In This Article
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In This Article
- How a Hedge Fund Works
- Types of Hedge Funds
- Hedge Funds vs. Mutual Funds
- Frequently Asked Questions (FAQs)
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Definition
A hedge fund is an investment structure that uses pooled money from accredited investors to invest in securities or other types of assets with the goal of producing positive returns.
Key Takeaways
- A hedge fund is an investment vehicle that uses pooled money to invest in securities and other assets.
- Hedge funds are limited to “accredited investors,” which includes institutional investors such as pension funds, and high-net-worth individuals.
- Hedge funds generally seek outsized returns by using riskier strategies than most other investment vehicles, such as investing with borrowed money, shorting stocks, or holding concentrated assets.
- Hedge fund fees and expenses can be significantly higher than index mutual funds and actively managed mutual funds.
- There are more than 3,800 hedge funds in the U.S. in 2022, a growth of about 3% annually since 2017, according to IBISWorld.
How a Hedge Fund Works
Hedge funds use pooled money from qualified investors to pursue outsized returns, often through high-risk strategies such as using leverage to invest, shorting stocks, or taking concentrated positions. Hedge funds have higher fees than index mutual funds and even most managed mutual funds.
Hedge Fund Eligibility Requirements
Hedge funds are not marketed to the general public or made available in a public offering. Instead, they are offered privately to institutional investors such as pension funds, and to high-net-worth individuals—usually individuals or couples with a net worth of $1 million or more. They are offered to investors through a private placement memorandum (PPM), which explains the investment strategy, fees and expenses, and redemption rules, much like a mutual fund prospectus. It is important to fully understand all aspects of a hedge fund before investing in it.
Hedge funds are often structured as limited partnerships, limited liability companies (LLC), or similar entities. The asset manager is listed as a general partner, and the investor clients are limited partners. Hedge funds with $150 million or more in assets under management must register with the U.S. Securities and Exchange Commission (SEC).
Note
Hedge funds are subject to the same prohibitions against fraud that other investment vehicles must follow, and hedge fund managers are fiduciaries who owe a duty of responsibility to investors.
Example of a Hedge Fund
The world’s largest hedge fund is operated by Bridgewater Associates, which was founded by Ray Dalio in 1975. Its website makes clear the company’s asset management services are for private investment funds and institutional clients, and it is “not available to provide investment advisory or similar services to most other investors.”
Hedge Fund Fees and Expenses
As with any investment vehicle, the fees and expenses of a hedge fund will impact total return. Hedge funds typically charge an annual asset management fee of 1% to 2% of assets invested as well as a “performance fee” of 20% of a hedge fund’s capital gains and capital appreciation. The investment documents provided by a hedge fund should include a full explanation of all fees and expenses.
Note
High fees are frequently cited as a drawback of hedge funds—investors will pay the 1% to 2% management fee no matter how the fund performs. Some hedge funds require the general partner to meet a certain level of return to qualify to receive a performance fee. The performance fee can act as an incentive for a general partner (fund manager) to take more risk.
Types of Hedge Funds
Hedge funds can pursue a wide range of investment strategies. Assets under management may include stocks, bonds, real estate, commodities, currencies, derivatives, and other alternative assets, many of which are illiquid. Some hedge funds have a variety of holdings, while others may be highly concentrated on a certain asset class. It is important to fully understand a fund’s investment strategy before investing to ensure that it matches your goals and risk tolerance.
Hedge Fund Research (HFR), a hedge fund industry data provider, has identified seven strategy categories for hedge funds:
- Equity: This is the largest category, with about one-third of hedge funds following this strategy. It may include shorting stocks, combining a long and short strategy, or focusing tightly on a certain sector, such as technology or biomedical.
- Event driven: Investments are based on mergers, acquisitions, consolidations, and other activity, with a goal of capturing the difference between a company’s current share price and the price at the time of the event.
- Fund of funds: This is a hedge fund that holds limited partnership interest in a basket of other hedge funds.
- Macro: Macro funds seek to predict the rise or decline of the broader economy. They are not committed to invest in any specific asset class. Rather, they can invest in equities, currencies, debt, futures contracts, or real estate.
- Relative value: These funds seek to exploit price differences between closely related investments by simultaneously purchasing and selling them. Because price differences are usually slim, funds that follow this strategy often use leverage to trade more than their total assets under management to produce sizable gains.
- Risk parity: This focuses on asset allocation diversification to match the amount of risk a portfolio manager is willing to take on to achieve the desired returns.
- Blockchain: This includes cryptocurrency and related technology.
Hedge Funds vs. Mutual Funds
While both hedge funds and mutual funds use pooled money to invest for growth, there are significant differences between the two investment vehicles.
| Hedge Funds | Mutual Funds |
|---|---|
| Pool money from accredited investors, which include institutional investors and high-net-worth individuals | Pool money from investors with a wide range of net worth |
| High minimum initial investments of $100,000 or more | Low or no minimum initial investment requiremen |
| Structured as general partnerships so they do not face heavy regulations from the SEC | Regulated by the SEC and must file quarterly reports |
| Limited windows for investors to invest and withdraw funds—often quarterly | Available for share purchases or redemption every day the markets are open |
| High fees and expenses, including as much as 20% of annual capital gains and growth | Low costs and asset management fees, particularly with no-load index funds |
| Use a range of investment strategies that may involve many types of assets in attempt to outperform in all types of markets | Typically adhere to a buy-and-hold securities based on a specified strategy spelled out in the prospectus |
In general, mutual funds are viewed as lower risk than hedge funds and have a lower barrier of entry for individual investors. Because fees and expenses can have a significant impact on overall return, the high costs of hedge funds can drag down performance.
Frequently Asked Questions (FAQs)
What is a hedge fund manager?
Similar to an actively managed mutual fund, hedge fund investment decisions are made by a general partner, who may have a team of assistants as well. It is important to research a fund manager’s background and historical performance to make sure the investment strategy used matches your goals and risk tolerance.
How does a hedge fund make money?
Hedge funds charge an annual asset management fee of 1% to 2% of assets under management as well as an annual performance fee, which can be up to 20% of a hedge fund’s profit. It is important to have a full understanding of a fund’s fees and expenses before investing, because these costs will have an impact on your total return.
How do you invest in a hedge fund?
Hedge funds are typically marketed to investors through private offerings. Prospective investors often have an existing relationship with the hedge fund’s general partner or other advisory personnel. Individuals who meet the definitions of the term “accredited investor” usually have a net worth (or joint worth with their spouse) of $1 million or have income over $200,000 ($300,000 if married) in each of the last two years.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Securities and Exchange Commission. “Hedge Funds.”
IBISWorld. “Hedge Funds in the US - Number of Businesses 2003–2027.”
Securities and Exchange Commission. “Investor Bulletin: Hedge Funds.”
National Association of Insurance Commissioners. “Hedge Fund Primer.” Page 1.
National Association of Insurance Commissioners. “Hedge Fund Primer.” Page 4.
Bridgewater Associates. “Ray Dalio.”
Securities and Exchange Commission. “Implications of the Growth of Hedge Funds.” Page 33.
Hedge Fund Research. “HFR Hedge Fund Strategy Classification System.”
Securities and Exchange Commission. “Accredited Investor.”
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