What is a Hedge Fund?

Hedge funds are trying to play chess in a world of checkers…

While ETFs tend to passively track market indexes and mutual funds pool and invest the money of any type of investor, hedge funds use intense research and trading strategies to pursue risky opportunities that most investors won’t have access to — they’re limited to “accredited investors” because they’re so sophisticated and complex. And it’s all in the hope that greater risk will bring greater reward.

There are two key players you’ve got to know to understand hedge funds. These are the primary positions that interact with and run a hedge fund:

Limited Partner: They go by “LP” for short and are the investors whose money is managed by the General Partner (more on that below) — All the LP funds are pooled together into the fund. Since hedge fund strategies can be particularly risky, the LPs generally have to be “accredited,” as institutions or wealthy individuals with a certain minimum amount of money. LPs in hedge funds tend to be significant sources of money themselves, including university endowment funds or pension funds for firefighters or major financial institutions or entire government funds (aka “sovereign funds”).

General Partner: They go by “GP” and are responsible for managing the fund. The GP is a pro fund manager who directs the LPs investment using whatever strategy the hedge fund employs, which could be anything from simply buying and selling stocks to more complicated strategies involving foreign currencies, bonds, real estate, or options contracts. GPs are sometimes used synonymously with “the fund” itself since they’re the people who are paid to manage the fund for a living.

“Two and twenty” (aka “2 and 20”). Get to know it. That’s a common model of how the hedge fund’s general partners (GPs) make a living managing the money of their investors, the limited partners (LPs). The funds are typically organized as limited partnerships for tax purposes, and earn money through “two and twenty” fees. Two and twenty fees occur at two different points in the fund’s development. The concept was developed with the earliest hedge funds and has inspired related fee concepts (variations on “2 and 20”) that are growing in popularity.

This is a key difference between hedge funds and other types of funds. While mutual funds feature an expense ratio (aka a “management fee”), most hedge funds also charge a “performance fee,” snagging some of the profits from their investments (most venture capital funds do the same thing). Here’s how it breaks down.

The 2% “asset management” fee: When an investor (the LP) invests its money through a hedge fund, the hedge fund manager (the GP) automatically takes a 2% fee for managing the whole operation. This often goes toward the fund’s operations, like paying for office space and salaries. This can be a bit controversial because the hedge fund earns it even if the fund is losing money or if the markets are uncertain and the fund just lets the money hang out on the sideline, uninvested — it’s still getting paid 2%. Here’s an example:

• A major university invested $150M in a hedge fund.
• $147M would actually be invested in whatever the fund’s pursuing.
• That’s because $3M (2% of $150M assets under management by the hedge fund) is typically taken by the fund as its management fee.

The 20% “performance” fee: After the hedge fund has invested the investors’ money, it often earns return on that investment. Before sending that profit back to the LPs, the GP takes a cut — A hefty 20% of those total profits. The purpose here is to align incentives, encouraging the fund to pursue major returns despite major risks because they can earn more money than off the simple 2% management fee. But unlike the management fee, a performance fee isn’t levied unless a profit is earned. This is the treat the hedge fund strives for after all its hard work crunching numbers and scouring for deals. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return. Here’s a hypothetical example of how the performance fee goes down.

• A GP is managing a fund of $100M.
• A couple companies that the hedge fund invested in have Initial Public Offerings (IPOs), allowing the fund to sell its shares in those companies for a $20M profit from the original $100M investment (a 20% return — Not too shabby).
• The LPs will receive $16M of that profit.
• That’s because $4M (20% of the $20M profit from the hedge fund’s investment) is kept by the fund as a performance fee for the strong investment.

Keep in mind, this example is just to walk you through how the “2 and 20” model works for a completely made-up hedge fund, and was simply created to illustrate our explanation — The hypothetical return does not represent the performance of any funds. Investing in hedge funds gets more complicated and involves a high degree of risk.

