Hedge Fund: A Definition And How They Work

A hedge fund is a type of investment in which qualified investors pool money and employ a variety of strategies to generate a return. These strategies can range from buying stocks and bonds to engaging in more complex investments, such as derivatives and commodities.

Hedge funds tend to be only for accredited investors, or those who have a certain net worth or annual income. If you’re considering investing in hedge funds, you should assess your risk tolerance and have a solid understanding of how these types of investment partnerships work.

How Hedge Funds Work

Hedge funds could consist of a variety of investments including traditional stocks and bonds. Most commonly though, a hedge fund manager is looking for high-return investments that could pay off big if they bet the right way. Think of securities like private equity, options, futures, or derivatives.

Because of the level of risk and capital involved, only accredited or high net worth investors are allowed to participate. Hedge funds get their investment dollars from any funds contributed by the general partner as well as the funds of other investors attracted to the fund, or limited partners. Based on an investing partner’s level of investment, they’re given shares in the fund and earn returns when those shares are sold.

It’s important to note that funds often restrict a hedge fund investor’s ability to cash in their shares in one of three ways:

• The shares may be subject to a lockup period of a year or more in which you can’t remove your funds.
• At the end of any waiting period, you may be restricted to selling your shares during certain windows that may occur on a monthly, quarterly or annual basis.
• There may be a fee associated with cashing in your shares.

With hedge funds, any returns earned from the fund are shared between the partners. The hedge fund manager earns a commission and/or management fees based on the returns. That’s because this person’s role is to oversee the funds invested. They’re responsible for picking the investments and the day-to-day strategy followed by the fund. Although each fund is different, one common fee structure is the “2 and 20 rule,” or 2% of the funds under management plus 20% of the profits.

A hedge fund aims to offer high returns by making big bets. Of course, with big bets can come big risks and the mitigation of those risks is where hedge funds get their name.

For example, if you were making a bet that the stock market was going to continue to rise over the next 6 months, you might hedge your bet by also investing some money in bonds, a medium that has a history of doing better as the stock market is going down. That way, even if stocks do not rise as expected, you will still have some investments providing a more predictable return.

Types Of Hedge Funds

Some of the most common types of hedge funds:

• Global macro hedge funds: These are hedge funds that are actively managed funds which aim to profit from market swings that may be caused by either economic or political events.
• Directional hedge funds: As one of the most common hedge fund strategies, these funds tend to trade stocks, but usually use derivatives, take short and long positions, and focus on one sector or concentrated portfolios.
• Equity hedge funds: You may find one that focuses on one country or focuses globally. These hedge funds will invest in stocks with a lot of potential, while hedging against downturns by shorting overvalued stock indices or individual stocks.
• Relative value hedge funds: Fund managers look for opportunities to take advantage of temporary price or spread inefficiencies in related securities.
• Activist hedge funds: This type of hedge fund invests in businesses and encourages actions taken to increase its stock price, including changing the board of directors, cutting costs, or restructuring assets.

Common Investment Strategies

There are plenty of strategies that hedge fund managers use to help maximize profit and protect against movements of securities in the market. Some of the most common ones include:

• Long/short hedge fund strategy:  Using equity and equity derivatives, the hedge fund manager will maintain both long and short positions. The fund will either be focused narrowly on certain sectors, or be diversified broadly as well as use quantitative methods to make investment decisions.
• Fixed-income hedge fund strategy: This strategy, while it may result in large losses, tends to produce smaller returns. It aims to make a profit by taking advantage of small price inconsistencies in interest rate securities.
• Event-driven hedge fund strategy: Hedge fund managers will maintain certain positions in organizations that are restructuring, in mergers, involved in shareholder buybacks, or other capital structure adjustments such as debt exchanges.

Example of How One Hedge Fund Tried To Generate A Profit

Though this example is a rare case, it can illustrate how hedge funds attempt to generate profit. A few hedge funds felt GameStop stock was overvalued in January 2021, so they decided to short-sell its shares, expecting to make a profit after selling it and buying back at a lower price. Instead, traders — mainly users of the social website Reddit and its subreddit r/wallstreetbets — purchased a significant number of GameStop's stocks, pushing up the price (also known as shorting a stock).

Within a week, the short squeeze significantly raised the price, and the high price and volatility kept going beyond the peak in January. In turn, some hedge funds suffered losses because they would be forced to buy the stocks they borrowed, or the shorted stock, at a much higher price than they sold for.

Understanding The Hedge Fund Industry

Alfred Winslow Jones is credited with creating the first hedge fund in 1949. He started out by creating a market-neutral portfolio by purchasing assets that are believed to increase in value and selling assets that are expected to go down.

In the ‘90s, hedge funds saw a surge and many strategies were utilized by managers, such as purchasing distressed investments, macro, activism, and arbitrage strategies. In the 2010s, the sector that had avoided regulations thus far now must report to the SEC due to the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Regulations And Oversight

The Securities and Exchange Commission (SEC) requires those who want to put their money in hedge funds to be accredited investors. This often means banks and investment advisors, but an individual can be an accredited investor as well. In order to meet the requirements, the investor must qualify as one of the following:

• Any person or couple whose net worth exceeds $1 million. For the purposes of calculating your assets, certain things like the value of your home aren’t included.
• You made an income of more than $200,000 as an individual in each of the last 2 years. If you’re making joint income with a spouse or partner, you have to have made more than $300,000 in each of the last 3 years.

Beyond SEC requirements, the hedge fund itself may set rules for the amount of assets you can have under its management.

Trends And Future Outlook

Hedge funds haven't changed over the last several years, though there are trends that point to higher volatility, an increase in returns in diversified portfolios, and increases in performance tail risk. Performance tail risk refers to the probability that an investment will perform far better or far worse than its average past performance.

That being said, you need to have a significant sum of money to be able to invest in a hedge fund, aside from needing to be an accredited investor. If you’re someone who is just dipping their toes or don’t have a lot of money to invest, consider investing in stocks, mutual funds, ETFs, and index funds before jumping into more complex investment vehicles.

Hedge Fund FAQs

How do I invest in a hedge fund?

To invest in hedge funds, you’ll need to take the following steps:

1. Get accredited: You need to make sure you’re an accredited investor and meet the requirements to invest in hedge funds.
2. Research hedge fund managers: To find hedge funds that are open to new investors, you may need to seek the help of a financial advisor. Consider factors such as fees and annualized rate of return.
3. Contribute to a fund: Once you verify that you’re an accredited investor, you’ll need to work with the hedge fund manager to provide funds and monitor your investments.

How much money do you need to have to invest in a hedge fund?

Though it will depend on the hedge fund, most investors will need anywhere from at least $100,000 to $2 million or more to invest.

The Bottom Line

Hedge funds enable investors to pool their money with others under the active supervision of a hedge fund manager or general partner. The manager selects investments aimed at getting a higher return than you could through most other investment vehicles. You must have a certain net worth or income to invest directly in hedge funds. Because of this, hedge funds are generally exempt from most regulatory oversight that applies to other investments.

Before investing in a hedge fund, make sure you understand the types of investments being made. Also understand the fee structure and when and how you can cash out and your risk tolerance.

If hedge funds aren’t for you, there are still many other investing strategies. To start building your investment fund, sign up for the Rocket Money℠ app to start automating your savings.