Hedge Funds and Fund of Funds
Hedge funds operate outside the regulatory framework that governs mutual funds. Understanding their structure, exemptions, and characteristics matters because the exam tests the specific ways hedge funds differ from registered investment companies.
Hedge Fund Structure and Legal Exemptions
Most hedge funds are organized as private placements under Regulation D and rely on exemptions from the Investment Company Act of 1940 to avoid registering with the SEC as investment companies.
Two key exemptions allow hedge funds to operate without 1940 Act registration:
| Exemption | Investor Limit | Investor Qualification | Key Restriction |
|---|---|---|---|
| Section 3(c)(1) | No more than 100 beneficial owners | Accredited investors | Cannot make a public offering |
| Section 3(c)(7) | Up to 2,000 beneficial owners | Qualified purchasers ($5M+ in investments for individuals, $25M+ for institutions) | Cannot make a public offering |
- Registered hedge funds: A small number of hedge funds voluntarily register under the 1940 Act and file with the SEC, making shares available to a wider investor base
- Unlike mutual funds, hedge funds are not required to calculate daily net asset value (NAV), limit leverage, or deliver a prospectus
Exam Tip: Gotchas
- Section 3(c)(1) limits the fund to 100 beneficial owners, NOT 100 investors. Beneficial ownership is counted at the entity level; a fund of funds investing in the hedge fund may count as a single beneficial owner, but look-through rules can apply.
- Qualified purchaser is a HIGHER bar than accredited investor. Section 3(c)(1) requires accredited investors; Section 3(c)(7) requires qualified purchasers ($5M+ in investments for individuals). These are often confused on the exam.
Blind Pools and Blank Check Companies
- A blind pool raises capital without disclosing specific investments; investors trust the manager's strategy and judgment
- A blank check company, also called a Special Purpose Acquisition Company (SPAC), has no business operations and raises funds solely to acquire or merge with another entity, typically within 24 months
Hedge Fund Characteristics
Hedge funds differ from registered investment companies in several ways:
Liquidity and Lock-Up Provisions
- Limited or no liquidity: Hedge fund shares are not traded on exchanges; redemptions are typically restricted to specific windows (quarterly or annually)
- Lock-up provisions: Investors must commit capital for a minimum period (commonly 1-2 years) during which withdrawals are prohibited or subject to early redemption penalties
- Contrast with mutual funds: mutual fund shares can be redeemed at NAV on any business day
Exam Tip: Gotchas
- Hedge funds have NO daily redemption. Unlike mutual funds, which must redeem shares at NAV on any business day, hedge fund investors may be locked in for 1-2 years with redemptions only at quarterly or annual windows.
Fee Structure: "2 and 20"
The typical hedge fund fee structure is known as "2 and 20":
| Fee Component | Amount | Based On |
|---|---|---|
| Management fee | 2% annually | Assets under management (AUM) |
| Performance/incentive fee | 20% of profits | Gains above a benchmark (high-water mark) |
- The high-water mark ensures performance fees are only charged on new profits. The manager must recover any prior losses before earning incentive fees
- Total fees are significantly higher than mutual fund expense ratios (typically 0.5%-1.5%)
Think of it this way: If a hedge fund starts at $100, drops to $80, then climbs back to $100, the manager earns zero performance fees on that recovery. The "high-water mark" is $100, and the manager only collects the 20% incentive fee on gains above $100.
Limited Transparency
- Hedge funds are not subject to the same disclosure requirements as registered investment companies
- Investors receive limited information about specific portfolio holdings, leverage levels, and counterparty exposures
- No requirement for standardized prospectus delivery
Investment Strategies
Hedge funds employ a wide array of strategies unavailable to or restricted for registered investment companies:
| Strategy | Description |
|---|---|
| Long/short equity | Simultaneously buying undervalued and shorting overvalued securities |
| Global macro | Bets on broad economic trends using currencies, interest rates, commodities |
| Event-driven | Targets mergers, acquisitions, bankruptcies, restructurings |
| Market-neutral | Offsetting long and short positions to eliminate market risk |
| Distressed debt | Purchasing debt of companies in or near bankruptcy |
- Heavy use of leverage, short selling, and derivatives (strategies that are restricted or prohibited for mutual funds)
- Some hedge funds invest in tangible/real assets (real estate, commodities, precious metals) alongside financial instruments
Fund of Funds (FOF)
A fund of funds is a pooled investment that allocates capital across multiple hedge funds rather than investing directly in securities.
Advantages
- Diversification across multiple managers, strategies, and asset classes
- Lower investment minimums than direct hedge fund investment (may start around $25,000 vs. $1 million+)
- Professional manager selection: the FOF manager performs due diligence on underlying hedge funds
- May be registered under the 1940 Act, making it accessible to non-accredited investors
Disadvantages
- Double layer of fees: The fund of funds charges its own management and performance fees ON TOP of the fees charged by each underlying hedge fund
- Diluted returns: The additional fee layer reduces net returns to investors
- Less control: Investors cannot choose which specific hedge funds receive their capital
Exam Tip: Gotchas
- Fund of funds charge fees ON TOP of the underlying hedge fund fees. If the exam asks about the primary disadvantage of a fund of funds structure, the answer is this "double fee" layer and its impact on investor returns.
- A fund of funds may be registered under the 1940 Act, making it accessible to non-accredited investors, but the underlying hedge funds typically are not registered.
Tax Treatment of Hedge Fund Distributions
Hedge fund tax reporting differs fundamentally from mutual fund tax reporting:
| Feature | Hedge Funds | Mutual Funds |
|---|---|---|
| Tax form | Schedule K-1 (partnership) | Form 1099-DIV / 1099-B |
| Income character | Passed through (retains character) | Distributed as dividends or capital gains |
| Phantom income | Yes: taxed on allocated gains even if not received in cash | No: only taxed on actual distributions |
- Income retains its character as passed through: short-term capital gains, long-term capital gains, interest, and dividends are each reported separately on the K-1
- Phantom income: Investors may owe taxes on gains that were reinvested by the fund rather than distributed as cash
- Registered hedge funds that distribute income follow standard investment company distribution rules
Think of it this way: Suppose the hedge fund makes $1 million in trading profits but reinvests all of it. As a partner, your share of that $1 million shows up on your K-1, and you owe taxes on it even though you never received a check. That is phantom income.
Exam Tip: Gotchas
- Hedge fund investors receive Schedule K-1s, not 1099s. This is because hedge funds are structured as partnerships, not investment companies.
- Phantom income means you can owe taxes on money you never received. The fund allocates gains on paper even if profits were reinvested rather than distributed as cash.