Hedge funds allow wealthy people to pool their resources in an effort to achieve higher returns than the stock market typically provides. Managers are typically paid a percentage of the profits they bring in, so they have an incentive to use risky tactics to boost profits for their shareholders.
All hedge funds are organized legally in the same way, use roughly the same investment strategies, and levy roughly the same fees on their investors. Still, we need to delve deeper into the subject to get a firm grasp on what exactly a hedge fund is.
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How Hedge Funds Works
Accredited investors are required to invest in hedge funds. To qualify as an accredited investor, one needs to have a minimum liquid net worth of $1 million or a minimum annual net income of $200,000 (or $300,000 when married). The Securities and Exchange Commission (SEC) assumes that investors with substantial wealth possess some level of financial sophistication and thus allows them to invest in less-regulated securities offerings.
The most common form of hedge fund is a limited partnership. Hedge fund investors are limited partners, and the hedge fund itself is the general partner. Money contributed by limited partners is pooled and then invested by the hedge fund.
Hedge funds are able to take more risk in their investments because the SEC does not regulate them as closely as it does mutual funds. Managers can invest in a wide range of markets (equities, fixed income, commodities, equities, real estate, cryptocurrencies, etc.) and frequently employ sophisticated strategies (such as leverage, short positions, and derivatives such as options). There is the potential to profit from just about anything.
Hedge fund investments are oftentimes low-liquidity investments. Depending on the nature of the investment, the initial investment may be locked up for anywhere from several months to several years before it can be withdrawn or redeemed. To put it another way, this structure frees up the fund managers to take riskier positions without constantly having to provide liquidity to the investors.
How Hedge Funds Make Profits
There are two main types of fees that hedge funds collect: management fees and performance fees.
An average management fee for a hedge fund is 2% per year. The amount of this charge is proportional to the market value of the investors’ holdings. In other words, if you invest $1 million, the management fee for that year will be around $20,000. This cost is allocated to running the hedge fund and can be used to pay the manager a salary.
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The primary responsibilities of the fund manager include the construction of the investment portfolio and the control of the fund’s cash inflows and outflows. Every investment the fund makes and every approach it takes is decided upon solely by them. It’s not unusual for the manager of a hedge fund to also be the company’s sole owner.
Standard practice calls for a 20% performance fee on profits. As a result, if the hedge fund manager is successful and your investment is increased from $1 million to $1.2 million, the manager will take another $40,000 (20% of $200,000). No additional charges will be incurred regardless of the fund’s performance.
Though “2-and-20” has been the norm for some time, the underperformance of hedge funds since the 2008 financial crisis has increased the pressure on hedge fund firms to reduce their fees.
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