Hedge fund definition

a privately-owned fund which pools money from a limited number of investors with the objective of maximizing returns in bull and bear markets


What is a hedge fund?

Hedge funds are commonly registered as a limited partnership (LP) or a limited liability company (LLC). As the name implies, the investor’s liability in both structures is limited, and they are shielded against future actions from creditors. Investing in hedge funds is allowed for accredited investors with a certain level of income and assets required for investing in such a fund.

Because of the limited financial regulation, hedge fund managers have opportunities to invest in different financial assets and instruments. They can invest in futures, forwards contracts, options, stocks, different debt instruments etc. They can even short stocks - which means selling a stock at a higher price and buying the stock at a lower price. With such a wide variety of financial instruments, hedge funds managers are also able to achieve positive returns in times when the market is moving downwards. Alternatively, managers can increase the risk level of the fund but offer higher returns for investors.

Fees charged by hedge funds

Fees charged by investment funds have an influence on the overall return for investors. Hedge funds managers charge two basic types of fees. The first one is an asset management fee, which can be up to 2% per year. The manager receives this fee when the hedge fund is making a positive return as well as when the fund is recording negative results. A performance fee is the second type. This fee is usually around 20% of the profit made by the hedge fund. These fees, paid to the manager of a hedge fund, are sometimes referred to as “2 and 20”. Investing in hedge funds with such high fees is one of the reasons why these funds are available only to wealthy, accredited investors.

Difference between a hedge fund and a mutual fund

At first glance, hedge funds and mutual funds appear to be similar as they both involve investors pooling money with the expectation of making profits in the future. But there are some significant differences. While hedge funds only accept accredited investors, mutual funds pool money from both wealthy and small investors. Moreover, mutual funds have a higher level of liquidity, which means investors can easily sell or buy ownership in the fund because they are traded daily. Lastly, another major difference is that hedge funds are riskier but can also make higher returns because of the instruments available and aggressive investment strategies.

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