What's the definition of a hedge fund? Well, simply put, a hedge fund is nothing more than an investment company that invests its clients' money in alternative investments to either beat the market or provide a hedge against unforeseen market changes.
Obviously, though, there is much more to it than that. Hedge funds generally have similar legal structures, relatively comparable investment strategies, and charge about the same amount of fees to their investors. To really understand the definition of a hedge fund, we need to dig a little deeper.
Hedge fund definition
Technically speaking, a hedge fund is typically structured as a limited partnership. Third-party investors like pension funds, banks, and wealthy individuals invest in the partnership as limited partners while the hedge fund management group serves as the general partner.
The hedge fund's management invests the limited partner's money in any number of different ways in an attempt to generate what the pros call "alpha," meaning a risk-adjusted return above the market.
To do that, hedge funds use a huge variety of strategies and tactics. They invest with (and in) debt, complex derivatives, stocks, bonds, options, commodities, and other esoteric investments. Some hedge funds buy large stakes in companies and then use those positions to influence management to make dramatic changes to the businesses. Many times these changes lead to huge profits for investors and the hedge fund itself.
Other hedge funds stay behind the scenes, using financial models and analyses to drive decision making.
Whatever the strategy, hedge funds are all opportunists. They are not limited to just stocks or bonds like other investment vehicles; hedge funds have been known to lease oil tankers to store millions of barrels of crude oil, buy real estate, or launch proxy fights at Fortune 50 companies. When they see the opportunity to make money, they invest.
Likewise, hedge funds make sure that they are paid well for their work and expertise. While fees vary from hedge fund to hedge fund, typically the fund managers charge the limited partners a 2% annual management fee, as well as taking 20% of any profits.
Are hedge funds a bad thing?
Since the financial crisis, the hedge fund industry has come under intense scrutiny. While millions of Americans lost their jobs, their homes, and their retirement savings in the crisis, a select few hedge funds minted billions by betting against the sub-prime housing market. That disconnect between Main Street Americans and Wall Street hedge funds sparked public vitriol against the industry, understandably.
Likewise, hedge fund managers have been accused and convicted of insider trading, questionable business practices, and unethical conduct.
At the core, though, there's nothing bad or evil about hedge funds or the managers who run them, excluding those few bad apples.
Hedge funds were originally invented to provide large investment companies with a way to mitigate their market risks through exposure to alternative assets. Those assets were selected because they would be uncorrelated with the markets. If the Dow Jones or S&P fell, hedge funds would reduce overall losses by investing in assets that would do well when the stock market fell.
That role in the investing universe has obviously expanded to become what the industry is today, but at its core, this is a necessary function for large investors.
The financial crisis and its aftermath brought increased regulation to the industry, which was a needed change. That increased oversight should help to reduce the number of bad players in the hedge fund industry.
Should you invest in a hedge fund?
For most retail investors, investing in a hedge fund is not only a bad idea, it's probably also impossible. Because of the laws and regulations governing this industry, any investor who invests with a hedge fund must qualify as an accredited investor. That means you must have income greater than $200,000 for the past two years, or a net worth exceeding $1 million, excluding your personal residence.
Beyond just getting your foot in the door, hedge funds also charge very high fees and invest in highly volatile and risky securities. For most everyday investors like you and me, that's a bad combination. Any profits are immediately dinged because of the high "2 and 20" fee structure, and oftentimes these risky bets don't work out, resulting in big losses.
Despite the media coverage and celebrity-like status of many top tier hedge fund managers, the reality is that an investment with a hedge fund is best left to institutional and ultra-rich investors. These investors and firms use these investments as they were originally designed -- as hedges against unforeseen shocks to their core portfolios in stocks and bonds.