enhanced indexing, the investment manager aims to closely replicate index returns, volatility, and correlation characteristics while adding a small amount of alpha. In contrast, in pure active management, the investor pays no attention to any benchmark and simply attempts to generate returns by the implementation of his or her views. Hedge funds are designed to represent this purest form of active management. WHAT IS A HEDGE FUND? A hedge fund is an unconstrained, loosely regulated investment vehicle for which a portion of manager compensation is a performance fee. Hedge funds are intended to be unadulterated exposure to active management, reflecting only the managers' views on future asset returns, and not reflecting any concept of benchmark index. II Constraints. Hedge funds are vehicles that allow investment managers to engage in pure active management, with no consideration of a benchmark, and unconstrained with respect to the use of short selling (see Figure 27.1), leverage, instruments, and strategies. Consequently, hedge funds are sometimes referred to as belonging to "skill classes" rather than asset classes. The attraction of hedge funds is that they offer investors an opportunity to both enhance expected returns as well as reduce risk. 11 Regulation. In the United States, the Securities and Exchange Commission does not regulate hedge funds. As a result, hedge fund investing is restricted to qualified investors who can meet certain net worth and income standards. These requirements are intended to distinguish sophisticated investors who are able to effectively evaluate the risks of unregulated vehicles. Due to this freedom from regulatory oversight, however, hedge fund managers are not allowed to solicit clients. Hedge funds exploit an investment technique known as short selling, or selling an asset that the investor does not own with the intention of repurchasing it later. The investor may expect that the asset's price will drop, resulting in an outright profit, essentially reversing the timing of the old piece of stock market advice from "buy low and sell high" to "sell high and buy low." Alternately, the investor may sell an asset short as a hedge against another asset, or in order to exploit the relative price movements between two assets. As an example, the mechanics of short-selling stock in the United States are straightforward, but important to understand. Short sellers employ a "prime broker" who locates the borrowable stock and acts as custodian of the stock. The investor identifies the asset to sell short and notifies their prime broker of the intent. The broker then locates a "shortable" security, one that the owner has already agreed may be borrowed and sold short. The prime broker borrows the asset and sells it, using the proceeds as collateral for the shorted security. In addition, in the United States, the short seller must post margin, or further security for the short-sold asset, in accordance with Regulation T The short seller must pay a borrowing fee, plus any income paid on the asset, to the owner who loaned the security. FIGURE 27.1 The Mechanics of Short Selling Source: Tremont Advisers, Inc.