What Is a Hedge Fund?

If the year were 1987, this article would have been written by a condescending, middle-aged, white, Wall Street man who was all “understand what the men at the bar are talking about while you silently sit next to them, sipping on a cosmopolitan.” But it’s 2018, I’m 23, not white, and women run the show now. This article isn’t to help you understand what the finance bros blocking the bar are arguing about—this is so you, a financially savvy woman, can learn a new way to maximize your profit.

Maybe you’ll even teach the boys something in the process.

Hedge funds are liquid assets with leverage that are not capped by regulators. They are investment funds with a limited partnership of investors that use high-risk methods in the hope of accruing greater gains. (A general partner assumes responsibility for the asset management and general fund operations, while limited partners are only liable for their contributions—thus the term limited partnership.) With a hedge fund, there are few rules about what you can and can't do.

Step One: Have either a $200k annual income over the past two years OR a net worth that exceeds one million dollars, excluding the cost of your primary residence. This is in case something goes wrong; then you’ll still have a decent amount of money to fall back on. There is also a lock-up period during which investors may not redeem or sell shares, so if you need money quickly, consider an alternative investment strategy.

Step Two: Consult a financial advisor. You can’t just waltz in and get involved in the hedge fund game: you will need to find someone trained in the business to lend you a helping hand, such as an investment manager, portfolio manager, hedge fund analyst, or hedge fund administrator.

Step Three: Sit back (or get super involved; whichever you prefer is totally fine) and watch the money roll in. (You'll need to consider your risk-adjusted return, of course.)

Hedge funds are only typically only available for the individuals with a high net worth. Unlike playing the stock market or investing in Bitcoin, it’s not a free-for-all. The lack of inclusivity makes hedge funds all the more exclusive.

Since a hedge fund is only limited by it’s mandate, it offers wider investment latitude than other funds. With hedge funds, you can invest in pretty much anything: land, real estate, derivatives, stocks, and currencies. Other funds and alternative investments, like mutual funds, will limit you to sticking with stocks and bonds, usually in long form only.

Hedge funds heavily involve leverage, meaning that those with hedge funds frequently used borrowed money to maximize returns. This is great in theory, but historically, it has had some major downfalls (more on that later).

Hedge funds have a pretty nice structure for fees. Hedge fund administrators bypass an expense ratio (or how much it costs for an investment company to operate your mutual fund) and instead go straight for charging ratio or performance fees. This fee, commonly referred to as Two and Twenty, means a 2% asset management fee and then a 20% cut of any gains and returns.

Mutual funds are investment funds that gather money from multiple investors in order to buy securities, and are managed by professionals. Hedge funds are more aggressively managed by hedge fund managers than their mutual counterparts, and can also capitalize on futures and speculations. Because of this, hedge funds are considered a more risky investment vehicle—even though they can offer a higher long-term capital gain.

In short, no, they aren't the same.

1949 was a big year—Indonesia gained independence, China officially became a communist state, and Alfred Winslow Jones created the first hedge fund.

In 1948, Jones, a former writer and sociologist, had written an article about investment trends. Inspired by his findings, Jones (and his company, A.W. Jones and Co.) decided he wanted to play the financial game for himself. After Jones's idea proved successful, the popularity of hedge funds continued to increase. This led to a boom during the high markets of the 1990s.

Like most investment vehicles and other ideas, hedge funds have evolved over time since their creation.

After the financial crisis in 2008, the United States and Europe made regulations to the system in order to prevent the global market from tanking again. These modifications sought to increase government insight and to eliminate certain regulatory gaps.

Actually, this isn’t "some" lingo: it’s literally just one phrase. The words "net asset value" kept popping up while doing my research, and I quickly had to come to terms with how I had no idea what this meant.

Net Asset Value: the value of a mutual fund. This is determined by deducting the fund's liabilities from the market value of all of its shares, and then dividing by the number of issued shares. It’s also a noun.

Three main types of hedge fund exist: open-ended, closed-ended, and listed. Here they are again, but with a little more detail.

Open-ended: Along with issuing shares to new investors, these hedge funds also allow periodic withdrawals at net asset value for each share.

Closed-ended: These issue a limited number of shares at the inception. New shares aren't created to please managers and investors. Instead, they are only able to be bought and shared on the market.

Listed: Exchange-traded funds, or shares that are sold and traded at stock exchanges. These shares can be purchased by non-accredited investors, which also sounds a bit like one of those loopholes for which hedge funds are known.

