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What is a hedge fund?


A hedge fund is an investment fund that collects pools capital from accredited and institutional investors and invest in securities or other type of investments with a goal to generate high returns. What makes them different from mutual funds besides type of investors and diversity of investments is that they are less regulated and have more freedom when utilizing investing strategies that carry greater risk and potential for loss. Reason why it is available to wealthy investors is their knowledge and understanding of risks involved and ability to afford higher fees and potential loses. This means they can use short selling and other speculative activities unlike mutual funds. To be considered accredited investor individual must have a net worth of $1,000,000 at least or annual income of at least $200,000. Term accredited investor is defined in Rule 501 of Regulation D of Securities and Exchange Commission.

Even though hedge funds are not subject to some regulation that protect investors, because they pool money from sophisticated investors, but they subject to prohibition against fraud. Just like mutual funds not all hedge fund use the same investing strategies so investors can pick and choose ones that correspond with their investment style. Reading the offering memorandum is the best way to inform yourself about base and investment strategies of fund, risks, fees and expenses and all other important categories. Like with any investment, the higher returns, the higher is the risk but hedge funds use some speculative investing practice like leverage, using borrowed money to make investment making it extremely risky.

Another important issue is understanding fees involved as they impact your return on investment. Hedge funds have two and twenty fee structure which means that you pay asset management fee of 2% and performance fee of 20% from the fund's profit. This caused some controversy over 2% fee because fund manager could get substantial amount of money if if he didn't make profit for fund. This brings us to the questions about fund manger. It's a smart move to research mangers' background, qualification and if there where any disciplinary issues.

Hedge funds are connected with high returns on investment but investors should be aware of illiquidity. This is connected with two topics. The first is, hedge funds can hold assets that are hard to sell and hard to evaluate. Investor should be aware of fund's evaluation process and assessment of value from some independent source because depending on how much fund values its assets cost of fees will be affected. Also, investors won't be able to redeem their shares because hedge funds put them at usually one year lock-up period. Withdrawals may happen quarterly and bi-annually but some hedge funds have authority to suspend redemption under certain circumstances. Hedge funds can have extraordinary gains but also can lead to heavy losses. 
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