"Hedge fund" is a phrase coined in the 1940’s. Originally limited to private and unregistered investment pools, these funds used fairly sophisticated hedging and arbitrage practices to make significant returns off of the corporate funds market. In the past, hedge funds were the exclusive playing grounds for wealthy and experienced investors. But, as many things in the investment world are prone to experience, hedge funds have widened their activities to include other financial instruments and activities. In today’s terminology, "hedge fund" is a bit misleading because many of these funds use no hedging techniques at all. Now, a “hedge fund” really indicates a private and unregistered investment pool.
The first hedge fund was set up by Alfred W. Jones in 1949. In 1952, he converted his general partnership fund into a limited partnership investing with several independent portfolio managers and created the first multi-manager hedge fund.
Like mutual funds, hedge funds take investors’ money and collectively invest it. The biggest difference between hedge and mutual funds is that, unlike mutual funds, hedge funds are not required to register under the federal securities laws. Because hedge funds usually accept only experience and savvy investors and since their securities are not publicly offered, they are able to bypass registration issues. Some hedge funds are also restricted in the number of investors allowed to join.
Another major difference between hedge and mutual funds is the amount of regulation required for the protection of investors. Mutual funds are subject to fairly tough regulations that require a certain degree of liquidity, demand that mutual fund shares be redeemable at any time, protect against conflicts of interest, assure fairness in the pricing of fund shares, force disclosure and transparency, limit the use of leverage, and more. Hedge funds are free from these kinds of regulation, which allows them to practice leverage and other sophisticated investment techniques unavailable to mutual funds. Just in case you’re alarmed by the lack of regulations governing hedge funds, they are still required to operate under the antifraud provisions of the federal securities laws.
Hedge funds are risky, and usually favored by investors who know they can afford their investment losses (although, of course, they would prefer not to). Be wary of them.