We previously discussed the term “hedge,” which is often used to mean “protection” or “insurance.” It’s easy to assume a hedge fund must provide protection in some way, but that’s not true of most modern hedge funds.
The term originally came from Alfred Jones, who in 1949 formed the first “hedge fund.” His fund invested in common stocks and reduced (or “hedged”) risk by using short positions. Many structural features from that original model still show up today, but modern hedge funds generally aren’t known for protection-based strategies.
Hedge funds share several features with other funds (for example, mutual funds and ETFs):
There are important differences as well. The biggest is regulation: most pooled investment vehicles are highly regulated, while hedge funds generally are not. With fewer regulatory constraints, hedge fund managers can use strategies that publicly available funds are typically prohibited from using, such as:
Most hedge funds require a minimum investment of $1 million (or more) and limit participation to accredited investors*. This helps hedge funds avoid many of the regulations that apply to publicly available investment pools.
The term “accredited” comes from Regulation D, a subsection of the Securities Act of 1933. “Reg D” permits an exempt transaction for securities offered primarily to accredited investors. In practice, that means:
Most securities offerings go through a registration process that requires significant investor disclosures and regulatory oversight. Hedge funds typically avoid that process. You’ll learn more about SEC registration in a future chapter.
*Investors meeting certain requirements tied to wealth or investment experience are defined as accredited investors according to Regulation D.
Because hedge funds operate with limited supervision and regulation, managers often pursue investments with unusual risk/return profiles. Many managers are also compensated based on fund performance, which can create an incentive to take significant risk in pursuit of large returns.
A common hedge fund fee structure is “2 and 20,” meaning:
This is the fee structure for several Bridgewater Associates hedge funds, one of the largest hedge fund companies in the world, with an approximate portfolio size of $150 billion (as of November 2022). Even ignoring the 20% performance fee, 2% of $150 billion is $3 billion. Bottom line: hedge funds can generate substantial fees.
Some hedge funds use exotic strategies and invest in unusual assets. For example, some hedge funds made significant gains on Madoff claims. Bernie Madoff ran a Ponzi scheme that defrauded investors of nearly $60 billion. Victims were eligible to file claims against his assets through a bankruptcy court process.
Bankruptcy proceedings are often slow and don’t guarantee a payout. Some hedge funds bought these claims from victims at deep discounts and then waited for a settlement. For example, someone with a $100,000 claim against the Madoff estate might sell that claim to a hedge fund for $10,000. If the claim ultimately paid out, the hedge fund would earn a 10x return.
Another investment hedge fund managers often gravitate toward is special purpose acquisition companies (SPACs), also called blank check companies. These organizations raise money from investors without having a defined operating business. Instead, the SPAC commits to acquiring or merging with another business within a short period (usually two years or less). Investors are essentially buying into the SPAC executives’ plan, even though they don’t yet know the specific company their money will be invested in.
A blind pool investment is another common hedge fund investment that resembles a SPAC but is somewhat more transparent. SPACs don’t disclose the businesses or industries they intend to target, while blind pool investments typically disclose the industries or sectors they plan to target.
Because hedge funds aren’t available to the general public for several reasons, funds of hedge funds can be a more accessible alternative for the average non-accredited investor. These funds typically invest in a dozen or more hedge funds, which can provide diversification.
Funds of hedge funds also tend to have lower minimum investments (often around $25,000). Even with diversification and lower minimums, they’re still risky investments and are generally suitable only for aggressive investors. Another key drawback is cost: funds of hedge funds charge their own management fees on top of the fees charged by the underlying hedge funds.
Sign up for free to take 9 quiz questions on this topic