What is Hedge Fund?

Updated on April 19, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Hedge Fund Definition

A hedge fund is an aggressively invested portfolio made through the pooling of various investors and institutional investors’ funds. It invests in various assets, which generally is a pool of assets providing high returns in exchange for higher risk through various risk management and hedging techniques.

Key Takeaways

  • A hedge fund constitutes a diversified portfolio sourced from various institutional investors. Central to its management strategy is the pursuit of elevated returns, albeit accompanied by an augmented risk profile. The fund employs a diverse array of risk management and hedging techniques to counterbalance this risk.
  • Participation in hedge funds is exclusively accessible to a select cohort of investors, and their performance is assessed through absolute return measurements.
  • Hedge funds predominantly draw funding from sources such as pension funds, charitable foundations, university endowments, and affluent individuals with substantial net worth.

Explanation

To invest in them, you need Money like Bill Gates, and to manage them, you need Brains like Einstein. Due to various strategies and great returns, hedge funds have been in the limelight. They have confronted the traditional fund sector with a substantial challenge. They have attracted more attention and media interest than the traditional sector. You must have also heard a lot about Hedge funds.

They have successfully gotten the pool of talented fund managers due to their lucrative compensation packages. Over the years, they have attracted a powerful flow of capital.

You can say that the Hedge Fund is a type of pooled investment. But isn’t Mutual Fund the same? So what makes Hedge Fund different from the others?

The significant difference is:

Investment in Hedge Funds is open only to a limited group of investors, and its performance is measured in absolute return units.

If you go by the nomenclature of Hedge Funds, the term Hedge (Hedging) means lowering the overall Risk. This is usually done by taking an asset position that helps offset the existing Risk.

Hedge Fund Definition

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Hedge Funds Video Explanation

 

How do Hedge Funds Work?

  • It takes both Long & Short Positions.
  • It uses Arbitrage.
  • It includes buying and selling of undervalued securities as well.
  • It trades options or bonds.
  • And invests in any opportunity that exists in the market.
  • So you can say that its primary aim is to reduce volatility & Risk and preserve capital.

While discussing reducing risks, you may be amazed to know how Hedge funds do it. In doing so, they use a variety of instruments and amazingly weird strategies too. They are also flexible in their investment options.

What I mean by this is that they can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.

Well, that’s a lot of different things in one sentence. So let’s now move forward and take a look at its characteristics.

Hedge Funds Characteristics

One common thing you will notice about Hedge funds is that they vary enormously in investment returns, volatility, and Risk.

  • Some of them can deliver non-market correlated returns.
  • Significant investors in Hedge funds are Pension funds, endowments, insurance companies, private banks, and high Net Worth individuals and families.
  • Experienced investment professionals manage hedge Funds.
  • They are illiquid investments.
  • They have little to no regulations.
  • They are known to use Aggressive Investment Strategies.

Hedge Funds Organization Structure

  • The primary organizational structure for Hedge Funds is the one with a General/Limited Partnership Model.
  • The General Partners here manage the fund, whereas the Limited partners are involved in investing in the partnership. The limited partners are liable only to their paid-in capital amounts.
  • Also, the Typical structure used for the General partners is the Limited Liability Company. A Limited Liability Company is a flow-through tax entity, and investors are limited in liability to the amount of their investment.

You can check out the infographic for the diagrammatic representation of the What is Hedge Fund?

Reading time: 90 seconds

Hedge-Funds-Infographics

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Hedge Funds Fee Structures

Hedge Fund Managers are compensated with two types of Fees:

  1. Management Fee
  2. Performance-based Incentive Fee

A Management fee is measured by Asset under Management and is usually calculated as a percentage of the size of the fund. This fee can be anywhere from 1-4% of net assets under management; however, 1-2% is the most common range.

The Performance-based incentive fees can be 15%-20% of the Profits the Hedge Fund makes.

Due to the High Incentive-based fees, the hedge Fund Managers always aim at absolute returns rather than just beating the benchmark returns.

Investors in Hedge Funds

The following are the major investors in Hedge funds:

  • Pension Funds
  • Charitable Foundations
  • University Endowments
  • High Net Worth Individuals

Minimum Investing Requirements in Hedge Fund

Remember that Hedge funds aren’t for everyone. You have to meet the definition of an accredited Investor to invest in Hedge Funds. You will be considered as an accredited Investor if you meet the following requirements:

  • The net worth of more than $1 million, owned alone or jointly with a spouse.
  • Earned $200,000 in each of the past two years.
  • Earned $300,000 in each of the past two years when combined with a spouse.
  • Having a reasonable expectation of making the same amount in the future.

