What is a hedge fund?

A hedge fund is a professionally-managed investment fund for accredited investors. Hedge funds seek high returns, often by using aggressive and technologically-advanced management strategies. Most hedge funds are established as private investment companies or partnerships with a limited number of investors, each contributing a large initial investment. Since they focus on serving wealthy investors, hedge funds in the U.S. are less regulated than the types of investments available to retail investors. Hedge fund investments are usually less liquid than other investment options available to ordinary retail investors. The word “hedging” itself historically refers to various methods of risk-reduction used by commodities producers and other financial-market participants. The earliest hedge funds used “shorting” techniques to protect large investors against downward price movements, yet nowadays the term refers to mean any private investment vehicle which relies on alternative strategies to achieve gains. Although the exact number of hedge funds is difficult to determine, recent estimates range between 8,000 to 10,000 active funds, many of which are focused on U.S. markets. In 2012, approximately 1,500 new fund managers were licensed in the U.S., according to a report by Deloitte.

How do hedge funds differ from mutual funds and exchange-traded funds?

Although hedge funds are similar to mutual funds in that both are investment pools managed by professionals using specific strategies, hedge funds typically require a large investment whereas mutual funds and exchange-traded funds (ETFs) are open to retail investors with much smaller investment amounts. Also, an ETF typically tracks an index or a basket of assets, with its net asset value (NAV) calculated daily, and can be traded daily in an open market like a mutual funds, but hedge funds are far less liquid-- Even if the NAV of a hedge fund is calculated daily, this investment can usually only be bought and sold in a private transaction under specific conditions. Also, most hedge funds require a minimum one-year period of participation by the individual investor, while mutual funds and ETFs can be bought and sold daily. Of course, since investors expect hedge funds to outperform mutual funds and ETFs, the commissions and fees are likewise substantially higher. Finally, mutual funds and exchange-traded funds are regulated by financial-markets authorities with a much higher level of oversight and scrutiny than are hedge funds, since accredited investors are considered more capable of performing due diligence than retail investors.

Why invest in a hedge fund?

Investors choose hedge funds for a variety of reasons. First, since they are less regulated than ordinary mutual funds, hedge funds attract investors who have a greater appetite for gains and a higher tolerance for risk. Hedge funds can invest in speculative or illiquid ventures which are potentially highly profitable, yet unavailable to mutual funds. So, the strategies employed by hedge-fund managers are more flexible and wide-ranging than those available to mutual fund managers, and may include “shorting” of securities and other techniques not authorized for mutual fund managers. Also, because hedge fund participation is limited, investors can often customize their holdings in order to achieve specific investment objectives. Finally, although many mutual fund managers are compensated by salary, most hedge fund managers have invested a significant amount of their own personal money into their funds, so the interests of the management are expected to be closely aligned with those of their investors.

Types of hedge funds

Many hedge fund strategies are focused on absolute return, that is, they seek gains in both rising and falling markets. In general, hedge fund strategies may be classified into four types-- Global macro strategies, directional strategies, event-driven strategies, and arbitrage or relative-value strategies. The prospectus and written materials should clearly describe the philosophy, strategy, market sectors, and methods of a particular fund. Strategies which rely on managers' choices of investments are called discretionary or qualitative, while systematic or quantitative strategies are based on computer-generated choices. Strategies based on absolute return may be further categorized as either market neutral or directional. Market-neutral funds attempt to neutralize the effect of price swings in the overall market; in contrast, directional funds seek to capitalize on trends and inefficiencies in the market and therefore tend to fluctuate along with the overall market. As well, hedge funds may be distinguished according to the market sector(s) in which they are focused, or the type of asset classes they hold or trade, or the degree of diversification in their holdings.

Global macroeconomic

Global macro funds seek to profit from world macroeconomic trends and events, and they may also rely on either discretionary or systematic methods to choose and trade investments. Such strategies may be further classified according to whether they seek to profit by following trends, or by anticipating the reversal of those trends.


Directional hedge fund strategies rely on indicators of market movements or market inefficiencies in order to choose investments whose values are expected to move in a predictable way. Sub-types of these strategies include emerging markets, sectors and industries, fundamental growth and fundamental value.

Event-driven strategies

Fund use event-driven strategies to capitalize on opportunities arising from corporate events including mergers and acquisitions, consolidations, and bankruptcies. Event-driven fund managers analyze the valuations of companies before and after these corporate transactions in search of profitable inconsistencies. Event-driven strategies may be further classified as focusing on distressed securities, risk arbitrage, or special situations. Event-driven strategies in general are common during bull markets, while distressed-asset strategies become more popular during bear markets. Distressed-securities strategies involve buying bonds and other debt instruments issued by companies in financial distress, while risk arbitrage seeks to profit from perceived pricing discrepancies between companies undergoing mergers or acquisitions. Special situations refers to events in which the value of a company's equity or debt may suddenly rise or fall, such as during spin-offs, restructuring, share issuance or buy-backs, or other unusual events which may unexpectedly affect the company's value.

