What Is a Hedge Fund?

Learn how it operates, how it makes money, and who can invest in one

If you've ever wanted to ask someone, "What is a hedge fund?", never fear! The term hedge fund is a catch-all that describes numerous types of arrangements in which a private investment partnership or company, run by a manager who works for a fixed fee, share of the profits, or some combination thereof, raises capital from outside investors and deploys that capital according to a predetermined strategy, perhaps even within a narrowly defined asset class.
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Unless you have been living under a rock for the last two decades, whenever you've turned on the television or radio you've probably heard some news story about a hedge fund. With the proliferation of hedge funds in recent years, have you ever wanted to ask someone, "What is a hedge fund?", but didn't want to appear unknowledgeable? It's actually a great question and not one to be ashamed of. Here, learn exactly what a hedge fund is and how they work, as well as some of the other relevant details that pertain to making an investment in a hedge fund.

What Is a Hedge Fund?

First, let's answer the million-dollar question. A hedge fund isn't a specific type of investment. Rather, it is a pooled investment structure set up by a money manager or registered investment advisor. This pooled investment structure is often organized as either a limited partnership or a limited liability company. (The latter has become much more common in recent decades due to the major advantages of LLCs over their competing incorporation forms. In olden days, the former was much more popular — such as Warren Buffett's limited partnerships — while before that, traditional c-corporations were even used (e.g., Benjamin Graham's Graham-Newman Corporation).

What Does a Hedge Fund Do?

Within a hedge fund, the hedge fund manager raises money from outside investors and then invests it according to whatever strategy he or she has promised to use. There are hedge funds that specialize in "long-only" equities, meaning they only buy common stock and never sell short. There are hedge funds that engage in private equity, which is the buying of entire privately held businesses, often taking them over, improving operations, and later sponsoring an initial public offering. There are hedge funds that trade junk bonds.

 There are hedge funds that specialize in real estate. There are even hedge funds that put money to work in specialized asset classes such as patents and music rights. Simply stated, hedge funds can specialize in just about anything.

Where Did Hedge Funds Get Their Name?

Many generations ago, the original hedge funds were structured to hold stocks both long and short (positions were "hedged") to reduce risk so the investors made money regardless of whether the market increased or decreased. The name stuck and expanded to include all sorts of pooled capital arrangements.

How Are Hedge Fund Managers Paid?

The hedge fund managers are compensated based upon whatever terms or arrangements are found in the operating agreement. Some hedge fund managers receive the standard "2 and 20", which means 2% of net assets per year plus 20% of profits above a predetermined hurdle rate. Other hedge fund managers are paid on a pure profit arrangement. Going back to the now famous Buffett partnerships, Warren Buffett took between 25% and 50% of profits but also agreed to cover partner losses to varying degrees, exposing himself to far more risk than many professionals would be comfortable doing.

 Nearly all hedge funds feature a "high water mark", meaning if the fund declines, the manager must make up the losses before he or she can earn additional pay. 

Who Can Invest In Hedge Funds?

Technically, most people are probably eligible to invest in hedge funds. Practically, only "accredited investors" and/or "sophisticated investors" will be able to do so as a result of government regulation that makes it highly unlikely a hedge fund manager is going to admit you to the partnership or firm unless you qualify. Even if the hedge fund manager were inclined to make an exception, he or she can really only admit 35 non-accredited investors so they will want to keep those spots open for close friends and family members.

If you didn't know what hedge funds are, it's likely that you don't know what accredited and sophisticated investors are. Accredited investors must meet one of the following standards:

  • Personal income of $200,000 or more per annum by himself or herself. If married, combined income must be $300,000 or more per annum. This income must have been earned for at least two consecutive years and the investor must have reason to believe he or she will maintain this level of income in the future.
  • Personal net worth of $1,000,000 or more, either individually or with a spouse, excluding your primary residence.
  • An executive, partner, director, or other qualified person tied to the hedge fund itself (this allows employee and manager participation).
  • An employee benefit plan or trust fund with a net worth of $5,000,000 or more not specifically formed for the purposes of making the investment.
  • Any entity in which all of the equity investors are accredited investors on their own merit.

Sophisticated investors have both the knowledge and experience necessary to evaluate and understand the risks and merits of an investment.

How Does a Hedge Fund Work?

To better familiarize you with the subject, let’s take an extreme example. Imagine you set up a company called “Global Umbrella Investments, LLC” as a Delaware LLC. The operating agreement, which is the legal document that says how the company is managed, states that you will receive 25% of any profits over 3% per year and that you can invest in anything — stocks, bonds, mutual funds, real estate, startups, art, rare stamps, collectibles, gold, wine.

Along comes a single investor who invests $100 million into your hedge fund. He writes the company a check, you put it into a brokerage account, and deploy the capital according to any guidelines that were spelled out in the operating agreement. Perhaps you use the money to buy up local restaurants or maybe you start a new company. Either way, the point is that every day when you wake up and go to the office, your purpose is to put your investor’s cash to work at the highest rate possible (adjusted for risk, of course), because the more you make him, the more you get to take home.

For argument’s sake, imagine that you made an unbelievable investment the first year, doubling the company’s assets from $100 million to $200 million. Now, according to the company’s operating agreement, the first 3% belongs to the investor with anything above that being split 25% to you and 75% to your investor. In this case, the $100 million gain would be reduced by $3 million for that hurdle rate. The remaining $97 million is split 25% to you and 75% to your investor.

The net result is that you walk away with $24.25 million in compensation. Your investor gets the $3 million hurdle earned and $72.75 million from the split to which he is entitled above that hurdle, bringing his cut to a grand total of $75.75 million.