Hedge Funds Strategies

A varied range of hedging strategies is available to hedge funds. Some of them are listed below:

  1. Long/Short Equity
  2. Market Neutral
  3. Merger Arbitrage
  4. Convertible Arbitrage
  5. Capital Structure Arbitrage
  6. Fixed-Income Arbitrage
  7. Event-Driven
  8. Global Macro
  9. Short Only

You can go through our detailed article on Hedge Fund Strategies to learn more about the strategies.

Key Differences between Hedge Funds and Mutual Funds

#1 – Performance

The performance of Mutual Funds is measured relative to its relevant index—for example, the S&P 500 Index or other similar mutual funds in that sector. In contrast, Hedge funds are expected to profit even though the relative indexes are down.

#2 – Regulation

Mutual funds are highly regulated. On the other hand, hedge funds are not as regulated as mutual funds.

#3 – Fees

Fees paid in the case of Mutual Funds depend upon the percentage of Assets under Management. In the case of hedge funds, fixed and incentive fees are paid to the fund managers.

#4 – Unstable Conditions

Where Mutual funds cannot save their portfolios against declining markets, Hedge Funds can do so due to the various strategies used.

# 5 – Future Performance

You can say that the performance of Mutual funds mainly depends on the direction of the Equity Markets. In the case of Hedge funds, though, future performance is not drastically affected by the Equity market direction. Again the credit goes to the amazing strategies used here.

Benefits of Hedge Funds

  • Most hedge funds have unique strategies crafted by their brainy Fund Managers. Due to this, funds can generate positive returns in both rising and falling equity and bond markets.
  • A wide range of Hedge Funds Strategies is available, which will help you meet your investment objective.
  • If you include hedge funds in your balanced portfolio, reduce the overall portfolio risk.
  • Years of Statistics and Data have helped prove that hedge funds have higher returns and lower overall Risk than traditional investment funds.
  • It is a long-term investment solution.
  • It helps in Portfolio diversification.

Tips for Investing in Hedge Funds

  • Be an Accredited Investor –You need to meet the minimum level of investment and income to be an accredited investor. Find out where you stand before investing.
  • Know the Fees – The Management fee can be between 1%-2%, and the Incentive fee can be up to 20%. Understand the costs properly, as prices can greatly impact your investment return.
  • Understand the Fund Prospectus – Go through the fund prospectus and other related material properly. Ensure you understand the terms and conditions, the Risk involved, Strategies, Time horizon, etc.
  • Know Limitations, if any – Understand the opportunities to redeem and the lock-up period correctly.

Conclusion

So that’s about what Hedge Fund that I had to contribute to. From what we have heard about Hedge funds until now, we can say that hedge funds have brought innovative investment strategies into this Investing world. It has given a new sense of excitement to the investment community.

So what do you say, sounds like a wonderful Investing idea?

Frequently Asked Questions (FAQs)

1. What is the importance of hedge funds?

Hedge funds play a vital role in diversifying investment portfolios and potentially delivering higher returns. They offer strategies that may hedge against market volatility and provide opportunities for both institutional and high-net-worth investors to access specialized investment approaches.

2. What are the risks associated with hedge funds?

Hedge funds encompass a spectrum of risks that warrant careful consideration. Market volatility, a pivotal risk, exposes investments to unpredictable fluctuations, potentially affecting returns. Liquidity constraints are a concern, as certain strategies can limit the ability to swiftly convert holdings to cash. Employing leverage and intricate tactics can magnify risks, potentially leading to substantial losses. 

3. What is private equity vs. hedge funds?

Private equity and hedge funds are distinct. Hedge funds use various strategies to generate returns, while private equity involves investing in private companies to acquire, improve, and sell them. Private equity is a subset of alternative investments, which includes hedge funds.

Reader Interactions

Comments

  1. Gaurav says

    Really good explanation of Hedge Fund Dheeraj. Was able to get good initial grasp of it, keep it up.

    • Dheeraj Vaidya says

      Thanks for your kind words!

  2. Kalpesh Chouhan says

    Great Work Dheeraj, Good to know about the Hedge fund in Crisp.

  3. Abu-Sofyian says

    Nice one Dheeraj! i have been enlightened on hedge funds very well. Thanks buddy!

    • Dheeraj Vaidya says

      Thanks Abu :-) Glad you liked the article.

  4. Rajiv kumar says

    Hi dheeraj..insightful…. complex topic with ease language and understanding. Gr8 going..keep on going.

    • Dheeraj Vaidya says

      Thanks Rajiv!