A hedge fund is basically an investment pool contributed by a limited number of partners (investors) and operated by a professional manager with specific goals in mind - mainly to maximize returns and minimize risk. And, because of their nature, hedge funds are typically only open to qualified (read: well off) investors, although not exclusively - institutions, investors with connections to the manager, or even the managers themselves also frequently invest.

Hedge funds often have a wide range of securities that they are invested in, and while not all are required to register with the U.S. Securities Exchange Commission (SEC), large hedge fund managers and a few other exceptions must register. When the investment structure is created, it is typically structured in two ways: As either a limited partnership (LP) or a limited liability company (LLC). The former is a structure wherein the partners are only liable for the amount of money they personally invest, while the latter is a corporate structure where investors can't be held individually responsible (or liable) for the company's liabilities.

Regardless of the structure, the hedge fund is operated by a manager who invests the money into different assets to achieve the fund's goals. Different kinds of hedge funds have different goals (like funds that invest in "long only" equities - only buying common stock and not selling short; or ones engaged only in private equity). But a common goal for almost all hedge funds is their aim at market direction neutrality - meaning they try to make money despite the market fluctuating up or down. So, hedge fund managers often act more like traders.

Hedge funds got their name from investors in funds holding both long and short stocks, to make sure they made money despite market fluctuations (called "hedging"). But now, hedge funds have many different kinds of structures with different assets and securities.

How Does a Hedge Fund Work?

The basic structure of a hedge fund is an investment or partnership pool where a fund manager invests in different securities and equities that match up with the fund's goals. However, one of the biggest distinguishers about hedge funds is that they are almost always only available to "accredited investors" - or investors with a certain amount of capital.

In order to be considered an "accredited investor," you must qualify by one of the following: Have a personal annual income of $200,000 or more for yourself only (not combined - if you are married, the combined income has to be $300,000 or more annually), you must have a personal net worth of over $1 million (this could be either yourself or combined with your spouse), must be a higher-up (executive, director, etc.) involved in the hedge fund, or have an employee benefit plan or trust fund worth at least $5 million (made before investing).

As per government regulations, hedge fund managers can only accept 35 non-accredited investors to any given firm or partnership, and are often reserved for people the manager knows (like friends or family).

Structure of a hedge fund

The main structure of a hedge fund rests on the following basic components:

  • They are typically only available to qualified or "accredited" investors (who are worth a net $1 million or have an annual income of $200,000 per year).
  • They have a wide spread of investments (to include stocks, bonds and mutual funds, but can also invest in real estate, food, currency, art, or whatever the fund's goals can encompass).
  • They frequently leverage other funds like borrowed money to attempt to increase returns (which can increase risk but also increase returns).
  • They have a "2 and 20" fee structure, where an expense ratio and a performance fee are charged.

But what is the "2 and 20" structure, and how does a hedge fund make money? (Glad you asked).

What Is a '2 and 20'?

Most hedge funds operate on a "2 and 20" manager compensation scheme, which gives the hedge fund manager 2% of the assets and an incentive fee of 20% of the profit every year. However, this structure has widely been criticized given that even if the hedge fund loses money that year on the profits, the fund manager still makes a cozy amount from that 2% of the invested assets.

For example, if a hedge fund manager set up a fund and got an investor to invest $1 million, the manager would get 2% of that amount (so $20,000) no matter what - and, if the investments did well and the manager was able to double the amount to $2 million, the manager would walk away with an additional $400,000 (20% of $2 million).

Still, given their nature, hedge funds often have very aggressive investment goals, and are very lucrative in producing strong profits.

Different Kinds of Hedge Funds

As mentioned before, a hedge fund's main goal is to minimize risk and maximize profits for its investors. However, there are several different kinds or strategies of hedge funds that do different things. The goals of the hedge fund will determine its investments. Some of the most common include macro or global hedge funds and equity funds.

Macro Hedge Funds

Some hedge funds, like macro hedge funds, invest in stocks, bonds, futures, options and sometimes currencies in hopes of maximizing on changes in macroeconomic variables like global trade, interest rates, or policies. These kinds of investments are usually highly leveraged and highly diversified. However, historically, these types of funds have been the biggest busts (like Long-Term Capital Management, for example).

Equity (Long/Short) Hedge Funds

Another kind of hedge fund, called an equity hedge fund (also known as long/short equity), attempts to hedge against declines in equity markets by investing in stocks or stock indices and later shorting them (if they're overvalued).

But, in a long/short hedge fund, managers invest in undervalued stocks and split up investment between investing long in stocks while shorting other stocks. For example, the fund could have 60% of its funds invested long in stocks and 40% in shorting stocks, leaving a net exposure up to equity markets of 20% (60%-40%=20%, but keeping gross exposure at 100% to avoid leveraging). But, if the fund manager decides to invest 70% long in stocks and keep 40% in shorting stocks, the gross exposure would increase to 110% (with 10% leverage).

Relative Value Arbitrage Hedge Funds

These hedge funds typically buy securities that are expected to appreciate while simultaneously selling short a similar security (like a stock or bond from a different company in the same sector or the like) that is expected to depreciate in value.

Distressed Hedge Funds

Despite the title, these funds are not in trouble - they are simply frequently involved in loan payouts or restructurings. These funds may even help companies turn themselves around by buying some of the securities (like bonds that have lost value due to financial instability within the company) in hopes they will appreciate. Or, distressed hedge funds may buy cheap bonds if they think they will appreciate soon - still, as you can imagine, these types of bets can be risky given that the company's stock or bonds are not assured to appreciate.

Hedge Fund vs. Mutual Fund

Still, hedge funds and mutual funds sound suspiciously the same - after all, they have the same basic structure (a group of investors putting their money into a collective pool that is managed by a fund manager and is used to invest in different securities), but there are some key differences.

First, while hedge funds have requirements for investment (such as being an "accredited" investor with a certain amount of net worth or income), mutual funds typically do not.

Additionally, while mutual funds have daily liquidity (meaning their assets can be quickly bought or sold without affecting the market value), hedge funds often do not. Many hedge funds only have subscriptions or redemptions every month or only quarterly (meaning they accept investors that frequently).

Still, hedge funds are able to invest in a much wider spread of investments than mutual funds can. So, hedge funds can invest in traditional stocks, bonds and other commodities, but can also invest in things like real estate, the food industry, currencies and more. Because of this, hedge funds are often riskier investments than mutual funds (combined with the fact that many hedge funds operate on the hedging structure explained above).

And, making them riskier or more aggressive than mutual funds, hedge funds are able to short sell stocks and leverage more speculative positions that often make it easier to make money even when the market is bad. Mutual funds, on the contrary, are not able to operate the same way in favor of a safer modus operandi.

Yet another difference is that hedge fund managers earn hefty profits from operating the funds, both in a percentage of the assets and typically 20% of the fund's profits (realized and unrealized), while mutual fund managers usually only get a percentage of assets.

How to Invest in a Hedge Fund

Before you invest in a hedge fund, you must make sure you are prepared and suitable (financially) for the venture. The obvious way to do this is to ensure you meet the "accredited" standards for investors for hedge funds mentioned above.

Still, you also need to decide how aggressive and risky you wish to be, what you would like to invest in, and what your goals are. By researching different funds, you should keep these goals in mind when choosing what fits best with your desires and capital availability.

Some of the biggest hedge funds include Bridgewater Associates LP, JPMorgan Asset Management, Vanguard Russell 1000 Gro I, and Fidelity Sel Defense and Ae. 

Check out some of the best hedge funds here, based on our own editors' opinion.