Hedge Fund

A hedge fund is a privately offered pooled investment fund that uses a broad range of strategies to seek returns, and that is structured to avoid the regulatory constraints placed on mutual funds and other public funds. Because it is sold only to a limited group of sophisticated investors, it qualifies for exemptions from registration under the Investment Company Act of 1940, which is what frees it to short-sell, borrow, concentrate positions, and trade derivatives in ways a public fund cannot.

The name is a historical artifact more than a description. The first such fund "hedged" by holding some stocks long and selling others short to reduce market exposure, but the modern category includes funds that take large directional bets and are not hedged in any protective sense. A hedge fund is defined by its private structure and its freedom of strategy, not by any promise to limit risk.

The regulatory exemptions are the foundation of the whole structure. A hedge fund typically relies on section 3(c)(1) of the Investment Company Act, which allows a private fund with no more than 100 beneficial owners, or section 3(c)(7), which allows an unlimited number of investors provided they are all qualified purchasers, a higher bar than accredited investor, broadly an individual with $5 million in investments. Either way the fund is closed to the general public, which is the trade the law strikes: fewer investor protections in exchange for restricting access to those presumed able to fend for themselves.

Strategies are the fund's defining variable. Long/short equity funds buy undervalued stocks and short overvalued ones. Global macro funds bet on interest rates, currencies, and economies. Event-driven funds trade around mergers, bankruptcies, and restructurings. Arbitrage funds seek small, reliable price gaps. Many use leverage to amplify positions, which raises both return potential and the risk of forced selling if a trade moves against them.

Fees follow the "2 and 20" template: a management fee historically around 2 percent of assets, plus a performance fee of about 20 percent of profits. Well-designed performance fees apply only above a hurdle rate and a high-water mark, so the manager is not paid twice for recovering losses it already charged for. Liquidity is limited by design: funds impose lockup periods during which money cannot be withdrawn, require advance notice for redemptions, and can invoke gates that suspend or ration withdrawals in stressed markets. The average hedge fund's net-of-fee performance relative to a simple stock-and-bond mix has been widely debated, and the dispersion between the best and worst funds is large, so the category average tells an individual investor little about any specific fund.

An investor who meets the accreditation or qualified-purchaser test subscribes to the fund, agreeing to its lockup and redemption terms. The manager deploys the pooled capital according to the fund's strategy, reports a periodic net asset value, and charges the management fee continuously and the performance fee when gains exceed the high-water mark. Investors redeem, subject to notice and any gates, when they want out.

A hypothetical example of how the performance fee interacts with a high-water mark. An investor puts in $1,000,000. In year one the fund gains 20 percent, or $200,000, and the manager takes 20 percent of that, $40,000, leaving the investor at $1,160,000, which becomes the high-water mark. In year two the fund loses 10 percent, and no performance fee is charged. In year three the fund rises back above $1,160,000; the manager charges 20 percent only on the gain above that mark, not on the recovery up to it. The high-water mark is what prevents the investor from paying a performance fee twice on the same dollars.

Pros

• Access to strategies unavailable in public funds, including ones designed to make money when markets fall.
• Potential for returns with lower correlation to stocks and bonds, which can diversify a portfolio.
• Skilled managers have flexibility to act on opportunities a constrained public fund cannot.

Cons

• High "2 and 20" fees take a large share of gross return, and the average fund's after-fee edge over a cheap index portfolio is contested.
• Leverage, short selling, and derivatives can produce large, fast losses.
• Lockups and redemption gates mean money is not reliably available when wanted, including in exactly the stressed markets when investors most want out.
• Limited transparency into holdings, and wide dispersion between top and bottom funds.