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What is a Hedge Fund?Many investors may be familiar with mutual funds, where a fund manager pools the funds from multiple investors to create a “pooled investment vehicle” and invests the funds as a whole on behalf of all the individual participants of the fund. A hedge fund is similar to a mutual fund in that it is also a pooled investment vehicle, but a hedge fund is actively managed, often uses leverage (borrowed money), and typically uses alternative investment strategies. These strategies are often used to seek higher returns than traditional investment strategies, although this also comes with higher risk. Aside from the usual anti-fraud protection, hedge funds are not regulated by the US Securities and Exchange Commission (SEC) so are not required to comply with the stringent regulatory requirements that apply to many traditional investments such as stocks, bonds, and mutual funds. The SEC provides useful information on hedge funds here. Hedge funds tend to target investment returns that outperform the market but that comes with higher risk. The investment strategy of hedge funds often means they are targeting returns that are uncorrelated with the wider market.
The History of the Hedge FundThe history of the hedge fund goes all the way back to the late 1940s, when the first hedge fund strategy emerged in an effort to create a “market-neutral” portfolio by taking long positions in some stocks and balancing that with short positions in other stocks. This developed further in 1952 with the creation of the first hedge fund product structured as a pooled investment vehicle which utilized a hedged strategy and leverage, and included a performance fee entitling the fund manager to share in the profit of the fund alongside the investors. Over the seventy or so years since their creation, hedge funds have had their share of ups and downs. Through some periods, hedge fund returns have exceeded those of traditional investments, but there have also been times where their returns have been substantially lower than traditional markets. The hedge fund sector has grown since its inception and attracts interest from a range of investors. According to industry data analyst Statista, global hedge fund Assets Under Management (AUM) have grown from $118 billion in 1997 to $4.5 trillion in late 2021.
How Do Hedge Funds Work?A hedge fund manager creates a hedge fund by pooling together investment funds from a group of individual investors under a Limited Partnership (LP) or Limited Liability Company (LLC). Hedge fund managers set investment strategies for the fund covering elements such as risk, leverage, asset class, redemption, etc. and then invests the fund’s money with the objective of generating returns for the fund. While the original hedge fund concept involved taking long and short positions in the stock market, the term hedge fund has now expanded to encompass a range of pooled capital arrangements. Hedge funds can deploy their funds across a wide range of investments including traditional and alternative investments, which might include specific bonds, stocks, angel investments, real estate, venture capital, precious metals, collectibles, and more. Hedge funds have an operating agreement describing the terms of its operation and its fee structure. They often include a management fee as a percentage of assets, which is often in the range 1% to 2%. A performance fee often applies too, with 20% being relatively common, meaning that the hedge fund manager takes 20% of any profit generated by the fund before distribution to the investors.
Requirements of a Hedge Fund and Who Can Invest in a Hedge Fund?Because of the high-risk, complexity, and lack of regulatory protection, hedge funds are not available to ordinary retail investors on the public market. Hedge fund investors must be a Qualified Purchaser or Accredited Investor, which requires certain minimum levels of financial experience, qualification, income, net worth, or investment assets. The SEC’s Hedge Fund Investor Bulletin includes additional information and resources relevant to hedge fund investing.
Who Manages a Hedge Fund?A hedge fund manager is a person or firm responsible for the management of the fund. Hedge fund managers set the investment strategy, make investment decisions, and manage the operation and performance of the fund.
The Advantages of Hedge FundsHedge funds allow qualified investors to access investment opportunities with the potential to achieve high returns. An investor may consider including a hedge fund in their investment portfolio to benefit from alternative investments that may have the potential for higher returns than traditional investments. Typically, most hedge funds have some liquidity options compared to some direct alternative investments, for example startup investments or collectibles, which usually do not. Most alternative investments are highly illiquid, whereas a hedge fund investor typically has greater access to their funds. However, it is important to understand that most hedge funds have lockout periods during which investors are unable to withdraw their funds and there are often restrictions on the timing for withdrawals, so hedge funds do come with liquidity restrictions.
The Risks of Hedge FundsHedge funds are generally a high-risk investment, with the level of risk varying according to the fund investment strategy. Risks include speculative investments and the use of leverage (borrowed money), as well as lock-out periods when investors are unable to withdraw their funds. The structure of many hedge funds means the potential exists for hedge fund investing to fail completely and for investors to lose their entire investment.
Should I Invest in a Hedge Fund?The decision of whether to invest in a hedge fund depends on an investor’s personal circumstances and their investment goals, objectives, risk appetite and liquidity needs. The high-risk nature of hedge funds means it is important to take a portfolio perspective and to maintain an appropriate balance of risk and return in the overall investment portfolio.
Other Pooled Investment VehiclesAs noted above, a hedge fund is a type of pooled investment vehicle, where an individual’s funds are combined with other investors. Examples of some other pooled investment vehicles include:
- Mutual funds, which invest in regulated stocks, bonds, and debt, and can be accessed by retail investors on the public market.
- Exchange-traded funds (ETF), which track a particular market index such as the S&P 500 or a specific commodity, sector, or asset. They can be traded on a stock exchange in a manner similar to stocks.
- Real Estate Investment Trusts (REIT), which invest in property on behalf of its investor pool.
Hedge Funds vs. Mutual FundsHedge funds and mutual funds are both managed investment portfolios that utilize pooled funds from various investors but there are some important differences between the two, as noted below.
|Element||Mutual Funds||Hedge Funds|
|Regulation||Highly regulated||Only lightly regulated|
|Access||Available to regular retail investors on the public market||Available only to accredited investors and qualified purchasers on the private market|
|Risk||Varies according to the fund objectives, ranging from low risk to high risk||High risk|
|Return||Varies according to the fund objectives, with some funds aiming for average market returns and others aiming for higher or lower than the market||Targets higher than average market returns|
|Liquidity||High liquidity||Lower liquidity than mutual funds but with a few liquidity advantages compared to some direct alternative investments|
|Fees||Low to moderate fees||High fees, including profit performance fees|