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Hedging Your Bet? Everything You Need To Know About Hedge Funds

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.

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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.

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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:

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    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:

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    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:

    Strategies

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

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    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:

    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.

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    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:

    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.

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    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.

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    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.

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    Hedge Funds vs. Mutual Funds

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

    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.

    This article is part of GOBankingRates’ ‘Economy Explained’ series to help readers navigate the complexities of our financial system.

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    Last updated: Aug. 25, 2021

    This article has been updated with additional reporting since its original publication.