What are Hedge Funds?

Q. What are hedge funds?
A. Hedge funds are often misunderstood. The term "hedge fund" has its origins at least as far back as sociologist Alfred Winslow Jones, who is often referred to as the father of the hedge fund industry. The idea of hedging and the concept of hedge funds came from his idea of reducing or eliminating market risk by offsetting (or hedging) long positions in undervalued equities (stocks he believed would rise in value) with other short positions (stocks he believed would fall in value). This in theory removed the reliance on a rising overall market in order for the hedge fund to make money. In effect, the hedge fund would depend less on the market and more on the skill of the hedge fund manager in determining the value of the stocks within the fund.

Today, hedge fund styles and strategies have expanded, and the definition of a hedge fund has more to do with the structure of the investment vehicle rather than the method of investing. Hedge funds are commonly set up as a limited partnership with the hedge fund manager acting as the general partner and the investors in the hedge fund acting as limited partners. Hedge funds are able to invest using numerous strategies, which may include one or combinations of short-selling, arbitrage, leverage and, of course, hedging. These hedge fund strategies are applied across a diverse array of asset classes, including stocks, bonds, commodities, and currencies.

Q. Are there special risks associated with hedge funds?
A. Yes. In addition to the general risks described for all alternative investments, investing in hedge funds may involve a high degree of risk. These investors often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. All hedge funds are unique and any investor should carefully consider all risks prior to placing money with a particular hedge fund. Specific risks can be found in the hedge fund's offering memorandum.

Q. Who invests in hedge funds?
A. Hedge funds are generally only suitable for sophisticated, high net worth investors including qualified individuals, endowments, institutions, funds of hedge funds, family offices, and pensions.

Q. Are there minimum investments for hedge funds?
A. There is no standard as to hedge fund minimum investments. Minimums are commonly set by the hedge fund manager or hedge fund sponsor, and although typically hedge funds may have a $250,000 or $500,000 minimum investment, there are also hedge funds with minimums well over $1 million.

Q. What types of fees do most hedge funds charge?
A. Hedge funds typically charge a fee based on the amount of invested assets (a "management fee"), and a profit based fee (an "incentive fee"). Typically the hedge fund management fee may be set at 1%-2% of assets annually, and the hedge fund incentive fee may be set at 20%-25% of yearly profits. There are many variations to this basic hedge fund fee structure, some fairly common. Many hedge funds observe a “high-water mark." Under this structure, if an investor loses money with a hedge fund during a given period, no incentive fees will be charged in later periods until these losses are recovered. Another common variation is the "preferred return" or "benchmark." This means that a hedge fund will not collect an incentive fee until a certain return is achieved.

Frequently Asked Questions about Alternative Investments

Frequently Asked Questions about Managed Futures