Hedge funds and how they work

A hedge fund pools the money of contributing investors and attempts to achieve above-market returns through a wide variety of investment strategies. Larger investors are attracted to the higher returns advertised by hedge funds, though actual returns are not necessarily better than the average market rate of return.

Hedge fund investment strategies can include the following:

  • Leverage. There may be a considerable quantity of leverage (that is, investing borrowed funds) to achieve outsized returns on a relatively small capital base. 
  • Short sales. Hedge funds may borrow shares and sell them, in the expectation that the price of a security will drop, after which they buy the securities on the open market and return the borrowed securities. This is a very risky strategy, since a share price increase can introduce potentially unlimited losses.
  • Derivatives. Investments are made in any number of derivatives, which can pay off based on a vast number of possible underlying indices or other measures.

Because of the enhanced use of leverage, as well as other speculative strategies, there is a much higher probability of loss in a hedge fund than would be the case in a more traditional investment fund that only invests in the securities of well-established companies.

The level of potential loss is accentuated by the common requirement that investments cannot be withdrawn from a hedge fund for a period of at least one year. This requirement is needed because some hedge fund investments cannot be easily liquidated to meet a cash withdrawal demand by an investor. The requirement also allows a hedge fund manager to employ longer-term investment strategies.

Hedge funds do not necessarily subscribe to a particular investment philosophy, so they can roam the investment landscape, looking for anomalies of all types to take advantage of.

Hedge funds avoid oversight by the Securities and Exchange Commission (SEC) by only allowing investments by large institutions and accredited investors (individuals with large net worths or incomes). This means that hedge funds do not have to report as much information to their investors or the SEC. 

Hedge funds typically do not accept small investments, with minimum contributions starting as high as $1 million. Hedge fund managers are compensated with a percentage of the total assets in the investment pool, as well as a percentage of all profits generated. For example, a fund manager could take 2% of all capital under management, as well as 20% of all profits earned.

The term "hedge" in the name "hedge fund" is a misnomer, since it seems to imply that a fund attempts to mitigate its risk. This term comes from the early days of hedge funds, when funds attempted to reduce the risk of securities price declines in a bear market by shorting securities. Nowadays, the pursuit of outsized returns is the primary goal, and that cannot usually be achieved while risk is also being hedged.