What is a hedge fund?

Hedge funds are pools of money from investors that invest in securities or other investments hoping to get positive returns. These funds are generally limited to accredited investors — high-net-worth individuals — and often use speculative investing tactics, such as short-selling and taking advantage of leverage. Hedge funds are usually limited partnerships managed by professional fund managers.

Often, hedge funds are named after their investment strategies. For example, equity hedge funds invest in equities, while event-driven funds invest in asset-backed securities, real estate and more. Funds may also engage in different strategies, such as high-frequency trading, which uses powerful computers to make rapid-fire trades that capitalize on small market movements, arbitrage and investing in pre-IPO companies not yet open to the public.

Here’s what else to know about hedge funds.

Why do people invest in hedge funds?

Hedge funds offer the potential for attractive returns, diversification benefits and upside regardless of market conditions, sometimes allowing investors to profit even when the market is declining. They can also offer variable market exposure, and can assume significant short positions, which means the fund can profit from a security’s declining value. This can help the fund add value to a portfolio regardless of market conditions. Hedge funds also offer diversification benefits for investors since their returns may not track traditional investments such as stocks and bonds.

Put another way, wealthy investors often invest in hedge funds because they can offer strategies not used by mutual funds or other more conservative investments. Pension funds and insurance companies also invest in hedge funds for similar reasons.

How do hedge funds make money?

Hedge fund managers are paid a percentage of assets under management — the investor money they’re managing — which is typically between 1 and 2 percent, plus a performance fee. The performance fee was historically 20 percent of the profits, but as of 2022, was closer to 16 percent. This structure is based on the idea that the hedge fund manager will earn above-average returns, so additional compensation is justified.

Hedge fund vs. mutual fund

While both types of funds are managed portfolios of securities, mutual funds are considered safer, more highly regulated investments. They provide a more predictable return than hedge funds and have lower fees — notably, many mutual funds do not have a performance fee. Beyond that, mutual funds have been around for decades, and these funds are open to the public. Mutual funds must register with the SEC and provide investors with certain information, such as the fund’s objective, investment strategy, expenses and financial statements. Plus, mutual funds provide liquidity to investors. You can place an order to buy into a fund or sell shares when the market is open. Mutual fund trades are completed at the end of the trading day. Meanwhile, hedge funds have minimum holding periods and restrictions on when investors can withdraw money. And, unlike mutual funds, hedge funds are generally only available to accredited investors with a liquid net worth of over $1 million or an annual income exceeding $200,000.

Finally, hedge funds are known for taking higher risk positions and using alternative strategies. They’re typically managed much more aggressively than their mutual fund counterparts, with varying lock-up periods (when you’re not allowed to sell) and redemption allowances (fees charged to the investor when shares are sold).

How do you compare hedge fund performance?

Investors can compare hedge funds, mutual funds and other investments using a number of metrics. For starters, let’s take the yield on an investment, also known as the annual dividend yield, interest yield or bond yield. This is the rate of return generated by the fund’s dividends, interest and bond payments and is typically expressed as a percentage.

The rate of return is the return or gain on an investment, expressed as a percentage. It’s the net gain or loss over the investment’s time period, divided by its initial cost. Another calculation is percent return, which is the difference between the initial value of the investment and its value at a specific time, divided by the initial value of the investment. The result is multiplied by 100 to get the percentage return. Annualized percent return allows an investor to standardize the rate of return over different time periods. It lets the investor compare investments with different holding periods, such as 20 years and five years.

Keep in mind, when comparing fund performance, you’ll also want to factor in transaction fees and consider the role of taxes and inflation.

What are the different types of hedge funds?

Hedge funds are generally classified by their investment strategy, of which there are many. Here are some of the popular types of hedge funds:

Global macro funds: These funds typically use macroeconomic strategies, meaning they take positions on the direction of economies, interest rates and currencies. They also can combine technical and quantitative analysis to identify favorable market conditions.

Equity hedge funds: Equity funds use fundamental analysis of individual stocks to find specific companies in which to invest, either long or short.

Relative value hedge funds: Fundamental analysis is used to uncover relative value of various types of securities, such as convertible bonds, mortgage-backed securities, debt securities and other fixed-income assets.

Event-driven funds: These funds employ relative value or arbitrage strategies to buy and sell securities before or after a corporate event, such as a merger or bankruptcy filing.

Arbitrage funds: This strategy seeks pricing anomalies among securities and exploits them, such as when one security is trading at a discount relative to another or when a security is trading at a premium before it becomes publicly available.

The downsides of hedge funds

Hedge funds can be aggressive and risky investments. Some of the regulations designed to protect investors don’t apply to hedge funds. And, if the assets in a fund are below a certain amount, the fund isn’t required to register or file reports with the SEC.

Hedge funds also often rely on leverage to amplify their returns which can expose investors to a wide range of investment risks. And, this type of investment is generally only open to accredited investors, which again, means you must have a net worth of at least $1 million.

Additionally, a concentrated investment strategy and lack of liquidity can lead to huge losses, and long lock-up periods mean access to these investments is limited. On top of that, fees can be much higher than other investments, and investors are exposed to the risk of loss with out-of-pocket costs that may outweigh expected returns.

Bottom line

Even if you qualify as an accredited investor, be sure to talk with a financial professional before investing in a hedge fund. You’ll want to understand the expected returns, risks and fees associated with a fund before committing.

Correction, Feb. 10, 2023, 4:00 pm ET: A previous version of this article stated that hedge fund performance fees were set around 20 percent of profits. The story has been amended to say that while the fee has been historically around 20 percent, it was closer to 16 percent as of 2022. A clarification was also made around when mutual fund trades are executed.