What Is a Hedge Fund? Unraveling the Mysteries of Alternative Investments

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The concept of a hedge fund may confuse many people. Most people hear the term and think of great wealth, but ask themselves, what is a hedge fund?

At the basic level, a hedge fund is a private investment partnership allowing wealthy people to pool their money to invest in non-traditional financial products.

The goal is to achieve above-average total returns, beating stocks, bonds, and cash using alternative investments not available to everyday retail investors. For instance, a hedge fund may invest part of its portfolio in private equity or debt. The strategy is attractive to high- and ultra-high-net-worth individuals. As a result, the industry has grown, and hedge funds reportedly manage more than $4 trillion in assets today.

Although most investors know the words “hedge fund,” they are not really sure about them. In this article, we will answer the question, what is a hedge fund?

What Is a Hedge Fund?

A hedge fund is a financial partnership of accredited retail and institutional investors managed by professional managers. It invests in non-traditional assets using sophisticated techniques to earn above-average total returns.

More specifically, the United States Securities and Exchange Commission (SEC) defines them in the following way:

“Hedge funds pool money from investors and invest in securities or other types of investments with the goal of getting positive returns. Hedge funds are not regulated as heavily as mutual funds and generally have more leeway than mutual funds to pursue investments and strategies that may increase the risk of investment losses. Hedge funds are limited to wealthier investors who can afford the higher fees and risks of hedge fund investing, and institutional investors, including pension funds.”

Several key points emerge from this definition of a hedge fund. First, you must be an accredited investor. Second, they use unconventional strategies, making them riskier than typical stock, bond, and cash investments. Lastly, they are expensive.

What Is an Accredited Investor?

Not everyone can put money in a hedge fund, and they are not usually accessible through your broker or online platform. The SEC requires a person to be an accredited investor

From a retail investor's perspective, it is someone whose personal net worth, or joint net worth with a spouse or partner, is greater than $1,000,000. Alternatively, a person can have a personal income of more than $200,000 in each of the past two years. It also includes a person with a spouse or partner with a joint income of more than $300,000 in each of the past two years.

The bottom line is most investors do not meet the SEC definition. Even if they do, hedge funds usually have a minimum investment requirement of $100,000 or higher, limiting access to the average investor.

Hedge Funds Are Risky

Hedge funds use strategies that potentially increase risk and absolute returns. They typically use leverage, borrowing money from banks and other institutions to invest or trade assets. They may also use debt to raise capital. The use of leverage or borrowed money increases possible gains but also losses.

Some strategies include short selling of stocks, meaning borrowing shares, selling them to buyers, and betting the price will decline. Short selling of stocks is a speculative strategy that may involve substantial losses, making this a risky strategy.

They also trade derivatives, options, futures, commodities, fixed-income securities, etc., which can have wild price swings. In addition, they conduct arbitrage, buying securities and trading at varying prices in different markets.

However, the overall goal is to maximize absolute returns but hedge the downside risk.

Hedge Funds Are Expensive

These funds make their money through a fixed management fee and performance structure. Most hedge funds charge “2 and 20,” meaning the fixed cost is 2% of assets under management (AUM) and a 20% incentive fee of the total gains.

The management fee is earned by the hedge fund regardless of whether they make money or not for their investors. For example, $1 million invested in a fund results in a $20,000 fixed expense. The performance fee is only earned on profit. So, if the fund has a total return of 20%, the performance fee is 20% of $200,000 or $40,000.

The performance fee adds to the cost but may also motivate a manager to take more significant risks to generate higher profit and fees.

In contrast, most index funds charge only a fraction of total assets. For instance, the popular Vanguard Total Stock Market Index Fund (VTSAX) has a low expense ratio of 0.04%. The low costs and market returns have made it one of the biggest mutual funds.

Hedge Fund Strategies Differ

Dozens to hundreds of hedge fund strategies exist. But generally, they can split into five categories: long/short equity, merger arbitrage, event-driven, global macro, and quantitative.

Long/Short Equity Strategy

Funds in this group take a long position in an undervalued stock but also sell short an overvalued stock in the same industry. In this way, they can limit volatility compared to index funds. This most common strategy relies on computational modeling of valuation trends. The hedge fund can make money in both directions depending on the pair trade. But it is also possible for losses.

Merger Arbitrage Strategy

Merger arbitrage is a more straightforward but popular strategy for fund managers. They will buy mispriced shares during a merger or acquisition. The practice is common; even Warren Buffett has said many pros about the approach.

The strategy works because mergers and acquisitions (M&A) must go through regulatory approval. For this reason, some M&A is not completed. Hence, the target company's share may be trading lower than the acquisition price. Hedge funds bet the deal will close and acquire the target company at a discounted share price. If the deal closes at the initially announced price, they make money.

Event-Driven Strategy

Hedge fund managers can take a long or short position in a company based on an expected future event, like a spin-out, M&A, restructuring, or bankruptcy. In many cases, these special situations may cause a company's stock or bond price to climb or fall. Funds with a position before the event profit.

Global Macro Strategy

Another type of hedge fund may follow a global macro strategy, meaning they look at economic and political trends. They may trade based on opportunities in exchange rates, interest rates, business cycles, trade imbalances, etc. Funds following this strategy can invest in almost any asset class.

Quantitative Strategy

A fifth and popular strategy is quantitative. Hedge funds develop complex algorithms to analyze market trends and find trading opportunities. The system may automatically execute the trade, too, with human oversight. An example of this type of strategy is high-frequency trading.

Pros and Cons Of Hedge Funds

The pros and cons are important to consider when asking what a hedge fund is. As discussed above, most people do not qualify to invest in a hedge fund. But for those that do, the below tradeoffs are worth considering before investing your hard-earned money.

Pros of Hedge Funds

  • Diversification – Hedge funds provide diversification for the wealthy. Placing a small percentage of your total assets in a hedge fund may mitigate stock and bond market risks.
  • Flexibility – Hedge funds have more flexibility than mutual funds. Mutual funds must invest according to their mandate. On the other hand, a hedge fund can invest in almost any asset class. They can also use short selling, leverage, and debt to increase returns.
  • Less Market Volatility – An essential attribute of hedge funds is they often have lower volatility because they hedge their positions. This is often the case in a long/short equity strategy.

Cons of Hedge Funds

  • High Fees – A main con is the high fees compared to index funds. Everyday retail investors seeking to minimize expense ratios may want to stick with index funds. The high costs of hedge funds require them to take more risk for greater returns to justify their fees.
  • Lock-Up Period – Hedge funds usually have a lock-up period between one and five years. This fact means you cannot withdraw your original investment. After the lock-up period, withdrawals are often restricted to specific times.
  • Less Regulation – Hedge funds have less regulation they must follow compared to mutual funds because they are private partnerships. Whether or not a hedge fund must register with the SEC depends partially on the assets under management. The point is they have fewer transparency and disclosure requirements.

The Bottom Line About Hedge Funds

If you are thinking about investing in a hedge fund, knowing the details about them is important. The high costs, minimums, and risks probably do not make sense for the average person. However, for accredited investors, a hedge fund can meet goals like diversification and lower volatility. That said, perform your diligence and understand what a hedge fund is before committing money.

Author: Prakash Kolli

Bio:

Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor and blogger on dividend growth stocks and financial independence. Some of his writings can be found on Seeking Alpha, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, Entrepreneur, FXMag, and leading financial blogs. He also works as a part-time freelance equity analyst with a leading newsletter on dividend stocks. He was recently in the top 1.5% (126 out of over 8,212) of financial bloggers as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.