Table of Contents
Imagine that you and several friends decide to combine your money together to invest in a business. You all vote on who should be your “fund manager,” the person responsible for choosing the businesses you invest in. Because you’re able to invest a greater amount of money together than you’d be able to invest individually, you make a bigger return on your investment. This is a simple example of how hedge funds work.
Essentially, hedge funds are types of investment pools, or “money pots,” that allow several individuals or institutions to put their money together with the goal of making as much profit as possible. What sets hedge funds apart from other funds, such as mutual funds, is that they often use advanced investment strategies that are considered high-risk/high-reward.
Investing in a hedge fund can be risky and requires a large initial investment, which is why it’s typically only available to “accredited” or “qualified” investors, such as people or institutions with a lot of money (like millionaires or large corporations). If you’re considering working for a hedge fund, or even starting one, you can expect to work in a high-pressure environment, to do a lot of research, and to manage demanding clients. Because hedge fund investment managers are considered experts in financial markets, they must spend a lot of time analyzing investment opportunities and building a client base.
In this article, learn how hedge funds make money, how they differ from other investment funds, and what it requires to start or work for one.
- A hedge fund is a type of investment fund that pools capital, aiming to generate high returns.
- These funds are managed by professionals known as hedge fund managers, who use complex strategies to maximize returns and minimize risks.
- The term “hedge fund manager” can apply to either a company or an individual, but is usually an organization or limited partnership.
- The majority of hedge funds (about 70%) are located in the United States.
- Total hedge fund assets under management (AUM) reached a record high of $5.13 trillion in 2022, according to Statista.
- Starting a hedge fund requires a combination of financial expertise, extensive startup capital, and the ability to comply with legal and regulatory requirements.
- Hedge fund investment strategies can be risky, therefore they’re generally meant for wealthy individuals and institutional investors who can afford to take losses.
What Is a Hedge Fund?
A hedge fund is a type of investment fund and trading platform that pools capital from other investors and invests that money in a variety of assets. Hedge funds work with both institutional investors and accredited investors, meaning individuals or institutions with a high net worth.
Hedge funds make investments in a wide variety of financial markets. They typically take both long and short positions (or make investments) in assets including:
- Real estate
- Derivatives (financial instruments that are tied to underlying assets)
These investments are considered “alternative investments,” or those that don’t fall into one of the conventional investment categories of stocks, bonds, and cash. The aggressive strategies hedge funds use can lead to significant losses, therefore this type of investing isn’t for everyone. These funds usually use complex portfolio construction and risk-management techniques to make the best investments possible that are likely to return profits, but still, their investments involve significant risks and pressure.
How Hedge Funds Make Money
“Hedge funds utilize market inefficiencies as their main source of return. Their primary source of risk is idiosyncratic risk, or the inherent risk involved in investing in a specific asset, such as a stock.”Black Rock
Many funds use investment strategies including derivatives (like options and futures) and leverage (borrowing money to increase investments) to amplify their bets.
Hedge funds make money in two main ways:
- Investment Profits: This is the money funds earn when they’ve made successful investments. For example, if a hedge fund buys shares of a company, and the price of those shares goes up, then they make a profit when they sell those shares. This is very similar to investing in the stock market as an individual.
- Management and Performance Fees: Hedge funds typically charge their investors two types of fees. The first is a management fee and the second is a performance fee.
- A hedge fund will typically earn a fixed percentage, usually around 2%, of the total asset value of the fund just for managing money. This type of management fee is often paid annually regardless of the performance of the fund.
- With performance fees, a fund takes a percentage of the fund’s profits from its investors, typically around 20%. This fee is only paid when the fund makes money. This model of fees is often called the “2 and 20” model (2% to the manager and 20% to the fund).
- The average hedge fund fee structure is a 1.45% management fee and a 17.04% performance fee.
Imagine that a hedge fund manages $100 million in assets one year. If the fund charges a 2% management fee, it makes $2 million a year just for managing the assets, regardless of the fund’s performance.
