What Is a Hedge Fund?
Learn how it operates, how it makes money, and who can invest in one
If you're curious about hedge funds and what they are—or if you're wondering whether you can invest in one yourself—then this overview will give you the basics. Here, learn exactly what a hedge fund is, how these funds work, and who is eligible to be an investor.
What Is a Hedge Fund?
A hedge fund isn't a specific type of investment. Rather, it is a pooled investment structure set up by a money manager or registered investment advisor and designed to make a return. This pooled investment structure is often organized as either a limited partnership or a limited liability company.
To invest in a hedge fund, generally you'll need to meet certain income and net worth requirements.
Why Is It Called a Hedge Fund?
The original hedge funds were structured to hold stocks both long and short. Therefore, the positions were "hedged" to reduce risk, so the investors made money regardless of whether the market increased or decreased. The name stuck and the term expanded to include all sorts of pooled capital arrangements.
What Do These Funds Do?
Within a hedge fund, the hedge fund manager raises money from outside investors and then invests it according to whatever strategy he has promised to use. For example, there a hedge funds that:
- Specialize in "long-only" equities, meaning they only buy common stock and never sell short
- Engage in private equity, which is the buying of entire privately held businesses, often taking them over, improving operations, and later sponsoring an initial public offering
- Trade junk bonds
- Specialize in real estate
- Put money to work in specialized asset classes such as patents and music rights
Those are just a few examples. Hedge funds can specialize in just about anything. There are even hedge funds that are made up of other hedge funds.
Fees and Costs of Hedge Funds
The managers of a hedge fund are compensated based on the terms or arrangements found in the operating agreement.
Some hedge fund managers receive the standard "2 and 20," which means 2% of net assets per year plus 20% of profits above a predetermined hurdle. Other hedge fund managers are paid on a pure profit arrangement.
How Does a Hedge Fund Make Money?
The primary goal of a hedge fund is to make a return. But how do these funds accomplish that?
To illustrate, let’s take an extreme example. Imagine you set up a company called “Global Umbrella Investments, LLC.” It's a Delaware LLC, so the costs are low to start it and your members can remain anonymous.
The operating agreement, which is the legal document that spells out how the company is managed, states that you will receive 25% of any profits over 3% per year and that you can invest in anything—stocks, bonds, mutual funds, real estate, startups, art, rare stamps, collectibles, gold, wine. The 3% is called the "hurdle," because it's the milestone you must first reach before profits are paid out.
Along comes a single investor who invests $100 million into your hedge fund. He writes your company a check, you put the cash into a brokerage account, and then you deploy the capital according to any guidelines spelled out in the operating agreement. Perhaps you use the money to buy up local restaurants, or maybe you start a new company. Either way, your purpose every day is to put your investor’s money to work at the highest rate possible (adjusted for risk, of course). The more money you make for your investor, the more you get to take home.
For argument’s sake, imagine that you made an incredible investment the first year, doubling the company’s assets from $100 million to $200 million. Now, according to the company’s operating agreement, the first 3% belongs to the investor with anything above that being split 25% to you and 75% to your investor. In this case, the $100 million gain would be reduced by $3 million for that hurdle rate. The remaining $97 million is split 25% to you and 75% to your investor.
So you receive $24.25 million in compensation. Your investor gets the $3 million hurdle earned plus $72.75 million from the split, bringing his cut to a grand total of $75.75 million.
Who Can Invest?
Generally, only "accredited investors" will be able to invest in hedge funds, due to government regulations.
Hedge funds are not subject to some of the federal rules that protect everyday investors, and this makes them riskier than other investing options.
Accredited investors can be a person or an entity. If the investor is a person, they must meet one of these criteria:
- Have a personal income of $200,000 or more per year. If married, combined income must be $300,000 or more per year. This income must have been earned for at least two consecutive years and the investor must have reason to believe she will maintain this level of income in the future.
- Have a personal net worth of $1 million or more, either alone or with a spouse, excluding the primary residence.
If the investor is an entity, it may:
- Be a trust with a net worth of $5 million or more, not specifically formed for the purposes of making the investment, and run by a "sophisticated" investor.
- Be any entity in which all of the equity investors are accredited investors on their own merit.
The Securities and Exchange Commission describes a sophisticated investor as a person with sufficient investing knowledge and experience to make informed decisions about the risks of the potential investment.