Hedge Fund: Definition, Examples, Types, and Strategies

What Is a Hedge Fund?

A hedge fund is a limited partnership of private investors whose money is pooled and managed by professional fund managers. These managers use a wide range of strategies, including leverage (borrowed money) and the trading of non-traditional assets, to earn above-average investment returns.

A hedge fund investment is often considered a risky, alternative investment choice and usually requires a high minimum investment or net worth. Hedge funds typically target wealthy investors.

Understanding Hedge Funds

Hedging Their Bets

The term "hedge fund" refers to an investment instrument with pooled funds that is managed to outperform average market returns. The fund manager often hedges the fund's positions to protect them from market risk.

They do so by investing a portion of the fund's assets in securities whose prices move in the opposite direction of the fund's core holdings. Theoretically, should the prices of the core holdings move down, the prices of the securities acting as a hedge should move up. As a result, the hedge can offset any losses in the core holdings.

For example, a hedge fund that focuses on a cyclical sector, such as travel, may invest a portion of its assets in a non-cyclical sector such as energy, aiming to use the positive returns of the non-cyclical stocks to offset any losses in cyclical stocks.

Risk

Hedge funds use risky strategies, leverage, and derivative securities such as options and futures. Therefore, an investor in a hedge fund is commonly regarded as an accredited investor. This means that they meet a required minimum level of income or assets. Typical investors are institutional investors, such as pension funds and insurance companies, and wealthy individuals.

Investments in hedge funds are considered illiquid as funds often require investors to keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.

Types of Hedge Funds

Four common types of hedge funds are:

• Global macro hedge funds: These are actively managed funds that attempt to profit from broad market swings caused by political or economic events.
• Equity hedge funds: These may be global or specific to one country, investing in lucrative stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices.
• Relative value hedge funds: These funds seek to exploit temporary differences in the prices of related securities, taking advantage of price or spread inefficiencies.
• Activist hedge funds: These aim to invest in businesses and take actions that boost the stock price such as demanding that companies cut costs, restructure assets, or change the board of directors.
  

Common Hedge Fund Strategies

Hedge fund strategies cover a broad range of risk tolerance and investment philosophies. They involve a large selection of investments, including debt and equity securities, commodities, currencies, derivatives, and real estate.

Common hedge fund strategies are classified according to the investment style of the fund's manager and include equity, fixed-income, and event-driven investment goals.

• A long/short hedge fund strategy is an extension of pairs trading, by which investors go long and short on two competing companies in the same industry based on their relative valuations.
• A fixed-income hedge fund strategy gives investors solid returns, with minimal monthly volatility and aims for capital preservation; it takes both long and short positions in fixed-income securities.
• An event-driven hedge fund strategy takes advantage of temporary stock mispricing, spawned by corporate events like restructurings, mergers and acquisitions, bankruptcy, or takeovers.
  

Examples of Hedge Funds

The most notable hedge funds, based on assets under management (AUM), include:

• Bridgewater Associates: Founded in New York in 1975 and headquartered in Westport, Conn., global leader, with more than $124 billion in AUM.
• Renaissance Technologies: Founded in 1982 and headquartered in East Satauket, N.Y., with mathematical- and statistical-based investment strategies, and over $106 billion in AUM.
• AQR Capital Management: Founded in 1998 and headquartered in Greenwich, Conn., with applied quantitative research investment strategies, and over $94.5 billion in AUM.

Hedge Fund Compensation

Australian investor Alfred Winslow Jones is credited with launching the first hedge fund in 1949 through his company, A.W. Jones & Co. Raising $100,000, he designed a fund that aimed to minimize the risk in long-term stock investing by short-selling, now referred to as the long/short equities model.

In 1952, Jones converted his fund to a limited partnership, added a 20% incentive fee as compensation for the managing partner, and became the first money manager to combine short selling, the use of leverage, and a compensation system based on performance.

Today, hedge funds employ a standard "2 and 20" fee system, which refers to a 2% management fee and a 20% performance fee.

The management fee is based on the net asset value of each investor's shares, so an investment of $1 million garners a $20,000 management fee that year to cover the operations of the hedge and compensate the fund manager.

The performance fee is commonly 20% of profits. If an investment of $1 million increases to $1.2 million in one year, $40,000 is the fee owed to the fund.

Hedge Fund vs. Mutual Fund

Hedge funds are not as strictly regulated by the Securities and Exchange Commission (SEC) as mutual funds are.

Mutual funds are a practical, cost-efficient way to build a diversified portfolio of stocks, bonds, or short-term investments. They are available to the general public and average investor.

Hedge funds normally will only accept money from accredited investors who include individuals with an annual income that exceeds $200,000 or a net worth exceeding $1 million, excluding their primary residence. These investors are considered suitable to handle the potential risks that hedge funds are permitted to take. 

A hedge fund can invest in land, real estate, stocks, derivatives, and currencies while mutual funds use stocks or bonds as their instruments for long-term investment strategies.

Unlike mutual funds where an investor can elect to sell shares at any time, hedge funds typically limit opportunities to redeem shares and often impose a locked period of one year before shares can be cashed in.

Hedge funds employ the 2% management fee and 20% performance fee structure. In 2022, the average expense ratio across all mutual funds and exchange-traded funds was 0.37%.

What to Consider Before Investing

As investors conduct research to identify hedge funds that meet their investment goals, they often consider the fund or firm's size, the track record and longevity of the fund, the minimum investment required to participate, and the redemption terms of the fund. Hedge funds operate in many countries, including the U.S., United Kingdom, Hong Kong, Canada, and France.

According to the SEC, investors should also do the following when deciding whether or not to invest in a hedge fund:

• Read the hedge fund’s documents and agreements which contain information about investing in the fund, the strategies of the fund, the location of the fund, and the risks anticipated by the investment.
• Understand the level of risk involved in the fund’s investment strategies and whether they equate with your personal investing goals, time horizons, and risk tolerance. 
• Determine if the fund is using leverage or speculative investment techniques which will typically invest both the investors’ capital and the borrowed money to make investments.
• Evaluate potential conflicts of interest disclosed by hedge fund managers and research the background and reputation of the hedge fund managers.
• Understand how a fund’s assets are valued as hedge funds may invest in highly illiquid securities and valuations of fund assets will affect the fees that the manager charges.
• Understand how a fund's performance is determined and whether it reflects cash or assets received by the fund as opposed to the manager’s estimate of the change in the value.
• Understand any limitations to time restrictions imposed to redeem shares.

The Bottom Line

Hedge fund investing is considered a risky alternative investment choice and requires that investors can make a large minimum investment or have a high net worth. Hedge fund strategies involve investing in debt and equity securities, commodities, currencies, derivatives, and real estate.

Hedge funds are loosely regulated by the SEC and earn money from the 2% management fee and 20% performance fee structure.