This illustration shows the typical “2 and 20” fee structure for many hedge funds. It’s intended to show the concept that a hedge fund receives a 2% management fee, based on the size of the fund (that part’s upfront and ongoing based on the total number of assets being invested) and a 20% performance fee, based on the returns generated by the fund (that part’s determined at the end of the year only if the investments have a positive return). You can learn more about each fund’s particular fee structure in the Private Placement Memorandum (PPM). This list is not exhaustive of the potential investments available to hedge fund managers.

The name says it all. Hedge funds. The concept is based on “hedging” — Hedge fund managers may pursue one risky opportunity and “hedge” (manage its risk) by coupling it with another investment that seeks to limit potential losses.

Hedge funds pursue a variety of strategies for their investments. Some core strategies used are buying “long” (purchasing a stock as a long-term investment), selling “short” (selling the stock at a high price in anticipation of buying it back at a lower price to earn a profit), options (buying or selling contracts to purchase at a future date and specific price), and more.

Hedge funds also use more complicated forex (foreign exchange) transactions and quantitative trading techniques. They react based on interest rate changes and new alternative investment opportunities. Hedge funds are also well known for investing heavily in research to ensure maximum access to and analysis of publicly-available information with due diligence, developing insights along the way.

Hedge funds are also able to pursue these more complicated strategies because investors are “locked-up” — Unlike a stock that you can sell anytime, hedge funds require that investors be unable to “cash out” their investments immediately. Investors have to wait for long stretches of time typically while their funds are being put to use (this is why hedge funds are known as “illiquid” investments).

Not everyone. Hedge funds are risk-focused investments pursuing market-beating returns. But that requires intense, aggressive, and complicated strategies, so hedge funds are generally limited to institutional investors and “accredited investors.”

Institutional: Your typical hedge fund investors (the LPs in the fund) have a significant amount of money to put to work (it’s a key reason why they’re able to take on significant risk and why they’re pursuing large returns). Here are some typical institutional investors:

• University endowments
• Pension funds
• Financial institutions
• Funds of funds
• Sovereign government funds
• Central banks

Accredited investors: Wealthy individuals can also invest in hedge funds if they meet the government’s qualifications of being “accredited” (aka regulators believe they’re sophisticated enough investors to understand the risk and wealthy enough to afford losing all of their potential investment). These are the requirements:

• $1M minimum net worth (excluding the value of your “primary residence”).
• And income of least $200K each year for the last two years ($300K combined income if you’re married)

Now it gets counter-intuitive. You’d think that because hedge funds pursue risky investing strategies, they’d be more regulated — But they aren’t. These funds are limited to just the sophisticated accredited investors, because they’re less regulated than most consumer facing funds, like mutual funds are ETFs. For this reason, it’s especially important to understand how hedge funds work, their strategies, the fee structure, and any other details if you’re able to invest in one.

For example, while mutual funds are required to show certain types of performance numbers for investors (like the fund’s performance over the last year), hedge funds don’t have to show this. But just like mutual funds, hedge funds are held to the same standards and regulations when it comes to fraud, like stealing money or lying about their underlying investments to investors.

Pursuing a hedge fund also means an investor should dive deep into the Private Placement Memorandum (“PPM”). Similar to an S1 with an Initial Public Offering (IPO), the PPM provides critical background info on the fund, its focus, strategy, potential, and concerns. It’s more than disclosure material, revealing both the positive and negative elements of the hedge fund, so you can make a knowledgeable and informed choice.

We’re big fans of how the Securities & Exchange Commission (SEC) offers some helpful info on government regulation of hedge funds and accredited investors here. Worth a read.

*By clicking a third-party URL or hyperlink, you’ll be accessing a third-party website. Robinhood Financial LLC is not implying that any monitoring is being done by Robinhood Financial LLC of any information contained on the third-party website. Robinhood Financial LLC is not responsible for the information contained on the third-party website or your use of or inability to use such site, and we don’t guarantee their accuracy and completeness. *