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Financial Literacy

What is a Hedge Fund?

If you watch financial media with any regularity, you’ve heard the term “hedge fund” before. Headed by a manager (typically a registered investment advisor), these funds are for eligible qualified investors to pool their money and invest. They have an extremely high barrier to entry and don’t play by the same rules as other managed investment products. That said, they also carry a tremendous level of risk. 

The big draw of hedge funds is their highly leveraged nature, which leads to significant return on investment (ROI). These funds are where high-net-worth individuals park their wealth and let it work for them. And while they’re not infallible—many have suffered mightily in the Great Recession of 2008—they’re a solid investment bet with proven returns. 

What is a hedge fund

Hedge Funds Are Risk-Seeking Funds

Historically speaking, hedge funds were founded on the principle of mitigating risk—hence their name. Today, they’re the opposite: they capitalize on risk. They’re known as risk-seeking funds and take on much more risk than other managed funds to ensure the highest possible ROI.

Most hedge funds are illiquid, which means investors can’t access their money without significant notice—usually one year. This “lock up period” serves two purposes. First, to hedge against the volatility that comes with riskier investments and second, to maintain leveraging capabilities. Today’s hedge funds protect themselves from major shortcoming and downturns through tactics like arbitrage, and tend to see exponential return on investment. 

A Focus on High-Net-Worth Individuals

Who’s qualified to invest their money into a hedge fund? While every fund has its own stipulations and criteria, most cater exclusively to high-net-worth individuals. Minimums for hedge fund participation might be something like two years of annual net income above $200,000 or a net worth of $1,000,000 (excluding primary residence). Many funds go even further, setting minimum caps on net worth or the value of assets under management. 

The reason middle-income and regular investors aren’t accepted into hedge funds is because of the high cost of operating these funds and the risks they take. These funds use leverage to generate risk, which means they need to attract investors with higher sums available. 

Types of Hedge Funds

Hedge funds tend to follow a theme, with a clear investment thesis. The fund manager will dictate the type of fund based on how they choose to leverage investors’ money. Some of the most common types include:

  • Global macro funds. These funds invest in global macroeconomic trends affecting currency, interest rates, commodities, equities and anything else affecting world markets. Because they focus on the largest macro trends, they’re among the most volatile. 
  • Long/short funds. These are funds that make a play on the price movement of markets. Short funds look for overvalued equities that will fall in value; long funds seek out undervalued equities soon to rise. Some focus on one; others play both directions. 
  • Event-driven funds. Event-driven funds capitalize on one-time situations such as bankruptcies or divestitures, or even mergers and acquisitions. These events can take a while to play out, and often require some level of market timing. 
  • Merger/arbitrage funds. These funds capitalize on M&A activity by going long in the company that’s acquired and shorting the acquirer. The result is usually significant net gain, with a healthy position in the acquiring company after the transaction. 

There are numerous other hedge fund strategies. Most revolve around capitalizing on both sides of a stock market transaction (arbitrage). In many cases, it’s a great way to manage risk, while maintaining a highly leveraged position. 

Performance-Driven Incentives

Like a mutual fund, participation in a hedge fund comes with an expense ratio or a management fee. This is commonly called the “2 and 20” fee, which is shorthand for the expense structure of most funds: 2% of assets under management and 20% of all profits generated. The fund itself takes the 2% and the fund manager responsible for the gains takes the 20%, which equates to a performance fee. 

While these fees may seem astronomical by comparison to mutual funds or ETFs, it’s important to remember that they’re proportional to the returns of the hedge fund and the effort that goes into managing it. Participants tend to see extremely high ROI because of the high-risk, high-reward nature of these funds. That, combined with their leverage, make for substantial returns—returns every hedge fund participant is willing to pay. 

Why are Hedge Funds so Important?

When it comes to the total global pool of managed assets, hedge funds actually hold very little. What makes them so prolific is their focus on risk and leverage. The total net wealth of the world’s assets comes to $431 trillion; however, they represent only about $3.6 trillion as of 2019. So why all the fuss and focus in the financial media? 

It’s because of the freedom hedge funds have. They can invest in anything and are loosely regulated in how they do so. For example, it can combine leverage and derivative investments to extrapolate tremendous returns—something retail investors can’t do due to regulations. As institutional investors, hedge funds can also tap into investment opportunities and products unavailable to retail investors, which are likely to outperform the market substantially. 

Should You Invest in a Hedge Fund?

If you’re a high-net-worth individual looking for a place to park your wealth to watch it grow, it makes sense. With unique high-risk, high-reward opportunities available and the prospect of fewer regulatory hurdles, hedge funds do right by their investors in returning often-astronomical results to members. And while they come with significant fees, performance tends to justify these costs. After all, just look at the annualized results from well-known funds like Citadel, Millennium and D.E. Shaw.

To learn more about hedge funds and the various types of investing, sign up for the Investment U e-letter below. This daily newsletter brings you stock tips and trends that can help you build wealth in your life.


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