---
title: "What is a Hedge Fund?"
description: "What is a hedge fund? What their managers do--and why the wealthy love and hate hedge fund investments."
canonical_url: https://trendshare.org/how-to-invest/what-is-a-hedge-fund
markdown_url: https://trendshare.org/ai/what-is-a-hedge-fund.md
published: 2013-07-28
last_updated: 2017-08-28
content_license: https://trendshare.org/about/disclaimer
---
# What is a Hedge Fund?

Source: https://trendshare.org/how-to-invest/what-is-a-hedge-fund
Updated: 2017-08-28
If you read the financial news long enough, you'll probably hear about hedge
funds and hedge fund managers. (You'll probably hear that hedge fund managers
are terrible people who avoid taxes and are responsible for half of the
country's woes.) Is that true? What is a hedge fund? What does a hedge fund
manager do? It's easy to get caught up in hyperbole, so let's demystify all of
this.

## What is a Hedge Fund?

In simple terms, A hedge fund is a private partnership formed to invest
money.

Easy, isn't it? Think of a group of twenty people who pledge a million
dollars each, hire a manager, and tell that manager "Get us 20% returns every
year on our investment." At its core, that's all hedge fund investments
are.

The details are a little more interesting.

### A Hedge Fund is Private

Unlike a mutual fund or an ETF or an index fund, the average investor can't
place a trade with a broker and buy into the hedge fund. Because the fund is
structured as a limited partnership, membership is not open to the public.

### A Hedge Fund is Exclusive

Hedge funds are huge; they start with a lot of money and try to build ever
bigger assets. The average investor with several tens of thousands of dollars
in a 401k won't have the kind of money necessary to buy into a hedge fund.

Moreover, it's unlikely that even the few regulations applied to a hedge
fund would allow such a small investor. [SEC](https://www.sec.gov/)
regulations generally require that members be [accredited investors](https://www.sec.gov/investor/alerts/ib_accreditedinvestors.pdf) (PDF link). In simple terms, these investors need a net worth of
at least a million dollars (excluding the value of their primary residence) or
must meet a minimum earned income level for the past couple of years, with
reasonable expectation to continue to do so.

That leaves out most people.

### A Hedge Fund has Few Regulations

Unlike a mutual fund, a hedge fund has far fewer regulations (at least in
the United States). Part of this comes from privacy and exclusivity. Part of it
comes from lobbying. The few regulations on hedge funds tend to prohibit
outright fraud and to promote the idea of fiduciary duty to treat member money
with care.

Hedge funds are free to borrow money to invest (investing using leverage),
to use short-selling, and to engage in other speculative investment practices.
See [the SEC's hedge fund investor alert](https://www.sec.gov/investor/alerts/ib_hedgefunds.pdf) (PDF link) for more information.

## Where do Hedge Funds Invest?

A hedge fund may invest in almost anything. In practice, they tend to follow
more exotic financial instruments than boring stocks and bonds. Because of
their size and their appetite for high returns, they tend to take higher risks
and speculate on distressed companies, futures and options, high-frequency
trading, and arbitrage.

In other words, many hedge funds try to predict financial trends, whether
it's changes in value of currencies in relationship to each other, the prices
of commodities such as gold, silver, and oil, or differences in prices between
financial assets at the sub-second level.

Some hedge funds spend time and assets performing corporate takeovers.
Several talking points in the 2012 US Presidential elections focused on Mitt
Romney's work at [Bain Capital](http://www.trackhedgefunds.com/bain-capital), a hedge fund known (and widely criticized) for its leveraged
buyout operations.

## Criticisms of Hedge Funds

One persistent criticism of hedge funds is that their underregulation has
created a financial instrument which sucks available capital out of more
productive uses. For example, given the choice of investing $100,000,000 in a
factory to produces things to sell, which can generate a 6% return, and
investing that $100,000,000 in a hedge fund which promises a 9% return (for
substantially more risk), the global trend has been to invest in the hedge
fund. Unlike investing in a factory which produces real goods and services (and
jobs....), the hedge fund investment will likely deal with moving money between
banks and other funds, making financial busy work but not producing anything of
productive value.

Further, due to the structure of compensation for these funds, fund
overseers may make hundreds of millions of dollars every year and pay a
fraction of the taxes of a factory worker. In specific, [a hedge fund manager can pay capital gains taxes—15%—on a significant portion of his or her income](http://www.epi.org/publication/pm120/) instead of the 30%+ the rest of us would have to pay.

This costs the US Treasury millions of dollars of revenue every year (if not
*billions*).

Finally, due to limited regulation and oversight and reporting duties, it's
easier for an unethical hedge fund manager to report false returns and defraud
his or her clients. [Kirk Wright](https://www.bizjournals.com/atlanta/stories/2008/05/19/daily54.html) and [Bernie Madoff](http://www.madofftrustee.com/) are
two extreme examples.

## Hedge Funds versus Value Investing

Most people don't have the kind of money needed to buy into a hedge
fund—accredited investors are rare—so there's little reason to
wonder about this kind of financial instrument. There aren't really any hedge
funds for small investors, by definition. With that said, analyzing hedge funds
can be instructive.

A hedge fund probably fails to deliver value to a value investor for a few
reasons. It's difficult to analyze. Unlike a business which must produce real
cash, what does the hedge fund invest in? (If investment growth comes from
derivatives and other non-productive vehicles, you can't use standard modeling
techniques, like free cash flow analysis or owner earnings projections.)

It's run by a professional money manager. What does a hedge fund manager do?
Besides charging exorbitant fees, the same thing any other investment manager,
except riskier, to justify charging higher fees. Keep in mind that the
definition indicates some degree of *hedging*; no matter the direction
the market or the underlying securities go, the fund attempts to make a
positive return. (If stocks go down, the fund is supposed to make money. Think
about what that means for derivatives and other more exotic investments.)

It's underregulated, so the risks of fraud and mismanagement are higher and
the odds of having those detected are lower.

You may not be able to buy in and out of the fund at your discretion. Many
hedge funds require members to invest their money for at least a year at a
time.

There are better opportunities elsewhere. Comparing an index fund versus a
hedge fund is easy; the index fund is better for most investors.

Unfortunately, global investors can't avoid the market and taxation
distortions of hedge funds—corporate takeovers, tax avoidance, and
derivative liquidity chasing are all effects of the current US hedge fund
structure—but that is a problem which needs a political solution.

You're probably better off on your own, investing in businesses you
understand. While hedge funds may promise big rewards, their lack of
transparency (and inaccessibility) make them inadvisable for most
investors.