What is a Hedge Fund?

Dan Westfall

Dan Westfall

What is a Hedge Fund
The allure of big gains is what typically draws people to dive deeper into Wall Street’s many enticing investment options. Hedge Funds are one of the most popular type of firms where big money invests.

Hedge Funds often get the media attention because of the popular and very wealthy hedge fund managers like Jim Simons, Ray Dalio, and David Tepper. If you haven’t heard of any of these guys, then you’ve most likely heard of Bernie Madoff. Madoff ran a hedge fund that turned into a Ponzi scheme, which all unraveled in 2008 with the stock market meltdown.

How Hedge Funds Work

Hedge funds are a type of investment firm that pools money together from accredited investors* and invests the money based on that manager’s investment philosophy. They are very actively managed, often using leverage to buy stock and/or derivative securities like options and future contracts. The goal of a Hedge Fund can vary, however, at its core, the exist to hedge risk – hence the name “hedge” fund.

Difference Between Mutual Funds and Hedge Funds

Whats a hedge fund

Hedge funds often get a bad rap for the extremely high fees they charge. There is also a pattern of underperformance as an industry vs a basic index like the S&P 500. Both of these issues are valid concerns, but the same can be said about mutual funds. The biggest difference between mutual funds and hedge funds is that most mutual funds don’t use leverage. Therefore, the returns are not magnified like a hedge fund’s returns can be.

Hedge Funds Fees

Your typical actively managed mutual fund expense ratio is somewhere around 1%. And, if you work with a financial advisor, they may also charge around 1% for their services for a total fee of 2% combined.

Hedge funds are notorious for charging 2 and 20. This refers to the 2% annual management fee, along with a 20% fee based on gains of the investment. Those fees can vary. But, as a general rule of thumb, those are around where mutual fund and hedge fund are concentrated.

What is a Hedge Fund?

Hedge funds are just another way to invest money in a more non-traditional way. This is opposed to just buying and holding stocks, index funds, or investing in actively managed mutual funds or ETFs. There is definitely a barrier to entry here. This is because you not only have to be an accredited investor* but you likely need a significant amount of money outside of retirement accounts (IRAs, 401k, etc.) that you plan to invest and keep locked up for a period of time.

Hedge fund-like strategies can be implemented on a small scale for individual investors using some of the same tools, like stock options, that hedge funds use. Vanguard has made a name for itself based on its buy and hold investment philosophy. However, their money is also made through active management as well.

Hedge Fund Investors

The argument for years has been that the fees mutual funds and investment managers charge eats away at too much of your return vs a basic benchmark, like the S&P 500 index. But, with better active investment management, these benchmarks can be beaten. Good investment and hedge fund managers have shown this to be true.

*Accredited Investor is an individual or married couple with a net worth of at least $1 million. It can also be an individual that has made at least $200k (or married couple made $300k) in each of the last 2 years.

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