Hedge Funds Explained: Definition, Strategies & How They Operate

The Reddit debacle around GameStop introduced people who might not otherwise be exposed to the finer points of advanced investment options to a whole new level of finance vocabulary. One of the purported goals of the people who started the movement of GameStop and several other stocks sold short was to stick it to hedge funds. For many, that led to an obvious question.

What Is A Hedge Fund?

A hedge fund is a form of investment partnership in which a general partner makes the investment decisions and pools money with others who are looking to invest their funds. Any returns earned from the fund are then shared between the partners. The general managing partner earns a commission and/or other fee based on the returns.

A hedge fund aims to offer high returns by making big bets. Of course, with big bets can come big risk and the mitigation of those risks is where hedge funds get their name.

Hedging is when you make a big bet on something, but you also take part of those funds and take the other side of the bet. That way, if you were wrong, you can hope to mitigate your losses.

For example, if you were making a bet that the stock market was going to continue to rise over the next 6 months, you might hedge your bet by also investing some money in bonds, a medium that has a history of doing better as the stock market is going down.

We’ll get into this a bit later when we cover what you have to do to invest in a hedge fund, but in exchange for less oversight from regulatory bodies, investment in hedge funds is generally limited to well-capitalized individuals who, at least in theory, have the ability to absorb a significant loss.

If you’re just getting involved in stock trading, you may not want to get involved in investing in individual hedge funds because of the lack of regulatory oversight.

How Hedge Funds Work

Now that you have some of the basics, let’s take a second and get into how these funds actually work. It all starts with a hedge fund manager.

The role of a hedge fund manager, also called a general partner, is to oversee the funds invested by the general partner and the other investors. They’re responsible for picking the investments and the day-to-day strategy followed by the fund. In exchange, they get paid well. Although each fund is different, one common fee structure is the “2 and 20 rule.”

They charge 2% of the funds under management as well as 20% of the profits. Depending on the fund, the charge for profits may only apply if the profits are above a certain level.

Hedge funds get their investment dollars from any funds contributed by the general partner as well as the funds of other investors attracted to the fund. They’re generally limited partners.

Hedge funds could consist of a variety of investments including traditional stocks and bonds. Most commonly though, a hedge fund manager is looking for high-return investments that could pay off big if they bet the right way.

Think of things like options to buy or sell stocks in the future, derivatives tied to benchmarks that the manager is betting will go one way or the other or futures contracts that require you to buy or sell at a certain price in the future, no matter what the market will bear at that time.

Based on a partner’s level of investment, they’re given shares in a fund; this is the most common way to get paid. You sell your shares to take advantage of the returns on your investment. It’s important to note that funds often restrict your ability to cash in your shares in one of three ways:

• The shares may be subject to a lockup period of a year or more in which you can’t remove your funds.
• At the end of any waiting period, you may be restricted to selling your shares during certain windows that may occur on a monthly, quarterly or annual basis.
• There may be a fee associated with cashing in your shares.

Hedge Fund Investment Requirements

The Securities and Exchange Commission (SEC) requires those who want to put their money in hedge funds to be accredited investors. This often means banks and investment advisors, but an individual can be an accredited investor as well. In order to meet the requirements, the investor must qualify as one of the following:

• An accredited investor can be any person or couple whose net worth exceeds $1 million. For the purposes of calculating your assets, certain things like the value of your home aren’t included.
• You can also qualify as an accredited investor if you made an income of more than $200,000 as an individual in each of the last 2 years. If you’re making joint income with a spouse or partner, you have to have made more than $300,000 in each of the last 3 years.

Beyond SEC requirements, the hedge fund itself may set rules for the amount of assets you can have under its management.

Are Hedge Funds Risky?

Every investment involves risk, but investment in hedge funds is definitely on the riskier end of the spectrum. Investing in stocks or mutual funds certainly offers no guarantee of safety or positive returns, but these forms of investment come with strict reporting requirements that aren’t necessarily followed by hedge funds.

When thinking about your risk tolerance, be sure to consider the fact that there’s not really oversight from regulatory bodies in the same way that there would be for other investments. You can earn a profit, but there’s also nothing preventing you from taking a big loss with limited potential for recovering anything, even in the event of mismanagement.

The other thing to consider is that these hedge fund managers can be wrong as often as they are right. When evaluating these funds, make sure it’s clear where they’re getting the numbers they report. If they don’t have a history of outperforming broader index funds anyone can get in on, it’s definitely not worth the risk.

Finally, fees should also play a role in your decision. Mutual funds often charge lower fees, so you need to make sure that the fee structure is worth it.

The Bottom Line

Hedge funds enable investors to pool their money with others under the active supervision of a hedge fund manager or general partner. The manager selects investments aimed at getting a higher return than you could through most other investment vehicles. You have to have a certain net worth or income to invest directly in hedge funds. Because of this, hedge funds are generally exempt from most regulatory oversight that applies to other investments.

Before investing in a hedge fund, make sure you understand the types of investments being made. Also understand the fee structure and when and how you can cash out. Finally, know your risk tolerance. The potential for higher returns also means the potential for more devastating losses.

Before undertaking an investment strategy of any kind, make sure you know what you’re getting into. It’s never a bad idea to consult with a financial advisor. For more tips and tricks, check out other articles in our personal finance section.