Hedge Fund
What is Hedge Fund?
A hedge fund is a private investment fund, open only to institutions and wealthy investors, that can borrow, sell short and trade derivatives freely.
Because a hedge fund is sold privately to investors the law treats as able to fend for themselves, it escapes many restrictions placed on funds marketed to the general public. It can borrow to enlarge its positions, sell short to profit when a price falls, concentrate in a few bets and trade derivatives, all of which widen the range of possible gains and losses. Strategies vary enormously, from paired long and short stock positions to macro bets on currencies and interest rates to fully automated quantitative trading. Managers usually charge a fee on assets plus a share of gains. Unlike a mutual fund, a hedge fund normally locks investors in for a period, limits when money can be withdrawn, and discloses far less about what it holds.
Hedge Fund: a worked example
Suppose a fund charges 2 percent of assets a year plus 20 percent of gains, and an investor commits $1,000,000. Over the year the holdings gain 10 percent, which is $100,000. The management fee is 0.02 × $1,000,000 = $20,000 and the performance fee is 0.20 × $100,000 = $20,000, so $40,000 of the $100,000 goes to the manager and the investor keeps $60,000. Had the holdings lost 10 percent instead, the investor would be down $100,000 and would still owe the $20,000 management fee, because that fee is charged on assets whatever the result.
The mistake students make with hedge fund
The name misleads students into reading a hedge fund as a cautious, hedged, low-risk investment. Hedging is one strategy among many, and plenty of funds run concentrated positions funded with borrowed money. The label describes the legal structure and who is allowed in, not the level of caution. Hedge funds are also not mutual funds; they are private, restricted and far less transparent.
Hedge Fund questions
What is the difference between a hedge fund and a mutual fund?
A mutual fund is sold to the general public, must publish its holdings, faces limits on borrowing and short selling and lets investors redeem shares each business day, while a hedge fund is sold privately, discloses little, can borrow and sell short freely and can restrict withdrawals. The investor base is the root of the difference. Selling to ordinary savers brings the heavier rulebook.
Who can invest in a hedge fund?
Hedge funds are generally limited to institutions such as pension funds and endowments plus individuals who meet regulatory wealth or income thresholds, often called accredited or qualified investors. Minimum investments are large. The funds are not sold to the general public, which is what keeps them outside the rules written for public funds.
Why are hedge funds less regulated than mutual funds?
Hedge funds face lighter rules because securities law aims its strongest protections at products offered to ordinary savers, and hedge funds are offered privately to a limited number of sophisticated investors instead. The trade-off is strict limits on how and to whom they may be marketed. They still fall under anti-fraud law and, above a certain size, registration and reporting requirements.
Formula / Example
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