What is a Hedge Fund? Business explained

Many people have heard about hedge funds, but have very vague understanding of how hedge funds work. What is a hedge fund and what’s the difference between hedge fund and a regular mutual fund? Although on a first sight both are very similar, this articles explains ways how hedge funds can work and mutual funds can not.

Hedge Fund Basics

First of all, hedge fund offers more sophisticated investment strategies. Mutual funds are strictly regulated and often aren’t flexible enough to adapt to fast changing market conditions. Most mutual investment funds work in a single niche, such as for example US Stocks or even more specific Small Cap Asia Fund. If this market goes into red zone, fund manager can’t rearrange the money into more profitable assets. Stock mutual funds aren’t allowed to use financial derivatives such as futures or options, nor take short positions, they can only buy stocks and sell stocks they already own. Hedge funds, on the opposite, can trade all kinds of financial assets in both “short” and “long” directions. If the fund manager expects asset fall, he can still make money by “shorting” it or he can choose to buy alternative assets.

Hedge funds basics are hidden in the name. The word ‘hedge’ stands for hedging, or, in other words, limiting risks. This is usually achieved through sophisticated investment strategies, diversification and usage of derivatives. It’s not uncommon for a hedge fund to use leverage (trading loan) in pursuit of profit increase, which increases risks, so hedging techniques become even more important.

Hedge funds require high ‘buy-in’ (minimum investment amount) and are often positioned as ‘suitable for experienced investors only’. They are considered alternative investments and attract many institutional investors and high-net worth individuals. Currently hedge funds are on the verge of popularity and there are some funds with reduced size of minimum investment.

A lot of people are looking to invest in hedge funds, but don’t know where to start or how to find a reliable fund. In the US hedge funds must accept only qualified high net-worth investors (over $1 million excluding primary home), but many European and Asian countries don’t have such restrictions. They accept investors without considering their net-worth and have lower initial deposit requirements.

Hedge fund business model

Hedge funds are famous for their incredibly lucrative hedge fund business model. Typically they charge significantly higher commission than mutual funds. On top of asset management fee they may take percentage from any gains. For example, a common commission structure of a hedge fund looks like this: 2% asset management fee plus up to 20% from any gains. Despite high commissions, investors worldwide are interested in hedge funds, because they are looking for alternative investments with solid returns.

What is a hedge fund – example

Let’s imagine you have decided to open a hedge fund “Example”. You hired consultants and filled out all paperwork. Hedge fund “Example” has no strategy limitations (buy anything anywhere). It has 10 investors and each one contributes 10 million dollars, so the hedge fund balance becomes 100 million dollars. During its first year the fund growth by 30% which comes to 130 million dollars. You as a hedge fund manager receive 2 000 000 (2% asset management fee) plus 6 000 000 (20% from 30 000 000 profit). Despite the managing team keeps a large portion of profit, hedge fund “Example” investors still receive solid 22% capital increase in a single year, which equals 2 200 000 dollars.

Average hedge fund return

Hedge funds investments are usually long-term. Financial advisors recommend that investors put their money into hedge funds for no less than 5 years. Usually hedge funds require investors to commit for minimum 3 months or longer. Many people are interested in average hedge fund returns, but due to the closed nature of hedge funds, many don’t publish their returns publicly. Besides in a hedge fund returns depend on a managers decisions more than in other types of investments. Top hedge funds may grow by more than 40% a year, while average ones would barely hit 2%. Instead of looking for ‘average hedge funds returns’, investors are advised to look for funds or fund managers with proven track record or strategies with higher potential.

Once you get understanding of hedge fund basics, you may choose to learn more about hedge fund strategies.Some funds don’t limit themselves to a certain strategy, region or type of assets, while others do. There are many different classifications of hedge funds by type and by strategy. Hedgefundresearch.com offers seven categories: Equity Hedge, Event-Driven, Fund of Funds, Macro, Relative Value, Risk Parity or Blockchain. Hedge funds are considered alternative investments because of their aggressive and wild work style.