What Is a Hedge Fund?

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A hedge fund is an exotic mutual fund marketed to wealthy individuals and corporations for the express purpose of earning a profit in any market environment. Hedge funds are largely unregulated, and are allowed to employ trading methods like short selling and other strategies unavailable to mainstream mutual fund managers. Hedge fund managers charge a performance fee based on the annual results of the fund, in addition to the management fees charged by every mutual fund.

History

The first hedge fund was started by Alfred W. Jones in 1949. He attempted to offset the risks of buying stock by selling short the shares of the stocks he determined would drop in value if the stocks he purchased appreciated. He also increased the leverage of his portfolio. Leverage and short selling are hallmarks of the modern hedge fund. Jones is also credited with pioneering the hedge fund fee schedule. He set his hedge fund up as a limited partnership to avoid the requirements of the Investment Company Act of 1940 and he charged the fundholders a twenty percent performance fee on the annual profitability of the fund. If the fund didn't make a profit, Jones received no compensation. Modern hedge funds still limit the number of investors in the fund for the same reason. By limiting the number of investors, they avoid many of the regulations that typical mutual funds must abide by. Additionally, today's hedge funds use a compensation scheme similar to Jones' performance-based fees, but they've added fixed management fees to the total fees. The most common fee structure in today's hedge funds is known as "2 & 20"; a 2 percent management fee and a 20 percent performance fee.

Function

A hedge fund is designed to provide fundholders a profit, no matter the market. If the fund manager deems real estate to be a better investment than stock, the manager will buy real estate. If the market is dropping the manager will sell short to take advantage of the downward move. No investment is too exotic for a hedge fund, whether it is a complicated financial derivative or a Honus Wagner baseball card.

Size

The overall hedge fund market is estimated to total one and a half trillion dollars. This figure fluctuates more chaotically than that of the broader mutual fund market due to the spectacular rises and falls of hedge funds.

Considerations

Hedge funds are only for wealthy investors and corporations. Most hedge funds have a minimum initial investment of $1 million or more. What regulations do exist in the hedge fund market limit the total number of investors allowed in a fund and establish minimum net worth requirements for those investors. The typical net worth requirement for a hedge fund investor is a minimum of $5 million.

Warning

Hedge funds are not always liquid investments. When a hedge fund is performing poorly or is plagued by many redemption requests, the fund manager may discontinue redemptions for a time, in essence locking investors into the fund.

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