Hedge funds limit their participants to accredited investors. An accredited investor is defined as someone with a liquid net worth greater than $1 million or an annual net income greater than $200,000 (or $300,000 with a spouse). The SEC allows accredited investors to invest in less-regulated securities offerings because it assumes investors with that much wealth will have a level of financial sophistication.
Hedge funds are structured as limited partnerships. The investors are limited partners while the hedge fund company is a general partner. The hedge fund pools money from its limited partners and invests it on their behalf.
Key Characteristics of Hedge Funds
- Hedge Funds Exclude Small Investors
Fund Managers Have a Wide Latitude
The Funds Often Use Leverage
Funds Have a “2 and 20” Fee Structure
Investments in hedge funds are often relatively illiquid. You can only buy in or withdraw during certain periods, and there’s often a lock-up period of several months to several years after the initial investment. Operating this way allows fund managers to take more aggressive positions without the need to provide liquidity to the investors at all times.
The Hedge Fund Industry Today
The hedge fund industry has made a comeback since then. Total assets under management grew from about $2.2 trillion in 2012 to about $3.6 trillion in 2019.
The number of operating hedge funds has grown as well, at least in some periods. There were fewer than 5,000 hedge funds in 2002. The number passed 10,000 by the end of 2015. However, losses and underperformance led to liquidations. By 2019, the number of funds worldwide had reached more than 16,000 according to Preqin.
How hedge funds make money
Hedge funds typically charge two fees: management fees and performance fees.
A hedge fund company typically charges a 2% management fee. This fee is based on the net asset value of each investor’s shares. So, if you invest $1 million, you’ll pay about $20,000 as a management fee that year. This fee goes toward covering the operations of the hedge fund and may be used to directly compensate the fund manager.
The fund manager’s job is to develop the investment portfolio and manage inflows and outflows of cash into the fund. They’re directly in charge of each investment decision and the strategies the fund will use. Often the fund manager and hedge fund company owner are the same.
The performance fee is usually 20% of profits. So, if the hedge fund manager does well, and they increase your investment from $1 million to $1.2 million, they’ll take another $40,000 (20% of $200,000). If the fund does poorly and loses money, there’s no additional fee.
While “2-and-20” has been standard in the industry for some time, hedge funds’ underperformance since the 2008 financial crisis has put pressure on hedge fund companies to lower their fees.