What Is a Hedge Fund?
Hedge funds are actively managed investment products that employ advanced trading techniques. They are mostly reserved for wealthy investors.
April 25, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
The investment landscape can be a confusing place.
With thousands of companies to invest in, hundreds of industries and dozens of asset classes, it’s enough to make your head spin.
Many people choose to outsource their investment management, either to a financial advisor or to a mutual fund or hedge fund.
But what is a hedge fund, exactly? And can everyday investors use them?
What is a hedge fund?
Hedge funds are actively managed investment funds that pool money from a variety of investors.
The money is then managed by a team of investment professionals. The hedge fund employees decide how to allocate investments, what to buy and sell and what overall strategy to follow.
A hedge fund operates somewhat like a mutual fund, in that they pool money from many different sources. The difference is that hedge funds are usually much more exclusive than mutual funds and may be less liquid (some hedge funds require you to remain invested for a certain period of time, whereas mutual funds can be bought and sold at any point).
Many hedge funds employ advanced techniques, including market timing, hedging, investing with borrowed money and more.
The goal of hedge funds is typically to earn higher returns than is available elsewhere. Managers aim to earn high returns and to protect from downside risk during market downturns.
Hedge fund example
There are many hedge funds out there, but Bridgewater Associates is one of the largest. The company manages more than $150 billion in client assets.
Can I invest in a hedge fund?
Most hedge funds are not accessible to everyday investors.
What is a hedge fund’s main target clientele, then? It’s mostly professional investors and high net-worth individuals.
Many hedge funds have extremely high minimum investments — minimums of $100,000 or even $1 million are common.
Plus, many funds only accept investments from accredited investors. Accredited investors must either earn more than $200,000 per year or have a net worth of at least $1 million.
These restrictions are due to certain regulations from the Securities and Exchange Commission (SEC). Specifically, rule 504 and rule 506 of Regulation D. These regulations limit the number of investors that a hedge fund can accept and impose other restrictions on hedge funds.
The result is that most hedge funds are only accessible to wealthy investors.
How do hedge funds work?
Hedge funds pool money from professional investors, university endowments, pension managers and wealthy investors. They then use this pooled money to make investments.
Each hedge fund employs a different style of investment strategy. Some are extremely aggressive, while others are focused more on preserving capital rather than taking large risks.
Hedge funds are managed by small teams of investment professionals.
There will usually be one or two primary managers, who oversee the work of dozens (or even hundreds) of professionals.
Hedge funds may have employees who focus on researching new opportunities, others who perform technical analysis, others who oversee technical capabilities/IT and so on.
Hedge funds often pay very well, but are known for requiring long hours and difficult working conditions.
Each fund employs a different overall investment strategy, making it difficult to characterize what a “typical” hedge fund looks like.
Hedge funds may conduct any of the following types of trading styles (and often use a combination):
Active trading and swing-trading
Long-term buy-and-hold investing
Activist investing, where a fund takes a large stake and then attempts to make changes in the company
Investing or trading on margin (borrowed money)
Trading in advanced instruments like derivatives and options
Short-selling stocks (betting against companies)
Hedging (balancing each trade with a contrarian trade, somewhat like an insurance policy)
Arbitrage (taking advantage of mismatched prices in different markets)
And much more
The goal of most hedge funds is to earn high returns. However, there are some funds that focus on preserving capital, which often take a more cautious approach to investing.
Hedge funds make money by charging fees. Each fund has different fees but most use a similar structure.
Management fees: Charged as a percentage of assets under management (AUM), the management fee is charged every year, regardless of fund performance. 1-2% per year is a standard hedge fund management fee.
Performance fees: Charged as a percentage of profits that the hedge funds makes. If a fund profits $100 million and charges a 20% performance fee, they would pocket $20 million before passing on the rest of the profits to investors. 15-20% per year is a typical performance fee for hedge funds.
The so-called “2-and-20” fee structure was long considered the standard. This refers to a 2% management fee, plus 20% of profits. However, hedge fund fees are steadily declining, as the industry seeks to compete with lower-cost investments like index funds.
As mentioned, most hedge funds have a minimum investment amount. It’s often quite high — $100,000 or even more. This makes hedge funds inaccessible to most everyday investors.
Pros and cons of hedge funds
Potential for market-beating returns
May have some downside protection in market crashes
Employ advanced strategies
Managed by investment professionals
Allow access to inaccessible investments (like private equity, real estate, etc.)
Charge very high fees
Many hedge funds underperform the market
Not accessible to most investors due to high minimums
Insides are important to consider. Hedge fund fees are very high and investment fees can have a substantial effect on long-term returns.
Plus, some hedge funds actually underperform the stock market, or their relevant benchmark, when you account for fees.
Alternatives to hedge funds
If hedge funds aren’t a great option (and aren’t even accessible to most investors), where should investors turn?
Index funds, mutual funds and ETFs can all present good alternatives. Find out more in our investing 101 guide.
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