What Is a Hedge Fund?
A hedge fund is a pool of money that is invested in stocks and other assets. Hedge funds are generally more aggressive, riskier, and more exclusive than mutual funds. Their managers have freer rein to invest in a wide variety of assets and to use bolder strategies in pursuit of higher profits, and are rewarded with much higher fees than mutual funds charge.
The hedge fund industry has grown tremendously in recent years. By mid-2023, more than $4.3 trillion was being managed by 9,370 hedge fund managers, with more than 29,000 funds offered globally.
Key Takeaways
- 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 hedge fund industry has grown from one fund and manager in 1949 to 9,370 managers and more than 29,000 funds worldwide.
- The U.S. is home to about 67% of the world's hedge funds.
- Europe hosts about 18% of the world's hedge funds.
History of Hedge Funds
Former writer and sociologist Alfred Winslow Jones' company,A.W. Jones & Co.,launched the world's first hedge fund in 1949. Jones was inspired to try his hand at managing money while writing an article about investment trends earlier that year. He raised $100,000 (including $40,000 out of his pocket) and tried to minimize the risk of holding long-term stock positions byshort-sellingother stocks.
This investing innovation is now called the classiclong/short equitiesmodel. Jones also employedleverageto enhance returns. In 1952, he altered the structure of hisinvestment vehicle, converting it from ageneral partnershipto alimited partnershipand adding a 20%incentive feeas compensation for the managing partner.
Jones was the firstmoney managerto combine short selling, leverage, and shared risk by partnering with other investors. For this innovation, and by implementing a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.
Hedge funds took off in the 1990s when a number of high-profile money managers deserted the mutual fund industry for fame and fortune as hedge fund managers. A hedge fund's ability to attract investors tends to rely heavily on the reputation of its manager for delivering results.
Hedge Fund Industry at a Glance
- The industry had about $4.3 trillion in assets under management as of mid-2023, according to the PreqinGlobal Hedge Fund Report for the year.
- Therewere more than 9,000 hedge fund managers.
- Hedge funds charge relatively high fees. A 2% management fee and a 20% "performance fee" are standard.
- About 35% of the money in hedge funds comes from private or public pension funds. Other major contributors include endowments and foundations.
Some very wealthy individuals invest in hedge funds. Minimum investments of $100,000 are common, and some require $1 million or more.
Notable Hedge Funds
Notable hedge funds today include Renaissance Technologies (also known as RenTech or RenTec), founded by the mathematical genius Jim Simons. Renaissance specializes in systematic trading using quantitative models derived from mathematical and statistical analyses.
Pershing Square is a high-profile activist hedge fund run by Bill Ackman. Ackman invests in companies he feels are undervalued with the goal of taking a more active role in the company to unlock value. Activist strategies typically include changing the board of directors, appointing new management, or pushing for a sale of the company.
Carl Icahn, a well-known activist investor, leads a prominent hedge fund. In fact, one of his holding companies, Icahn Enterprises (IEP), is publicly traded and gives investors who can't or don't want to invest directly in a hedge fund an opportunity to bet on Icahn's skill at unlocking value.
Hedge Funds Regulation
Hedge funds face little regulation from the Securities and Exchange Commission (SEC) compared to other investment vehicles. The SEC only requires hedge funds to register if they have more than $150 million in private funds and manage one or more funds.
Hedge funds operate in many countries besides the U.S., and follow the regulations of their home countries.
Funds with assets under management of $500 million or more must file quarterly and report the details of their liabilities and assets.
Significant Regulatory Changes
In May 2023, the SEC adopted measures to force large hedge funds to disclose more information via its Form PF, the form used for confidential event reporting.
Are Hedge Funds Risky?
Hedge funds are risky in comparison with most mutual funds or exchange-traded funds. They take outsized risks in order to achieve outsized gains. Many use leverage to multiply their potential gains. They also are unconstrained in their investment picks, with the freedom to take big positions in alternative investments.
How Do Hedge Funds Make Money?
The standard compensation for hedge fund managers is called the "2-and-20" rule. That's a 2% fee plus 20% of the profits the fund earns above a specified minimum.
Are Hedge Funds in the Financial Services Industry?
Hedge funds are part of the broader financial sector but are less regulated by the government than other financial products such as mutual and exchange-traded funds.
The Bottom Line
A hedge fund, like an actively-managed mutual fund, is a pool of money from many sources invested by a team of financial professionals.
But that's where the similarities end. Hedge funds aren't regulated as much as mutual funds and they operate with far less disclosure. They pursue more flexible and riskier strategies in the hopes of obtaining big gains for investors and themselves.
But perhaps what sets them apart from mutual funds the most is that they have much higher minimum investment requirements.
The majority of hedge fund investors are accredited, meaning they earn very high incomes and have existing net worths in excess of $1 million. For this reason, hedge funds have earned the dubious reputation of being a speculative luxury for the rich.
