This page of our SIE Study Guide covers the alternative investment vehicle known as hedge funds. Hedge funds pool money from sophisticated investors, typically accredited or institutional investors, and then invest the capital with the goal of quickly generating large returns. These funds carry specific entry and suitability requirements as they are high-risk portfolios that have less liquidity than mutual funds.
The majority of hedge funds in the U.S. are structured as limited partnerships, with the fund managers acting as general partners (GP) and the investors acting as limited partners (LPs). General partners have unlimited liability while limited partners are only liable up to the amounts they invest.
- Because of the unlimited liability component, most hedge fund general partners are actually LLC entities with the individual fund managers acting in their capacity as members/owners of the LLC. Doing so shields the fund managers’ personal assets thereby giving them limited personal liability.
- Like mutual funds and DPPs, hedge funds offer pass-through tax treatment which means that profits are taxed only once at the investor level.
Hedge funds often use leverage—borrowed money—to increase their investment returns. Hedge funds can buy securities on margin, for example, which means borrowing money from a broker to purchase a larger number of securities. Similarly, they can also purchase securities using credit lines from third-party lenders.
In either scenario the fund is hoping to use borrowed money to increase their gains, but keep in mind that leverage also comes with the risk of magnifying losses in the event the investments lose value.
Hedge funds are considered to be generally illiquid as most will require that your money remain invested for a period of time, at least one year, before you can make withdrawals. This is known as the lock-up period.
Investors must typically be considered accredited in order to invest in a hedge fund. As a reminder, individuals can be accredited investors if they have (1) a net worth of at least $1,000,000 (alone or with a spouse) or (2) earned income of at least $200,000 ($300,000 with a spouse) in each of the previous two years with the expectation to earn the same amount in the current year.
Most hedge funds require a minimum investment of $100,000 up to $2 million. Additionally, they come with much higher fees than other packaged portfolios like mutual funds or ETFs.
The standard hedge fund compensation structure is known as two and twenty and means that the fund charges an annual asset management fee of roughly 2% of the amounts invested and a performance fee of roughly 20% of the fund’s profits above the hurdle rate, a predetermined threshold of return the fund must meet before the performance fee is earned. These fees can vary across funds but two and twenty is still considered to be the standard.
Private Equity Funds
Many people confuse hedge funds with private equity funds and vice versa. While there are certain similarities between the two, there are also many important differences, namely their investment strategies and goals.
- Types of investors;
- Compensation structure; and
- Legal structure (limited partnership).
Beyond these similarities, the two invest in significantly different things. Hedge funds will invest in just about anything, including equity securities, debt securities, currencies, derivatives, and more, in order to quickly generate short-term profits.
Private equity funds, on the other hand, are more concerned with long-term returns. They invest directly into companies by purchasing private companies or acquiring controlling interests in publicly traded companies. Though they tend to have longer lock-up periods, private equity funds are considered to carry less risk than hedge funds.