What Is a Hedge Fund?

A hedge fund investment offers flexibility to generate returns.

Put simply, the definition of a hedge fund is: An investment vehicle that pools investor money to invest in securities or other investments to generate a positive return for the fund’s investors. Although similar to mutual funds, hedge funds are less heavily regulated, allowing them to pursue a wider range of investment strategies. 

Hedge funds are typically structured as limited partnerships. The founders of a fund manage it and serve as the general partners. The investors are limited partners in the partnership. Keep reading to find out the basics of hedge funds, so you can better decide if investing with one is a good option for your portfolio.

How Hedge Funds Work

To hedge an investment means to counter its risk by making an additional investment that would mitigate, or lessen, the loss should the primary investment go awry. In hedge fund investing, the hedge fund manager makes these investments on behalf of the investment pool, similar to how a mutual fund manager makes the investments on behalf of a mutual fund. But due to lighter regulations, a hedge fund manager might use additional investing techniques such as shorting investments and using leverage.

Shorting an investment — a stock, for example — means borrowing it, selling it, and then buying it back at a lower price to earn a profit before repaying the stock to the owner. Leveraging an investment means purchasing it with borrowed money.

Hedge fund managers can employ a variety of investment strategies, but many use some form of long/short strategy in which every long investment — stock purchase — has a corresponding short investment. The investments don’t have to be balanced, and they frequently aren’t. For example, a hedge fund might have a long investment in Apple stock and a smaller, short investment in a computer technology index. If things go as planned, the larger investment will earn substantially more than the corresponding short investment. If the larger investment falters, the profitable short investment will reduce the loss from the corresponding long investment.

Check Out: Top 10 Hedge Funds in the U.S.

Advantages of Hedge Funds

Hedge funds offer a few benefits that investors might find appealing:

  • Hedge funds have the ability to use leverage to increase the possible returns — although this also increases the potential risk.
  • Top hedge funds might allow for additional investor diversification because the investors aren’t limited to investing in securities from the stock market.
  • Hedge funds theoretically have greater profits in rising markets and lower contractions during falling markets, thereby maximizing profits and minimizing losses.

Check Out: You Don’t Have to Have Millions to Invest in a Hedge Fund, Thanks to This Founder

Disadvantages of Hedge Funds

Before you commit to investing in a hedge fund, understand the drawbacks:

  • One of the most-cited disadvantages of hedge funds is the high fee structure. Most hedge funds charge a 1 to 2 percent fee on assets regardless of the fund’s performance, plus an additional 20 percent fee on the fund’s earnings. These fees reduce the investors’ overall returns.
  • Most hedge funds are structured with an initial lock-up period that restricts investors from selling, or redeeming, their positions. Many hedge funds also have monthly, quarterly or annual liquidity windows in subsequent years. The money is locked up the rest of the time.
  • Hedge funds are only available to accredited investors. An accredited investor is defined by the Securities and Exchange Commission as a person with earned income that exceeds $200,000 — $300,000 for married couples — per year in each of the previous two years, or someone with a net worth of over $1 million, not counting his primary residence.

Also See: 6 Best Long-Term Investments

Hedge funds are best suited for wealthy investors seeking additional diversification or higher returns. Hedge funds are a poor match for investors looking for liquidity and transparency.