It is difficult to provide a general definition of a hedge fund. Initially, hedge funds would sell short the stock market, thus providing a “hedge” against any stock market declines. Today the term is applied more broadly to any type of private investment partnership. There are thousands of different hedge funds globally. Their primary objective is to make lots of money, and to make money by investing in all sorts of different investments and investments strategies. Most of these strategies are more aggressive than than the investments made by mutual funds.
A hedge fund is thus a private investment fund, which invests in a variety of different investments. The general partner chooses the different investments and also handles all of the trading activity and day-to-day operations of the fund. The investor or the limited partners invest most of the money and participate in the gains of the fund. The general manager usually charges a small management fee and a large incentive bonus if they earn a high rate of return.
While this may sound a lot like a mutual fund, there are major differences between mutual fund and hedge fund:
1. Mutual funds are operated by mutual fund or investment companies and are heavily regulated. Hedge funds, as private funds, have far fewer restrictions and regulations.
2. Mutual fund companies invest their client’s money, while hedge funds invest their client’s money and their own money in the underlying investments.
3. Hedge funds charge a performance bonus: usually 20 percent of all the gains above a certain hurdle rate, which is in line with equity market returns. Some hedge funds have been able to generate annual rates of return of 50 percent or more, even during difficult market environments.
4. Mutual funds have disclosure and other requirements that prohibit a fund from investing in derivative products, using leverage, short selling, taking too large a position in one investment, or investing in commodities. Hedge funds are free to invest however they wish.
5. Hedge funds are not permitted to solicit investments, which is likely why you hear very little about these funds. During the previous five years some of these funds have doubled, tripled, quadrupled in value or more. However, hedge funds do incur large risks and just as many funds have disappeared after losing big.