How Do Hedge Funds Work?

Hedge funds are collective investments where eligible investors pool their money together, with the aim of achieving higher than the market returns. The majority of hedge funds also have the objective to provide positive absolute returns regardless of the prevailing market climate.

Unlike mutual funds, hedge funds are not deemed as a regulated investment (although this depends on the country of domicile, for example, some US hedge funds are captured by some specific regulations) and have the flexibility to invest in a broader set of investment opportunities. They are usually positioned more aggressively and use sophisticated techniques such as derivatives trading, short selling, or investing in complex securities such as commodities.

Key Learning Points

  • Hedge funds target institutional investors and wealthy individuals by offering them potentially above-market returns achieved in all market environments.
  • They are less constrained by regulation and can invest in complex securities as well as employ sophisticated techniques.
  • Hedge funds also use different transparency rules, meaning that they are not required to disclose details of their portfolio as often as mutual funds.
  • Hedge fund investors are usually charged high management fees and a performance fee.

Key Features of a Hedge Fund

Hedge funds have the privilege of investing in complex securities and employ techniques that might not be allowed in a mutual fund structure due to regulatory restrictions. For example, a hedge fund might borrow money to boost returns (also known as gearing) or may take large short positions against a company where the manager believes prices will decline.

In addition to the very high entry requirements, to which usually only institutional investors such as sovereign wealth funds, or high-net-worth individuals can meet, there are typically lock-up periods during which the investors cannot withdraw their money. This is due to the illiquid nature of most hedge fund strategies as they might invest in a number of illiquid assets such as private companies or real assets.

Investment Process

Although the hedge fund investment process may vary drastically, it often starts with setting up the investment objectives of the strategy and its risk parameters. Identical to mutual funds, hedge fund managers are usually supported by a team of analysts that generate investment ideas and advice on portfolio positioning and optimization. The whole process would normally require running a quantitative analysis in order to find investments with high potential returns, along with meeting company executives and reading specialist third-party research.

In the pursuit of high returns, hedge funds are often positioned more aggressively and take higher risks. Due to their alternative nature (investing in a variety of complex securities), the returns of hedge funds usually show a very low correlation with those delivered by the market. Therefore, investors view them not only as an “all-weather” engine for growth but also as a diversifier that can reduce the overall risk in their portfolio.

In addition, the quest to outperform the market comes at a higher price. The “two and twenty” rule is common for the hedge fund industry – this relates to their fees structure, which usually charges a 2% management fee and a 20% performance fee.

investing in a hedgefund multiple choice question