A partnership where investors (accredited investors or institutional investors) pool money together to invest in a variety of assets
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What is a Hedge Fund?
A hedge fund, an alternative investment vehicle, is a partnership where investors (accredited investors or institutional investors) pool money together, and a fund manager deploys the money in a variety of assets using sophisticated investment techniques. Hedge funds, as opposed to other funds, can use leverage, take short positions, and hold long/short positions in derivatives. They are less strictly regulated by the Securities and Exchange Commission (SEC) as opposed to other funds.
Summary
- A hedge fund, an alternative investment vehicle, is a fund that pools investors’ money together and utilizes sophisticated investment strategies to generate returns.
- Hedge funds are only accessible to accredited and/or institutional investors.
- The four main classifications of hedge fund strategies are event-driven, relative value, macro, and equity hedge.
Defining Accredited and Institutional Investors
Hedge funds are only accessible to accredited and/or institutional investors.
An accredited investor is an individual or business entity that is allowed to invest in securities that may not be registered with the financial authorities. In the United States, one must have a net worth of at least $1,000,000 (excluding the value of the primary residence) or an annual income of at least $200,000 for the past two years. Rule 501 of Regulation D of the U.S. Securities and Exchange Commission goes into further detail in defining “accredited investors.”
An institutional investor is a non-bank individual or company that trades securities on behalf of its members in large dollar or quantity amounts. Institutional investors include pension funds, mutual fund companies, insurance companies, commercial banks, mutual funds, or hedge funds. Due to the deep pockets of institutional investors, they play a major role in the securities market.
Common Hedge Fund Strategies
Hedge Fund Research, Inc. identifies four main classifications of hedge fund strategies. Each strategy entails different risk and reward profiles:
1. Event-driven strategies
Strategies that seek to gain from inefficient price changes due to specific corporate events, corporate restructurings, mergers and takeovers, asset sales, spin-offs, bankruptcies, and other events.
2. Relative value (arbitrage) strategies
Strategies that seek to gain from price discrepancies between related securities whose price discrepancy is expected to be resolved over time.
3. Macro strategies
Strategies that seek to gain from global economic events and trends such as interest rate changes, currency changes, political changes, and others, by acquiring holdings with positive or negative exposure to such macro events. Macro strategies revolve around the prediction and projection of macro events.
4. Equity hedge strategies
Strategies that seek to gain from long and/or short positions in equities and derivatives.
Hedge Fund Fee Structure
A common hedge fund fee structure is called “2 and 20”. It means that the fund manager will charge a 2% management fee applied to the assets under management and a 20% incentive fee on returns greater than a specified hurdle rate. Incentive fees are only collected when the portfolio generates a higher return than the hurdle rate. Hurdle rates can be “hard” or “soft”:
1. Hard
A hard hurdle rate means that incentive fees are only collected on returns in excess of the benchmark. For example, if a hedge fund returned 25% with a 10% hurdle rate, incentive fees would be collected on the excess return of 15%.
2. Soft
A soft hurdle rate means that incentive fees are collected on the entire return of the portfolio so long that the return is greater than the hurdle rate. For example, if a hedge fund returned 25% with a 10% soft hurdle rate, incentive fees would be collected on the total portfolio return of 25%.
Example of a Hedge Fund Fee Structure
ABC Fund is a hedge fund with $100 million assets under management. The fund follows a “2 and 20” fee structure with a hard hurdle rate of 15%. Incentive fees are calculated on gross gains and not gains net of management fees. The performance of the hedge fund is provided below. Calculate the total fees paid to the fund managers.
Since the portfolio generated a return of 100%, which is above the 15% hard hurdle rate, the fund managers are entitled to an incentive fee.
- First, we calculate the management fees as $1,000,000 x 2% = $20,000.
- We then calculate dollar return above the hard hurdle rate as [$2,000,000 – $1,000,000 x (1+20%)] = $800,000. This is the dollar amount that the incentive fees will be charged against.
- Lastly, we calculate the incentive fees as $800,000 x 20% = $160,000.
Total fees paid to the fund managers are $20,000 + $160,000 = $180,000.
Additional Resources
To get a better understanding of the hedge fund universe, check out CFI’s Introduction to Hedge Funds course.To keep learning and advancing your career, the following resources will be helpful:
FAQs
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.
