What are hedge funds?

What are hedge funds

Pooling money from investors, hedge funds invest in securities or other kinds of investments, the aim being positive outcomes. Hedge funds, not regulated as stringently as mutual funds and by and large have more latitude than mutual funds to go after investments and strategies that may accelerate investment loss risk. Hedge funds are restricted to well-heeled investors who can afford higher fees, hedge fund investing risk, and institutional investors who embrace pension funds.

A hedge fund can also be understood as an investment firm that uses sophisticated strategies concerning short selling, derivatives, leverage, and alternative asset classes to return yields for investors. Not only are hedge funds more complex relative to traditional mutual funds, but they are also regulated to a lesser degree and tend to look rather obscure. 

As a result, investors might get the feeling they do not exactly understand what they are supposed to do. As a consequence of this, hedge funds cater to high net worth individuals, leaving the run-of-the-mill investor out in the cold. 

Investing in hedge funds – teaser 

It is indeed possible to invest in hedge funds. However, there are limitations as to the king of investors constituting a hedge fund’s investor pool. As a rule, it is quite challenging for individual investors to access a high-performance hedge fund. This compels many to either look for oblique methods of investing in hedge funds or entirely to abandon this dream. 

Hedge funds: objective & features 

A common topic among most mutual funds is their neutrality as to market direction. Since they expect to make money regardless of the market trends up or down, hedge fund management teams are more akin to traders than classic investors. A few mutual funds use these techniques to a greater degree than others. However, not all mutual funds go for actual hedging. 

There are a number of essential features setting hedge funds apart from other pooled investments. The most conspicuous feature is the limited availability of hedge funds to investors. 

Qualified or accredited investors

Hedge fund investors are expected to meet specific net worth requirements – as a rule, a net worth in excess of $1 million or a yearly income in excess of $200,000 for the preceding two years. 

Wider investment capability 

The investment capability of a hedge fund is restricted only by its mandate. Real estate, land, currencies, derivatives, and alternative assets – there is little a hedge fund cannot invest in. Conversely, mutual funds usually have to keep fixated on socks or bonds. 

Frequent leverage use 

Hedge funds frequently use leverage or borrowed money, magnifying their returns, possibly exposing them to a broader range of investment risk. This was shown during the Great Recession.

 In the subprime meltdown, hedge funds were particularly impacted owing to increased exposure to accelerated exposure to collateralised debt obligations and high leverage levels

Fee structure 

Hedge funds charge both a performance fee and an expense ratio. The common fee structure is called two and twenty – a 2% asset management fee and a 20% cut of yielded gains. 

There are a number of particular features demarcating a hedge fund. However, they are private investment vehicles permitting only rich individuals to invest. The wide capability is sometimes risky, just like it sounds. A handful of prominent financial blowups have concerned hedge funds. Be that as it may, the flexibility given to hedge funds has caused a few of the most promising money managers to produce spectacular long term returns. 

Two & twenty structure 

The target of acid-laced criticism is the 2 and 20 manager compensation scheme – employed by most hedge funds. 

The 2 and 20 compensation structure implies that the hedge fund’s manager goes for 2% of assets, and 20% of profits annually. It is not hard to see why the 2% gets the criticism. 

Regardless of the hedge fund manager losing money, the expert still pockets a 2% AUM fee. A manager overseeing a billion-dollar fund could be earning $20 million yearly in compensation without stretching a muscle. Even wiser is the instance of the fund manager who makes $20million dollars even as the fund loses money. They are then obligated to explain the reason why account values plummeted even as they got paid to the tune of $20 million dollars. A tough sell, it generally does not make the cut. 

In the hypothetical instance above, the fund charged no asset management fee, rather taking a higher performance cut. This affords the hedge fund manager the opportunity to make more money alongside investors. Regrettably, this no-asset-management-fee-structure is hard to find in the prevailing hedge fund world. As a result, the 2 and 20 structure still holds fast, notwithstanding the number of funds that are taken up with a 1 and 20 setup. 

Kinds of hedge funds 

Hedge funds may follow different degrees of strategies, embracing equity, macro, relative value, activism and distressed securities. 

