Types of Hedge Fund Investors

INDIVIDUAL INVESTORS
In the United States, individuals provide more money to hedge funds than
does any other group. They were prominent among early hedge fund in-
vestors. They have always been an important group to understand for mar-
keting, investment policy, tax reporting, and public policy.
On first impression, one would think that the motives of individual in-
vestors should be easy to understand because they should have the same
concerns about returns, risk, and taxes. In fact, investors' interests may dif-
fer markedly.
Individuals are likely to invest directly in single-manager hedge funds.
Other types of investors are much more likely to invest in funds of hedge
funds (see Chapter 2 for a description of funds of funds). Recently, how-
ever, individuals have begun placing much of their new money into funds
of hedge funds.
High-Net-Worth Individuals
Most individuals who invest in hedge funds are affluent and are taxed at
high marginal rates. High-net-worth individuals have a disproportionate
portion of the investment assets simply because of their high net worth.
Federal securities laws also severely restrict middle-income and low-
income investors from investing in hedge funds (see Chapter 8), so high-
net-worth individuals contribute most of the investment dollars from
individuals.
Security regulations define a high-net-worth individual in a variety of
ways. An individual who is an "accredited investor" has income of at least
$200,000 or assets of $1 million (see Chapter 8 for greater detail about se-
curities regulations related to accredited investors and other topics dis-
cussed in this chapter). Other regulations draw the line at $2 million for a
"qualified eligible participant" (QEP). Finally, a "qualified purchaser" is
an individual investor with a net worth exceeding $5 million.
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Regardless of how these break points are defined, the typical investor
has a high marginal tax rate. Yet the typical hedge fund produces most of
its return as short-term capital gains or ordinary income, both of which are
taxed at high marginal tax rates. In contrast, other investments are taxed
more favorably. Municipal bonds are not taxed at the federal level and
may be exempt from state and local income tax. Other investments, such
as common stocks, provide a large part of their return in the form of capi-
tal gains that may be taxed at a lower rate for long-term gains. The tax
may be postponed indefinitely (if the investment is held indefinitely), or
may even escape income taxation if held until death.
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