How Do Hedge Funds Work

Hedge funds often get mentioned in financial news programs on television, or in business-related magazines and newspapers. Many people have heard of the term, but it’s often not clear to people what exactly a hedge fund is, and what makes it different from a mutual fund or other investment. For people who are actively interested in investment, and who are looking to widen their range of investment possibilities, hedge funds are worth studying.

 

The Basic Setup of Hedge Funds

 

In a nutshell, a hedge fund is a financial arrangement where investors band together as partners and choose someone to manage their money, with the goal of growing their funds. The person, who is designated as the one in charge of choosing where to invest the funds, is usually called the fund manager. Essentially, the fund manager calls the shots and is expected to have the expertise needed to know where the best to invest the money. The other partners in the group are the investors. They are the people who pony up the cash, in order to get the hedge fund growing.

 

It’s important to keep in mind though, that the numbers involved in starting and maintaining a hedge fund are quite large. In fact, such a fund often ends up as a tool for wealthy individuals and organizations to increase their worth. This is because the cost of entry is rather high. Current regulations require investors to have a net worth of more than a million dollars, not including their primary home. It’s either that or having an annual income above $200,000 over the last two year period. So a hedge fund is clearly something that can be harnessed mostly by individuals in a higher income bracket.

 

How Hedge Funds Make Money

 

One of the advantages of hedge funds is that they can basically invest in whatever they want in order to gain the highest possible return for investors. This is in sharp contrast to mutual funds, which are usually limited to investing in stocks, bonds and government securities. Hedge funds, on the other hand, can choose to invest in real estate, gold, currency, or whatever other asset is felt will appreciate sufficiently. The fund manager has free rein to move funds into various instruments and assets, all in the name of higher returns.

 

Another key benefit of hedge funds, which also happens to be the basis for the name, is that the fund can make money in a market, which is moving up, as well as one which is moving down. It can do this, for example, by shorting stocks, which are expected to drop in value. This is where the hedge in hedge fund comes from. Investors are able to protect themselves from losses in a down market, through the use of this type of investment vehicle.

 

Costs and Downsides of Hedge Funds

 

There are, of course, risks and downsides associated with hedge funds. For example, one particularly double-edged tool these funds make use of is leverage. Through the use of borrowed money, a fund manager can transform a small gain into a huge one. But at the same time, this also correspondingly means that a small loss can quickly balloon into a significant one, resulting in major losses, especially when financial crises strike.

 

There is also the fee and cost structure associated with hedge funds. One particularly popular setup is for the fund manager to earn two percent of the assets of the fund each year, plus twenty percent of any profits gained. Some hedge funds use something similar, but where only one percent of the assets are charged annually. This has seen criticism because it means that even if the manager guides the fund to major losses, he or she will still earn one or two percent of total assets. That’s a very hard situation for many investors to swallow.