Hedge Funds

<div class="Section1">Domestic hedge funds are generally set up as limited partnerships.&nbsp;Thus, holders of interests in hedge funds are taxed on their distributions as limited partners. For the treatment of cash distributions, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7751">7751</a>. For the treatment of capital gain on the sale or exchange of interests, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7754">7754</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7755">7755</a>.<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; <em>Lagreide v. Comm</em>., 23&nbsp;TC 508 (1954).<br /> <br /> </div></div><br />

<div class="Section1">There is no statutory or regulatory definition of <em>hedge fund</em>, a type of pooled investment vehicle, but such funds have several characteristics in common. As described by the SEC, “hedge funds are organized by professional investment managers who frequently have a significant stake in the funds they manage and receive a management fee that includes a substantial share of the performance of the fund.”<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> “Hedge funds were originally designed to invest in equity securities and short selling to ‘hedge’ the portfolio’s exposure to movements of the equity markets. Today, however, advisors to hedge funds utilize a wide variety of investment strategies and techniques designed to maximize the returns for investors in the hedge funds they sponsor.”<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Hedge funds are varied in investment style, strategies, and objects of investment. A 2004 SEC staff report noted that they “invest in equity and fixed income securities, currencies, over- the-counter derivatives, futures contracts, and other assets. Some hedge funds may take on leverage, sell securities short, or use hedging and arbitrage strategies. … Hedge funds offer investors an important risk management tool by providing valuable portfolio diversification because hedge fund returns in many cases are not correlated to the broader debt and equity markets.”<a href="#_ftn3" name="_ftnref3">³</a> A <em>fund of funds</em> is a fund that invests in several hedge funds.<br /> <br /> Traditionally, hedge fund investors were limited to the very wealthy. Beginning in the mid-to-late 1990s, the SEC was increasingly faced with a number of important policy concerns, including: (1) the growing number of hedge funds; (2) the accompanying growth of hedge fund fraud; and (3) the growing exposure of smaller investors, pensioners, and other market participants to hedge funds (due, in part, to the lowering of minimum investment requirements by some hedge funds).<a href="#_ftn4" name="_ftnref4">⁴</a> To address these concerns, in 2004 the SEC adopted a rule requiring certain hedge funds to register with the SEC and be subject to that agency’s oversight.<a href="#_ftn5" name="_ftnref5">⁵</a> But a federal court rejected the rule and it was subsequently removed.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  SEC Final Rule Release No. IA-2333, Registration Under the Act of Certain Hedge Fund Advisers, at www.sec.gov/rules/final/ia-2333.htm.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  SEC Final Rule Release No. IA-2333, Registration Under the Act of Certain Hedge Fund Advisers, at www.sec.gov/rules/final/ia-2333.htm.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  United States Securities and Exchange Commission, <em>Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission</em> (September 2003), at www.sec.gov/spotlight/hedgefunds.htm.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  SEC Final Rule Release No. IA-2333, Registration Under the Act of Certain Hedge Fund Advisers, at www.sec.gov/rules/final/ia-2333.htm.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.  SEC Rule 203(b)(3)-2, 17 CFR 275.203(b)(3)-2.<br /> <br /> </div>