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 Market Mysteries of the week

   What exactly is a hedge fund? 

Answer:

It’s a pool of money managed by a professional investor. Hedge funds are typically exclusive investments for the ultra-wealthy and institutional investors.

What is a fund?

A fund is a pool of money invested in a particular way.

 As investors, we might want to 

invest in more than one company simultaneously

, but that can be logistically difficult. 

First, we 

might not have enough money to afford a share of every stock

 we want. So, financial institutions pool together millions or billions of dollars and invest in a set of companies. The institutions (like Vanguard or Fidelity) structure that pool of investments as a fund and sell us shares of it. That way, we can invest in their fund with a more reasonable amount of money, and our money essentially gets spread out and invested in all of the underlying companies.

Second, we 

might not want to have to do the work to choose

 which companies to invest in. We can decide to buy index funds or exchange-traded funds (ETFs) if we want a cost-efficient investment in every company in a particular economy or industry. Or, 

we can pay a little extra for a Wall Street portfolio manager to “actively” choose which companies

 in a particular economy or industry will perform the best. These “actively-managed” mutual funds cost a little more, eating into your returns, so you need to make sure you choose good managers.

Is a hedge fund like a mutual fund?

It’s like a special, expensive mutual fund for wealthy people and big institutional investors

 like pension funds or endowments. Hedge funds are not publicly available to regular, “retail” investors. They’re structured as private investment vehicles where you sign legal partnership documents, and you legally need to have a 

net worth of over $1 million

 (not counting your home) to invest. 

Hedge funds also 

require you to lock up your money 

with them for a period of time and require you to give notice of withdrawal months or years in advance.

Why is it called a hedge fund?

Because they’re famous for hedging! Just like when you make two sets of plans for Saturday night in case that date doesn’t work out, professional investors also use different strategies to 

hedge their bets 

and 

limit their downside risk

. 

Hedge funds will try to limit the swings of their overall portfolio by taking bets in both directions. They might make a big investment in Coca-Cola, hoping the stock rises, but then make a smaller bet that Pepsi’s stock will fall (aka a “short”). That way, if some beverage catastrophe happens, and both stocks fall, they make some money on the Pepsi stock going down to limit the loss of the bigger investment in Coke going against them.

Why would you invest in a hedge fund?

Investors are looking for ways to 

increase their returns

or limit their portfolio volatility

, dampening the swings in value. Lower volatility makes investing less emotionally taxing but also allows the value to compound faster.

Investors are always looking for ways to get above-average returns. If you’re a professional investor who is (or seems to be) really good at choosing investments, a bunch of wealthy people and institutions will give you their money to invest on their behalf. 

Why do they have such a bad reputation? 

Hedge funds charge super-high fees and have been known to attract bad actors.

Fees for a basic index fund might be as low as 0.02%, but hedge fund fees can be over 100x higher. Hedge funds often charge around 2% management fee and 20% performance fee, aka “two and twenty.” That means if you’re managing $1 billion, you get paid $20 million (2%) per year in management fees, and then if your investments grow 10%, or $100 million, you keep an additional $20 million (20%) of that profit. If they were to have a great year, up 100% (2x), their fee share of that profit would be $200 million. Funds can calculate it in different ways, but the point is 

they're making a lot more than the mutual fund or index fund providers

. 

Since hedge funds are private, the portfolio managers can act with fewer eyes watching. They restrict withdrawals to do more complex or time-intensive investments like buying a big stake in a company and forcing a change in leadership or strategy. They can also 

use a lot of leverage, taking on extra risk for extra return.

Hedge funds are really just a structure of investing, so the investment strategies, the amount of risk, and the underlying companies or assets can vary widely. Just like how there are all different kinds of index funds and mutual funds, there are many different kinds of hedge funds. 

Many of them can be very boring

, designed to be those helpful hedges that balance and diversify a portfolio. But when you combine big egos, a lot of money, and privacy, there’s bound to be 

some misbehavior

.

⚡The Share Scoops Team

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