 A macro hedge fund invests in bonds, stocks, and currencies to profit from macroeconomic variable change, like global interest rates and economic policies across nations. 

An equity hedge fund could be country-specific or global. It could invest in attractive stocks whilst hedging against equity markets downturns , by shorting overvalued stock for stock indices. A relative value hedge fund takes advantage of the inefficiencies of price or spreads. Aggressive growth, income, value, emerging markets, and short selling are among other hedge fund strategies. 

Hedge funds: well-known strategies 

  • Long short equity

Long short equity works by making use of profit opportunities in both possible upside and downside expected price moves. The strategy assumes long positions in stocks identified as being relatively underpriced whilst selling short stocks deemed overpriced ;

  •  Equity market neutral

Equity market neutral outlines an investment strategy where the manager tries to use differences in stock prices by being long and short to an equal degree in intimately related stocks. These stocks could be inside the same industry, sector, country, and industry, or they may share similar market capitalisation features. These funds are brought about with the objective of furnishing positive returns irrespective of if the overall market is bearish or bullish ;

  •  Merger arbitrage

Merger arbitrage or risk arb concerns simultaneous buying and selling of stocks of two merging companies, leading to riskless profits. a merger arbitrageur assesses the likelihood of a merger not closing on time or not closing at all ; 

  • Global macro

A global macro strategy bases its holdings mainly on several countries’ general economic and political views or their macroeconomic principles; holdings may include long and short equity positions, currency, fixed income, commodities, and futures markets. ; 

  • Volatility arbitrage

Volatility arbitrage tries to profit from the difference between an asset’s predicted future price volatility, such as stock, and the implied options volatility based on that asset. It may expect volatility spreads to either widen or narrow to forecasted levels. The strategy uses options and suchlike derivative contracts ; 

  • Convertible bond arbitrage

Convertible bond arbitrage concerns taking simultaneous long and short positions in a convertible bond and its underlying stock. The arbitrageur expects to profit from market movement by having the right hedge between long and short positions. 

Yet another well-regarded strategy is the fund of funds approach concerning mixing and matching hedge funds and pooled investment vehicles. The mish-mash of asset classes and strategies aims to provide a more stable long-term investment return relative to those of any of the individual funds. The mix of underlying strategies and funds may control the Risk, returns, and volatility. 

Investing in hedge fund: considerations 

You have to be cognizant of the following if you are setting out on your hedge fund journey: 

  • Accredited investor

As a rule, you have to be an accredited investor, which means having a minimum level of assets or income ; 

  • Fund’s prospectus and ancillary material

Ascertain that you are able to make sense of the level of risk involved in the fund’s investment strategies. Understand the degree to which the risks are compatible with your personal investing goals, risk tolerance, and time horizons. The higher the potential returns, the higher the risks you must assume; 

  • The valuation of fund assets

Hedge funds hold investments that are hard to sell and hard to value. You ought to be able to understand the valuation process . you have to be able to make sense of the extent to which a fund’s holdings are valued by independent sources; 

  • Making sense of fees

Fees affect ROI. Hedge funds generally charge an asset management fee of 1-2% of assets, in addition to a performance fee to the tune of 20% of the hedge fund’s profit. A performance fee could motivate a hedge fund manager to take more significant risks in the expectation of the yielding of a larger return;

  •  Redeeming shares and your rights

Hedge funds generally restrict opportunities to redeem or cash in your shares to four times a year or less, frequently imposing a lock-up period of a year or longer, during which the cashing in of shares is not permitted ;  

  • Researching hedge fund managers

Ascertain that the hedge fund managers are qualified, and seek out their history in the securities industry; 

  • Asking questions

You are permitting that your money be taken care of by someone else you ought to know if your money is going somewhere you could approve of, the manner of its investment, and options for retrieval. 

Hedge funds investment advantages

Hedge funds give some worthwhile benefits over traditional investment funds. Some sizable investment benefits: 

  • Investment strategies capable of yielding positive returns in both appreciating and depreciating bond and equity markets; 
  • Overall portfolio risk reduction and volatility reduction in a balanced portfolio; 
  • Investment style variety that gives investors the ability to exactly customise an investment strategy; 
  • Access to the most talented investment managers.  