Hedge funds are administered by professional law investment firms, ensuring that people who know what they’re doing are the ones managing your funds.

Hedge fund managers often invest their own money into the hedge funds they manage. The earn an annual management fee (for example, 3% of assets of the fund) and a performance fee (such as 15% of the increase of a fund’s net asset value during the year).

This is done to align the interest in the investment managers with the desires of the investors. It’s teamwork.

Ready to start your fund? Looking to become a hedge fund manager? Have a look at the strategies used to make these funds successful!

Global Macro: This hedge fund strategy involves focusing the bases of holdings on both the overall income and the political views of various countries.

Equity Market Neutral: This investment strategy focuses on exploiting investment opportunities. It’s unique to a special group of stocks while maintaining an otherwise neutral exposure to large groups of stocks defined (for example: sector, industry, market, and region).

Convertible Arbitrage: A simultaneous purchase of “convertible” securities, along with the short sale of the same issuer’s common stock. Convertible securities include convertible bonds, preferred stocks turned into common stock, capital notes, and warrants.

Fixed-Income Arbitrage: The strategy discovers and exploits the inefficiencies of bond pricing. Think of it as similar to how how computer hackers manipulate holes in software, but in the case of fixed-income arbitrage, with actual money instead.

Distressed Securities: Here’s a wild one. This method preys on corporate bonds, bank debt, and trade claims of companies in distress (read: almost bankrupt). Short sales under distressed securities are difficult, making the funds long.

Merger Arbitrage: Merger arbitrages have the nickname risk artbitrage. Risk arbitrages speculate on successful completions of mergers and acquisitions. Very risky, indeed.

Hedged Equity: These are similar to exchange-traded funds (playing the stock market). For these funds, you buy long equities expected to increase in value, while selling shorter ones expected to decrease.

Emerging Markets: Emerging markets focus on less mature markets. Again, this hedge fund strategy is quite risky, since it is impossible to entirely guarantee if an immature market will succeed or not.

Fund of Funds: In this investment strategy, funds invests in other hedge funds—typically between 10 and 30 of them. Funds of funds are more liquid, but you also have to pay both the hedge fund manager and the manager of the fund of funds.

As was stated above, the ambiguity of hedge funds allows them to yield a higher profit.

Hedge funds have a higher risk factor than the stock market.

Which leads us to what could perhaps be considered the biggest hedge fund con of them all...

Ah, yes, the Ultimate Con.

The 2008 Financial Crisis ruined thousands of lives. A lot went into play in order for things to turn out the way they did, and the term "hedge fund" was definitely tossed around multiple times.

Hedge funds began selling mortgage-backed securities, along with other derivatives (like debt obligations). They were allowed to do this, thanks to a severe lack of regulations. Things were looking pretty good, until interest rates on houses increased, while the demand for houses slowed. Homeowners saw their homes decrease in value, and at the same time they couldn’t afford the payments. This caused them to default.

Once you default, you’re basically saying no one is getting paid. Prime brokers that once held derivatives suddenly weren’t sure if they were holding onto either a gold mine or a bomb, and these prime brokers became reluctant to lend to each other. Not lending also means no money. No money means a market downfall is well on the way. Companies like Bear Stearn and Lehman Brothers lost it all because of their hedge funds.

Hedge funds weren’t solely responsible for the market collapse, but they were a key player. It’s terrible, but it happens. Regulations were passed so it hopefully never happens again.

If you’ve got the money lying around, then yes, you should, Scrooge McDuck. As much fun as it is to bathe in piles of gold coins, it’s even more fun to use it as a hedge fund investment and watch your investments grow.

Yes, hedge funds have the capability of restructuring the global economy, but that shouldn’t be a deterrent. Not many people are given the opportunity to skillfully earn an exuberant amount of money. As long as you are cautious in your decisions—and consider your risk-adjusted return and discuss your decision with your portfolio manager—a hedge fund investment could help you realize greater long-term capital gains.

From Where Are You Getting this Information?

You don’t think I’m smart?

Kidding. I'm not a hedge fund analyst. In fact, I’ve literally never taken an economics class in my life. Aren’t you glad you’ve read this far into this article to discover this truth? That being said, I did thorough research to make sure I'm providing accurate information. I want us all to be successful in the hedge fund business. The majority of the facts in this article were corroborated by Investopedia, along with The Wall Street Journal.