What a hedge fund is, and how it differs from other funds

What is a hedge fund?

A hedge fund is a private pooled investment vehicle defined by how it invests, not by what it holds. It may own equities, bonds, currencies, commodities or derivatives, and it often combines them with borrowing and short positions. The name is a historical leftover: the first funds paired long and short stock positions to hedge market moves. Today many hedge funds hedge little, and some take more risk than a long-only fund.

Hedge funds are not an asset class. They are a set of strategies that use the usual asset classes in unusual ways. Most aim for an absolute return (a positive result in any market) or a good return for the risk taken, so they often judge themselves against zero or a hedge fund index rather than a stock market benchmark.

What tools does a hedge fund use?

Three tools set hedge funds apart from most mutual funds. Leverage means investing more than the fund’s own capital by borrowing or by using derivatives. Short selling means selling borrowed securities to profit from a price fall. Derivatives such as futures, options and swaps let the fund take positions cheaply or hedge them. Not every hedge fund uses all three, and some use none.

The funds are open mainly to institutions and accredited investors , individuals who meet income or net worth tests. That limit is why hedge funds fall under light regulation : fewer rules on what they may hold, how much they borrow, and how much they disclose. The price of that freedom is less transparency and more room for fraud or error, so due diligence matters.

What are the distinguishing features?

Hedge fund investment featuresdefined by how the fund invests, not by what it holds

• Fewer legal and regulatory constraints Memorize private offering, lighter disclosure
• Flexible mandates Memorize shorting and derivatives allowed
• Larger investment universe Memorize equities, credit, rates, foreign exchange (FX), commodities
• Aggressive styles Memorize concentrated positions in credit, volatility and liquidity risk premiums
• Liberal use of leverage Memorize borrowing, shorts and derivatives
• Liquidity constraints Memorize lockups, notice periods, gates
• High fees Memorize management plus incentive fee

Less transparency creates an information gap between manager and investor. Incentive fees help close it, because the manager earns most when investors do.

How do they compare with other funds?

	Hedge fund	Mutual fund	Private equity fund
Investors	institutions, accredited individuals	the public	institutions, accredited individuals
Regulation	light	heavy	light
Tools	leverage, shorting, derivatives	mostly long-only, limited leverage	control stakes, deal leverage
Liquidity	monthly or quarterly, with lockups and gates	daily	locked for the fund’s life (about 10 years)
Fees	management + incentive	flat management fee	management on committed capital + carry
Horizon and assets	shorter, mostly liquid securities	varies, liquid securities	long, private companies
Benchmark	absolute return or risk-adjusted	market index	vintage peers, internal rate of return (IRR)

Against an exchange-traded fund (ETF) the contrast is the same as against a mutual fund: an ETF is a public, exchange-traded, heavily regulated fund that anyone can buy, with low fees and no limits on selling.

Two points the exam likes. Hedge fund managers often invest their own money in the fund, which aligns interests, while mutual fund managers need not. And hedge fund fees are negotiable by investor, while a mutual fund charges everyone the same.

Why can’t you leave when you like?

A hedge fund may hold positions that take time to build and are costly to unwind in a stressed market, such as concentrated, leveraged or distressed holdings. Redemption limits stop a rush for the exit from forcing bad sales.

Hedge fund redemption termsthey let the manager hold illiquid, long-dated positions

• Lockup period Memorize no redemptions for an initial stretch
• Soft lockup Memorize early exit allowed for a fee
  • Redemption fee paid to the fund, not the manager
• Notice period Use it advance warning before a redemption date
• Liquidity gate Memorize caps how much can leave at once

A lockup is an initial period in which investors cannot redeem. A liquidity gate limits the share of the fund that can be redeemed at one time, so assets can be sold over a longer period. A soft lockup allows early redemption for a fee, normally paid to the fund rather than the manager, to protect the investors who stay.

Exam tip Lockup = no exit for a while. Gate = a cap on the total leaving. Soft lockup = early exit for a fee paid to the fund.

How are managers paid, and what is a high-water mark?

Managers charge a management fee on assets plus a performance fee (also called an incentive fee) on profits. A high-water mark is the previous peak value on which a fee was paid. After a loss, the manager earns no incentive fee until the fund climbs back above that peak. That protects investors from paying twice for the same recovery.

$$F = p \times \max\left[0,\; V_1 - H\right]$$

Here $p$ is the incentive fee rate, $V_1$ the fund value at the end of the period and $H$ the high-water mark.

Go deeper Why alignment matters: co-investment and the high-water mark

Because investors cannot see everything a hedge fund does, they rely on incentives. A manager with personal money in the fund shares the losses, and a high-water mark stops a manager from collecting fees on a swing up and down around the same level. Neither removes the need to check the manager’s controls, reporting and fee calculations before investing.

Go deeper Fee models and side letters

The long-standing structure is ‘two and twenty’: a 2% management fee and a 20% share of profits. Under pressure from investors, some newer funds charge the greater of a 1% management fee or a 30% share of outperformance against a benchmark (sometimes called ‘1 or 30’). Fees are negotiable, and a manager may sign a side letter giving one investor different terms, such as lower fees or more information. Fee arithmetic is covered in the performance and returns module.

Go deeper After 2008: more transparency and due diligence

The 2008 crisis and fraud cases such as Madoff’s led institutional investors to demand more transparency, control over leverage and operational checks. Several hedge funds have also failed through complex strategies in market turmoil, which is why investors review strategy, liquidity, reporting and fees before committing.