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The “Hedge Fund Rule”

The hedge fund industry has started to gain an increasing popularity, which has led to the rising instances of fraud. As a result the SEC has embarked on the implementation of several rules that are intended to limit the cases of schemes. Additionally, these policies targeted the protection of the securities market. The rise in the popularity of the hedge fund industry and its relative lack of regulation has motivated the SEC to increase its supervision. The institution had no control over the large amounts of money that have been generated by hedge funds for their clients. Initially, only wealthy individuals were able to take advantage of the benefits of hedge funds, but today pension funds, insurance companies, universities and other institutional buyers have been attracted.

As a result the Investment Advisor Act of 1940 was revised to create the so called "hedge fund rule", which came into action in the beginning of 2005. It included a revision on the term "client", which under the new conditions included shareholders, members, beneficiaries, or limited partners of the hedge fund. As a result, previously unregistered hedge fund advisors with less than 15 clients, have now to make the necessary proceeds to register with the SEC. The new regulation was intended to:

  • Deter fraud
  • Provide the SEC with a supervisory authority
  • Foster strong compliance rules
  • Increase standards for investments in hedge funds

This "hedge fund rule" has been opposed in the middle of 2006, since a D.C. Circuit Court defied the categorization of clients made by the SEC. It stated that the individual investors of the fund should be excluded and the hedge fund managers should be only included in the funds they manage. As a result of this ruling, managers that have up to 15 funds under their management are not required to register with the SEC.

Hedge fund regulations differ from those applied to mutual funds in some additional ways. Rules that are applied to mutual funds, but not to hedge funds include:

  • A required degree of liquidity
  • Redemption of mutual fund shares at any time
  • Protection against conflicts of interest
  • Guarantee of fair fund share pricing
  • Disclosure regulations
  • Limit on leverage

As a result hedge funds enjoy higher degree of freedom regarding the use of such techniques as leverage, short selling and etc., which leads to the higher returns that hedge funds generate relative to mutual funds. However, hedge funds are not exempt from US federal securities laws regarding anti-fraud provisions.

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