What Are Hedge Funds, How Do They Work, And Should You Invest in One?

ByJulija A.
May 25, 2022

Whether you are just starting a company and looking for investors or want to invest your money into a prospective enterprise, you'll likely come across the term "hedge fund."

But, what are hedge funds? How do they work?

In short, hedge funds are investment vehicles that allow individuals and institutions to invest in a diversified mix of assets and strategies. Most of the time, these are available only to high-net-worth individuals and institutional investors.

That said, let’s explain what they are, how they work, what types of hedge funds exist, and whether or not you could make use of them.

Hedge Funds: Definition and Purpose

A hedge fund is an investment company that pools money from accredited or institutional investors and invests it in various asset classes, including stocks, bonds, commodities, and currencies.

Of course, the main goal of hedge funds is to generate returns for their investors that outperform traditional investments, such as index funds. To achieve this, hedge fund managers use different strategies, including long/short positions, leverage, and derivatives.

This type of investment is not without risks, especially since fund hedge fund managers often use riskier tactics to achieve the results.

How Do Hedge Funds Work?

As we mentioned before, hedge funds are usually only available to accredited or institutional investors. This is because they are considered high-risk investments, and most hedge funds need investors who can afford to lose a significant amount of money if the fund’s strategy fails.

Hedge Funds Invest in Equities and Bonds

Similar to mutual funds, hedge funds often invest in bonds and equities. However, they have more liberty when it comes to selecting the investments they would like to back. You'll often find that hedge funds go for more speculative investments, such as companies (sometimes even bankrupt ones), private equity, art, or derivatives.

Hedge Funds Have a Minimum Investment Threshold

Another thing potential investors should be aware of is the high minimum investment threshold required to invest in hedge funds. 

As mentioned before, hedge funds accept only "accredited investors." According to the IRS, accredited investors are individuals or institutions that have a net worth of at least $1 million, not including the value of their primary residence, or an annual income of $200,000 or more in the last two years (or $300,000 combined if married) with the expectation to make the same amount in the current year.

This high minimum investment makes hedge funds a high-risk proposition, and only those who can afford to lose the money should invest it. Investors that don’t match this criterion but are looking for a hands-off approach to investing can rely on robo-advisors or online marketplaces that offer full broker support.

Hedge Funds Aren't Heavily Regulated

Hedge funds’ investments are not as heavily regulated by the Securities and Exchange Commission (SEC) as some other investment types. This can be seen as an advantage by some, as it allows the fund more flexibility in how it is managed. However, it also means that there is less protection for the investors.

Hedge funds may hide the truth about their investment returns because they provide little transparency. The lack of information makes it difficult for investors, who have no way of gauging whether or not a fund is reporting accurate investment results. There were instances of the Securities and Exchange Commission (SEC) prosecuting hedge funds that presented inaccurate and embellished investment returns.

Difference Between Hedge Funds, Mutual Funds, and Private Equity Funds

Now that we have the basics of a hedge fund explained, let’s look at the differences between hedge funds and mutual funds.

At first glance, investing in a mutual fund might seem the same as putting down money in a hedge fund, since they are both pooled investment vehicles. However, mutual funds are typically open to all investors and have lower investment minimums. They also have a regulated investment strategy, which means that fund managers cannot use as much leverage or derivatives.

Hedge funds and private equity funds are both types of investment vehicles, but they have some key differences.

Private equity funds invest in companies, usually by buying a company's controlling interest. This type of investment is often used to finance turnarounds or fund expansion. PE funds are also closed investments, and investors cannot pull their money out before the fund manager releases it.

On the other hand, hedge fund companies can invest in a variety of asset classes (primarily public), and investors can get their money out without waiting for the investment to close.

How Do Hedge Funds Make Money?

Hedge funds typically rely on asset management and performance fees to earn money. These may vary from fund to fund, but the hedge fund industry often follows the 2-20 rule.

The  2-20 rule involves both fees, with a typical asset management fee revolving around 2%. There is some variation, but hedge funds will often charge their investors 20% of the profit in performance fees.

The management fee involved with investing in a hedge fund has been getting a lot of negative attention in recent years. Considering that the hedge funds often manage billions of dollars, people are not happy being charged regardless of whether a trade was successful or not.

This is why some of the largest hedge funds are now moving to a 1-20 setup for their fees.

Types of Hedge Funds and Strategies

There are many types of hedge funds and strategies they use to make money.

Some of the more popular ones for hedge funds investments include:

Long/Short Equity: Long/short equity is when the fund buys stocks that they believe will go up in value (long) and sell stocks fund managers believe will go down in value, which is known as short-selling.

Global Macro: Other hedge funds may rely on a global investment strategy and take a top-down approach, looking at global economic trends in order to make their investment decisions.

Relative Value: Relative value funds seek out investments where they believe the market has mispriced an asset to add them to the hedge fund portfolio. These funds try to profit from the difference between the forecasted price of an asset and the implied volatility of the options based on the same asset.

Merger Arbitrage: Merger Arbitrage funds take advantage of mergers and companies’ market capitalization. They accomplish this by simultaneously buying and selling stocks of the companies for a risk-free investment.

Additional hedge fund strategies also include the so-called equity market neutral (EMN) approach, short selling, aggressive growth, and a focus on emerging markets, to name a few.

