A hedge fund is basically an alternative investment that pools money from investors to invest in various assets. Hedge funds are operated by a professional money manager with certain goals like minimizing risk and maximizing returns. The funds are basically accessible only to accredited investors. What are hedge funds and how do they work? How do hedge funds make money?
What are hedge funds?
Hedge funds pool money from clients and invest it in stocks or other types of investments to generate higher returns. Hedge funds are usually only open to accredited investors due to the high investment risk involved and higher fees. The funds can invest in anything from foreign exchange to real estate and other alternative assets. This is one of the ways that hedge funds vary from mutual funds, which usually only invest in stocks or bonds.
There are a few notable benefits of hedge funds.
- Hedge funds have a variety of investment strategies that can generate profits in both falling and rising equity and bond markets.
- Hedge funds can add diversification to a portfolio and reduce risk.
- The fund is managed by the world’s top investment managers.
- Balanced portfolios reduce the overall risk and volatility.
Hedge funds face fewer regulations from the SEC than other investment vehicles. However, hedge funds have a few disadvantages.
- The fund depends on the fund manager’s investment decisions.
- Hedge funds are only accessible to rich or accredited investors who can withstand huge losses from the fund’s risky trading strategies.
- Hedge funds usually have a lower level of liquidity compared to mutual funds. Your funds might be blocked for a few years.
- The cost of hedge fund investing is higher compared to mutual funds.
- Hedge funds are exposed to potentially huge losses due to concentrated investment strategies.
How do hedge funds make money?
Hedge funds earn money by charging a performance fee and a management fee. Although the charges differ between funds, the common fee structure is known as “2 and 20.” The hedge fund manager would receive 2 percent of the assets under management and a 20 percent cut of generated profits every year.
For example, a hedge fund has $100 million assets under management and charges standard 2 and 20 fees and generates 10 percent annual returns. The hedge fund will earn about $4 million in annual fees, $2 million as a management fee, and $2 million as a performance fee. However, the structure is widely criticized. The hedge fund manager earns a high amount even if the fund loses money that year.
How do hedge funds work?
A hedge fund is often a limited liability company (LLC) or a limited partnership (LP). A hedge fund manager raises money and invests the funds in equities and various other securities that match up with the fund’s objectives. There are hedge funds that engage in private equity, trade junk bonds, or that specialize in "long-only" equities or real estate.
Renaissance Technologies, Bridgewater Associates, and Pershing Square are among the largest hedge funds in the U.S.