What are hedge funds and how do they work?

What do hedge funds do? We hear a lot of talk about hedge funds in television and film, without always having a clear understanding of hedge fund meaning or significance. A hedge fund is a type of investment only available to advanced investors, like institutions and individuals with large and valuable assets.These funds are an alternative type of investment that are managed more actively than others, due to their more risky investment strategies or asset classes..

What is a hedge fund? Meaning and definition

This specific type of investment is most well-known for their high minimum buy-in requirements and high returns, though they are also characterized by their relative freedom from regulation and theoretically reduced exposure to market risk, relying not only on fluctuations in the stock market but also the talents of the individual portfolio manager that manages the fund. 

Hedge fund definition Hedge funds are pooled funds coming from many individual investors, managed according to more risky strategies in the hopes of achieving above-average returns that are then shared among the investors. These kinds of funds are deemed more risky because they are more speculative in nature compared to other investment vehicles. 

Compared to other forms of investment open to retail investors, such as mutual funds, hedge funds are pooled funds of individual or, for UK hedge funds, to retail investors. Because of this, hedge funds are less regulated, meaning that hedge fund managers are able to use  this relative freedom from regulation to pursue more high risk strategies, like shorting as a result.

Another advantage of hedge funds is that they are able to hedge market risk by providing greater diversity in the investment portfolio, including assets from more cyclical markets, like travel, with more assets from food or utility companies, which are typically more resistant to downturns in the market. However, as opposed to other investment vehicles, hedge funds can look to opportunities outside the stock market and use derivatives to short their positions on the market, so that the fund yields returns in the black regardless of downturns in the market.

How does a hedge fund work?

Originally, hedge funds were intended to hedge market risk by assuming both long and short stock positions, making positive returns regardless of dips in the market. Now, however, the term is used more generally, to refer to pooled capital from individual investors.

Hedge funds are created when managers raise capital from individual investors and then invest that capital into the investment vehicles that fit with the investment strategy they plan to employ. The investment strategy will typically be detailed in an operating agreement, specifying the percentage fee that the fund manager will earn for managing the assets, as well as any fees related to the performance of the fund, while the rest is returned to the investors as profit. The performance fee of the operating agreement works to incentivise the managers to make gains and take risks. In operating agreements, it’s not uncommon to find a 1% to 2% fee for management of the assets and a 20% performance fee for the managers, though some managers are paid only through the gains of the portfolio.

What types of hedge funds are there and what strategies do they use?

The different types of hedge funds are characterised by the composition of their portfolios and the kind of investment strategies that they pursue, and range from commodity hed funds,  macro, relative value, equity and more. Commodity hedge funds invest in raw materials like precious metals or oil, while macro hedge funds  invest in company stocks and bonds, relying on economic variables like interest rates and national economic policies to generate profit. Relative value hedge funds take advantage of temporary differences in the price of securities, comparing prices to sector benchmarks and taking long and short positions on pairs of securities. Equity hedge funds invest in attractive stocks while shorting stocks or indexes that are deemed to be overvalued. 

These are just a few examples of the different kinds of hedge funds, though there are still others.

Hedge fund strategies

Some of the more common strategies employed by hedge fund managers include pairing long and short equity investments, taking advantage of merging companies through merger arbitrage, diversifying assets of the portfolio to achieve a so-called “equity market neutrality”, and more. 

Long and Short equity investments – This kind of hedge fund strategy seeks to make returns in both market upturns and downturns by shorting stocks that are deemed overpriced or taking long positions on stocks that have been underpriced.

Merger Arbitrage – This strategy seeks to exploit company mergers by both buying and selling stocks of the merging companies at the same time, while checking the risk of the merger not closing in time or falling through.

Equity Market Neutrality –  The equity market neutral strategy involves taking advantage of differences in stock prices, taking on long and short positions on stocks that have a close relationship. For example, the stocks may have similar market caps or may both be from the same industry or sector. 

Macro – Hedge fund managers that use macro strategies base their portfolio composition on projections in trends in macroeconomic or political developments in a country, seeking to capitalise on national interest rates, currency exchange rates or politics.

Mixing strategies and asset classes to generate more stable returns long-term is also a popular strategy among hedge fund managers. Blending approaches with other pooled investment vehicles creates greater stability in returns than compared to those achieved by the individual funds. 

Hedge fund requirements

But now you’re probably wondering how to invest in a hedge fund. Hedge funds are not open to all private investors. In fact, in order to be able to invest in a hedge fund, you need to meet specific minimum requirements. Because hedge funds are more free from regulation by financial authorities, the establishment of certain minimum criteria in order to contribute to the funds acts as a means of ensuring the protection of the fund investors. 

Some of the entry requirements that need to be met in order to be able to access the funds include setting high annual income thresholds or a high net worth for investors, which serves as a proxy for demonstrating that those investors have sufficient knowledge and understanding of the risks associated with hedge funds. As a result, initial investments required from investors are typically very high, so that only accredited investors are allowed to invest in hedge funds. 

Fees and costs of hedge funds

Due to the general absence of regulation of hedge funds, to protect individual investors from the risks associated with hedge funds, stringent requirements for access to the investment vehicle were developed, such as screening for only high income investors who can demonstrate to possess adequate knowledge and understanding of the risks associated with hedge funds. In that regard, the initial investments made by investors are  much higher than traditional investment funds, as well as the management fees charged by the hedge fund manager.

A hedge fund example

The hedge fund manager develops the portfolio, which can be composed of different types of asset classes (such as real estate, bonds, stocks or more complicated financial instruments like derivatives), while also deciding the time horizon of the investment, the debt structure of the fund and the amount of equity to be raised. At the same time, he must also project the yield of the investment and define the terms of the operating agreement of the fund.

He then pitches the hedge fund portfolio to investors to raise capital. Once the manager has secured the commitment of his investors and the funds have been raised, he begins working in order to obtain the returns projected to investors. As the value of the fund increases over time, the earnings are distributed to the investors according to the terms set up in the operating agreement, while a certain percentage of the profits are paid to the manager of the fund.