What Are Hedge Funds?

By Brett Melson Wednesday, April 8, 2009

In the news we have heard quite a bit about the hedge fund. However, what really is a hedge fund?  How can someone invest in the hedge fund? How have the hedge funds been able to provide such large returns in years past?

The term “hedge fund” is generally used to refer to a variety of investment vehicles pursuing an investment strategy. In the United States, hedge funds are generally structured as Delaware limited liability companies or Delaware limited partnerships.

Interests in hedge funds are offered and sold in private offerings to sophisticated individuals and entities; hedge fund interests cannot be offered to the general public or advertised through any public means.

By carefully structuring their operations, hedge funds are able to operate without publicly disclosing their activities and investments and can employ strategies and take on levels of debt (or “leverage”) that would otherwise be impossible for more highly regulated entities. The fund can avoid regulation by limiting the number of its investors to 100. Each US investor has to be an "accredited investor."

An accredited investor is either (i) a person with at least $1 million in net worth (including house, cars, boat, etc.) or who has made at least $200,000 a year (or $300,000 jointly with a spouse) for the past two years and expects to make that much in the current year, or (ii) an entity (partnership, corporation, trust, etc.) with $5 million in net worth. For the average American, investing in the hedge fund is simply not possible.

A hedge fund is managed by hedge fund managers. Typically, they are compensated through both an asset-based and a performance-based fee or allocation. For example, a hedge fund adviser commonly receives a management fee equal to 2% of all of the fund’s assets each year, as well as 20% of any gain for a year. 

The managers often have a lot of money in their hedge funds to show that they believe in their strategy and have an incentive to perform, but that is not required. Many investors simply will not invest in the fund if the manager does not have a large portion of his or her own money invested. 

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