What exactly does a hedge fund do? ›
Hedge funds are financial partnerships that employ various strategies in an effort to maximize returns for their investors. Unlike mutual funds managers, hedge fund managers have free reign to invest in non-traditional assets and employ risky strategies. The U.S. is home to about 67% of the world's hedge funds.
Why are hedge funds so rich? ›
Hedge funds seem to rake in billions of dollars a year for their professional investment acumen and portfolio management across a range of strategies. Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM).
Do hedge funds pay well? ›
The top individual Portfolio Managers can earn hundreds of millions or billions each year. Hedge funds offer a much higher pay ceiling than investment banking, (sometimes) better hours and work/life balance, and the chance to do more interesting work.
Are hedge funds legal? ›
Are Hedge Funds Legal? Yes, they are legal. That is, if they are doing the right thing. The usual problems that present are insider trading and market manipulation.
What is the minimum investment for a hedge fund? ›
It is not uncommon for a hedge fund to require at least $100,000 or even as much as $1 million to participate. Unlike mutual funds, hedge funds avoid many of the regulations and requirements within the Securities Act of 1933.
What do hedge funds do all day? ›
Hedge funds are actively managed by professional managers who buy and sell certain investments with the stated goal of exceeding the returns of the markets, or some sector or index of the markets. They take the greatest risks while trying to achieve these returns.
Do billionaires use hedge funds? ›
The recent Forbes 400 (richest American billionaires) list has about 112 people, by my count, who made their fortunes in some form of Finance, Investments, Hedge Funds, insurance or banking.
Why can't anyone invest in hedge funds? ›
To invest in hedge funds as an individual, you must be an institutional investor, like a pension fund, or an accredited investor. Accredited investors have a net worth of at least $1 million, not including the value of their primary residence, or annual individual incomes over $200,000 ($300,000 if you're married).
Why do most hedge funds fail? ›
Strategies Used by Hedge Funds
Some strategies, such as managed futures and short-only funds, typically have higher probabilities of failure given the risky nature of their business operations. High leverage is another factor that can lead to hedge fund failure when the market moves in an unfavorable direction.
Who Is the Richest Hedge Fund Manager? Ken Griffin of Citadel is both the richest hedge fund manager and the highest paid. In 2022, he earned $41. billion, and by the beginning of 2023 his net worth was estimated at $35 billion.
Is my money safe in a hedge fund? ›
While hedge funds are only lightly regulated and carry high inherent risks, funds of hedge funds are thought to offer security because professional managers are picking the hedge funds that make up the pools.
How much does a PM at a hedge fund make? ›
Pay at this level depends almost 100% on performance, which means that PMs could make a few hundred thousand USD… up to $1 million or even $10 million+. On average, though, a PM at a mid-sized fund that performs decently might earn between $500K and $3 million.
Who Cannot invest in a hedge fund? ›
You generally must be an accredited investor, which means having a minimum level of income or assets, to invest in hedge funds. Typical investors include institutional investors, such as pension funds and insurance companies, and wealthy individuals.
Is BlackRock a hedge fund? ›
BlackRock manages US$38bn across a broad range of hedge fund strategies. With over 20 years of proven experience, the depth and breadth of our platform has evolved into a comprehensive toolkit of 30+ strategies.
Can anyone get into a hedge fund? ›
Earn a bachelor's degree
Most entry-level positions at investing firms or hedge funds require this degree. When preparing for a career in a hedge fund, consider earning your bachelor's degree in math, accounting, finance, investment banking, economics or business.
How does a hedge fund make money? ›
How do hedge funds make money? Hedge funds take a management fee of between one and two per cent of the amount you invest. In addition, the hedge fund manager will receive a performance fee (usually around 20 per cent on any profit).
How do hedge funds work for dummies? ›
Hedge funds use pooled funds to focus on high-risk, high-return investments, often with a focus on shorting — so you can earn profit even when stocks fall.
Why would anyone use a hedge fund? ›
Hedge funds can provide your portfolio with alternative sources of return and different risk exposures by accessing asset classes in unconventional ways, such as shorting, and greater use of derivatives and leverage. Some hedge fund strategies are designed to capture positive returns in all market environments.
What are the pros and cons of hedge funds? ›
Hedge funds employ complex investing strategies that can include the use of leverage, derivatives, or alternative asset classes in order to boost return. However, hedge funds also come with high fee structures and can be more opaque and risky than traditional investments.