Investing in hedge funds: disadvantages 

Hedge funds carry an amount of risk as well. 

  • Focussed investment strategy exposes them to possibly big losses;
  •  Hedge funds are less liquid relative to mutual funds; 
  • They generally need investors to lock up money for a time duration; 
  • Leverage can possibly turn minor loss into major. 

How to start a hedge fund: the basics 

It cannot be stressed enough that hedge funds are complicated instruments, entailing plenty of nuanced investigating on your part. You have to have an eye for detail. Hedge fund due diligence is, therefore, something for which the investor himself has to bear responsibility. 

For starters, chew on this: would you like to be a trust, an LLC, or an LLP? 

Starting costs 

The startup costs can be a real burden. You are not wide off of the mark if you reckon a six-figure sum. Sophisticated fund startup costs can run into millions. 

The majority of hedge fund managers will expend most of their first-year money on salaries and third party service fees, like consultants and lawyers. The COO or Chief Operating Officer will have to be hired right away. 

You must secure a considerable amount of capital to manage and make the fund operations worthwhile. Investors would like to see that you have a substantial amount of assets under management (AUM) prior to entrusting you with their money. 

The ‘incubation platform’ option 

Rather than fully forming your own hedge fund, you might also like to go in for an incubation platform. 

The So-called emerging manager business model permits you to start trading in your hedge fund, and seeking investors whilst building an audited track record. 

If you are inclined to this pathway, network folks in the field who are in the kno of things. 

The most apparent advantage of the incubation platform option is that it permits you to spend more money on things like talent and systems acquisitions, prime brokers, fund administrators, third party marketers and auditors. 

The ‘template service’ option 

Using a hedge fund template service option, you can have your costs streamlined by up to 90%. That is to say, you will have reduced costs from anywhere between 60% to 90%. The legal templates you access, thanks to this service, are the same ones wealthy attorneys use. 

You need to be aware that you may have to have legal representation down the road. You can put it off for the time being, but it would be best to retain a very good lawyer as your compliance and legal counsel. 

Investing in hedge funds in the UK 

Approvals & regulations 

To start hedge funds in the UK, hedge fund managers must get approval per the Financial Services and Markets Act 2000. The most basic step involves learning the navigation of the governing body. The Financial Conduct Authority or FCA grants regulation and authorisation approval. 

Applications before the FCA can take up to six months for approval. A requirement stipulates that the investment manager demonstrate sufficient financial resources and the right staff, systems, and controls. 

Post-approval, hedge funds may be monitored for up to a year. The oversight embraces conduct of business rules, compliance, complaints, and financial records and reporting. 

How to start a hedge fund in the UK: key elements 

Besides regulation and authorisation, the hedge fund founders must also decide on the following: 

  • Jurisdiction

The jurisdiction and the fund administrator’s location do not have to tally. The fund’s location defines the taxes that it is subject to. The investor, not the fund, is taxed on the basis of location ; 

  • Structure

Fund structure depends on the kinds of investors and their needs. Included are voting rights, the ability to use leverage, and tax status;

  •  Providers & oversight

British law demands that hedge funds have two independent directors located offshore. On meeting certain criteria, a hedge fund may appoint a UK based investment manager ; 

  • Components

The fund is broken up into two components – share classes and fees. 

Share classes – management and investment classes are just two share classes that the fund creates. Management shares by and large hold voting rights, whereas investment shares are deemed nonvoting. 

Fees – out of the Asset under Management (AUM), the 2 and 20 structure pays a 2% management fee. 


An official partnership of investors pooling money, a hedge fund may not appear so remarkable at first glance. Hedge funds operate with the least disclosure. Hedge funds go for big gains, which, in turn, translate into big profits for fund managers. The minimum investment requirements are way high relative to mutual funds. Deemed a speculative luxury for the rich, hedge fund investors earn very high incomes. Starting a hedge fund in the UK provides a fund with a very sound foundation indeed. InvestBy is the leading online broker that offers best trading services and 350+ trading instruments from different financial markets. Read InvestBy review.

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