What Is a Hedge Fund? And How Do They Work?

Investing
Updated: 2nd Jul 2021
Written by Parker Pope
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Investing
July 2, 2021
Written by Parker Pope

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Let’s say that you bought Apple at $100 back in 2016 or 2017, but you could only afford one share. 

Your position in Apple would have been worth $100. Now, in 2021, there has been a huge rise in the stock price, and, after some complicated math, your one share of Apple would now be worth about $548. 

That equates to a 548% profit!  Go tell your friends about your market genius!

The problem is that you can’t buy that Ferrari, let alone one of the lug nuts, for $548. 

This is because you couldn’t use leverage to buy thousands or even millions of shares back in 2016. 

Warren Buffett, by contrast, was able to buy 10 million shares of Apple, netting him a profit of over $100 billion. 

His deals work a bit differently, but he was able to use leverage to generate massive profits.

At the end of the day, high-level and high-net-worth investors are always looking to use leverage to enhance their profits. This is where hedge funds come into play.

Let’s examine hedge funds so that you understand what they are, how they work, and whether they are a good fit for your portfolio. 

Just to be clear, Warren Buffett neither runs a hedge fund nor does he invest in hedge funds. The example was just to illustrate the power of leverage.

What Is a Hedge Fund?

A hedge fund is an investment group made up of investors who combine their money to execute a particular strategy and use leverage to maximize profit potential.

A fund manager manages the hedge fund, usually a market expert and a ringleader. 

The hedge fund manager raises the capital by bringing in several large investors as well as wealthy individuals.

How Do Hedge Funds Work?

Hedge funds started as funds that would use long and short positions to “hedge” a core long stock position.

Now, however, hedge funds can use any financial instruments imaginable to make a profit. 

As long as the fund makes money, hedge fund managers can generally invest the funds in assets ranging from stocks and real estate all the way to private equity and even music rights.

Hedge funds are generally only for high-net-worth individuals and investment firms with cash they don’t have the time to invest. 

This is mostly to enhance the exclusivity of the hedge fund, but the money is also charged hefty fees, which will be discussed later.

What Are the Requirements to Become a Hedge Fund?

It goes without saying that starting a hedge fund requires far more than knowledge of stocks and bonds

Hedge fund managers usually start the fund, and they come from highly advanced finance backgrounds.

Once that’s out of the way, you must file as an LLP, LLC, or corporation within the state the fund will be operating. 

The specific requirements and costs vary from state to state, so check your state’s website to find out more.

Then, your fancy new hedge fund must register with the Securities and Exchange Commission (SEC) as a hedge fund. 

This requires SEC Form D to be filled out. It includes names of large investors, the fund’s investment strategy, and other pertinent information so the SEC can monitor it.

How Do Hedge Funds Make Money?

Most hedge funds make money in two ways: management fees and performance fees.

Management Fees

when investors deposit their money into the hedge fund, they agree to pay a management fee or an expense ratio. 

Each investor must pay the management fee each year based on the fund managers’ total assets regardless of whether the fund manager made or lost money during that year. 

This fee is generally the smaller of the two in the fee structure.

Performance Fees

The hedge fund makes the most money when they can charge performance fees.  When the fund makes a profit, it will keep a sizable chunk of those profits as the performance fee.

Hedge Fund Fee Structure Explained

When an investor wants to deposit money with a hedge fund, one of the first things to be discussed will be the fund’s fee structure. 

This is the combination of the management fee and the performance fee.

One of the most typical fee structures is known as “Two and Twenty.” This means that the fund charges a management fee of 2% and a performance fee of 20%. 

As a refresher, this means 2% is charged on the money invested regardless of performance, and 20% is charged on the profits made by the fund.

Let’s use an example and say a hedge fund manages $500 million in a hedge fund. 

If the fund makes 45% profits for the year and the assets under management (AUM) for the year’s end are $725 million. 

The hedge fund would keep $14.5 million as the management fee and $45 million as the performance fee!

Now, let’s say the fund lost money. If the AUM drops to $400 million, there are no performance fees charged, but the fund still keeps $8 million in management fees.

Hedge Funds vs. Mutual Funds

The main two differences between hedge funds and mutual funds are the charged fees and the types of investors who can invest in the funds.

Mutual funds are available to anyone, provided they meet the minimum investment, which can be $0 but typically $1,000. 

The fees charged by mutual funds are generally significantly less because they are limited to investing in specific instruments such as stocks and bonds.

Mutual funds are also more heavily regulated to ensure a safer product for the average investor. 

Investments are clearly stated, including past performance, current holdings, and risk profiles. 

Since many more people can invest in hedge funds, they also offer investors more liquidity to sell their positions easier.

