What is a Hedge Fund? All the Essential Information

If you’re part of the investment scene, you’ve probably heard of a hedge fund. But, do you know what the term means?

This word can be elusive to some people, so we’ve decided to discuss questions like “What is a hedge fund?” and “How does a hedge fund work?” and mention the most notable hedge funds and most common strategies in the world today.

Without further ado, let’s get into it!

what-is-a-hedge-fund

Hedge Fund 101

Firstly, let’s go over the origin of a hedge fund, its meaning, and the differences between hedge funds, mutual funds, and private equity funds.

A hedge fund is a type of investment fund that investors use to reduce the risk they’re taking on with their investments. These funds are typically open to a limited number of investors, and they aren’t regulated in the same way as other types of funds. Hedge funds can invest in various assets, including stocks, bonds, and commodities.

The word “hedge” is used in finance to refer to a strategy employed to protect an investment from losses. Just like a regular garden hedge protects your garden and ensures privacy!

Hedge fund investors use these funds to achieve several different goals. For example, some of them want to reduce the overall risk of their portfolio by diversifying it with more than one asset class, while others use them to bet on specific investments. Hedge funds can also generate profit for investors through dividends and interest payments.

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Hedge Funds vs Mutual Funds

If everything we’ve explained seems familiar, you’re not wrong. Namely, many characteristics of hedge funds can also apply to mutual funds as they’re both types of investment funds.

However, there are several key differences between the two. Firstly, hedge funds are typically only open to a limited number of investors, and they are not regulated in the same way as mutual funds. Secondly, a hedge fund is much riskier than a mutual fund. Thirdly, there is a hedge fund for different assets, while mutual funds can only invest in security.

Lastly, a hedge fund investment is usually much more expensive, as the minimum investment amount is usually $1 million.

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Hedge Funds vs Private Equity Funds

One might also draw parallels between a hedge fund and private equity (PE) fund. Hedge funds and private equity funds are both restricted to institutional investors, but that’s where the similarities end.

In terms of differences, a hedge fund is an open-end fund, which means that hedge fund investors can add or pull money whenever they like. Conversely, PE funds are closed-end funds, meaning that the fund manager will lock the fund, and the money will go towards long-term investments, usually staying there for up to a decade.

Additionally, hedge funds mainly invest in the public market, while PE funds invest in the private ones.

How Does a Hedge Fund Work?

A hedge fund operates in an interesting and relatively straightforward way. Accredited investors give their money to a hedge fund manager, who pools investments from many wealthy people. Then, these managers invest everyone’s money into a public market asset they’ve agreed on previously and generate profit that will be split between all investors.

Moreover, the team of professionals managing the hedge fund uses various strategies to generate returns for investors. For example, they will often use leverage or borrowed money to make investments.

Further Reading: What is Leverage in Trading?

How Do Hedge Funds Make Money?

Hedge fund companies make money in two ways: through management and performance fees and the use of the 2-and-20 rule.

Therefore, hedge funds charge their investors a management fee of 2% and a performance fee of 20% under this rule.

Management Fees

The management fee is a fixed percentage of the amount of money an investor has invested in the fund. So, if you invest $1 million, you’ll need to pay approximately $20,000 in management fees for that year, which covers daily fund expenses.

Performance Fees

On the other hand, the performance fee is typically based on the amount of profits the fund has generated. For example, if the fund makes $200,000, and the performance fee is 20%, you’ll need to pay $40,000 on top of your management fee. However, if the fund didn’t generate profit or lost money during the year, you won’t need to pay any performance fees.

Types of Hedge Funds

Although we’ve been talking about a general “hedge fund” throughout this guide, you’d be surprised to know that there are many types of hedge funds. Therefore, each type invests in different assets. Below, we’ll look at some of the most popular categories.

Long/Short Equity

This type of hedge fund invests in hedge fund stocks, and it uses a variety of strategies to generate returns. Here, investors can choose whether to buy long or short shares, depending on market value.

Event-Driven

Event-Driven hedge funds invest in companies undergoing a change, such as a merger or an initial public offering. Here, there are other subcategories, including merger arbitrage and distressed funds.

Equity Market Neutral

By investing in an Equity Market Neutral hedge fund, investors exploit differences in share prices by buying long and short shares in closely related stocks. These strategies usually generate positive returns.

Quantitative

This type of hedge fund makes investment decisions by analyzing large market data sets. A hedge fund example of this quantitative trading in action is high-frequency trading.

Global Macro

Global Macro hedge funds invest in bonds, currencies, and other global securities, depending on exchange rates, commodity prices, or interest rates worldwide. Usually, this is done by analyzing global macroeconomic trends.

Largest Hedge Funds

what-is-a-hedge-fund

Unsurprisingly, the largest hedge funds are typically those with the most assets under management. The ten most notable ones manage a total of $841 billion in assets. Here are some of the industry giants.

Bridgewater Associates

Bridgewater Associates is the biggest hedge fund company in the world. It singlehandedly manages more than $154 billion in assets. The company’s headquarters are located in Connecticut, USA.

Alpinum Investment Management

The second-largest hedge fund is Alpinium Investment Management, an alternative investment firm headquartered in Zurich, Switzerland.

BlackRock

BlackRock takes the third spot in the list of largest hedge funds, offering both institutional and retail investors access to alternative investments. The company is located in New York, USA.

Asset Management One International

Asset Management One International’s assets are worth a staggering $92 billion. Moreover, this is a European company with headquarters in London, UK.

Renaissance Technologies

Renaissance Technologies is the fifth most notable hedge fund which uses automated trading strategies and trades in different markets. It’s located in New York, USA.

Finishing Thoughts

That’s it for our hedge fund guide!

Hopefully, you were able to grasp the concept of hedge funds, pinpoint the differences with other investment funds, and decide whether this type of investment is beneficial for you.

If you have a little more money on the side, consider investing it for great returns.

FAQ

What is hedging in finance?

In finance, hedging is a risk management strategy used to protect against the losses that an investment may incur.

How to become a hedge fund manager?

To become a hedge fund manager, you will need to understand the financial markets and a track record of generating high returns. You will also need to be able to manage a team of investment professionals.

What is a hedge fund in simple terms?

A hedge fund is an investment fund that sophisticated investors typically use to make high-risk, high-return investments.

What is a hedge fund manager?

A hedge fund manager is an individual responsible for the day-to-day operations of a hedge fund, which includes making investment decisions and managing the fund’s assets.

How to start a hedge fund?

To start a hedge fund, you will need to register and become a member of an investment advisor. Additionally, you will need a team of investment professionals to guide you in the right direction.

ABOUT AUTHOR

Despite her formal background in linguistics, Maja has always been fascinated by the world of finance. She has spent years and years analyzing the market, including trades, investments, pitfalls to avoid as well as the stock exchange. As of recent, she has been studying some non-mainstream stocks in Canada. When I’m not immersed in numbers, I like to spend time with my dog and plan my next trip.

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