Now, let’s say the fund makes a 10% return on its investments that year, meaning it earns $10 million. If the fund charges a 20% performance fee, it earns $2 million for its performance (20% of the $10 million profit).
In this example, the hedge fund made $4 million total that year ($2 million in management fees and $2 million in performance fees).
Hedge Funds vs. Other Investment Funds
According to U.S. Securities and Exchange Commission, hedge funds are less regulated than other types of investment funds, such as mutual funds. This means they have more freedom in their investment strategies. On the other hand, it makes hedge fund investing more risky.
Both hedge funds and mutual funds aim to generate returns for investors, but they do so in different ways and must adhere to different regulations. According to the Office of Investor Education and Advocacy, unlike some other types of investment funds, hedge funds are not subject to certain regulations that govern other funds. Because they use different strategies to earn money, these two types of funds are suitable for different types of investors.
Compared to mutual funds, hedge funds often take more aggressive positions and bet on specific outcomes rather than diversifying. This means that hedge funds can often make money even when the overall market is down. On the other hand, they can lose large amounts of money when their bets go wrong.
Hedge funds and traditional investment funds, like mutual funds, both pool money from investors to invest in securities. However, they differ significantly in terms of their structure, strategies, risk profile, and regulatory oversight.
Here are some other key differences between these types of funds:
- Investor Qualifications: Traditional investment funds like mutual funds are open to all investors, regardless of their net worth or income. Hedge funds, on the other hand, are only open to accredited investors who meet certain income and net worth requirements. The reason hedge fund investors need to be qualified is due to the risk involved.
- Investment Strategies Used: Mutual funds generally use a long-only strategy, which means they buy securities with the expectation that they will increase in value over time. Hedge funds, on the other hand, can employ a wider range of strategies, including short sells, which bet that securities will decrease in value. Hedge funds also use leverage (borrowed money), and invest in a wider variety of securities, including derivatives and commodities. This allows hedge funds to potentially make money in both rising and falling markets, while mutual funds make money mostly in rising markets.
- Regulations That Must Be Followed: Mutual funds are subject to strict regulatory oversight, including limits on the use of leverage and short selling. Hedge funds, on the other hand, face fewer regulations because their investors are considered more financially sophisticated. However, this also means that hedge funds are often less transparent.
- Fees That Investors Pay: Mutual funds often charge a management fee, which is a percentage of assets under management. Hedge funds, on the other hand, typically charge both a management fee and a performance fee (see above about the “2 and 20” structure). Due to charging two types of fees, investing in hedge funds is often more expensive for investors, but can pay off with greater profits. It also means that hedge fund managers have a strong incentive to perform well so everyone makes more money.
- Liquidity (Options to Sell and Withdraw Money): Mutual funds offer daily liquidity, which means investors can buy or sell shares at the end of each trading day. Hedge funds, on the other hand, often have lock-up periods where investors cannot withdraw their money whenever they’d like to. Hedge funds usually only allow withdrawals at certain agreed-upon times, such as quarterly or annually.
Types of Hedge Fund Strategies
“Many institutions invest in hedge funds for diversification benefits . . . Hedge funds—because they employ derivatives, short sales, or non-equity investments—tend to be uncorrelated with broad stock market indexes.”David Harper for Investopedia
Hedge fund investing is considered complex, which is why fund managers are often highly skilled, experienced, and well-versed in different types of investment strategies. The effectiveness of each strategy described below varies depending on the fund manager’s skill and the specific conditions in the financial markets.
Below are common types of hedge fund investments and strategies:
- Long and short betting involves betting on some stocks increasing in value and others decreasing.
- Buying funds that are expected to increase in value is called “going long,” while selling shares that are expected to decrease in value is called “going short.”
- The benefit of this strategy is that it can provide returns irrespective of the overall direction of the market.
- Funds use the market-neutral strategy to try and profit from the relative performance of different stocks without exposure to the overall market.
- The benefit is the opportunity to make money despite declining markets.
- When funds attempt to profit from specific events like company mergers, acquisitions, and bankruptcies, they use event-driven strategies.
- The main benefit is the opportunity to buy or sell assets at attractive prices.