Hedge funds are legally required to only take money from investors who are “accredited investors.” 

This means they must have either a $200,000 annual income or at least $1 million net worth. 

Hedge funds are usually far less regulated and carry more risk than mutual funds based on the wide availability of investment vehicles. 

This is why the SEC requires investors to have more experience as well as more financial protection individually.

>> Learn More: Check Out Our Guide on How to Start Investing

Hedge Funds vs. Private Equity Funds

While some hedge funds do buy and sell companies, they differ quite a bit from private equity funds. 

Hedge funds are open-ended, meaning investors can pull their money out when they want it. 

Private equity funds are closed end, meaning investor money is locked in until the project is completed.

Hedge funds are typically going for annual returns based on their fee structures, so buying and selling companies is only done when there is a shorter-term gain as compared with the goals of private equity companies.

Private equity funds will buy companies and keep many in their portfolio with the goal of growing them to sell, growing to increase cash flow, or selling them piece by piece. 

Many of these projects can take years or decades.

What Are Some Popular Hedge Fund Strategies?

Many hedge funds simply go for equity strategies. Depending on the size of the fund, equities can offer enough liquidity and variety that little else would be needed to turn a profit. 

Some funds profit from long positions, neutral positions, short positions, or combinations of all three.

Event-driven funds are focused on equities as well, but they look for outlier profit potential to make larger profits from their positions, whether they are long or short, on fewer positions throughout the year. 

These strategies rely on heavy research and intelligence gathering.

Macro strategies look at how the entire global economy operates and makes investments to capture profits when politics, weather, or war cause changes in how the market works.

The last strategy is called relative value. This is a data-driven strategy where traders try to find inconsistencies in the pricing of stocks.

Notable Hedge Funds

While there are over 3,000 hedge funds registered in the US, few make headlines with relative consistency.

Pershing Square

Run by fund manager Bill Ackman, Pershing Square is a very successful activist hedge fund. 

This means that they invest in undervalued companies and take an active role in turning those companies around.

Bridgewater Associates

Perhaps one of the most active personalities in the last year is Ray Dalio, who is the co-executive of the world’s largest hedge fund, Bridgewater Associates.

Dalio is famous for creating his flagship portfolio called the “All Weather” fund.

Renaissance Technologies

Run by Jim Simons, Renaissance has returned investors an average of 66% per year to investors since 1988. 

While perhaps not the oldest hedge fund, it is one of the oldest and most successful hedge funds with a quantitative strategy.

Are Hedge Funds Good to Invest in?

Hedge funds are not the best investment unless you have access to consistently successful fund managers and have most of your net worth tied up in safer assets. 

They are highly risky and highly speculative. 

Not only that, but investors may not even know the fine points of exactly how the fund makes money unless they are in the top investors.

Advantages of Hedge Funds

  • Market Volatility Could Be a Good Thing: having access to as many investment instruments as do hedge funds could guarantee that you benefit from volatility in the right ways.
  • Experts Running the Show: Hedge funds pay their people quite well. Naturally, the finest minds in finance and quantitative trading flock to hedge funds bringing several different views.
  • Various Investment Opportunities: It can be interesting to see what the fund plans to invest in next because, as we mentioned earlier, the range of opportunities is nearly unlimited as long as there is a potential to profit.

Disadvantages of Hedge Funds

  • Incredibly Risky: the wide-ranging investments hedge funds choose from means they are open to far more risk than any other investment vehicle.
  • Utilizes Leverage: We started with leverage to show how it can be used to make money, however, we’ll end with a note that high amounts of leverage could mean higher than normal potential losses (leveraged real estate assets from 2008, perhaps?)
  • Investor Losses Can Be Substantial: There are many hedge funds, but you’ve only heard of a few. That’s because several are new or growing, and several others have failed. When the hedge fund is forced to liquidate the company, investors could lose their initial investment and potentially more.

Bottom Line: What Is a Hedge Fund?

Hedge funds offer extremely attractive profit potential to those who invest with intelligence and understand what the hedge fund is trying to do. 

They are accessible only to high-net-worth individuals and can access several investment options not available to the wider public. 

The opportunity for such profits does come with higher fees and higher risks.

While the risks are clear, there are good hedge funds that toil day and night to find the next investment for their investors. 

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Parker Pope
Parker Pope
Parker has spent over 10 years studying the financial markets. He currently manages his own portfolios by trading options and futures, and he’s excited to share his experience with those interested in a hands-on approach to their investments. No fancy tricks or indicators, just a commitment to understanding risk management and knowing the “why.” While he invests actively, he’s built a wealth of knowledge about personal finance and commits his efforts to writing about topics to help people take control of their finances.