A hedge fund is an investment vehicle in which investors pool their money and purchase certain investments. Hedge funds aim to bring investors greater returns than they get in the stock market, or even with other types of funds. The name came from the fact that investments were often chosen as a “hedge,” or protection, against declining markets. A hedge fund can invest in just about anything, including short positions, junk bonds, real estate and private equity.

Unlike other investments, hedge funds are restricted to accredited investors. Keep reading to learn more.

Hedge Funds Explained

Hedge funds are private investment funds with a reputation for using high-risk tactics such as leveraging and short-selling the market to make money. Compared to other types of investments, hedge funds are lightly regulated by the federal government, particularly in terms of what they are required to disclose to the Securities and Exchange Commission.

Composition

Hedge funds are comprised of a hedge fund manager and investors. The manager decides how to invest the investors’ capital. With this level of responsibility, the manager should be qualified to manage money and not have a disciplinary record with the SEC.

Structure

There are several organizational structures for hedge funds, including the following:

• Fund of funds: Invests in other mutual funds or hedge funds

• Master feeder fund: Combined hedge fund structure in which offshore and domestic funds form a single offshore master fund.

• Parallel fund: Side-by-side fund with a U.S. fund and a domestic fund that parallel each other in trading and have separate investment portfolios

Requirements

Not everyone can invest in hedge funds. Because certain hedge funds are under no legal obligation to register with the SEC, investors must meet certain income and net worth requirements to be considered accredited investors. Here are some of the criteria:

• Income: Accredited investors can be individuals or institutions. Individual investors must have an earned income greater than $200,000 per year in each of the prior two years — or a $300,000 combined earned income for couples — and reasonably expect to earn the same for the current year. Or, they must have a net worth of over $1 million either alone or together with a spouse, not including their primary residence.

• Net worth: To calculate your net worth, add up the value of your assets and subtract your total liabilities. Do not include the value of your primary residence or mortgages/loans on your primary residence. If your mortgage is greater than the property’s market value, the portion of the loan exceeding market value can be considered a liability.

• Entity/Institution: Entities and trusts must have assets worth at least $5 million and be managed by a financially sophisticated person as determined by the SEC. Any entity comprised of accredited investors also qualifies.

Registration

The Dodd-Frank Wall Street Reform and Consumer Protection Act places certain restrictions on hedge funds. Under this law, these two groups must be registered in their states:

• Private investment funds with more than $150 million in assets

• Other funds with assets totaling between $25 and $150 million

Strategies

Like most funds, hedge funds use different investment strategies to grow wealth. Common strategies include the following:

• Arbitrage: Relies on leveraging the purchase and sale of closely-related investments

• Credit funds: Takes advantage of economic downturns and lending inefficiencies to invest in items such as distressed debt, government and corporate bonds, convertible notes and capital notes

• Event driven: Looks for investment opportunities in corporate mergers, takeovers and bankruptcies

• Global macro: Tries to predict movement in various countries’ economies and then use this analysis to invest in equity, debt, commodities, futures, currencies, real estate and other assets

• Long/short equity: Takes long and short positions on the market when making investment decisions

• Quantitative: Relies on tech-driven algorithms to reach investment objectives

Fees

Hedge funds typically use a 2-and-20 fee structure. Under this structure, the fund receives an annual management fee equal to 2% of the assets under management in addition to a performance or incentive fee equaling 20% of the profits. Investors get the remaining profit. These fees are typically higher than at a mutual fund.

Liquidity

Hedge funds might not be as liquid as other investments because of restrictions that limit your ability to redeem shares to a few times per year — or even up to a year or more.

Risk

Hedge funds tend to take on more risk than other investment vehicles, although the level of risk depends on two main factors:

• Investment strategy: Using speculative investment strategies like leveraging is very risky

• Allocation of assets: Futures and derivatives are riskier than other types of assets

Strategies with the greatest risk include investing in emerging and global markets. Arbitrage and market-neutral investments tend to carry a lower level of risk.

Types of Hedge Funds

Hedge funds are typically established in the form of investing strategy and style. Here are some of the common types of hedge funds based on what they are buying:

• Convertible arbitrage: Taking a long position, or buying, a convertible security while simultaneously taking a short position, or selling, the same company’s common stock

• Distressed securities: Buying stock in companies dealing with potential bankruptcy and other forms of distress

• Emerging markets: Buying securities in countries with emerging economies

• Event-driven investing: Buying securities based on events such as company mergers

• Fixed-income arbitrage: Buying and selling securities in the fixed income market

• Fund of hedge funds: A pooled fund that invests in other funds

• Macro: Purchasing stocks, bonds, currencies and commodities on the global market

• Market neutral: Buying securities that are independent of overall market performance

• Merger arbitrage: Buying stocks of two merging companies

How Do Hedge Funds Make Money?

First, a hedge fund must raise money from investors. It then uses this money to purchase securities and other vehicles. In exchange for capital, investors receive equity in the hedge fund. Some investors are also partial owners of the fund. The funds themselves make money by charging fees and taking a share of any profits.

Example of a Hedge Fund Profit

Say a hedge fund’s assets doubled from $100 million to $200 million in a single year. Here’s one way the money may be distributed:

• 2% of the total assets stay with the fund: $4 million

• 3% of the profit goes to the investor: $3 million

• 20% to 25% of the remaining profit is split by the investor and the manager: $19.4 million to $24.25 million

• 75% to 80% goes to the investor: $72.75 million to $77.6 million

How Hedge Funds Differ From Other Investments

Investors looking to hedge funds to diversify their portfolios might also be considering private equity or mutual funds. Before you invest in any of them, there are some key differences to understand.

Hedge Funds vs. Private Equity Funds

Although hedge funds and private equity funds both appeal to high-net-worth individuals, there are some important distinctions between them.

• Time horizon: Hedge funds look for short-term returns. Private equity funds look for longer-term returns.

• Capital investment: Hedge fund investors contribute all of their capital at once. Private equity fund investors provide capital as required.

• Legal structure: Hedge fund investments are open-ended and might have no restriction on the ability to transfer money. Private equity fund investments are typically close-ended, meaning they may have restrictions on transferability.

• Fee structure: Hedge fund investors have different fee structures than private equity funds based on items such as net asset value and performance. Individual funds might have different fee structures, so it’s best to research these before committing your money.

• Risk level: Because of investment strategies that might focus on leverage, futures and short-selling, hedge funds tend to be riskier than private equity funds.

Hedge Funds vs. Mutual Funds

Both hedge funds and mutual funds are pooled investments, but how they work differs.

• SEC registration: Mutual funds are registered with the SEC and can be sold to anyone. Most hedge funds are not registered with the SEC and can only be sold to accredited investors.

• Investment control: Hedge fund managers have greater control over the fund’s investment strategies than mutual fund managers.

• Management investment: Hedge fund managers typically invest some of their own money to earn the trust of other investors. Mutual fund managers don’t have this expectation.

• Liquidity: Mutual funds tend to be more liquid than hedge funds, which might be subject to lockup periods.

Are Hedge Funds Good Investments?

The first thing to know if you’re considering a hedge fund is whether you can afford to lose your money. Hedge fund investments are inherently risky and low-liquidity.

You need to be prepared to keep your money tied up for an indefinite amount of time. There’s also the possibility of losing most or all of your investment. On the flip side, you have the opportunity to enjoy higher returns than you would with other investment vehicles.

If you still think a hedge fund is for you, do your homework and consult a financial advisor. Read the prospectus, understand the risks and be fully aware of the fees you’ll be charged.

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