Examples of Hedge Funds

There are many big-name hedge fund companies out there, but some of the more famous ones include:

Bridgewater Associates: Bridgewater Associates is a global macro fund that was founded in 1975. The fund was established by Ray Dalio and had about $140 billion in assets under management in May 2021.

Renaissance Technologies: Renaissance Technologies is a quantitative hedge fund founded in 1982. The firm was founded by Jim Simons and Howard L. Morgan and had about $130 billion in assets under management in 2021.

Man Group: Man Group is a London-based hedge fund founded in 1783. The firm is currently run by Luke Ellis and had about $104 billion in assets under management as of April 2021.

How To Invest in Hedge Funds

The first step is to find a fund that meets your investment criteria. On the same note, different types of hedge funds and their hedge fund strategies carry different risk levels, so it is essential to do your research before investing.

Once you have found an interesting fund, the next step is to perform a thorough background check on the fund managers, investment strategies, and the fund's profits. The best place to start is the SEC, where you will be able to check the fund’s disciplinary record.

Every investment advisor or hedge fund manager must submit the Form ADV to the SEC. This form must include information about the hedge fund. For example, its business practices and services, the client list, and the fee structure. This form will also include past disciplinary events and potential conflicts of interest. This information will be crucial when selecting your hedge fund, as you want to leave your investment in the hands of someone reliable and trustworthy. 

If it all feels overwhelming, you can also rely on some hedge fund trackers to understand how these funds work. However, the best course of action would be to work with a certified financial planner to assess your financial status and existing portfolio. They are familiar with the available options and can suggest a hedge fund account that will match your investment goals.

Once you decide on a hedge fund, you should contact it and ask for its investor packet. This packet will contain information about the fund, including its investment strategy, performance history, and fees.

After reviewing the investor packet, the next step is to fill out an application and submit it to the fund. The fund will then review your application and decide whether or not to accept you as one of the fund's investors.

If you are accepted as an investor, you will then be required to sign a limited partnership agreement. This agreement outlines the terms of your investment, including the fees that you will be charged.

Pros and Cons of Investing in a Hedge Fund

There are both pros and cons to investing in this type of fund. Let's discuss them to help you understand whether it is the right option for you.

Pros of Hedge Funds

Some of the pros include:

  • High Returns

Hedge funds have high return potential, which is one of the main reasons why people invest in them.

  • Access to New Investments

Hedge funds often have access to investments that are not available to most investors, such as private equity and venture capital.

  • Portfolio Diversification 

Hedge funds can diversify your portfolio, which is always a good thing. It can reduce risk and create more earning opportunities.

  • Experienced Hedge Fund Manager 

Hedge funds are managed by some of the most experienced hedge fund managers around, so you can rest assured that your funds are in good hands.

Cons of Hedge Funds

Some of the cons of investing in a hedge fund include:

  • High Fees

Hedge funds typically charge high fees, which can eat into your potential returns.

  • Lack of Transparency

Hedge funds are not required to disclose their holdings, which can make it difficult to understand what you are actually investing in.

  • Illiquidity

Hedge funds are sometimes illiquid, meaning that you may not be able to get your money out as quickly as you want.

  • Loses can be significant: Losses can potentially be huge if the hedge fund investment falls through.

Conclusion

Hedge funds are investment vehicles that use a variety of different strategies in order to achieve high returns. Many wealthy investors invest in hedge funds because of the potential to earn high returns.

That said, there are both good and bad sides to investing in a hedge fund. Some of the pros include the potential for high returns, access to investments that are not available to most investors, and portfolio diversification. That said, potential investors should also be aware of the high fees, lack of transparency, and illiquidity common in hedge funds.

Before investing in a hedge fund, it is important to do your research well and understand what you’re getting yourself into. It’s not suitable for everyone, and many investors would likely benefit more from some other investment types. So, before you jump into this highly risky venture, make sure that it is the right decision for you and your portfolio.

FAQ

Can anyone start a hedge fund?

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Yes. In theory, almost everyone can start a hedge fund, but it is certainly not easy. In order to do so, you will need to have a lot of money saved up and have the ability to attract hedge fund investors. You’ll have to convince potential investors that you have a solid investment strategy and will be able to generate returns for them.

Can you lose money in a hedge fund?

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Yes. Like any other investment vehicle, there is always the potential to lose money in a hedge fund. That said, hedge funds typically use a variety of hedging techniques to reduce the risk of losses, so they are not as risky as some other types of investments.

What do hedge funds do exactly?

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A quick definition for anyone looking for the answer to the question “What are hedge funds and what do they do?” is as follows: they are a type of investment fund that use a variety of different strategies in order to generate returns for their investors. These strategies can include investing in stocks, bonds, and other securities and using various hedging techniques to reduce the risk of losses.

Hedge funds typically require their average investors to have a high net worth, making them not accessible to the average investor. However, they also take on more risk than traditional investment vehicles like mutual funds and generate more profit for their investors.

About author

Albert Einstein is said to have identified compound interest as mankind’s greatest invention. That story’s probably apocryphal, but it conveys a deep truth about the power of fiscal policy to change the world along with our daily lives. Civilization became possible only when Sumerians of the Bronze Age invented money. Today, economic issues influence every aspect of daily life. My job at Fortunly is an opportunity to analyze government policies and banking practices, sharing the results of my research in articles that can help you make better, smarter decisions for yourself and your family.

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