Hedge Fund: Definition, Examples, Types, and Strategies (2024)

What Is a Hedge Fund?

A hedge fund is a limited partnership of private investors whose money is pooled and managed by professional fund managers. These managers use a wide range of strategies, including leverage (borrowed money) and the trading of non-traditional assets, to earn above-average investment returns.

A hedge fund investment is often considered a risky, alternative investment choice and usually requires a high minimum investment or net worth. Hedge funds typically target wealthy investors.

Key Takeaways

  • Hedge funds are actively managed funds focused on alternative investments that commonly use risky investment strategies.
  • A hedge fund investment typically requires accredited investors and a high minimum investment or net worth.
  • Hedge funds charge higher fees than conventional investment funds.
  • The strategies used by hedge funds depend on the fund manager and relate to equity, fixed-income, and event-driven investment goals.
  • A hedge fund investor's investment usually is locked up for a year before they may sell shares and withdraw funds.

Hedge Fund: Definition, Examples, Types, and Strategies (1)

Understanding Hedge Funds

Hedging Their Bets

The term "hedge fund" refers to an investment instrument with pooled funds that is managed to outperform average market returns. The fund manager often hedges the fund's positions to protect them from market risk.

They do so by investing a portion of the fund's assets in securities whose prices move in the opposite direction of the fund's core holdings. Theoretically, should the prices of the core holdings move down, the prices of the securities acting as a hedge should move up. As a result, the hedge can offset any losses in the core holdings.

For example, a hedge fund that focuses on a cyclical sector, such as travel, may invest a portion of its assets in a non-cyclical sector such as energy, aiming to use the positive returns of the non-cyclical stocks to offset any losses in cyclical stocks.

Risk

Hedge funds use risky strategies, leverage, and derivative securitiessuch as options and futures. Therefore, an investor in a hedge fund is commonly regarded as an accredited investor. This means that they meet a required minimum level of income or assets. Typical investors are institutional investors, such as pension funds and insurance companies, and wealthy individuals.

Investments in hedge funds are consideredilliquidas funds often require investors to keep their money in the fund for at least one year, a time known as thelock-up period.Withdrawalsmay also only happen at certain intervals such as quarterly or bi-annually.

Types of Hedge Funds

Four common types of hedge funds are:

  • Global macro hedge funds: These are actively managed funds that attempt to profit from broad market swings caused by political or economic events.
  • Equity hedge funds: These may be global or specific to one country, investing in lucrative stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices.
  • Relative value hedge funds: These funds seek to exploit temporary differences in the prices of related securities, taking advantage of price or spread inefficiencies.
  • Activist hedge funds: These aim to invest in businesses and take actions that boost the stock price such as demanding that companies cut costs, restructure assets, or change the board of directors.

The appeal of many hedge funds lies in the reputations of their managers, which stand out in the closed world of hedge fund investing.

Common Hedge Fund Strategies

Hedge fund strategies cover a broad range of risk tolerance and investment philosophies. They involve a large selection of investments, including debt and equity securities, commodities, currencies, derivatives, and real estate.

Common hedge fund strategies are classified according to theinvestment style of the fund's manager and include equity, fixed-income, and event-driven investment goals.

  • A long/short hedge fund strategy is an extension of pairs trading, by which investors go long and short on two competing companies in the same industry based on their relative valuations.
  • A fixed-income hedge fund strategy gives investors solid returns, with minimal monthly volatility and aims for capital preservation; it takes both long and short positions in fixed-income securities.
  • An event-driven hedge fund strategy takes advantage of temporary stock mispricing, spawned by corporate events like restructurings, mergers and acquisitions, bankruptcy, or takeovers.

Examples of Hedge Funds

The most notable hedge funds, based on assets under management (AUM), include:

  • Bridgewater Associates: Founded in New York in 1975 and headquartered in Westport, Conn., global leader, with more than $124 billion in AUM.
  • Renaissance Technologies: Founded in 1982 and headquartered in East Satauket, N.Y., with mathematical- and statistical-based investment strategies, and over $106 billion in AUM.
  • AQR Capital Management: Founded in 1998 and headquartered in Greenwich, Conn., with applied quantitative research investment strategies, and over $94.5 billion in AUM.

Hedge Fund Compensation

Australian investor Alfred Winslow Jones is credited with launching the first hedge fund in 1949 through his company,A.W. Jones & Co. Raising $100,000, he designed a fund that aimed to minimize the risk in long-term stock investing byshort-selling, now referred to as the long/short equitiesmodel.

In 1952, Jones converted his fund to alimited partnership,added a 20%incentive feeas compensation for the managing partner, and became the firstmoney managerto combine short selling, the use of leverage, and a compensation system based on performance.

