What Is A Hedge Fund? A Jargon-Free Guide

If you’re confused about the question “what is a hedge fund?” you are not alone. Part of their allure is their exclusivity and secrecy.

Hollywood only adds to that mystique in portraying hedge fund managers, such as the charming yet ruthless Bobby “Axe” Axelrod in the popular TV show Billions.

While hedge funds are considered unique investments in the world of personal finance, in simple terms, they are nothing more than an investment vehicle similar to a mutual fund. The difference is that the fund manager has broader discretion to invest in a wider variety of financial products other than just stocks and bonds.

The popularity of hedge funds has exploded over the last few decades, and there are now almost 4 trillion dollars invested in hedge funds worldwide.

What Is A Hedge Fund?

At its most basic, a hedge fund is a partnership between a professional fund manager and investors (often referred to as limited partners). The manager and investors pool money into a fund, using different strategies to grow the fund.

If this sounds a lot like an actively managed mutual fund, you’re not wrong. The main difference between a mutual fund and a hedge fund is the amount of risk and diversity of products that a hedge fund can invest in versus a mutual fund.

Usually, a mutual fund is limited to investing in stocks and/or bonds. A hedge fund can invest in many other, often exotic, financial products. These can include real estate, derivatives, commodities, currency, and more.

Hedge Fund Strategies

While there are hundreds of strategies employed by hedge funds to generate returns for their investors, most can be grouped into four main categories:

• Global macro
• Directional
• Event-driven
• Relative value

Global Macro Strategy

Hedge funds implementing a global macro strategy look at the big picture economic and political trends worldwide and attempt to capitalize on these large-scale ideas. Examples of this strategy would be looking at global trade imbalances, growth of emerging economies, business cycles, and supply and demand.

Directional Strategy

A directional strategy hedge fund uses market trends and directional market movements to identify equities or other securities. Often computer modeling is used to do technical trend analysis. One example of a directional strategy is a long/short equity hedge fund, which identifies opportunities in potentially undervalued stocks (long positions) and overvalued stocks (short positions). If the stocks move in the trending direction, the fund will make money.

Event-Driven Strategy

An event-driven hedge fund strategy seeks to identify risks and opportunities in specific events and make trades that pay off if those risks or opportunities are realized. For example, there could be trading opportunities around large corporate events such as mergers, consolidations, liquidations, or bankruptcies.

Relative Value (Arbitrage) Strategy

A relative value strategy will attempt to take advantage of price discrepancies between securities, otherwise known as arbitrage. Investopedia defines arbitrage as “the simultaneous purchase and sale of the same asset in different markets to profit from tiny differences in the asset’s listed price. It exploits short-lived variations in the price of similar financial instruments in different markets or different forms.”

A simple example of arbitrage is buying collectibles at a garage sale for a few dollars and then selling them on eBay for $50, $100, or more. In this case, you are taking advantage of a price mismatch for what you could pay for something versus its value in the broader market. Some people do this as a side hustle (or even full time), making 1000 dollars a month or more. In the same way, hedge funds take advantage of price mismatches in the market to generate profits.

How Can You Invest in Hedge Funds?

Investing in a hedge fund is not as simple as buying a stock. Due to government restrictions and minimum investment thresholds, the average person cannot invest directly in a hedge fund.

So who can invest in a hedge fund?

Because of their high-risk nature, the SEC (Securities and Exchange Commission) stipulates you must be an accredited investor (or in some cases a qualified purchaser) to put your money into a hedge fund.

An accredited investor must have a net worth of $1 million, not including the value of their primary home, or an annual income of $200,000 if single and $300,000 if married. A qualified purchaser designation is even more stringent. You must have at least $5 million in investable assets.

If you meet these requirements, you can research funds online or get the guidance of a financial advisor who may have more access to available hedge fund investments. Another thing to be aware of is that most hedge funds require a significant minimum investment, usually anywhere from $100,000 to $1,000,000+.

All of these hurdles and restrictions put most hedge funds out of the reach of the average investor. If you’re just getting started and wanting to learn how to invest $1000, hedge funds are not the right product for you.

In many cases, high liquid net worth individuals invest in hedge funds to diversify their portfolios or mitigate a specific risk in their investments. For the average person, investing in broad-based index funds can be a better choice, as there are many risks to investing in hedge funds.

How Do Hedge Funds Make Money?

Hedge funds make money through their fee structure, as well as their underlying performance.

A typical hedge fund fee structure is “2 and 20”, which means they charge a 2% annual fee on the total assets under management, as well as a performance fee of 20% of the total profit.

There is much criticism of this fee structure, as it is not entirely aligned with investors’ interests. The fund will collect its 2% cut, even in a down year where the fund broke even or lost money.

Compared to the ultra-low fees of an index fund (0.1% or lower in many cases), the hedge fund manager must do significantly better than the overall market just to make up for their fees.

Benefits and Risks of Hedge Funds

Compared to investing index or mutual funds, hedge funds have some unique benefits and risks.

Benefits of Hedge Funds

• Flexible Investment Strategies – Unlike mutual funds, hedge funds have more latitude to use strategies such as leverage, short selling, and derivatives to increase returns.
• Reduced Losses in Market Downturns – Many hedge fund strategies attempt to be “market neutral” and provide a reasonably consistent return regardless of if the overall market is up or down.
• Diversification – With the ability to implement many different strategies, allocating some of your portfolio to hedge funds effectively “hedges” your risk of relying on the overall market.

Risks of Hedge Funds

• Fees – Compared to mutual funds and index funds, hedge funds have much higher fees, which requires their returns to be even higher just to break even.
• Lack of Transparency – Hedge funds are not regulated with the same scrutiny as publicly traded funds, so it is hard to assess whether the manager is making good decisions or not.
• Liquidity – Most hedge funds have lock-up periods from one to five years or more where you cannot take out your money, or if you can, there is a significant financial penalty.

Famous Hedge Fund Examples

Many prominent hedge fund managers attain celebrity status, at least within financial circles, and some have achieved household-name status, especially after the 2008 financial crisis. Here are some of the major hedge fund players today.

1. Blackrock Advisors

Blackrock was founded in 1984 and now has trillions of assets under management across many different hedge funds and even passively-managed index funds. Blackrock was made famous after the 2008 financial crisis by becoming one of the largest funds to accumulate single-family homes and earn a significant return on equity in real estate in the process.

2. AQR Capital Management

AQR Capital Management started in 1998 and has a significant focus on quantitative (computational) investing. Founded by Cliff Asness, David Kabiller, John Liew, and Robert Krail, the firm has more than $140 billion in assets under management.

3. Bridgewater Associates

Ray Dalio founded Bridgewater Associates in 1975, and it has grown to around $140 billion in assets. Dalio is a particularly public figure and has written many articles and books on macroeconomic trends and investing.

4. Pershing Square Capital Management

Headed by billionaire investor Bill Ackman, Pershing Square was established in 2003. Ackman is best known as an activist investor, putting money into struggling companies and helping steer them in a more profitable direction.

Final Word

While hedge funds can be a powerful investing tool, they also come with unique risks. For the average person who doesn’t have millions to invest, the high fees and minimums can turn off. But hedge funds can be an excellent way for high net worth individuals to diversify their portfolio and accomplish what their name says – hedging against downturns in the market or other portfolio risks.

This post originally appeared on Savoteur.