Hedge funds originated as a method for reducing risk with respect to the direction of the market (either long or short) by pooling investments in a mix of short and long market positions in a vehicle with optimal tax characteristics.

Today, the term has become a misnomer. The modern hedge fund is not necessarily hedged with regard to all, or any, of its positions. Instead, a hedge fund refers to an investment partnership comprised of a pool of funds placed in a tax-optimized vehicle -- it does not describe the fund’s trading policy.

Hedge funds are regulated by national and state securities laws, federal and state tax laws, audit and accounting principles, the Financial Accounting Standards Board, commodities trading laws and sometimes ERISA requirements. Generally, investment partnerships are structured so they are not required to register with the SEC. They accomplish this by comprising 100 or fewer holders, generally individuals whose net worth exceeds $1 million, and by not making a public offering. If the fund surpasses 500 investors, it is required to register with the SEC and become a hybrid entity, maintaining fiscal transparency but subject to a regulatory environment similar to that of a mutual fund.

In general, GAAP for investment partnerships requires that financial statements be prepared on an accrual basis, with securities positions recorded on their trade date and stated at fair value. Conformity with GAAP also requires a condensed schedule of investments, categorized by type of asset, country or geographic region and industry.

For domestic hedge funds, the limited partnership has proven to be the optimal type of entity, achieving both fiscal transparency and flexibility. Choice of structure in the offshore area is more complex. In general, the offshore vehicle is structured as a type of entity that is essentially similar to a domestic limited liability company but taxable for federal income tax purposes as a C corporation.

The successful hedge fund can achieve substantially superior compensation with greater freedom of movement than other vehicles such as mutual funds, RICs or REITs.