What Is a Hedge Fund?

Hedge Funds Explained

Hedge funds

The Balance / Bailey Mariner

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 (LLC). 

Learn more about how hedge funds work and whether you can qualify to invest in one.

Definition and Examples of a Hedge Fund

A hedge fund isn't a specific type of investment but rather a vehicle for investment. These funds pool money from participants to invest in costly, high-risk, high-reward securities and other opportunities. They are actively managed.

Hedge funds are designed to generate high returns. They are not regulated as closely as mutual funds, which allows them to make investments that may come with a greater risk of loss. Hedge funds are limited to wealthy investors and institutions, because they come with high fees paid to their managers.

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 copyrights

How Does a Hedge Fund Work?

Hedge funds were originally structured to hold both long and short stock positions, which meant that they were "hedged" to reduce risk. Investors could make money regardless of whether the market went up or down. The name stuck. Later, the term expanded to include all sorts of pooled capital arrangements.

Hedge funds can specialize in just about anything, including stocks, bonds, mutual funds, real estate, startups, art, rare stamps, collectibles, gold, or wine. There are even hedge funds that are made up of other hedge funds.

To operate, a hedge fund manager raises money from outside investors and invests those funds according to whatever strategy they've promised to use.

A hedge fund will have an operating agreement that spells out how it will be managed. It will include the fee structure, which is often a management fee of 1% to 2% of assets, plus a performance fee of 20%, which means that the fund manager would get to take 20% of any annual gains they make for you. The remainder would be your profit.

A performance fee encourages fund managers to take risks that earn higher rewards. The more money the fund earns, the more money both the investors and the fund manager get to take home. Many hedge fund managers receive the standard "2 and 20." Other hedge fund managers are paid on a pure profit arrangement. 

Requirements for Hedge Funds

You must meet certain income and net worth requirements to invest in a hedge fund. Generally, only "accredited investors" can invest in these funds, due to government regulations. Accredited investors can be either persons or entities.

Hedge funds aren't subject to all of the federal rules that protect everyday investors. That can make them riskier than other investing options.

To be an individual accredited investor in a hedge fund, you must meet one of these criteria:

  • You must have a personal income of $200,000 or more annually, or you and your spouse must have a combined income of $300,000 or more per year if you are married. This income level must have been maintained for at least two consecutive years, and you must have reason to believe that you will maintain it in the future.
  • You must have a personal net worth of $1 million or more, either alone or with a spouse, excluding their primary residence.

Institutions and entities are accredited investors if they are:

  • 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
  • Any entity in which all the equity investors are accredited investors on their own merit.

The U.S. Securities and Exchange Commission (SEC) describes a sophisticated investor as a person with enough investing knowledge and experience to make informed decisions about the risks of the potential investment.

Key Takeaways

  • A hedge fund is often a limited partnership or an LLC that pools money from investors to invest in high-risk securities and other assets.
  • These funds are limited to “accredited investors,” who must meet stringent financial requirements and have significant assets, due to their high fees and the investment risks involved.
  • Hedge fund managers are paid based on a fund's profits, which encourages them to take risks to earn more.
  • Hedge funds can specialize in investing in securities, businesses, junk bonds, real estate, or even patents and music copyrights.