Hedge funds: How they work, types of strategies, and some of the big players

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Hedge fund managers seek an edge with diversified strategies.

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Hedge funds are one of several types of alternative investments available to high-net-worth individuals and institutions. Hedge fund managers can invest in many different types of markets, including stocks, bonds, and commodities, but they also employ complex strategies such as taking long and short positions to capture price inefficiencies across investment products and geographies.

Wealthy individuals and institutions invest in hedge funds in hopes of making higher returns than they might in public stock and bond markets. But hedge fund managers can charge hefty fees, and investors may not have ready access to their cash if and when they want to withdraw it.

The Securities and Exchange Commission defines hedge funds as a pooled-money investment vehicle. That means hedge funds combine money from many investors to invest in securities or other types of investments in a single vehicle, with the aim of generating high returns.

Hedge funds are similar to mutual funds in that both investment vehicles pool money and are run by professional managers; however, mutual funds are heavily regulated by the SEC. One of the many differences is that hedge funds are allowed to pursue riskier strategies and investments. That increases the chance of higher returns, but also larger losses.

These vehicles are called hedge funds because they seek to “hedge,” or reduce overall portfolio risk, by investing in ways that are uncorrelated with a traditional stock-and-bond portfolio. That diversification is an attempt to spread out the risk across different strategies so total returns don’t depend on one type of asset class.

Because of the higher risks involved, the SEC limits access to hedge funds to accredited investors. This includes institutional investors such as pension funds and university endowments, along with high-net-worth individuals. To qualify as an accredited investor in the U.S., you must have a net worth of $1 million (not counting the value of your primary residence), or an income exceeding $200,000 (individually) or $300,000 (individual and spouse combined) in each of the previous two years.

You might indirectly own a hedge fund if you receive a pension, since these institutions may invest parts of their portfolios in alternative assets.

When investing in a hedge fund, the manager should send you a prospectus and other material related to the strategies it employs. These legal documents will spell out the risks involved with the strategy; the higher the return potential, the greater the risk of losing money.

Before you invest money with a hedge fund manager, check out their background. If they are registered with the SEC, a manager must send you Form ADV, which lists disciplinary history and other information. That information is also available on the SEC’s Investment Adviser Public Disclosure (IAPD) website.

Hedge funds employ many strategies. Here are a few common ones:

Not all hedge fund managers become household names, but a few are known even outside the world of investing.

Costs to invest in a hedge fund are hefty. Investors can expect to pay an annual asset management fee of 1% to 2% of the total assets under management, plus a 20% performance fee levied on profits. This fee structure is known as “two-and-twenty” and is charged each year. The performance fee is said to be an incentive for managers to earn higher returns and is sometimes paid only above a preset minimum known as a hurdle rate.

Some hedge fund managers become extremely wealthy even if their performance has been subpar. The management fee is assessed regardless of performance, particularly if the asset base grows through additional investment.

In the first quarter of 2023, BarclayHedge said total assets under management for the hedge fund industry was $5 trillion.

Measuring hedge fund manager performance is tricky because there’s no standard performance metric. Hedge funds can pick and choose how they measure performance, as opposed to mutual funds, where the SEC dictates how performance is measured.

Hedge fund data tracker Prequin explains a few common ways managers define performance:

Hedge fund strategies can be extremely complex, and they may require investors to lock up their money for a long time. That’s why these strategies are limited to wealthy individuals and institutions, who can more easily withstand wild price swings and invest money that they don’t need for day-to-day living expenses. Often, these accredited investors keep a small percentage of their total assets in hedge funds.

These are some risks:

Hedge funds offer wealthy individuals and institutions a way to invest in products and strategies where returns are tied more to a manager’s skill (“alpha”) than the market as a whole. But these strategies are very costly and may or may not provide outsize returns. And if a fund underperforms its benchmark—or even loses money—its management team may still get paid handsomely.

If you’re an accredited investor and you’re considering adding hedge funds to your portfolio, do your due diligence, and don’t expect transparency or immediate access to your money if you decide to withdraw your investment.