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man dangles over Wall Street, asking himself What is a hedge fund?

90 Second Lesson: What is a Hedge Fund? 

What is a Hedge Fund? A Quick Investing Guide

By now, you may have read our lessons on private equity fund structure, the stages of venture capital investments or angel investors. All of these investment structures are similar, though the extent of their governing rights and the maturity stages at which investors fund businesses differ in meaningful ways. In this lesson, we will add hedge funds to the pantheon of alternative investments.

So, what is a hedge fund?

How Hedge Funds Differ from Private Equity

A hedge fund is an alternative investment method in which a group of limited partners use high-risk or aggressive methods of investing in the hopes of making a high return, typically in a shorter period of time. Hedge funds are not required to register and report to the SEC, so their strategies can be opaque.

Hedge funds and private equity funds are similar in that they pool capital from investors and are actively managed by a fund manager. Their goal is to receive a high return on investment, and the fund takes a percentage in performance and management fees. For the most part, that is where their similarities end. However, there are many more differences between the two, such as the following:

  • Investment Methods –Hedge funds take larger risks than private equity (though PE funds are gradually taking more risks), use a wider variety of investment strategies and invest in a wide range of asset classes, such as securities, distressed debt and derivatives (e.g., futures and options). This allows hedge fund investors to hedge against market risk and downward market movement.
  • Liquid vs Illiquid – Hedge funds deal with more liquid transactions, including publicly traded securities or bonds, which can be traded quickly on the market and converted to cash. Private equity, however, invests in or acquires businesses, which is an illiquid investment, because it can take years to exit and make a return.
  • Open-Ended vs Close-Ended – Private equity investments are close-ended, meaning they have a specific term (no more than 10 years) and a set number of shares or investors. These investors cannot withdraw until the fund is liquidated, and new investors cannot enter the fund at this time. Hedge funds, however, can add investors or “redeem” (withdraw) investors on certain timetables, and their terms can be indefinite.
  • Compensation – Hedge funds are compensated based on net asset value (NAV) from year-to-year. In order for hedge funds to charge a fee, the NAV must pass the high watermark, which is the NAV at the time of the investor’s contribution. PE funds, however, only charge investors incentive fees once a predetermined “hurdle rate” is crossed.
  • Funding Rounds – Unlike PE and VC investors, hedge fund investors contribute all capital at the very beginning, rather than pledging to contribute more capital in the future on an as-needed basis. Hedge funds can raise money at any time.

Who Can Invest?

Hedge funds are attractive because of the potential for very high returns. However, not everyone can invest in a hedge fund. First, you must be an accredited investor with a net worth of $1 million or an annual income of $200,000 or more. However, large hedge funds can set their minimum contribution to $5 million or more. In the past, hedge funds were comprised of wealthy individuals, but hedge funds have become more institutionalized over time.

Investing requires due diligence, and investors should research top hedge fund managers or traders and hedge fund firms to find the right one. In addition, it doesn’t hurt to get the opinion of a financial advisor to determine if the risk is appropriate for your investment portfolio.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Opportunity Amidst Crisis- Buying Distressed Assets, Claims, and Securities for Fun & Profit and Options for the Accredited Investor.]

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