What Is a Hedge Fund?

Structure of a Hedge Fund

A hedge fund is typically organized as a limited partnership. The manager serves as the general partner, invests alongside the limited partners, and retains discretion over trading decisions. The structural features that follow from this arrangement are largely consistent across the industry:

• Minimum investment. Generally $250,000 to $1 million, with the more sought-after funds requiring $5–10 million.
• Lock-up period. Capital is normally locked for one to three years. After the lock-up expires, redemptions are usually permitted on a quarterly basis with 30 to 90 days’ notice.
• Limited disclosure. Hedge funds are not required to disclose their holdings publicly, although larger funds file quarterly 13F reports with the SEC listing their long equity positions. Strategy details, risk metrics, and full performance figures are shared only with investors.
• Performance-linked compensation. The manager is paid both a flat management fee and a fee tied to gains, an arrangement that produces incentives quite different from those of a mutual fund.

The “2 and 20” Fee Structure

The traditional hedge fund fee schedule is 2% management fee plus 20% performance fee:

• 2% management fee. Charged annually on assets under management, irrespective of performance. A fund of $1 billion collects $20 million per year on this line alone, even in a losing year.
• 20% performance fee. Charged on profits above a benchmark (commonly the risk-free rate, sometimes zero). A 10% gain on $1 billion produces $100 million of profit, of which $20 million accrues to the manager.

Combined, a fund managing $1 billion that returns 10% in a year collects $40 million in fees: $20 million in management fees and $20 million in performance fees. This arithmetic is the proximate reason hedge fund principals figure prominently on lists of the highest-paid individuals in finance.

Most funds operate with a high-water mark: the performance fee is charged only on profits above the prior peak NAV. A fund that loses 15% in one year and gains 10% in the next does not collect a performance fee in the second year, since the NAV has not recovered the previous high. The provision exists to prevent investors from paying twice for the same dollar of return.

The fee model has come under sustained pressure. [[John Bogle and the Index Fund Revolution|John Bogle]] and others have observed that, net of fees, the average hedge fund has underperformed an S&P 500 index fund over the past decade. Many funds have re-priced toward “1.5 and 15” or “1 and 10” in response, and a number of large allocators now negotiate bespoke terms.

Common Hedge Fund Strategies

Hedge Funds Compared with Mutual Funds

The Hedge Fund Debate

The case for and against the hedge fund vehicle is reasonably well-developed at this point, and the arguments on each side deserve to be set out plainly.

The Case in Favour

• Absolute returns. The strongest funds aim to produce positive returns in both bull and [[What Is a Bear Market?|bear markets]]. During the [[The 2008 Financial Crisis|2008 crisis]], while the S&P 500 fell 37%, a number of macro and managed futures funds posted double-digit gains.
• Diversification. Hedge fund returns are frequently uncorrelated, or only loosely correlated, with traditional equities and bonds, which can offer genuine portfolio diversification.
• Talent concentration. Performance fees attract analysts and traders who would otherwise work on bank trading desks or run personal capital.

The Case Against

• Fee drag. Net of the “2 and 20” structure, the average hedge fund has underperformed a 60/40 stock-bond portfolio over the past ten to fifteen years. [[Warren Buffett: The Oracle of Omaha|Warren Buffett]] won a well-publicized million-dollar wager that an S&P 500 index fund would outperform a basket of hedge funds over the decade from 2008 to 2017, and did so by a comfortable margin (one imagines the marketing departments would prefer this comparison were drawn less often).
• Survivorship bias. Published industry performance figures tend to exclude funds that closed because of poor results. The reported average therefore overstates the true average.
• Illiquidity risk. Lock-up periods imply that capital cannot be retrieved at the moment it is most likely to be needed: a market crisis, when liquidity is at its scarcest and most valuable.
• Operational risk. The light regulatory regime has accommodated significant fraud cases — Bernie Madoff and the Bayou Group among them — that have cost investors billions.

Hedge Funds from the Individual Investor’s Perspective

Most individual investors will not allocate to a hedge fund directly. The minimums and accreditation thresholds are decisive on that question. Even so, an understanding of how hedge funds operate is useful for several reasons.

• Hedge funds move markets. Large positions can shift prices materially. Knowledge of which strategies are crowded or fashionable helps in anticipating where buying and selling pressure is likely to originate.
• Several strategies are replicable on a smaller scale. [[Pairs Trading: Market-Neutral Strategy|Pairs trading]], [[Mean Reversion Trading|mean reversion]], [[Momentum Trading: Riding the Trend|momentum]], and basic long/short equity approaches are all techniques that individual traders can execute, with appropriate adjustments for capital and access to short inventory.
• 13F filings provide a partial window. Larger hedge funds disclose their long US equity positions quarterly. Studying what the most accomplished managers are buying and selling can supply trade ideas, with the qualification that 13F data is delayed and incomplete (no shorts, no derivatives, no non-US holdings).

One caveat is worth stating directly. The hedge fund industry as a whole has, on balance, struggled to justify its fees over the past decade. The best funds remain genuinely excellent; the median fund has not been. Identifying which is which from the outside is rather harder than it sounds, and the question of access — whether an investor can get into the funds that actually deserve the capital — is largely settled before any analysis of returns begins.

See also: [[Paul Tudor Jones: The Art of Macro Trading|Paul Tudor Jones]] · [[George Soros: The Man Who Broke the Bank of England|George Soros]] · [[Short Selling Explained]] · [[What Is a Mutual Fund?]] · [[Pairs Trading: Market-Neutral Strategy|Pairs Trading]]