Hedge funds are among the most secretive and most discussed players in finance. They manage trillions of dollars, employ some of the highest-paid people in the world, and are blamed or credited for many dramatic market moves. Yet most people never invest in one, and by law most are not allowed to.
What a Hedge Fund Is
A hedge fund is a private investment pool that collects money from wealthy individuals and large institutions such as pension funds and university endowments. In the United States, individuals generally must qualify as accredited investors, meaning they meet minimum income or net worth requirements. Because their clients are assumed to be sophisticated, hedge funds face fewer restrictions than mutual funds. They can borrow heavily, bet on prices falling, trade complex contracts, and concentrate their money in a few positions. The name comes from the first such fund, started by Alfred Winslow Jones in 1949, which bought some stocks and sold others short to hedge against a falling market.
Common Strategies
Most funds specialize. Long-short equity funds buy stocks they expect to rise and short those they expect to fall. Global macro funds bet on broad trends in currencies, interest rates, and commodities. Event-driven funds trade around mergers, bankruptcies, and other corporate changes. Quantitative funds rely on mathematical models and computers to find small patterns in huge amounts of data, often holding positions for only seconds or days. Activist funds take large stakes in companies and push management to change strategy.
Two and Twenty
Hedge funds are known for their fees. The traditional arrangement is called two and twenty: a management fee of 2% of the money invested each year, plus 20% of any profits. On a $100 million fund that gains 10%, the manager would collect $2 million in management fees and another $2 million from the profits. Supporters say this rewards skill. Critics note that managers share in the gains but not in the losses, which can encourage risk-taking. Competition and disappointing results have pushed many funds to charge less than the traditional rate.
Risks and Results
Borrowed money magnifies both gains and losses. In 1998, a fund called Long-Term Capital Management, run by star traders and Nobel Prize-winning economists, lost billions of dollars in a few weeks. Its positions were so large that the Federal Reserve organized a rescue by major banks to prevent wider damage. Performance is also less impressive than the industry’s reputation suggests. After fees, the average hedge fund has trailed a simple stock index fund over many recent periods. Defenders respond that the goal is not to beat the market but to deliver steadier returns that do not rise and fall with it.
Conclusion
Hedge funds are lightly regulated investment vehicles for the wealthy, using strategies that ordinary funds cannot. A small number have produced extraordinary results, and their trading helps keep prices accurate and markets liquid. They also carry high fees, limited transparency, and risks that have at times spilled over into the wider financial system. Understanding how they operate helps explain many of the forces that move markets, even for people who will never invest in one.