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A hedge fund is similar to a mutual fund. It pools money from multiple investors and invests it in securities like stocks and other assets. Unlike mutual funds, though, hedge funds use more aggressive and riskier strategies. They are also very exclusive, which means they are generally only open to accredited investors. Hedge fund managers can charge much higher fees than mutual funds because of the increased risks they take and higher returns they promise.
Key Takeaways
- Hedge funds are financial partnerships that employ various strategies to maximize returns for their investors.
- Hedge fund managers can invest in non-traditional assets and employ riskier strategies than mutual fund managers.
- Funds are compensated using a standard 2% management fee and a 20% performance fee.
- The majority of hedge fund investors are based in North America.
History of Hedge Funds
Former writer and sociologist Alfred Winslow Jones’ company, A.W. Jones & Co., launched the world’s first hedge fund in 1949. Jones was inspired to try his hand at managing money while writing an article about investment trends earlier that year. He raised $100,000 (including $40,000 of his own money) and tried to minimize the risk of holding long-term stock positions by short-selling other stocks.
This investing innovation is now called the classic long/short equities model. Jones also employed leverage to enhance returns. In 1952, he altered the structure of his investment vehicle, converting it from a general partnership to a limited one and adding a 20% incentive fee as compensation for the managing partner.
Jones was the first money manager to combine short selling, leverage, and shared risk by partnering with other investors. Because of his innovation and use of compensation based on performance, Jones earned his place in investing history as the father of the hedge fund.
Hedge funds took off in the 1990s when high-profile money managers deserted the mutual fund industry for fame and fortune as hedge fund managers. A hedge fund’s ability to attract investors tends to rely heavily on the reputation of its manager for delivering results.
Hedge Fund Industry at a Glance
Here are some vital statistics about the hedge fund industry as of the third quarter of 2024:
- The industry had about $4.9 trillion in assets under management (AUM) invested in 54,637 funds.
- There were over 10,000 hedge fund managers and almost 8,400 investors.
- About 36% of the money in hedge funds comes from private or public pension funds. Other major contributors include endowments and foundations.
Hedge funds charge relatively high fees. A 2% management fee and a 20% “performance fee” are standard. Their investors tend to be some of the very wealthiest individuals. Minimum investments of $100,000 are common, and some require $1 million or more.
Important
A hedge fund isn’t the same as a private equity fund even though both are alternative investment vehicles. Unlike hedge funds, private equity focuses on investing in private companies usually over the long term.
Notable Hedge Funds
Notable hedge funds include Renaissance Technologies (also known as RenTech or RenTec), founded by Jim Simons. Renaissance specializes in systematic trading using quantitative models derived from mathematical and statistical analyses.
Pershing Square is a high-profile activist hedge fund run by Bill Ackman. Ackman invests in companies he feels are undervalued by taking a more active role in the company to unlock value. Activist strategies typically include changing the board of directors, appointing new management, or pushing for a sale of the company.
Carl Icahn, a well-known activist investor, leads a prominent hedge fund. One of his holding companies, Icahn Enterprises, is publicly traded and gives investors who can’t or don’t want to invest directly in a hedge fund an opportunity to bet on Icahn’s skill at unlocking value.
| Top 5 Hedge Funds in the U.S. | |
|---|---|
| Hedge Fund Name | AUM |
| Bridgewater Associates | $124.0 billion |
| Renaissance Technologies | $105.0 billion |
| AQR Capital Management | $99.0 billion |
| Elliott Investment Management | $65.5 billion |
| Millennium Management | $61.1 billion |
Hedge Funds Regulation
Hedge funds face little regulation from the Securities and Exchange Commission (SEC) compared to other investment vehicles. The SEC only requires hedge funds to register if they have more than $150 million in private funds and manage one or more funds. Funds with AUM of $500 million or more must file quarterly and report the details of their liabilities and assets.
In May 2023, the SEC adopted measures to force large hedge funds to disclose more information via Form PF, which is used for confidential event reporting.
Funds that operate outside the U.S. follow the regulations of their home countries.
Are Hedge Funds Risky?
Hedge funds are risky in comparison with most mutual funds or exchange-traded funds. They take outsized risks in order to achieve outsized gains. Many use leverage to multiply their potential gains. They also are unconstrained in their investment picks, with the freedom to take big positions in alternative investments.
How Do Hedge Funds Make Money?
The standard compensation for hedge fund managers is called the 2-and-20 rule. That’s a 2% fee plus 20% of the profits the fund earns above a specified minimum.
Are Hedge Funds in the Financial Services Industry?
Hedge funds are part of the broader financial sector but are less regulated by the government than other financial products such as mutual and exchange-traded funds.
The Bottom Line
A hedge fund, like an actively managed mutual fund, is a pool of money from many sources invested by a team of financial professionals. But that’s where the similarities end. Hedge funds aren’t regulated the same way mutual funds are and operate with far less disclosure. They pursue more flexible and riskier strategies to net big gains for investors and themselves.
But perhaps what sets them apart from mutual funds the most is that they have much higher minimum investment requirements. The majority of hedge fund investors are accredited, meaning they earn very high incomes and have net worths of over $1 million. This is why hedge funds are considered to be a speculative luxury for the rich.
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