- Macro investing involves making investments based on the fund manager’s overall economic or political views.
- This strategy might involve trading in currencies, commodities, or interest rates, for example.
- The benefit is that it allows the fund to profit from large-scale economic trends.
- Similar to the other type of macro strategy, global macro investing happens when funds bet on large-scale (or worldwide) economic trends and events, such as stock market fluctuations, countries’ interest rates, or currencies.
- The benefit is the potential to make high profits, although the global market can be unpredictable.
- Quantitive investing occurs when funds utilize mathematical models and algorithms to make investment decisions.
- This approach reduces risk and helps spot opportunities that may be otherwise missed.
- Distressed securities describe funds buying the debt of companies that are in financial trouble or have already filed for bankruptcy.
- The benefit is that these securities can often be bought at a significant discount and could generate substantial returns if the company recovers.
- Relative value is a “buy and hold” strategy that takes advantage of price differentials between financials (such as stocks, bonds, commodities, currencies, options, and futures).
- Traders who use this strategy anticipate that the underpriced security will increase in value, while the overpriced security will decrease in value.
- The benefit is lowering risk while increasing the probability of profits.
- Activist strategies are used by funds that purchase a significant amount of a company’s shares, thereby influencing shareholders to make changes within the company.
- This strategy might involve the reorganization of a company, layoffs, or operational changes.
- The aim is typically to improve company performance and thereby increase shareholder value.
- Arbitrage involves taking advantage of price differences in different markets. For example, a fund might buy a stock on one exchange where the price is low and then sell it on another exchange where the price is high.
- The benefit of this strategy is that it can generate profits with relatively low risk.
- Fixed-income investing is when a fund invests in assets that provide a return in the form of fixed periodic payments and the eventual return of principal at maturity.
- This strategy typically involves investment in government, corporate, or municipal bonds, certificates of deposit, preferred stock, or other types of fixed-income securities.
- The benefit is that it creates a more predictable income stream and lowers risk.
- Credit involves investing in corporate or government debt.
- The benefit of this strategy is that it can generate regular income from the interest payments on the debt.
- This strategy involves using a variety of strategies within one hedge fund.
- The benefit is diversification, as the different strategies can balance each other out, reducing the overall risk.
Hedge funds manage other people’s money, so a strong sense of ethics is critical. It’s becoming more common for funds to increasingly adopt environmental, social, and governance (ESG) principles in their investment strategies.
For example, a survey conducted by Preqin found that 42% of hedge fund managers reported incorporating ESG factors into their investment processes in 2022.
Pros and Cons of Investing in Hedge Funds
“Markets display varying degrees of efficiency at different points in time, making for constantly-changing opportunity sets. The more uncertainty and the greater the dispersion of potential outcomes, the greater the potential opportunity to capitalize.”Daniel Murphy, Head of Portfolio Solutions at Goldman Sachs
The greatest advantage of investing with hedge funds is also the greatest drawback. Given their wider investment strategies, hedge funds have the potential for higher returns, but also for higher losses.
Pros of Investing With Hedge Funds
- Potential for High Profits/Returns: Hedge fund investing is best suited for investors with lots of capital that can afford to take losses while pursuing high returns. Some hedge funds deliver high returns and are very successful, including whether the overall market is up or down.
- Diversification: Hedge funds often invest in a wide range of securities and use strategies that are not correlated with traditional investments, which can lower the risk of losses.
- Experienced Management: Hedge funds are typically managed by experienced investment professionals with a deep understanding of the markets.
- Ability to Hold Cash: Unlike mutual funds, hedge funds are not required to remain fully invested in the market. This allows them to hold cash or use other strategies to protect against losses during market downturns.
- Access to Alternative Investment Strategies: These funds use strategies and invest in assets that may not be accessible to individual investors or more traditional investment vehicles.
- Flexible Regulations: In the United States, large hedge funds are generally subject to the regulations of the Securities and Exchange Commission (SEC), but they have more flexibility than other types of investment funds because they cater to accredited investors (those who meet certain income and net worth requirements). This is because accredited investors are considered more financially sophisticated and better able to handle the risks of hedge funds. Some of the key regulations include the need to register with the SEC, the requirement to provide certain disclosures to investors, and restrictions on marketing practices.
