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Hedge Funds - Taxes & Investing

Hedge funds can bring a big tax bite. Because managers buy and sell so frequently, investors incur high capital gains that are normally taxed at the ordinary income tax rate.

For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with having a significant amount of investment knowledge.

Unlike open-ended mutual funds, hedge funds do not provide a prospectus to investors. Instead, they provide an offering memorandum that sets specific guidelines regarding a hedge fund's investment strategy and the type of securities it can invest in.

The terms offered by a hedge fund are so unique that each fund can be completely different from another, but they usually are based on the following factors:

Hedge funds do not have daily liquidity like mutual funds do. Some hedge funds can have subscriptions and redemptions monthly, while others accept them only quarterly. The terms of each hedge fund should be consistent with the underlying strategy being used by the manager. The more liquid the underlying investments, the more frequent the subscription/redemption terms should be. Each fund also specifies the number of days required for redemption, ranging from 15 days to 180 days, and this, too, should be consistent with the underlying strategy. Requiring redemption notices allows the hedge fund manager to efficiently raise capital to cover cash needs.

Many funds have a lock-out period, which is an initial period of time during which investors cannot remove their money. Some funds require up to a two-year "lock-up" commitment, but the most common lock-up is limited to one year. In some cases, it could be a hard lock, preventing the investor from withdrawing funds for the full time period, while in other cases, an investor can withdraw funds before the expiration of the lock-up period, provided they pay a penalty. This second form of lock-up is called a soft lock and the penalty can range from 2 to 10% in some extreme cases.

While there are a variety of different combinations that can be used to structure a hedge fund and its related companies and investors. The above summary briefly describes one very common method used to structure the hedge fund and its management company. There are many others and just as hedge funds are creative with their investment strategies, they can also be very creative with their organizational structure.

Hedge funds are more expensive than mutual funds, even though a portion of the fees is performance-based. Typically, they charge an annual fee equal to 1% of assets managed (sometimes up to 2%), plus they receive a share - usually 20% - of the investment gains. The managers of many funds, however, invest their own money along with the other investors of the fund and, as such, may be said to "eat their own cooking."

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