What is a Hedge Fund – A Definition

A hedge fund is a largely unregulated private investment fund that uses any available investing strategies to increase returns. It is common for the fund managers to have leveraged long and short positions in both domestic and foreign markets. The theory is that the freedom allows hedge funds to have a positive return when the market is up, down or even sideways.

History

The name for hedge funds came about when Alfred W. Jones realized that asset prices are tied to the performance of the overall market. With this discovery, he attempted to short assets that he expected to fall while buying assets he expected to rise. This negated the effect of the overall market performance and since this effected hedged his risks, it became known as a hedge fund.

In the modern age however, hedge fund managers’ primary goal is to maximize returns. Therefore it is often argued that hedge funds actually carry more risk than other types of funds even though the name has stayed with the industry.

Regulations and Requirements

Hedge funds have much fewer restrictions than mutual funds. For example, hedge funds do not need to disclose all its investments to investors while mutual funds do. However, there is one requirement that investors of hedge fund must meet that mutual fund investors do not – that investors need to be considered “accredited investor”.

The definition of varies depending on who you ask, but the federal securities law define an accredited investor as an individual with a net worth of at least $1 million as well as having $200,000 in income for the past two years with the reasonable expectation of the same (or higher) income in the current year.

Bluntly speaking, hedge funds are only traditionally available to the rich and the super rich.

Fees

Hedge funds usually charge very high fees. A common fee jargon is “2 and 20”, which means that the hedge fund will charge a 2% management fee (based on the assets you have invested with them) and a 20% performance fee (based on the returns the fund generates). Even though you might think that this is high, other funds are known to charge as high as a 5% management fee and 50% performance fee!

While the fees are extremely high, the lure for investors to these funds are the higher returns that the fund can produce. The thinking goes something like this. If someone can make me $100, giving away $50 (leaving me with $50) is better than someone making me only $20.

Some funds also charge a withdrawal (or sometimes called redemption) fee if you take money out of the fund. The common argument is that it keeps the funds more stable and allow the fund managers to deploy long term strategies.

There are times when hedge funds will even disallow withdrawals (usually at times when the fund’s performance is extremely badly). This keeps the funds from needing to liquidate investments when asset prices are usually very low, which further hurts returns. In reality, the reason to stop withdrawals are that too many redemption in times of fear might wipe out the fund completely.

What Does All This Mean for Us

Only a handful will meet the requirements of investing in a hedge fund, so many can become jealous when good hedge fund performance hit the news. However, considering that most hedge funds actually under perform the market, many people who qualify actually will be better just buying into an index fund anyway. In addition, the high fees coupled with the lack of transparency of these funds make it almost impossible to determine which funds have the strategies to beat the market on a consistent basis. Therefore, I’m not alone in thinking that there is no need to envy the people who can invest in hedge funds.

Further Reading

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