Drawbacks of Hedge Fund Investing
- Risky and Susceptible to Losses: The use of leverage, short sells, and other risky strategies can lead to substantial losses in some cases. For example, “bear traps” occur in this type of investing climate, in which a stock loses value and a fund experiences losses when they expected returns.
- High Fees: Hedge funds often charge both a management fee and a performance fee, which can eat significantly into returns.
- Lack of Liquidity: Many hedge funds have lock-up periods during which investors cannot withdraw their funds.
- Lack of Transparency: Because these funds are not required to disclose their holdings or strategies to investors, it can make it difficult to understand all the risks involved.
- Regulatory Oversight: While hedge funds are subject to regulations, they are not as closely monitored as mutual funds and other investment vehicles, which may increase certain risks.
Characteristics of Highly Successful Hedge Fund Managers
Becoming a hedge fund manager typically requires a combination of education, experience, personal traits, and skills. Here are some of the key factors:
- Education: Most hedge fund managers have a bachelor’s degree in a relevant field like finance, economics, or accounting, plus many earn advanced degrees, such as a Master’s in Business Administration (MBA) or a Master’s in Finance. Additionally, some hold financial certifications like the Chartered Financial Analyst (CFA) designation.
- Experience: In most cases, hedge fund managers have significant prior experience in the financial industry. This might include roles in investment banking, equity research, trading, or portfolio management, which teaches them the dynamics of financial markets and analysis.
- Analytical and Decision-Making Skills: Being able to understand and interpret complex financial data is a must for hedge fund managers. They must understand and act upon economic conditions, market trends, individual companies, and various types of securities. Therefore, being decisive and having solid judgment are key qualities that most successful investors possess.
- High Stress and Risk Tolerance: Given the nature of hedge fund investing, which often involves taking calculated risks to achieve high returns, successful hedge fund managers often have a high tolerance for pressure, risk, and stress. They also need a high degree of work motivation to keep up with demanding schedules and clients.
- Entrepreneurial Spirit: Some hedge fund managers start their own funds, which requires a strong business acumen, an entrepreneurial mindset, and the ability to attract clients and manage a business.
- Interpersonal Skills: Building and maintaining relationships with clients, team members, and other industry professionals is critical for funds. Therefore, effective communication and negotiation skills are essential.
Here are some of the most well-known, highly-successful hedge funds and their managers (or former well-known managers):
- Bridgewater Associates: Ray Dalio
- Renaissance Technologies: James Simons
- Soros Fund Management: George Soros
- Citadel LLC: Kenneth Griffin
- D.E. Shaw & Co.: David Shaw
- Elliott Management Corporation: Paul Singer
- Two Sigma Investments: David Siegel and John Overdeck
- AQR Capital Management: Cliff Asness
- Third Point LLC: Daniel Loeb
- Pershing Square Capital Management: Bill Ackman
How to Start a Hedge Fund
Starting a hedge fund can be appealing for several reasons:
- Profit Potential: With the “2 and 20” fee structure, successful hedge fund managers can make a lot of money, sometimes in the millions annually.
- Complexity: Hedge funds have more freedom to invest in a wide variety of assets and use complex strategies, which keeps things challenging and interesting.
- Challenge: Running a hedge fund can be intellectually exciting because the markets and client base are always changing.
If you’re interested in starting a hedge fund, here are the steps you’d need to follow:
- Develop Your Investment Strategy: Create a strategy for making profits based on your expertise and experience in the market (it should be well-defined and thoroughly tested).
- Create a Business Plan: Form a business plan that outlines your fund’s goals, investment approach, risk management policies, and target investors, as well as your fund’s structure, fees, and expenses.
- Form a Legal Entity: To start a hedge fund, you need to form a legal entity, such as a limited liability company (LLC) or a limited partnership (LP).
- Register With Regulatory Agencies: Depending on the jurisdiction where your hedge fund is located, you may need to register with regulatory agencies, such as the Securities and Exchange Commission (SEC) in the United States.
