What is a Hedge Fund?

Hedge funds are alternative investments using pooled funds to earn active returns, or alpha for their clients. Hedge funds make use of aggressive strategies such as the use of derivatives to leverage both domestic and international markets with the goal to generate high returns.

For those of you who know mutual funds, pensions and other investment vehicles, hedge funds differ due to the more relaxed regulations. Therefore, they are accessible only to accredited investors as they require fewer SEC regulations than other funds.

Hedge Fund Characteristics

Hedge funds are illiquid

One key characteristic of hedge funds is that they all are illiquid. This is because each hedge fund locks investors’ money for the period of time the managers decide to. This can be a two-year period or more. This is why investing in a hedge fund can be a long-term proposition since the money can be locked up for years.

Little Regulatory Oversight

The best thing about hedge funds is that they do not need to register or comply with the U.S. Securities and Exchange Commission (SEC). Furthermore, most funds and their managers are not required to register with the Financial Industry Regulatory Authority or the Commodity Futures Trading Commission.

Even though they are not required to do so some of them choose to register with some of these bodies in order to gain trust from their investors and in order to show them some kind of protection (not protection from losing money of course).

Aggressive Strategies

Hedge fund managers differ a lot from traditional money managers. Hedge fund managers have a broad array of investment techniques that are not feasible for a tightly regulated investor, such as short selling and leveraging. They are using aggressive strategies in order to achieve the higher returns that are expected given the level of risk involved.

Managers receive bonuses for fund performance

This is the main difference that distinguishes mutual funds from hedge funds. Managers in hedge funds get individual compensation in the form of a performance fee (SEC regulations forbid mutual funds, for example, from charging performance fees.) Therefore, managers will try to push even harder for bigger gains.

Most of the hedge funds out there are build on the 2 to 20 structure meaning that the fund manager receives an annual fee equal to 2 percent of the assets in the fund and an additional bonus of 20 percent of the annual performance. This is more like a standard bonus structure for hedge fund managers and it rarely changes.

This gives managers an additional boost to want to generate more profits since they know they will have 20% of it at the end of the year.

hedge fund
Secretive about performance

Hedge funds that choose to stay secretive about their performance do so because they do not want “copycats” to follow the same techniques to reach higher returns. Moreover, it is not required for them to report their performance, disclose their holdings or take questions from shareholders so why should they? They prefer to stay secret about their performance so they can continue being on the top and delivering good returns without competitors in the industry being “noisy” about them.

Use biased performance data

The numbers you see in the papers can be misleading since managers are not required to report performance numbers to anyone other than the fund investors. Those who report their numbers do so voluntarily and they tend to have good performance.

Advantages and Disadvantages of Hedge Funds

  1. Can generate profits during both rising and falling equity and bond markets
  2. High returns
  3. Access to the world’s most talented investment managers.
  4. No limits on investment strategies
  1. Losses can be large
  2. Illiquid
  3. The use of leverage, therefore can increase losses and vice versa

Different Types of Hedge Funds

A macro hedge fund invests in stocks, bonds, and currencies hoping to profit from changes in macroeconomics such as global interest rates and countries’ economic policies.

An equity hedge fund can be investing in attractive stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices.

Other types include aggressive growth, income, emerging markets, value and short selling.

Popular Hedge Funds Strategies

Long/Short Equity

This strategy intends to profit from both an upside and a downside price movement. Hedge funds take a long position in stocks that are considered to be underpriced while shorting stocks that are deemed to be overpriced.

Neutral Equity

Managers use this strategy to produce positive returns regardless of the overall market behavior that can be bullish (going up) or bearish (going down). The strategy here is to take long and short positions of equal size in stocks that are similar, in the same industry, country, sector or even have similar characteristics such as market capitalization and historical correlation. By doing so, manages attempt to exploit opportunities in different stock prices.

Merger Arbitrage

Merger Arbitrage involves purchasing and selling the two stocks of two merging companies to create riskless profits. A manager who approached this strategy will review the probability of a merger not closing on time or not closing at all.


The macroeconomic approach is usually based on the overall economy, politics of various countries or other macroeconomic factories. This can include investments in currencies, fixed income, equity, commodities, and derivatives. It usually depends on cultural and seasonal changes, for example, Biden’s administration aims to improve transportation and produce more electric vehicles than before. Hedge funds will take this information and focus more on what is called “green investing”.

Volatility Arbitrage

This strategy involves options and other derivative contracts because it is using the forecasted price target of a stock and the implied volatility of options based on that asset. Exploit this strategy by clicking on the options term.

Funds of funds

As the name has it, the fund of funds approach is a very popular one that involves mixing and matching other hedge funds and pool investment vehicles. This is done in order to hedge risk and control volatility by the use of underlying strategies and funds. For example, one fund is riskier than the other due to its exposure in the derivatives market and the other fund involves exposure in a “safer” market such as the stock market. By doing so you can eliminate risk and increase returns.

We hope that this lesson cleared out the hedge fund term for you. Learn another Trading term quickly, because you know what they say, strike while the iron is hot!