What is a hedge fund?

What is a hedge fund?

Find out what hedge funds are and how they work with this beginner-friendly, jargon-free guide.
0/5 Star rating
Beginner
8 min read
Written by: Max Adams
January 29, 2021
Updated: January 29, 2021

Hedge funds are a major feature of our modern financial landscape. The name conjures up images of people in vastly expensive suits making huge trades and being paid a fortune – but what exactly are hedge funds, and how do they work?

Like with most financial topics, the answer to this is easier than hedge fund managers like to pretend it is. This guide will take you through the basics of how hedge funds make their money, and look at a few key examples.

I. How do hedge funds work?

Hedge funds work by pooling a large amount of money from different investors and using this to place large trades in the financial markets. The pool of money (the fund) is placed in the hands of a specified hedge fund manager who decides how to invest it. 

The aim is to make money and increase the value of the fund, therefore generating profits for the people who have invested in the hedge fund.

To ensure people know how their money will be invested and can determine what return they’re likely to see, each hedge fund will have an operating agreement. This will specify what the fund’s investment strategy will be, and also describe how any profits will be distributed among investors in the fund.

Why the word ‘hedge’?

The ‘hedge’ part of the term ‘hedge fund’ refers to how these organisations mitigate risk when investing. To hedge an investment is to bet on both sides of it, so if you’re wrong you don’t lose as much money.

Early hedge funds adopted a strategy of going both long and short on investments, thereby seeking to make profits whether the markets moved up or down. Although not all of them operate like this anymore, the name ‘hedge fund’ has stuck over time.

II. How do hedge funds make money?

Hedge funds make money by charging fees to people who are invested in the fund. Typically these will come in two different varieties: a management fee and a performance fee. These fees are often structured in a ‘2-and-20’ fashion explained below:

  • Management fee. This is the fee that investors have to pay simply for being invested in the fund. Typically a management fee will be in the region of 2% of the value of the assets managed by the hedge fund.
  • Performance fee. To motivate hedge funds to make money for their investors, they also collect a percentage of any profits realised by the fund. This fee is often in the region of 20% of the profit made.

Hedge funds are widely known for undertaking risky and highly-leveraged trades in the pursuit of making huge profits. Because of the amount of money they control (often in the multiple billions of dollars) they have the influence to make trades that impact the whole of the stock market.

And what about the investors?

Hedge fund investors make money if the fund performs well and generates profits. As with any investment, the people invested in the fund are looking for its value to rise over time. Hedge fund investors provide the capital for the fund to trade, and share in the profits (or losses) as the hedge fund manager makes trades.

III. Who can invest in a hedge fund?

Only ‘accredited investors’ with a lot of money can invest in hedge funds. 

Individual investors are usually required to have an income of at least $200,000 a year, or wealth of over $1million in order to invest in a hedge fund. Institutions typically need to have a net worth of at least $5million and be run by someone the Securities Exchange Comission recognises as a ‘sophisticated investor.’

It’s an exclusive club.

IV. What is a hedge fund manager?

A hedge fund manager is a person who makes the decisions about how to invest the fund’s money. The success of a hedge fund will often depend in large part on the skill of its fund manager and their ability to navigate the financial markets.

What salary do hedge fund managers make?

This depends in large part on the value and reputation of the hedge fund they’re managing, but typically hedge fund managers command £300,000+ in terms of salary, and possibly a slice of the fund’s profits on top of that if they’re also a partner in the company.

V. How are hedge funds different from mutual funds?

Hedge funds are private investments, whereas mutual funds are publicly traded. This is the essential difference between the two.

On the face of things, it can seem like hedge funds and mutual funds do similar things: both pool investors’ money and place this in the hands of a fund manager to invest in the markets. But hedge funds manage a lot more money, are only open to high net worth investors, and operate with a lot more secrecy.

Anyone can buy or sell a stake in a mutual fund on an exchange, and as such they are strongly regulated by relevant financial bodies. Hedge funds are not available for public trading and do not have as much oversight from regulators.

VI. Are hedge funds regulated?

Not much, no. Regulatory bodies such as the SEC don’t look too closely at hedge funds because they’re recognised as being private operations that handle money for people who are qualified to trade in the financial markets.

This is a constant source of controversy in the financial world – particularly after the 2007-08 financial crisis, which was brought about in part by hedge funds making huge investments in financial products they didn’t fully understand.

VII. Examples of hedge funds

There are thousands of hedge funds in the world, each one with its own investing strategy. Some focus exclusively on long positions (investing only in stocks they think will rise in value over time), whereas others are more open to shorting the markets (trying to make profits by predicting which companies will fall in value). 

There are also so-called ‘activist’ hedge funds which look to make large enough investments to make management decisions in the companies whose shares they buy.

Here are just a few examples of notable hedge funds operating today:

Bridgewater Associates

Originally founded in 1975 by Ray Dalio, Bridgewater Associates is the largest hedge fund in the world, with over $150billion of assets under management as of January 2021. 

Today it is headquartered in Westport, Connecticut, and is well known for being an early pioneer of the ‘risk parity’ approach to investing – using market volatility as a key indicator in how to ensure investments are not overly risky.

Melvin Capital Management

Melvin Capital became a household name in January 2021 as the ‘GameStop hedge fund.’ The firm adopted a huge short position on GME shares, only to be plunged into financial difficulty as retail investors sent the GameStop stock price skyrocketing.

This represented probably the most attention the general public has ever paid attention to a single hedge fund, and it was all inspired by the Reddit community r/WallStreetBets. Similar short positions on stocks such as AMC and BB were later targeted as something of a ‘retail investor revolution’ emerged online with many major shorts being squeezed.

Renaissance Technologies

Renaissance Technologies is a hedge fund that takes a mathematical approach to investing money. Founded by Cold War codebreaker James Simons in 1982, Renaissance Technologies is most famous for its ‘Medallion Fund,’ one of the most high-achieving and secretive funds anywhere in the world.

The computational and quantitative approach taken by Renaissance Technologies makes it one of the most advanced hedge funds in history – if not the most – and today it has over $110billion in assets under management.

Related courses

Before you find out what a gamma squeeze is, you may wish to learn about the difference between short selling (shorting) and going long. If you have any further queries about how to invest in stocks and how the stock market works, our introductory courses provide great…