Today, hedge funds employ a standard "2 and 20" fee system, which refers to a 2% management fee and a 20% performance fee.

The management fee is based on the net asset value of each investor's shares, so an investment of $1 million garners a $20,000 management fee that year to cover the operations of the hedge and compensate the fund manager.

The performance fee is commonly 20% of profits. If an investment of $1 million increases to $1.2 million in one year, $40,000 is the fee owed to the fund.

Hedge Fund vs. Mutual Fund

Hedge funds are not as strictly regulated by the Securities and Exchange Commission (SEC) as mutual funds are.

Mutual funds are a practical, cost-efficient way to build a diversified portfolio of stocks, bonds, or short-term investments. They are available to the general public and average investor.

Hedge funds normally will only accept money from accredited investors who include individuals with an annual income that exceeds $200,000 or a net worth exceeding $1 million, excluding their primary residence. These investors are considered suitable to handle the potential risks that hedge funds are permitted to take.

A hedge fund can invest in land,real estate, stocks,derivatives, and currencies while mutual funds use stocks or bonds as their instruments for long-term investment strategies.

Unlike mutual funds where an investor can elect to sell shares at any time, hedge funds typically limit opportunities to redeem shares and often impose a locked period of one year before shares can be cashed in.

Hedge funds employ the 2% management fee and 20% performance fee structure. In 2022, the average expense ratio across all mutual funds and exchange-traded funds was 0.37%.

Read about Investopedia's 10 Rules of Investing by picking up a copy of our special issue print edition.

What to Consider Before Investing

As investors conduct research to identify hedge funds that meet their investment goals, they often consider the fund or firm's size, the track record and longevity of the fund, the minimum investment required to participate, and the redemption terms of the fund. Hedge funds operate in many countries, including the U.S., United Kingdom, Hong Kong, Canada, and France.

According to the SEC, investors should also do the following when deciding whether or not to invest in a hedge fund:

  • Read the hedge fund’s documents and agreements which contain information about investing in the fund, the strategies of the fund, the location of the fund, and the risks anticipated by the investment.
  • Understand the level of risk involved in the fund’s investment strategies and whether they equate with your personal investing goals, time horizons, and risk tolerance.
  • Determine if the fund is using leverage or speculative investment techniques which will typically invest both the investors’ capital and the borrowed money to make investments.
  • Evaluate potential conflicts of interest disclosed by hedge fund managers and research the background and reputation of the hedge fund managers.
  • Understand how a fund’s assets are valued as hedge funds may invest in highly illiquid securities and valuations of fund assets will affect the fees that the manager charges.
  • Understand how a fund's performance is determined and whether it reflects cash or assets received by the fund as opposed to the manager’s estimate of the change in the value.
  • Understand any limitations to time restrictions imposed to redeem shares.

What Tools Do Investors Use to Compare the Performance of Hedge Funds?

Investors look at the annualized rate of return to compare funds and to reveal funds with high expected returns. To establish guidelines for a specific strategy, an investor can use an analytical software package such as Morningstar to identify a universe of funds using similar strategies.

How Do Hedge Funds Compare to Other Investments?

Hedge funds, mutual funds, and exchange-traded funds (ETFs) all pool money contributed by many investors and attempt to earn a profit for themselves and their clients.

Hedge funds are actively managed by professional managers who buy and sell certain investments with the stated goal of exceeding the returns of the markets, or some sector or index of the markets. They take the greatest risks while trying to achieve these returns. In addition, hedge funds are more loosely regulated than competing investments, and they can invest in options and derivatives as well as esoteric investments that mutual funds cannot invest in.

Why Do People Invest in Hedge Funds?

A wealthy individual who can afford to diversify into a hedge fund might be attracted to the high-performance reputation of its manager, the specific assets in which the fund is invested, or the unique strategy that it employs.

The Bottom Line

Hedge fund investing is considered a risky alternative investment choice and requires that investors can make a large minimum investment or have a high net worth. Hedge fund strategies involve investing in debt and equity securities, commodities, currencies, derivatives, and real estate.

Hedge funds are loosely regulated by the SEC and earn money from the 2% management fee and 20% performance fee structure.

Hedge Fund: Definition, Examples, Types, and Strategies (2024)

FAQs

Hedge Fund: Definition, Examples, Types, and Strategies? ›

A hedge fund is a limited partnership of private investors whose money is pooled and managed by professional fund managers. These managers use a wide range of strategies, including leverage (borrowed money) and the trading of non-traditional assets, to earn above-average investment returns.

