What is a Hedge Fund?
A hedge fund is an aggressively managed investment fund that is typically open to a limited range of high net-worth investors who are required to pay a performance fee the fund’s investment professional team or investment manager.
A hedge fund is a term used to describe an investment partnership that is professionally run and managed by a licensed money manager. The fund may take the legal responsibility and structure of a limited liability company or a limited partnership so that if the hedge fund goes insolvent, the creditors attached to the fund cannot seek more money from the investors than what was originally put into the fund.
Hedge Fund Strategies:
Every hedge fund possesses its own investment strategy that will determine the investment approach the fund undertakes. As a general class, hedge funds will institute a strategy to incorporate a wide range of investments and trading activities when compared to traditional long-only investment funds. The wide range of investments is meant to mitigate risk through the adoption of “hedging” techniques. A typical hedge fund will invest in a broad range of assets including long and short positions, bonds, commodities, and currencies. Additionally, to institute a “hedge” the funds will also incorporate complex strategies that include exotic derivatives.
Hedge funds typically pool millions or billions of investment dollars and the gross assets of the underlying fund will typically be higher due to leverage. As a result, hedge funds dominate certain specialty markets such as the derivatives sector through the institution of high-yield investment instruments and distressed debt.
Although hedge funds develop and maintain a specific strategy, there are four predominant strategies (global macro, event-driven, relative value, and directional) by typical hedge funds. The particular investment strategy will shape the fund’s risk and return characteristics. The most common strategy instituted by a hedge fund is the “long/short” strategy, where the fund will take both long and short positions in equity shares traded on major exchanges.
Who Invests in Hedge Funds?
In the majority of jurisdictions in the United States, hedge funds are open to a limited pool of investors. Typically, the investors are comprised of wealthy professionals who meet the criteria established by the regulators of the funds. Upon meeting the regulations (primarily a minimum investment) the investors are accordingly exempted from the regulations that commonly govern ordinary investment funds.
Fees Associated with Hedge Funds:
Hedge fund managers will receive either a performance fee (or an incentive fee) along with a management fee. A typical hedge fund manager will charge a “2 and “20 fee, which refers to a management fee of 2% (taken from the fund’s net asset value each year) and a performance fee of 20% (which is charged based on the fund’s profit).
As is common with other forms of investment funds, the management fee of a hedge fund is calculated as a percentage of the fund’s net ass value. The management fees tied into a hedge fund are typically expressed as an annual percentage; however, they are most commonly calculated and paid out per month or quarter.
The management fees associated with a hedge fund is meant to cover the manager’s operating costs, while the performance fees are used to pay out employee bonuses.
Performance fees are a defining characteristic of a hedge fund. The manager’s performance fee is calculated based on a percentage of the fund’s profits, typically counting both unrealized and realized profits. By awarding the manager additional funds for the performance of the fund, performance fees intend to alight the interests of both the investor and the manager of the fund.