Why are U.S. hedge funds so popular?

For the right investor, with the right resources and experience, on the right fee schedule and at the right time, hedge funds can be a good thing, especially when the asset classes they focus on fit within the overall goal of asset allocation in ways that individuals who trade publicly in stocks and bonds, for example, cannot. How hedge funds work and some of the reasons why many wealthy investors consider hedge funds to be among the vehicles they want to use as part of their long-term protection and development of capital.

Now, I'd like to take some time to explain why it's nearly impossible for new investors to access high-quality hedge funds, and some of the rules that cover so-called private placements. A private placement means that you don't have the opportunity to participate in the investment as a member of the public, for example by buying on a stock exchange through a brokerage account, rather than only being offered to a select group In technical terms, if your brother-in-law started a new company launching a series of frozen yogurt stands and you had the opportunity to buy shares without the general public buying them, this would be considered a private placement investment.

To understand why hedge funds are inaccessible to the general public, you need to know that even though hedge funds are privately held and usually structured as limited partnerships or LLCs , their limited partnership units or LLC member units are in most cases securities.

For smaller fund managers, these rules are so complex and often prohibitive that the SEC or U.S. Securities and Exchange Commission allows several different types of pooled investment vehicles to avoid the registration requirements by exempting them. Most, but not all, of these exemptions are found in what is known as "Regulation D." Here, in Regulation D, the exemptions are found in the form of a "Rule".

Here, in Regulation D, you find the reasons why it is very difficult for new investors to purchase hedge funds.

In a way, this may actually be a good thing for society, because the average investor tends to have less experience, less financial sophistication, and less capacity, as measured by income and net worth, to absorb the significant risks that come with many hedge fund strategies. Instead, the best they can do is avoid trying to get into hedge funds altogether and throw in the gauntlet, investing in index funds or passive strategies, perhaps through separately managed accounts (if they have at least hundreds of thousands of dollars), while keeping an eye on tax efficiency and keeping mutual fund fees proportionately reasonable.

That said, let's dive into Regulation D and discover some of the requirements and restrictions.

Reason 1: Regulation D puts a limited number of seats on the roster for non-accredited investors

Specifically, there are three very important parts of Regulation D: Rule 504, Rule 505 and Rule 506. Each of these three rules has different pros and cons, but the common thread is that they allow a company or hedge fund to raise money from investors without having to file a lot of paperwork.

Common restrictions are the inability to raise capital from more than 35 unaccredited investors or to raise no more than $5 million in any 12-month period.

Reason 2: For years, Regulation D has promoted hedge funds in violation of the law

For years, Regulation D Sections 504,505 and 506 have generally prohibited advertising, making it virtually impossible to learn about hedge fund opportunities unless you have an existing relationship with an affiliated broker-dealer. This regulation was intended to protect investors, but some commercial publishers believe it is now outdated and for all intents and purposes, the SEC has changed its position. For whatever reason, hedge funds are largely not using their marketing power as some business journalists think they would so chillingly.

Only time will tell if this will continue to be the case in the future as the new rules become part of the landscape.

Reason 3: Hedge fund general partners can recognize who they want

Hedge fund managers, general partners and other executives can unconditionally accept or reject anyone they want into the fund, discriminating at will. This is not the same as investing in a mutual fund or investing in stocks Anyone who can afford to buy stocks has the right to do so. This can benefit hedge funds in many ways. For example, portfolio managers can ensure that only like-minded investors with the same capital allocation policy are admitted, thereby minimizing future conflicts and distractions. Unfortunately, this also means that outsiders will have difficulty gaining access if they are not already within the orbit of those who invest or are otherwise connected to the fund. This is an area where private banks and wealth management firms can play a role in introducing investors to fund managers, and vice versa.

A perfect example of this is currently the world's most famous investor. When Warren Buffett started hedge funds, you probably wouldn't have heard of him unless you were connected to him, his family, existing investors or his mentor, Benjamin Graham. His initial seven partners included family members and the family of his college roommate.  

Reason 4: You may not meet the minimum investment requirements for a hedge fund

The person running a hedge fund can set the minimum investment amount he or she wants in most cases. Since there is a limit to the total number of investors that can be allowed under the Rule 504,505 or 506 exemptions, they want to raise that number. Some hedge funds require a minimum investment of $100,000, while others may require $25,000,000 or more! It's just a matter of efficiency.

When someone says they bought a "hedge fund," it doesn't really tell you anything. A hedge fund is not necessarily a good investment, not a good or bad stock. It's just a descriptive term that tells you that you are dealing with some kind of pooled investment fund that may not be registered with the SEC because it falls under one of the exemptions to Regulation D. You could own a hedge fund that specializes in buying and selling hotels, one that buys stocks based on value investing, one that trades in fine art, or trades in rare stuffed animals! A hedge fund may be debt-free or highly leveraged. It may focus its activities on assets inside or outside the United States.