What is a Hedge Fund? Examples, Types, and Strategies (2024)

What Is a Hedge Fund?

A hedge fund is a limited partnership of private investors whose money is managed by professional fund managers who use a wide range of strategies, including leveraging or trading of non-traditional assets, to earn above-average investment returns.

Hedge fund investment is often considered a risky alternative investment choice and usually requires a high minimum investment or net worth, often targeting wealthy clients.

Key Takeaways

  • Hedge funds are actively managed alternative investments that commonly use risky investment strategies.
  • Hedge fund investment requires a high minimum investment or net worth from accredited investors.
  • Hedge funds charge higher fees than conventional investment funds.
  • Common hedge fund strategies depend on the fund manager and include equity, fixed-income, and event-driven goals.

What is a Hedge Fund? Examples, Types, and Strategies (1)

Understanding the Hedge Fund

The term "hedge fund" defines this investment instrument as the manager of the fund often creating a hedged bet by investing a portion of assets in the opposite direction of the fund's focus to offset any losses in its core holdings.

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 returns of the non-cyclical stocks to offset any losses in cyclical stocks.

Hedge funds use riskier strategies, leverage assets, and invest in derivativessuch as options and futures. The appeal of many hedge funds lies in the reputation of their managers in the closed world of hedge fund investing.

An investor in a hedge fund is commonly regarded as an accredited investor, which requires a minimum level of income or assets. Typical investors include institutional investors, such as pension funds, insurance companies, and wealthy individuals.

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

Types of Hedge Funds

Hedge funds target select investments and pools of securities primed for gains. Four common types of hedge funds include:

  • Global macro hedge funds are actively managed funds that attempt to profit from broad market swings caused by political or economic events.
  • An equity hedge fund 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.
  • A relative value hedge fund seeks to exploit temporary differences in the prices of related securities, taking advantage of price or spread inefficiencies.
  • An activist hedge fund aims to invest in businesses and take actions that boost the stock price which may include demands that companies cut costs, restructure assets or change the board of directors.

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Common Hedge Fund Strategies

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

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

A long/short hedge fund strategy is an extension of pairs trading, in 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 taking 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.

How Do Hedge Funds Make Money?

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 byshort-selling, now referred to as the long/short equitiesmodel.

In 1952, Jones converted his fund to alimited partnership,added a 20%incentive feeas compensation for the managing partner, and became the firstmoney managerto 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, 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 differ from mutual funds and 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 and are available to the general public and average investor.

Hedge funds can only accept money from accredited investors which includes 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 2021, the average expense ratio across all mutual funds and exchange-traded funds was 0.40% for the average investor.

What to Consider Before Investing

As investors 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 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 that they equate with 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.

Examples of Hedge Funds

As of 2022, the most notable hedge funds include:

  • Elliot Management Corporation with a 55-year-long history and over $50 billion in assets under management (AUM). Its core holdings are in the energy sector.
  • Bridgewater Associates is a global leader, with more than $235 billion in assets AUM, and a rate of return of 32% for the first half of 2022.

• Man Group offers a mix of long/short equity funds, private market funds, real estate funds, multi-asset funds, and fixed funds and its core value is responsible investing, which it achieves through its funds’ compliance with environmental, social, and governance ESG investing goals.

What Tools Do Investors Use to Compare the Performance of Hedge Funds?

Investors look at the annualized rate of return to compare funds and reveal funds with high expected returns. To establish guidelines for a specific strategy, an investor can use an analytical software package such as Morningstar to identify a universe of funds using similar strategies.

How Do Hedge Funds Compare to Other Investments?

Hedge funds, mutual funds, and exchange-traded funds (ETFs) all are pools of money contributed by many investors that aim to earn a profit for themselves and their clients.

Hedge funds are actively managed by professional managers who buy and sell certain investments with the stated aim of exceeding the returns of the markets, or some sector or index of the markets. Hedge funds aim for the greatest possible returns and take the greatest risks while trying to achieve them. They are more loosely regulated than competing products, with the flexibility to invest in options and derivatives and esoteric investments that mutual funds cannot.

Why Do People Invest in Hedge Funds?

A wealthy individual who can afford to diversify into a hedge fund might be attracted to the reputation of its manager, the specific assets in which the fund is invested, or the unique strategy that it employs.

The Bottom Line

Hedge fund investment is considered a risky alternative investment choice and requires a high minimum investment or net worth from accredited investors. Hedge fund strategies include investment in debt and equity securities, commodities, currencies, derivatives, and real estate. Hedge funds are loosely regulated by the SEC and earn money from their 2% management fee and 20% performance fee structure.

What is a Hedge Fund? Examples, Types, and Strategies (2024)


What is a Hedge Fund? Examples, Types, and Strategies? ›

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 is an example of a hedge fund strategy? ›

In long/short hedge fund strategies, managers make what are known as “pair trades” to bet on two securities in the same industry. For example, if they expect co*ke to perform better than Pepsi, they would go long co*ke and short Pepsi.

What is a hedge fund with an example? ›

A hedge fund is a private pool of money collected from an assortment of wealthy individuals and institutions such as trusts, college endowments, and pension funds. The pool is managed by a financial professional who invests the money in a variety of securities and financial contracts.

What is the most common type of hedge fund? ›

Long-short equity funds are probably the most common type of hedge fund. These funds go long (i.e., buy) stocks they think will appreciate in value and short (borrow and sell) stocks they think will fall in price.

What are hedging strategies? ›

Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position.

How many types of hedging strategies are there? ›

There are several effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators.

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.

How does a hedge fund pay you? ›

Hedge Fund Manager Compensation

Two and twenty (or "2 and 20") is a typical fee arrangement for hedge fund managers that is standard in the hedge fund industry. It is also common in venture capital and private equity. Hedge fund management companies typically charge clients both a management and a performance fee.

Why would anyone use a hedge fund? ›

Hedge funds originated as a vehicle to help diversify investment portfolios, manage risk and produce reliable returns over time. While hedge funds' investor base has evolved though the years – from individuals to institutions such as pensions, universities and foundations – their core goals have remained the same.

What is the most popular hedge fund strategy? ›

Top hedge funds follow Equity Strategy, with 75% of the Top 20 funds tracking the same. Relative Value strategy is followed by 10% of the Top 20 Hedge Funds. Macro Strategy, Event-Driven, and Multi-Strategy make the remaining 15% of the strategy. Also, check out more information about Hedge Fund jobs here.

Which hedging strategy is best? ›

As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per market day can be very low. Although they are initially expensive, they are useful for long-term investments.

What is a hedge fund's main goal? ›

A hedge fund manager focuses on achieving absolute returns by finding as many profit opportunities as possible that are immune to market gyrations—in industry lingo, generating alpha (returns uncorrelated to market performance) rather than beta.

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.

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 biggest hedge fund profit? ›

1 among hedge fund mangers for the biggest cumulative net profit since his firm opened, according to data from LCH Investments. Citadel, a Miami-based multistrategy hedge-fund firm, led the list with a $74 billion net gain for its investors since inception in 1990 through 2023.

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