What is a Hedge Fund?

February 17, 2011

Although hedge funds are in the news less than they were in the last couple of years, with the recent collapse of Level Global Investors, I thought it would be a good time to talk about “hedge funds.”  A hedge fund is a private company that pools cash for a group investment.  Sounds a lot like a mutual fund, right?  Yes, but mutual funds, unlike hedge funds are heavily regulated by the Investment Advisers Act.  Basically, a hedge fund is to a mutual fund (both seek returns from investors in vastly different ways) what Las Vegas is to Disney World (both provide entertainment, but in very different ways).   Different hedge funds have different strategies, but mostly, hedge funds are vehicles for risky investments that are aimed at producing huge returns for its investors. Recognizing that risk, there are rules that prohibit hedge funds from accepting investors that do not meet strict wealth requirements.  

How a hedge fund works is this:  A money manager sets up a company, and sells an interest in that company to investors.  The money manager takes the pooled money, and uses it to invest according the strategy that the manager (hopefully) articulated in the investment materials.  Generally, the manager gets paid by taking 2% of the company’s assets, and 20% of the profits.  Therefore, a good manager can make a ton of money.

The high-wealth investors generally sign away any rights to question or second guess the manager’s investment decisions, and often release the manager from all claims.  The real risk to hedge funds (and why they usually spectacularly collapse) is investor redemptions.  Usually, there is a mechanism where investors can cash out some or all of their investment for any reason.  Sometimes, those redemptions are capped, but when redemptions start occurring, they are hard to stop.  Akin to a “run on the bank” when a hedge fund has to sell out of positions to account for redemptions, its not long before the damage snowballs, and the hedge fund shuts down, leaving the remaining investors with the scraps.


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