A hedge fund is a pooled investment structure set up by a money manager or registered investment advisor and designed to make a return. This pooled structure is often organized as either a limited partnership or a limited liability company.
A hedge fund isn't a specific type of investment, but rather a vehicle for investment.
What Is a Hedge Fund?
Hedge funds were originally structured to hold both long and short stocks. The positions were therefore "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.
These funds are limited to wealthier investors because they come with higher fees paid to their managers and they nonetheless involve more risk than other types of investments.
How Does a Hedge Fund Work?
A hedge fund manager raises money from outside investors and invests those funds according to whatever strategy they've promised to use. There are hedge funds that:
- Specialize in "long-only" equities, meaning that 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 or music rights
Hedge funds can specialize in just about anything. There are even hedge funds that are made up of other hedge funds.
A Hedge Fund 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 (the legal document that spells out how the company is managed) states that you'll receive 25% of any profits over 3% per year. You can invest in anything—stocks, bonds, mutual funds, real estate, startups, art, rare stamps, collectibles, gold, or wine. The 3% mark is the "hurdle." It's the milestone you must first reach before profits are paid out.
A 3% hurdle and 25% profit share is generous. The standard is 2% and 20%.
Along comes a single investor who invests $100 million into your hedge fund. They write your company a check, you put the cash into a brokerage account, 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.
Your purpose every day is to put your investor’s money to work at the highest rate possible, adjusted for risk. The more money you make for your investor, the more money you get to take home.
Now imagine that you make an incredible investment in the first year, doubling the company’s assets from $100 million to $200 million. The first 3% belongs to the investor. The $100 million gain would be reduced by $3 million for that hurdle rate. The remaining $97 million would be split 25% to you and 75% to your investor.
You'd receive $24.25 million in compensation. Your investor gets the $3 million hurdle earned, plus $72.75 million from the split, bringing their cut to a grand total of $75.75 million.
Hedge Fund Requirements
You must meet certain income and net worth requirements to invest in a hedge fund. Generally, only "accredited investors" are able to invest in these funds due to government regulations. Accredited investors can be either a person or an entity.
Hedge funds aren't subject to some of the federal rules that protect everyday investors, and this can make them riskier than other investing options.
Individual investors must meet one of these criteria:
- They must have personal income of $200,000 or more annually. Spouses' combined incomes must be $300,000 or more per year if the investor is married. This income level must have been maintained for at least two consecutive years and the investor must have reason to believe they will maintain this level of income in the future.
- They must have a personal net worth of $1 million or more, either alone or with a spouse, excluding their primary residence.
If the investor is an entity:
- It can be a trust with a net worth of $5 million or more, not specifically formed for the purposes of making the investment, and it must be run by a "sophisticated" investor.
- It can be any entity in which all the equity investors are accredited investors on their own merit.
The U.S. 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.
Fees and Costs of Hedge Funds
Managers of hedge funds are compensated based on the terms or arrangements in their funds' operating agreements, but many hedge fund managers receive the standard "2 and 20." They receive 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.
- A hedge fund is often a limited partnership or an LLC that pools money from investors to invest in securities and other higher-risk options.
- These funds are limited to wealthier investors due to their high fees and the investment risks involved.
- Hedge funds can specialize in investing in businesses, junk bonds, real estate, or even patents and music rights.
- Hedge funds are limited to “accredited investors” who must meet stringent financial requirements.