What is a Hedge Fund?

When you’re are looking for ways to invest your money, it’s important to explore all of the options that are available to you. Traditionally, most people default to investing in stocks and bonds, but those aren’t the only means by which you can invest.

But exactly what is a Hedge Fund? Simply put, it’s an investment partnership that is coordinated and managed by an individual (hedge fund manager). Hedge Funds are sometimes classed as Limited Liability Companies or Limited Partnerships in order to legally protect the investors involved in the fund. If the company goes bankrupt, creditors could potentially go after the investors for even more money than they’re put into the fund, but with these protective measures in place, they’re safe.

Hedge Funds are namely for people who are incredibly wealthy, because the initial investment usually has a high minimum, and the partnership is only open to a select number of investors. Investments in hedge funds are illiquid, which means that they can’t be easily sold or exchanged for cash without incurring a significant loss in value. Also, due to the exclusive nature of hedge fund investment, individuals looking to sell their hedge fund assets are open to a limited pool of buyers. Hedge fund investors are usually required to keep their money in the fund for a minimum of one year.

Individuals who are interested in investing in hedge funds are required to be “accredited” in accordance with US laws. Accredited investors earn a minimum annual income, have sophisticated knowledge of investing practices, and a net worth in excess of $1 million.

How Do Hedge Funds Work?

The easiest way to illustrate how hedge funds work is with a fictional example.

Suppose Harry is the manager of Smith Investments, LLC. Stuart is a wealthy entrepreneur who’s looking to invest $100 million, and happens upon Smith Investments, LLC. He signs an agreement that states that there will be a 5% “hurdle rate,” which is the minimum rate of return on his investment, after which the profits of his investment will be split between them 60-30 (Harry, of course, gets the 30).

As the hedge fund manager, Harry is then entrusted to invest the money however he sees fit, whether that’s in art, collectibles, real estate, mutual funds, stocks, bonds, startup companies, or anything else of value. Hedge funds, by nature, are aggressively managed, and there is always an incentive to yield the highest returns possible. For this reason, hedge fund managers employ a variety of investment strategies, such as leveraged, long, short, and derivative positions in markets both domestic and international. Ultimately, the more money that Harry makes for Stuart, the bigger the cut that Harry gets to keep.

Now let’s imagine that Harry’s investment strategies yield a $50 million return. As per the operating agreement, the $50 million gain would be reduced by the $5 million “hurdle rate,” and the remaining $45 million would be split 60-30. Harry would end up with $13.5 million, and Stuart would have $36.5 million, the combination of the $5 million “hurdle rate” and 60% of the remaining $45 million ($31.5 million).

Check back with us next week, when we’ll compare hedge funds and mutual funds in order to outline how they differ!