A hedge fund is an investment vehicle. Investment and other activities are limited by the terms of organizing documents and state law governing the fund. However, a hedge fund is flexible in that it can be fashioned to pursue differing investment strategies.

Hedge funds have a variety of strategies, each with some risk. They include investing in assets mispriced relative to global alternative investments, investing in anticipation of a specific event, or investing in emerging markets.

Today a typical hedge fund uses leverage or debt to invest positions taken in financial markets. Success relies on stable access to credit.

A hedge fund's primary goal is the reduction of volatility and risk while preserving capital and positive returns. However, the level of risk varies with the strategy pursued.

A hedge fund that focuses on aggressive growth companies in technology or which seeks to profit from changes in global economies may have high volatility. A fund that focuses on purchases of discounted securities of distressed companies facing reorganization or bankruptcy, or which seeks investments emphasizing yield or current income rather than capital gains, may have low to moderate volatility.

A hedge fund can be less constrained than many other investment vehicles, such as vehicles that offer and sale of individual stocks and mutual funds.

A purchase of any of these alternative investments is subject to rules that must be followed in the offer, sale and retention of the securities.

These laws require that the securities offered be registered or satisfy registration exemptions under state securities laws and the federal Securities Act of 1933.

The company issuing these securities may be subject to requirements of the federal Securities Exchange Act of 1934. These requirements include distribution of detailed periodic and other reports to investors on company status.

A hedge fund may be excluded from the Investment Company Act. Although the fund may appear to fall within the definition of an investment company, it may satisfy one or more exclusions from that definition under the act.

One exclusion applies to a company having fewer than 100 investors. The second applies to a fund where each investor is a qualified purchaser, defined as an individual with over $5 million in investment assets.

While the first exclusion limits the number of investors, the second one does not.

A hedge fund offering is also subject to the securities registration and registration exemption provisions of the Securities Act. In addition, the offering must comply with state securities laws.

A hedge fund may reward its manager through a management fee and a performance fee. The management fee is usually calculated as a percentage of assets under management. It may be in the range of 2 percent.

The purpose of a performance fee is to provide incentives for higher performance of the fund.

Limitations on performance fees are sometimes used by a hedge fund. Fees vary, ranging from 20 percent of gross returns to more than double that amount.

Some mutual funds now include strategies that evolved in hedge funds. These hybrid funds hold themselves out as public hedge funds.

A clear distinction between a hybrid fund and a hedge fund is that the former is regulated as an investment company, including the amount of manager performance fees that may be paid. A hedge fund, in being excluded from the investment company, is not subject to such regulatory restrictions.

Here the term “hedge” is used in the context of a private offering by a fund excluded from the definition of an investment company.

A hedge fund is typically offered in reliance upon the registration exemption provisions of Regulation D of the Securities Act. It is also offered in reliance on provisions of state securities laws.

One provision of Regulation D limits the number of allowed purchasers, with limited exception. The exception consists of what are termed “accredited investors.”

The term accredited investor is defined in Regulation D to include an individual with a net worth of $1 million. The term further includes an individual who had income in excess of $200,000 in each of the then two most recent years (or joint income with the individual's spouse in excess of $300,000 in each of those years) and had a reasonable expectation of reaching the same income level in the then current year.

Success of a hedge fund also depends upon a stable base of investors. With a hedge fund being private in nature, there typically is no market for investor interests in the fund. The investor must have the ability to hold an illiquid investment for a period of time commensurate with the fund's investment strategy and the terms of its organizing documents.

A variation on a hedge fund is a fund of hedge funds, which allows the manager to select from a diversified portfolio of uncorrelated hedge funds.

It also allows selection of different funds that might be expected to react differently to events in the market place. This structure supposedly hedges risk even further than can be accomplished with a single fund.

Interests in a hedge fund must not be offered, sold or advertised to the public. To do otherwise causes loss of the registration exemption and places the organizers in the vulnerable position of making an unregistered offer and sale of securities in violation of state securities laws and the Securities Act.

As a result, unlike mutual funds, little public information is available on hedge funds. Yet, some hedge funds have become significant investors in public companies.

The prudent prospective investor carefully considers risk factors associated with hedge funds and consults with his or her investment adviser as to whether an investment in those funds makes sense.