What is a Hedge Fund?

by Paul R. Ruedi CFP®

 A hedge fund is an investment fund that pools the money of investors to achieve some investment objective. Hedge funds are less regulated than mutual funds and are able to employ much riskier investment strategies. They generally aim to provide high returns for their investors, and they charge very high fees for doing so.

The word “hedge” in the finance world means something an investor does to reduce risk and some hedge funds do pursue strategies that work as a hedge to other common strategies. But more often they are just unconstrained investment vehicles where their operators, called hedge fund managers, take on risk in the hope of reaping higher returns.

Hedge funds are only available to what are called accredited investors. To qualify as an accredited investor a person must have income greater than $200,000 ($300,000 for couples) or assets greater than $1 million. Organizations like banks, trusts, insurance companies, and brokers can also be considered accredited investors. The idea is that accredited investors are sophisticated and have a larger financial cushion should they lose their entire investment and thus do not need the protections that smaller investors need.

Hedge funds take on risk and attempt to achieve high performance numbers in several ways. They may use a lot of leverage by borrowing money to invest to try and increase their returns. They may use complex securities like options and futures that amplify risk and return. They may also pursue strategies like short selling to gain from a stock market drop or a price drop in a particular stock. Some hedge funds will sell some stocks short while buying different stocks allowing them to benefit, in theory, whether the market as a whole goes up or down.

Hedge funds often have two-part fees, commonly referred to as “two and twenty.” Though hedge fund fees have come down slightly in recent years, in the past it was common for hedge funds to charge two percent of the assets they managed for investors no matter how the fund did and twenty percent of any extra performance over a benchmark. Hedge funds are often criticized for charging such high fees.

Hedge funds have a certain mystique about them, but they are often bad investments for typical investors due to their high fees and potential for their risky investment strategies to completely blow up. For the typical investor, it is much better to pursue a boring, diversified, buy-and-hold strategy.

Paul R. Ruedi is a Certified Financial Planner™ professional with Ruedi Wealth Management in Champaign, Illinois.