How do hedge funds work and make money?

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What are hedge funds, how do they work, and how do they make money? Hedge funds are investment pools that invest in a broad range of assets, including stocks, bonds, commodities and even other hedge funds. The name “hedge fund” comes from the idea that it offers protection so that if one asset falls, another increases in value, thus providing protection so that the fund will protect investors’ capital.

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How do hedge funds work?

The goal of a hedge fund is to maximize returns while minimizing risk. Limited partners in a hedge fund contribute assets for management, while the general partner manages those assets according to their chosen strategy.

The general partner hedges his bets by investing in a mix of assets, following the strategy they touted when gathering assets for the fund. For example, they might combine some short positions on stocks with long ones with the goal that no matter what happens, the fund's value increases or at the very least, doesn't decrease much. Of course, every hedge fund has its ups and downs, no matter what strategy it follows.

Some examples of hedge fund strategies include long-only stocks, long/ short equities, merger arbitrage, market neutral, credit, quantitative and event-driven.

Investing in funds

Not all investors can invest in hedge funds. They are typically only open to accredited investors, which traditionally have been investors with a net worth of at least $1 million, excluding their primary residence, or those with at least $200,000 in annual income or $300,000 for couples. The Securities and Exchange Commission is in the process of expanding the definition of an accredited investor to include investors with certain professional licenses.

Most hedge funds have a minimum commitment required to invest. Typical commitments are in the $100,000 range or more. Many hedge funds have high commitments of $500,000 or even $1 million in order to invest with them. Certain funds have a limit to the number of investors they are allowed to have, so they want investors who can afford to allocate significant piles of cash to their fund.

How do hedge funds make money?

In addition to understanding how do hedge funds work, many people wonder how they make money. Funds make their money by charging fees on the assets they manage and the performance they manage on those assets.

The traditional fee structure for investing in hedge funds is 2 and 20, which means a management fee of 2% and a performance fee of 20%. In other words, they charge 2% of the assets to manage them and then 20% on performance if the assets increase in value. Not all funds follow this structure, however. In fact, as competition in the hedge fund industry increases, many funds have reduced their fees to remain competitive.

Many funds employ what's called a high-water mark, which means that during a time when the fund is losing money, the manager has to recover losses before they can charge a performance fee on new profits. Another common feature in a hedge fund's fee structure is a hurdle rate, which means they only charge a performance fee when the performance passes a hurdle of at least a certain percent. For example, if a fund has a 5% hurdle rate, it will only collect performance fees during periods when its return is higher than 5%.