What is a hedge fund and how does it work? (2024)

• Hedge funds are pooled investment funds that aim to maximize returns and protect against market losses by investing in a wider array of assets.
• Hedge funds charge higher fees and have fewer regulations, which can make them riskier.
• Individuals, large companies, and pension funds may invest in hedge funds as long as they meet asset requirements.

A hedge fund is a type of investment that's open to accredited investors. The goal is for participants to come out ahead no matter how the overall market is performing, which may help protect and grow your portfolio over time. But hedge funds come with some risks, which you'll need to consider before diving in.

What is a hedge fund?

A hedge fund is a private investment that pools money from several high-net-worth investors and large companies with the goal of maximizing returns and reducing risk. To protect against market uncertainty, the fund might make two investments that respond in opposite ways. If one investment does well, then the other loses money - theoretically reducing the overall risk to investors. This is actually where the term "hedge" comes from, since using various market strategies can help offset risk, or "hedge" the fund against large market downturns.

Quick tip: To invest in a hedge fund, you'll need to show you've earned at least $200,000 in each of the past two years ($300,000 for married spouses) or you've got a net worth of at least $1 million. The hedge fund will also have a minimum buy-in.

Understanding how hedge funds work

Hedge funds have a lot of leeway in how they earn money. They can invest both domestically and around the world and use just about any investment strategy to make active returns. For instance, the fund may borrow money to grow returns - known as leveraging - make highly concentrated bets, or take aggressive short positions.

But that flexibility also makes these investment vehicles risky, despite being called "hedge" funds. "There's no transparency in hedge funds, and most of the time, managers can do whatever they want inside of the fund," says Meghan Railey, a certified financial planner and co-founder/chief financial officer of Optas Capital. "So they can make big bets on where the market's going, and they could be very wrong."

The elevated risk is why only accredited investors - those deemed sophisticated enough to handle potential risks - can invest in this type of fund. To be considered an accredited investor, you'll need to earn at least $200,000 in each of the last two years ($300,000 for married couples) or have a net worth of more than $1 million.

Quick tip: Thinking about investing in a hedge fund? Start by researching the fund's manager, investment strategies, and past performance. You can use the SEC's Investment Advisor Public Disclosure (IAPD) website to check the manager's ADV Form. This form provides information about the fund, including any conflicts of interest or past disciplinary actions.

Hedge funds vs. the S&P 500

It's tough to compare hedge funds to the S&P 500 because there are so many different types of hedge funds, and the markets they invest in might be global-oriented, says Chris Berkel, investment adviser and founder of AXIS Financial. "However, we can say that a broad index of hedge funds underperformed the S&P 500 over the last 10 to 15 years," Berkel says.

Berkel points to data compiled by the American Enterprise Institute (AEI) from both the S&P 500 and the average hedge fund from 2011 to 2020. The data shows that S&P 500 index outperformed a sample of hedge funds in each of the 10 years from 2011 to 2020:

"The S&P 500 is a systematic risk, which cannot be diversified away," Berkel says. A hedge fund may provide some safeguards to your portfolio, which you won't get with the S&P 500.

Hedge funds pay structure

Investors earn money from the gains generated on hedge funds, but they pay higher fees compared to other investments such as mutual funds. "The management fee is charged every year, regardless of performance, and the incentive fee is charged if the manager performs in excess of a specific threshold, typically its high-water mark," Berkel says.

The fee is typically structured as "2% and 20%." So in this example, participants pay an annual fee of 2% of their investment in the fund and a 20% cut of any gains. But recently, many hedge funds have reduced their fees to "1.5% and 15%," says Evan Katz, managing director of Crawford Ventures Inc.

Once you put money into the fund, you'll also have to follow rules on when you can withdraw your money. "During market turmoil, most hedge funds reserve the right to 'gate,' or block, investors from redeeming their shares," Berkel says. "The rationale is that it protects other investors and helps the fund manager maintain the integrity of their strategy."

Outside of these lockup periods, you can usually withdraw money at certain intervals such as quarterly or annually.

Quick tip: Many hedge funds have reduced their fees from "2% and 20%" to "1.5% and 15%." You'll find these details listed in the hedge fund's offering memorandum.

A history of hedge funds

Alfred Winslow Jones is widely credited with creating the first hedge fund strategy in 1949. These hedge funds would buy stock in companies where value was expected to increase, and borrow and sell stocks where value was expected to decrease. The goal, Katz says, "was to try to make its investors profits in both 'bull' (up) and 'bear' (down) markets."

These investments became more popular over time but also became more regulated. Here are some quick highlights on the history of hedge funds:

• 1949: Alfred Winslow Jones launched the first hedge fund strategy, where he bought stocks he expected to go up and sold short stocks that he expected to decrease.
• 1952: Jones' company, A.W. Jones & Co., created the first hedge fund product that combined leverage and a hedged strategy, along with a 20% fee.
• 1960s: Hedge funds became increasingly popular after a 1966 article in Fortune magazine highlighted the performance of Jones's investment product.
• 1970s: The recession of 1969-1970 and the stock market crashes of 1973-1974 caused many hedge funds to close.
• 1980s: Assets under management were in the hundreds of millions at the start of the decade, then grew to around $1 billion per hedge fund at the end of the '80s.
• 1990s: Hedge funds continued to see extraordinary returns as hedge fund managers developed new strategies for investing.
• 2000s: More investors turned to hedge funds after the dotcom burst, and assets under management reached nearly $2 trillion per fund by 2008.
• 2010s: A combination of losses from the Great Recession and Bernie Madoff's Ponzi scheme led to fundamental changes in hedge fund regulations.

Are hedge funds regulated?

Hedge funds are regulated, but to a lesser degree than other investments such as mutual funds. Most hedge funds aren't required to register with the Securities and Exchange Commission (SEC), so they lack some of the rules and disclosure requirements that are designed to protect investors. This can make it difficult to research and verify a hedge fund before investing in this type of product. However, hedge fund investors are still protected against fraud, and fund managers still have a fiduciary duty to the funds they manage.

In the news: These 20 hedge-fund dealmakers are investing billions of dollars in the world's hottest companies and beating out venture capitalists.

The financial takeaway

Investing in hedge funds could help your portfolio grow, but you wouldn't want to concentrate your entire nest egg here. Hedge funds are illiquid, require higher minimum investments, are only open to accredited investors, and have fewer regulations than other types of investments, making them a risky endeavor.

"Start by consulting a financial professional who's not incentivized to sell you a hedge fund," Railey says. "Read the offering memorandum, ask some critical questions about past performance, and ask what their strategy is going forward." Then, she suggests, allocate no more than 5% to 10% of your overall investable assets into a hedge fund.

If you're not an accredited investor or you'd rather look at different investments, you still have options outside of your retirement accounts. For instance, you might decide to open an online brokerage account. Keeping your money in the market over time - instead of trying to buy and sell based on market conditions - can be a good strategy, Railey says. "Just start simple, stay simple, and add on complexity as time goes and you have more experience to be able to understand the difference."

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