A hedge fund is an alternative, private investment vehicle that pools capital from institutional investors and high-net-worth people in order to use complex, aggressive and flexible trading strategies. Unlike conventional mutual funds or exchange-traded funds (ETFs) which are very regulated and heavily marketed to the general public, hedge funds are relatively private and have relatively low regulations. While initially created to “hedge” portfolios against market downturns by taking long and short positions simultaneously, hedge funds have moved well beyond their name in the world of finance. Today, they use a variety of global financial instruments (equities, bonds, currencies, commodities, derivatives and private debt) to produce positive absolute returns in the market no matter whether market conditions are high or low (see the table).
Most of the fundamental structure of a hedge fund is different from traditional retail investment products. They are typically structured as a private limited partnership where portfolio managers are the general partners in the investments and rich investors or institutions are the limited partners. In these funds, high-risk investment strategies such as heavy leverage (borrowing capital to take on more investment risk), short selling (betting on asset price decline) and speculative derivatives trading are used in the investment to attract sophisticated investors, accredited investors, and qualified investors with the financial expertise to absorb potential losses. Furthermore, hedge funds enforce strict liquidity constraints through mandatory lock-up periods—often lasting from several months to a year—during which investors cannot withdraw their money, alongside infrequent redemption windows that protect the fund's strategy from being disrupted by sudden capital outflows.
The business of hedge funds, the management and the compensation structure are designed for the manager’s motivation to perform in the most aggressive manner as it is defined in the classic “two and twenty” model. In such a model, investors pay 1% to 2% annual management fees to cover operational and administrative costs and a performance fee (around 20%) on the return from the fund above the target or hurdle rate. In order to execute their strategies hedge funds lean on a network of prime brokers, custodians and independent administrators who take care of the clearing of trades, the financing, valuation verification and the regulatory compliance. This complex system enables hedge fund managers to do fast specialized trades in global markets that regular retail funds can’t.
Hedge fund strategies are as diverse as the financial markets themselves and can be broadly divided into global macro, event-driven, long/short equity, and relative value arbitrage. Global macro funds, for example, tap global geopolitical shifts, macroeconomic trends and central bank policies, and event-driven funds attempt corporate restructurings, mergers or bankruptcies. By making sense of market inefficiencies and liquidity in the markets, and introducing uncorrelated asset classes to institutional portfolios, hedge funds are an essential -- if not controversial-- part of the modern world of finance, balancing the demand for big alpha as well as the barriers to entry and systemic risk.
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