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, accredited-only 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 CMOs slice timing risk (PAC safest, companion riskiest, IO and PO strips moving opposite ways) and CDOs slice credit risk from senior down to equity. Match the risk to the product and these questions answer themselves.
Need more than the recap? This is a condensed summary. If it is not enough, read the full Hedge Funds and Asset-Backed Securities unit for the complete lesson.