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What Is a Hedge Fund?

Open the Wall Street Journal or log into bloomberg.com and it won’t be long before you come across an article about hedge funds. If you’re not an experienced investor or you don’t work in the finance industry, the term may go right over your head or get mixed up with other terms like private equity and venture capital. Investing lingo can be difficult to grasp, but here’s what you need to know to understand hedge funds. Whether you’re a newbie or a seasoned trader a financial advisor can provide customized insight into how best to reach your goals.

How Hedge Funds Work

A hedge fund is a pooled investment vehicle that uses a wide range of investing techniques to generate astronomical rates of return. Hedge funds are usually limited liability companies or limited partnerships.

They can work with many different kinds of assets, including stocks, bonds, futures, options, real estate, commodities, currencies and a wide variety of derivatives such as delta neutral investing and collaterized debt obligations. Normally, they’re used by institutions and high-net-worth individuals.

The minimum balance is far greater than an average retail investor can afford. A million dollars is not unusual. Sometimes the entry fee is far greater, and it’s not unheard of for hedge funds to even reject applicants who have a fortune to invest.

Once investors (or limited partners) add their money to a hedge fund, the manager picks the strategy that he or she thinks will yield the most money. Besides the broad array of securities that hedge fund managers can invest in, they have far more discretion of where to put their clients money, including what percentage of a portfolio can be in cash, than other fund managers.

The government agency responsible for overseeing the investment market in the U.S., the Securities and Exchange Commission, does not regulate hedge funds in any capacity. In other words, prospective clients should take special precaution to ensure that they fully understand and feel comfortable with a fund’s managers and investment strategy before coughing up any cash.

Types of Hedge Funds

There are many different kinds of hedge funds and each one uses a unique investment strategy. Here are a few popular hedge fund classes:

Long-Short Funds

A long-short equity position is a strategy that involves investing in stocks but it mirrors similar practices used often by options and futures traders.

In this trading scheme the investor takes a combination of long and short positions in a single portfolio. They take long positions (buying shares to profit off price gains) in stocks that they believe are undervalued and poised for growth. They take short positions (borrowing shares to sell and profit off price decreases) in stocks they believe are overvalued and poised to decline.

Market-Neutral Funds

Market-neutral funds are a type of long-short fund. What distinguishes this type of fund from others is that market-neutral fund managers seek to protect their portfolios from the rise and fall of prices in the general market. Your strategy would be to either invest in an equal number of securities in long and short positions or take steps to bring your relative risk level closer to zero.

While traditional funds — such as mutual funds and — strive to generate income for investors or profit from capital appreciation, the goal of market neutral funds is more singular: to stay neutral in the face of market volatility.

Event-Driven Funds

With event-driven funds, you’re trying to profit off of specific events that could affect the whole market. For instance, if you think that the price of a security will rise following a major earthquake, you might decide to buy into a stock and sell it later on. You could use the same strategy if there’s political instability or economic turmoil that leads to mergers and company buyouts.

A free, easy-to-use inflation calculator can give you a quick read on how much buying power you money will have in 10, 20 or 30 years from now.

Hedge Fund Fees

Hedge fund fee schedules ordinarily include two distinct charges: a management fee and an incentive fee.

Management fees are applied to the entirety of your assets under management (AUM), and they generally reside around a 2% annual rate. While this might seem tolerable, incentive fees can be much more significant at 10% to 20%. These are not necessarily consistent charges, though, as they are only added on if your portfolio generates profits. So if your portfolio sees a 10% return, and the incentive fee is 15%, you’ll receive an 8.5% net return.

Pros and Cons of Hedge Fund Investing

What Is a Hedge Fund

Many hedge funds use leverage when conducting trades, which means that they make investments using borrowed money. What’s appealing about this move is that it has the potential to leave investors with higher rates of return. The absence of SEC oversight is another appealing feature of hedge funds because of the flexibility it affords managers.

Try out our free asset allocation calculator.

Using leverage has the potential to create huge returns. But if a leveraged investment doesn’t perform well, the fund (and its investors) could face enormous losses. Hedge funds are also less liquid than mutual funds, meaning that your money could be locked up in the fund for a longer period of time that it would be in a mutual fund or exchanged-traded fund.

The Takeaway

What Is a Hedge Fund?

Think of a hedge fund as a mutual or an exchange-traded fund on steroids. It can seriously, suddenly supercharge your portfolio’s performance, but it can also do it serious damage. Part of the reason for that is that manager discretion is virtually unlimited, whether in terms of industries, global regions or securities traded. In other words, hedge funds are not for everyone. Even for people who are accredited investors it would be wise to keep a significant portion of their portfolio in investments that are less risky than hedge funds.

Tips on Investing

  • Consider talking to a financial advisor about how to best handle your financial assets. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect with professional advisors in your local area. It takes just a few minutes to get your personalized recommendations online. If you’re ready, get started now.
  • One of the quickest ways to get a good estimate of how your investments will grow is to take advantage of a free, easy to use investment calculator.

Photo credit: ©iStock.com/LdF, ©iStock.com/Newbird, ©iStock.com/Astrid Gast

Amelia Xu Amelia Xu has a degree in Economics from Princeton University. She is an expert in investing and taxes. Amelia is a Long Island native.
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