- Raise Capital: Once your hedge fund is registered and legally formed, start raising capital from investors. This can be done through various means, such as personal networking, marketing efforts, and partnerships with brokers or other financial intermediaries.
- Launch the Fund: Launch your hedge fund and start investing on behalf of your clients.
How to Know if a Hedge Fund Career Is Right for You
If you’re new to hedge funds and how they work, their structure and strategies might seem confusing at first. New investors and managers typically work with other types of investment funds before moving on to hedge funds, due to their complexity.
Before deciding to pursue a career in hedge fund investing, here are things to keep in mind and resources to familiarize yourself with:
- It Can Require Long Hours: The work in hedge funds can be intense and the hours long, especially for junior employees. It is not uncommon to work more than 60 hours a week, especially during busy times. Large hedge funds tend to be located in busy cities, so a commute from your home to an office may also come into play.
- You’ll Deal With Stress and Pressure: Due to the nature of the business, there can be a lot of pressure to perform well for clients. Decisions have significant financial implications and the markets can be unpredictable, so stress management skills are needed.
- You’ll Have Plenty of Learning Opportunities: Working at a hedge fund can provide valuable experience and exposure to a wide range of investment strategies and financial situations. The financial markets are always evolving, and successful hedge fund professionals are those who stay informed about the latest trends. Working in this type of fast-paced environment requires managers to be adaptable and able to make decisions quickly, often with incomplete information.
- Networking Relationships Matter: For a fund to be successful, a strong network needs to be built and maintained, as this leads to clients trusting the fund. On top of working in an office, expect to be networking and socializing with clients on a regular basis.
- Your Job Won’t Necessarily Be Secure: Finally, consider that job security can be somewhat uncertain at hedge funds, since funds that fail to perform well lose money and may need to let employees go.
Interested in learning more about other options like investing in real estate? Check out this article:
Leaders Media has established sourcing guidelines and relies on relevant, and credible sources for the data, facts, and expert insights and analysis we reference. You can learn more about our mission, ethics, and how we cite sources in our editorial policy.
- Fidelity Investments. Seeking protection with alternatives. Fidelity Learning Center. https://www.fidelity.com/learning-center/wealth-management-insights/seeking-protection-with-alternatives
- CNBC. (2021, June 28). Two and twenty is long dead: Hedge fund fees fall further below one-time industry standard. CNBC. https://www.cnbc.com/2021/06/28/two-and-twenty-is-long-dead-hedge-fund-fees-fall-further-below-one-time-industry-standard.html
- BlackRock. Alternative asset classes. BlackRock. https://www.blackrock.com/americas-offshore/en/education/alternative-asset-classes
- U.S. Securities and Exchange Commission. Hedge funds. Investor.gov. https://www.investor.gov/introduction-investing/investing-basics/investment-products/private-investment-funds/hedge-funds
- U.S. Securities and Exchange Commission. Introduction to hedge funds [PDF]. SEC. Retrieved June 7, 2023, from https://www.sec.gov/files/ib_hedgefunds.pdf
- Preqin. (2022). ESG Report 2022 Press Release [PDF]. Preqin. Retrieved June 7, 2023, from https://www.preqin.com/Portals/0/Documents/ESG%20Report%202022%20press%20release.pdf?ver=2022-06-27-100234-937
- Investopedia. (2015, April 20). 10 Most Famous Hedge Fund Managers. Investopedia. https://www.investopedia.com/articles/investing/042015/10-most-famous-hedge-fund-managers.asp
- GSAM (Goldman Sachs Asset Management). (2022). Drivers Wanted: Sources of Return in Alternative Investments. GSAM. https://www.gsam.com/content/gsam/global/en/market-insights/gsam-insights/2022/drivers-wanted-sources-of-return-in-alternative-investments.html
- National Association of Insurance Commissioners (NAIC). Capital Markets Primer: Hedge Fund [PDF]. NAIC. https://content.naic.org/sites/default/files/capital-markets-primer-hedge-fund.pdf