What are the different types of strategies created by hedge funds with examples? ›

The main hedge fund strategies are as follows:
  • Global macro strategies. ...
  • Directional hedge fund strategies. ...
  • Event-driven hedge fund strategies. ...
  • Relative value arbitrage strategies. ...
  • Long/short strategies. ...
  • Capital structure strategies. ...
  • Open-ended hedge funds. ...
  • Closed-end hedge funds.

What is a hedge fund and its types? ›

Hedge funds are financial partnerships that employ various strategies in an effort to maximize returns for their investors. Unlike mutual funds managers, hedge fund managers have free reign to invest in non-traditional assets and employ risky strategies.

What is an example of a hedge fund? ›

Among the most prominent hedge funds in the last few decades are: Bridgewater Associates, founded by Ray Dalio. AQR Capital Management, founded by Clifford Asness. Renaissance Technologies, founded by James Simons.

What are hedging strategies? ›

Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position.

What is the most common hedge fund strategy? ›

The most prevalent of the hedge fund strategies, equity strategies hedge funds take long positions in stocks perceived as undervalued and short positions in stocks considered overvalued. Equities' correlation with macroeconomic factors mean they are seen as a riskier class for investment than cash and bonds.

How many types of hedging strategies are there? ›

Types of hedging strategies

Here are some of the most common approaches that traders tend to use: Use of derivatives: futures, options and forward contracts. Pairs trading: taking two positions on assets with a positive correlation. Trading safe haven assets​: gold, government bonds and currencies such as the USD and ...

What is hedge fund in simple words? ›

Put simply, a hedge fund is a pool of money that takes both short and long positions, buys and sells equities, initiates arbitrage, and trades bonds, currencies, convertible securities, commodities and derivative products to generate returns at reduced risk.

What is the main purpose of a hedge fund? ›

Hedge funds pool investors' money and invest the money in an effort to make a positive return. Hedge funds typically have more flexible investment strategies than, for example, mutual funds.

How do hedge funds work for dummies? ›

Hedge funds use pooled funds to focus on high-risk, high-return investments, often with a focus on shorting — so you can earn profit even when stocks fall.

How does a hedge fund make money? ›

How do hedge funds make money? Hedge funds take a management fee of between one and two per cent of the amount you invest. In addition, the hedge fund manager will receive a performance fee (usually around 20 per cent on any profit).

How does a hedge fund pay you? ›

Hedge Fund Manager Compensation

Two and twenty (or "2 and 20") is a typical fee arrangement for hedge fund managers that is standard in the hedge fund industry. It is also common in venture capital and private equity. Hedge fund management companies typically charge clients both a management and a performance fee.

Do hedge funds pay income? ›

Domestic hedge funds are generally not appropriate for tax-deferred investors, such as retirement plans, foundations and the like, because they generate unrelated business taxable income for such investors. Additionally, most hedge funds do not make annual cash dividends or other distributions to investors.

What are the three types of hedging? ›

At a high level, there are three hedge strategy types that companies deploy:
  • Budget hedge to lock in a budget rate.
  • Layering hedge to smooth rate impacts.
  • Year-over-year (YoY) hedge to protect the prior year's rates (50% is likely achievable)

Which is the best example of hedging? ›

What is a good hedging example? Some common examples of hedging are using derivatives such as options or futures to mitigate losses, buying an insurance policy against property losses, etc.

What are the 3 common hedging strategies to reduce market risk? ›

Three popular ones are portfolio construction, options, and volatility indicators.

What are the 2 major types of investing strategies? ›

At a high level, the most common strategies for investing are:
  • Growth investing. Growth investing focuses on selecting companies which are expected to grow at an above-average rate in the long term, even if the share price appears high. ...
  • Value investing. ...
  • Quality investing. ...
  • Index investing. ...
  • Buy and hold investing.

How are hedge fund strategies classified? ›

This reading classifies hedge fund strategies by the following categories: equity-related strategies; event-driven strategies; relative value strategies; opportunistic strategies; specialist strategies; and multi-manager strategies.

References

Top Articles
Latest Posts
Recommended Articles
Article information

Author: Edwin Metz

Last Updated:

Views: 6261

Rating: 4.8 / 5 (78 voted)

Reviews: 85% of readers found this page helpful

Author information

Name: Edwin Metz

Birthday: 1997-04-16

Address: 51593 Leanne Light, Kuphalmouth, DE 50012-5183

Phone: +639107620957

Job: Corporate Banking Technician

Hobby: Reading, scrapbook, role-playing games, Fishing, Fishing, Scuba diving, Beekeeping

Introduction: My name is Edwin Metz, I am a fair, energetic, helpful, brave, outstanding, nice, helpful person who loves writing and wants to share my knowledge and understanding with you.