What Are Hedge Funds?

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Hedge funds can be defined as investment funds pooling the funds of high net worth individuals, institutions, and other sophisticated investors to invest with the intention of maximizing returns. Hedge funds are usually structured as private partnerships and therefore are not publicly offered. They are also less regulated than mutual funds. The word "hedge fund" was derived from the word "hedging" or "sheltering" investment to lower risk, yet the overwhelming majority of hedge funds undertake great risk in their pursuit.

Hedge funds are usually structured as limited partnerships or limited liability companies, with the managers as general partners and the investors as limited partners. This enables the managers to have the authority to make investment decisions and to limit the investors' liability to the value of their investment. Investment in a hedge fund usually requires that individuals satisfy strict requirements, such as having a high net worth or high income. For example, in the United States, investors need to be accredited. In other words, they must possess a minimum net worth of $1 million, excluding their primary residence, or have a minimum annual income of $200,000 for the last two years, if single, or $300,000, if married. Such rules ensure that only individuals with the ability to comfortably take significant financial risks can invest in hedge funds.

Managers of hedge funds have tremendous freedom to invest the fund's capital. Whereas mutual funds are tightly controlled and typically limited to stocks or bonds, hedge funds can invest in almost anything: stocks, bonds, goods, commodities, real estate, financial contracts, and private companies. Hedge funds are given so much freedom to use a broad array of plans in an effort to generate gains, whether the markets are good or bad. Some hedge funds attempt to profit from betting on the rise or fall of a given investment, and other hedge funds attempt to profit from differences in prices across similar investments. More often than not, it is for the intention of realizing positive gains regardless of the markets' nature, and not of continually beating an index that has been set as a standard, something common to do with mutual funds. One technique that has been sought after by hedge funds is hedging, or reducing the risk of loss.

For example, a hedge fund could buy up stock in a corporation that it predicts will increase in worth while at the same time betting that the overall market will decline, protecting the fund in case it makes a wrong guess regarding the company. Not every hedge fund uses hedging tactics, however, and some take quite a risk in the hopes of greater gain. A couple of other plans include long/short equity, where the fund purchases the stocks it believes will rise and short sells the stocks it believes will fall, and global macro, where the fund places bets on widespread economic trends such as interest rate or money value changes. Hedge funds are generally known for charging expensive fees, which are typically far greater than the fees charged by mutual funds. The most common fee structure is the "2 and 20," whereby the fund charges an annual management fee of 2% of assets under management, as well as a performance fee of 20% on profits.

If, let’s say, a hedge fund has $100 million and earns 10% return, it would be paying a $2 million management fee and an additional $2 million performance fee, if the whole return was profit. These fees reward the managers for their work and are designed to align the interests of the managers with those of the investors, but the critics say that the fees are too high, especially when the fund does not do well (since the management fee is always charged, regardless of performance). Hedge funds will make use of borrowing and take out loans to invest larger amounts. With borrowing, the hedge fund can boost its return, but it is also putting itself at risk for greater amounts of potential loss.

Most hedge funds have restrictions on when the investors are allowed to withdraw money, referred to as a lock-up period. Throughout this time, which can range from several months to years, the investors are not allowed to cash out money from the fund even if the fund is performing poorly. After the lock-up period is over, the investors are generally allowed to withdraw their funds only after specific periods, say quarterly or yearly, and even then they are generally required to give notice in advance. All these restrictions allow the fund managers to gain stability but also make hedge fund investments less liquid, or easier to hold onto, than stock or mutual fund investments. The dangers of hedge funds are huge, and investors ought to be aware of them before investing their money. Because hedge funds invest in complicated plans, borrowing, and in less-controlled markets, they are exposed to a high number of risks like market risk, liquidity risk, and operational risk.

Market risk arises because there is a chance that the investments will decrease in value because of the shift in market conditions, whereas liquidity risk arises because one cannot easily sell off some of the investments at a loss of value. Meanwhile, operational risk arises due to issues with the internal procedures of the fund (e.g. mistakes while trading or accounting). Many argue that hedge funds are a stabilizing force in the financial system, yet their role is debated. Hedge funds, on the one hand, bring money to markets, provide liquidity, and allow prices to balance with value by taking advantage of inefficiencies.

On the other hand, they are agents of market instability, especially in times of stress, as they borrow and engage in risky trade, critics argue. Others also note that the cost and risk of hedge funds make them unsuitable for most investors, and that their advantage goes to wealthy individuals and institutions that can handle the risk.