What Are Hedge Funds, and Why Is Everybody Talking About Them?

Everything you need to know

Updated 03/15/18
hedge funds
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Unless you work in finance or are a pro investor, you've likely only ever heard the term "hedge fund" nonchalantly mentioned in television shows, movies, or the news. Even if it seems that everyone else already understands the concept, rest assured that a lot of people are wondering exactly what hedge funds are. So we went to an expert for the answer: "A hedge fund is a pooled group of money," explains financial adviser Kristin O'Keeffe Merrick.

In order to invest in a hedge fund, you have to be what's called an accredited investor who satisfies a specific list of requirement. "Not everyone can invest in a hedge fund," Merrick says. This exclusive form of investment is set up like a business and is managed by a group of highly experienced people. Whether you're thinking of expanding your portfolio or just want to stay knowledgeable about financial options, Merrick breaks down everything you need to know about hedge funds.

What Are Hedge Funds?

Money invested by accredited investors is pooled together in an entity called a limited partnership to create what is known as a hedge fund, Merrick explains. These accredited investors must have a minimum income of $200,000 if they're an individual or $300,000 if they're a married couple, and they must have a net worth of at least a million dollars. If you don't meet these specifications, you can't invest in a hedge fund.

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How Do Hedge Funds Work?

Hedge funds are managed by a group of people who have specific strategies. "Portfolio managers, analysts, and operations people all work together to put together a group of investment products to make up the portfolio," Merrick says. For example, one hedge fund might exclusively invest in stocks, while another will trade with a variety of investments, from stocks and bonds to currencies and commodities. Additionally, Merrick notes that hedge funds are generally allowed to use any products they want to "hedge" themselves.

"So they could be long stock ABC and be short stock XYZ as a hedge if their bet goes awry," she explains. Whatever the strategy, the goal of a hedge fund is to create a return, which might be referred to as alpha. With the ability to invest in domestic and international markets, "hedge funds may be aggressively managed and can make use of derivatives," Merrick says. "The end goal is generating high returns either in an absolute sense, but more generally they use a specific market benchmark to gauge their success."

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What Does a Hedge Fund Manager Do?

"A hedge fund is set up like any other business. There is usually a CEO, COO, CFO, and, of course, employees who do the day-to-day work," Merrick says. A hedge fund manager might be the owner and head portfolio manager, although in larger entities there can be multiple PMs. In order to make day-to-day investment decisions, the PM watches markets, talks to colleagues and banks, and follows the news. This is a 24-hour-a-day job, so there's usually an entire team of people working for a fund. "Money never sleeps!" Merrick says.

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What Are the Benefits of Investing In a Hedge Fund?

"Because hedge funds are sophisticated and managed by experienced investment professionals, hedge funds are generally supposed to return higher returns than normal investments," Merrick explains. They're different from other types of investment because they face less regulation than mutual funds and other types of investment vehicles, and aren't limited in terms of investments and markets. "Mutual funds, on the other hand, have strict limits on the types of investments they can use," she adds.

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What are the Drawbacks of Investing In a Hedge Fund?

The biggest drawback to the hedge fund is that they're only accessible to wealthier people and to institutions that can meet the specific requirements of the accredited investor. Additionally, hedge funds have expensive fee structures. "The most common is what is called the 2&20 structure. This means you pay a 2% management fee per year—regardless of performance—and in addition, you give back 20% of the performance for the year," Merrick explains. Lastly, hedge funds aren't very liquid, meaning if you invest, your money will be tied up for a while. "Each fund has its own lock-up; some are a few years," she says.

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Now that you have the inside scoop on what hedge funds are and what it takes to become an accredited investor, think about whether or not this type of investment is right for you, or whether it's time to consider other investment opportunities.

Kristin O’Keeffe Merrick is a financial advisor at O’Keeffe Financial Partners LLC, 100 Passaic Ave., Suite 100A, Fairfield, NJ 07004, 973-227-3660. Views expressed are the current opinion of Kristin Merrick. O’Keeffe Financial Partners is not a registered broker/dealer and is independent of Raymond James Financial Services. Securities offered through Raymond James Financial Services Inc., Member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. Raymond James is not affiliated with MyDomaine.

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