Assets and leverage

Since they are less regulated than mutual funds, hedge funds are free to invest in and trade the broadest possible range of assets classes. Although many are focused on ordinary equity and debt issues, some funds specialize in illiquid assets, including derivatives such as options, futures, swaps and other speculative investments. As well, some funds hold precious metals, or even real estate. One of the benefits offered by hedge funds is their ability to use leverage, or borrowed money, to supplement investors' money. Global macro funds in particular often use leverage to profit from market trends; and, margin provides a powerful tool for commodities-focused funds. Opportunities for enhanced gains likewise bring increased risk, so leveraged funds require careful risk management. Still, although there have occasionally been voices warning of systemic risk in the event that certain highly-leveraged hedge funds may fail, the consensus view of U.S. regulators has been that individual failures of leveraged funds would not affect the overall economy. Fed report on regulatory reform

Who can invest in hedge funds?

According to securities laws in the U.S., Canada and various other countries, only accredited investors are allowed to invest in higher-risk investments such as hedge funds. In general, an accredited investor is defined as a wealthy individual or company with significant experience conducting financial business, including banks, sophisticated corporations, and other organizations which are expected to have the resources necessary to fully research and make informed decisions regarding investments. Such individuals and organizations are considered qualified to invest in hedge funds and other forms of investment not available to retail investors. Under current U.S., law, an individual investor is considered to be accredited if he or she has a net worth of more than $1,000,000 not including the value of his or her primary residence, or if he/she has an annual income of no less than $200,000 for each of the past two years, or a combined annual income of $300,000 if married, as well as the expectation that such income will continue in the following year. Still, due to concerns regarding the capabilities of individual investors to assess hedge fund investments, it has been proposed that the net worth qualification be raised to $2.5 million with provisions for periodic adjustments based on inflation. Dodd-Frank Wall Street Reform and Consumer Protection Act

Portfolio allocation

As with any investment, investors must consider a variety of factors regarding hedge fund investments. Appetite for gains and tolerance for risk are the primary considerations, and an investor's time horizon for holding a particular investment is also important, since hedge funds usually require a minimum holding period and may also face issues of liquidity in their portfolios. In addition, investors should assess their allocations among various asset classes and business sectors, since hedge funds typically require a substantial investment which may skew an investor's portfolio.

Performance and returns

Hedge funds aim to surpass the performance of market index benchmarks. In contrast to mutual funds, which tend to measure performance against a particular benchmark, most hedge funds attempt to profit regardless of the overall market conditions. The range of returns depends upon a fund's investment strategy, tolerance for risk, and market volatility. Although accurate comparisons of performance require in-depth research, the annual returns for a successful fund may range from 8 to 12% for asset-backed loan funds with predictable collections, up to hundreds or even thousands of percent in gains from highly-leveraged hedge funds focused on rapidly-growing small-cap tech issues. As always, potential gains are proportional to possible risks.

Fees and profit-sharing

Most hedge funds charge investors two types of fees-- A management fee, as well as a performance fee. The management fee is determined as a percentage of the hedge fund's NAV, and this usually ranges between 1 to 4% annually, with 2% as the average fee. This is typically paid either monthly or quarterly, and it is expected to cover the fund manager's operating expenses. In contrast, the performance fee is intended to provide the manager with a profit for good performance. Although some funds charge performance fees as much as 50% while others charge as little as 10%, the typical performance fee is 20% of the fund's annual profits. Because of perennial criticism regarding high fees, and a perception that hedge fund managers share profits without participating in losses, most funds specify a loss-carry-forward or “high-water mark” which provides that the performance fee is to be calculated based on net profits after accounting for any losses from previous years. Further, the payment of performance fees may also envision a “hurdle” to be overcome, such that the fund's returns must first exceed a given performance benchmark before the management receives compensation for performance. In addition to the above fees, in order to discourage short-term turnover of investors' money, especially during periods of weak performance, hedge funds often charge a redemption fee to those who withdraw money early, or those who withdraw more money than expected.

Tax and legal considerations

Since hedge fund managers are paid with a profit interest in a given fund, most of a manager's income is taxed as a return on the manager's interest rather than as compensation for services. Usually, when a manager in a hedge fund is compensated with a profit interest (“carried interest”), the manager is not taxed at that moment, since it would be difficult to determine the present value of a future profit. Rather, the manager or partner is generally taxed according to the income of the partnership. This allows the partner to defer taxes on income earned by the hedge fund. Most private equity hedge funds invest on a longer time line, which means that the income is considered long-term capital gains and taxable for individuals at a maximum of twenty percent; in effect, this allows partners to avoid the 39.6% marginal rate that might otherwise apply. In the constant struggle to reduce taxes, both managers and their investors continue to seek additional methods to convert gains from short-term trading into long-term capital gains, including the use of such vehicles as basket option contracts and offshore “blocker” corporations.

Disclosure and filing requirements

Since hedge funds are lightly regulated, they require much less disclosure and fewer filings than investments which are open to the general public. Still, investors often track hedge funds by researching their quarterly SEC 13f filings, which disclose a fund's long holdings in U.S. stocks, as well as American Depositary Receipts (ADRs), call and put options, and convertible bonds and notes. Of course, since funds are not required to disclose cash, short-sales or other asset classes, investors can glean the most valuable 13f information from those funds which hold primarily long positions in U.S. stocks. As with any type of investment, research and experience are the keys to investor success.