A hedge fund is a private investment pool that uses strategies most mutual funds cannot, and it is only open to wealthy investors

A hedge fund is a private investment company that pools money from investors and uses that money to buy and sell stocks, bonds, currencies, and other assets. The key difference from a mutual fund is that hedge funds can use borrowed money, short-sell (bet that prices will fall), and trade in ways that are restricted or forbidden for mutual funds. Because these strategies carry more risk, hedge funds are only allowed to accept money from investors who meet strict wealth thresholds — usually $1 million or more in investable assets.

A hedge fund manager runs the fund and makes all the investment decisions. In return, the manager typically takes a percentage of the money in the fund (often 2 percent per year) plus a cut of any profits the fund makes (often 20 percent). This fee structure is very different from a mutual fund, where you pay a flat percentage and the manager does not share in profits.

Hedge funds are not regulated the same way mutual funds are. They do not have to disclose their holdings to the public, they do not have to follow the same reporting rules, and they can take bigger risks. This lack of transparency is one reason they are only open to investors who are assumed to have the money and knowledge to handle losses.

Key Takeaways

  • Hedge funds use borrowed money and short-selling strategies that mutual funds cannot use, which means they can make larger gains but also larger losses.
  • You must have at least $1 million in investable assets to invest in most hedge funds, though some funds set the threshold higher.
  • Hedge fund managers charge both an annual fee (usually 2 percent) and a performance fee (usually 20 percent of profits), which is much higher than mutual fund fees.
  • Hedge funds do not have to publicly disclose their holdings or follow the same reporting rules as mutual funds, so you have less visibility into what they own.
  • The lack of regulation and higher fees mean hedge funds are riskier and more expensive than mutual funds, and they are designed for investors who can afford to lose money.

How hedge funds use borrowed money and short-selling

Most mutual funds buy stocks and hold them, hoping the price goes up. Hedge funds do this too, but they also use two strategies that mutual funds generally cannot: leverage (borrowing money to invest) and short-selling (betting that a stock price will fall).

Leverage means the fund borrows money from banks or other lenders and uses that borrowed money to buy more assets than the investors actually put in. If the investment goes up, the fund makes a larger profit. If it goes down, the losses are also larger — and the fund still has to pay back the borrowed money. This is why leverage increases both potential gain and potential loss.

Short-selling works like this: the fund borrows a stock from a broker, sells it when ready, and then buys it back later at a lower price (hopefully) and returns it to the broker. The profit is the difference between the sale price and the buy-back price. If the stock price rises instead of falling, the fund loses money. Mutual funds are mostly forbidden from short-selling because it is considered too risky for average investors.

Who can invest in a hedge fund and why the wealth requirement exists

The U.S. Securities and Exchange Commission (SEC) restricts hedge fund investment to accredited investors. An accredited investor is generally someone with a net worth of at least $1 million (not counting their home) or an annual income of at least $200,000 for individuals or $300,000 for married couples filing jointly. Some hedge funds set the minimum even higher.

The wealth requirement exists because hedge funds can lose money quickly and unpredictably. The SEC assumes that someone with $1 million in assets can afford to lose a significant portion of it without becoming destitute. A person with $50,000 to invest cannot afford that same risk, which is why they are not allowed to invest in hedge funds.

There is also a limit on how many accredited investors a hedge fund can have. Most hedge funds are structured to have fewer than 100 investors, which is one reason they do not have to register with the SEC or follow the same disclosure rules as mutual funds.

Hedge fund fees and why they are so much higher

Hedge funds charge two types of fees: a management fee and a performance fee. The management fee is typically 2 percent of the total money in the fund per year. If the fund has $100 million and charges 2 percent, the manager takes $2 million per year regardless of whether the fund made or lost money.

The performance fee is usually 20 percent of any profit the fund makes. If the fund gains $10 million in a year, the manager takes $2 million of that gain. This is called the "2 and 20" structure and is standard across the industry, though some funds negotiate lower fees.

By comparison, a typical mutual fund charges 0.5 to 1 percent per year total, with no performance fee. Over time, the difference in fees is enormous. If you invest $1 million in a hedge fund charging 2 and 20 and a mutual fund charging 0.75 percent, and both earn 8 percent per year, the hedge fund's fees will eat up a much larger share of your returns.

The difference between hedge funds and mutual funds

The main differences come down to who can invest, what strategies are allowed, and how much the manager is paid. Mutual funds are open to anyone and are heavily regulated by the SEC. They must disclose their holdings quarterly, they cannot use leverage beyond a small amount, and they cannot short-sell. Hedge funds are private, less regulated, can use leverage and short-selling freely, and only accept wealthy investors.

Because of these differences, mutual funds are considered safer and more transparent. Hedge funds are considered higher-risk and higher-reward. A mutual fund manager has an incentive to grow the fund steadily and keep investors happy. A hedge fund manager has an incentive to make the biggest possible profit, because they take 20 percent of it.

Neither is inherently better. A mutual fund is appropriate for most people saving for retirement. A hedge fund is appropriate only for investors who have enough money that they can afford to lose a large portion of it and still be financially find.

What "hedge" actually means

The term "hedge fund" comes from the original strategy these funds used: hedging. To hedge means to protect yourself against loss by making an offsetting bet. For example, if you own a stock and you are worried it might fall, you could short-sell a similar stock or buy a put option (a contract that pays you if the stock falls). If the stock falls, your short position makes money and offsets your loss.

Early hedge funds used this strategy to reduce risk: they would buy stocks they believed would rise and short-sell stocks they believed would fall, so they made money whether the market went up or down. Modern hedge funds still use this approach, but many have expanded to use dozens of other strategies, including trading currencies, bonds, commodities, and derivatives. The name "hedge fund" stuck even though many hedge funds today do not actually hedge much at all.

Why hedge funds are less transparent than mutual funds

Hedge funds do not have to file public reports with the SEC the way mutual funds do. They do not have to disclose what stocks or bonds they own, how much they paid for them, or what their strategy is. Investors in a hedge fund receive private reports, usually quarterly, but the general public never sees what the fund owns.

This lack of transparency is one reason hedge funds can take bigger risks and move faster than mutual funds. A mutual fund manager has to worry about how a risky trade will look to regulators and to the public. A hedge fund manager only has to answer to the investors who put money in the fund. On the other hand, this secrecy also means you have less visibility into what your money is doing, and it makes it harder to compare hedge funds to each other or to mutual funds.

Frequently Asked Questions

Can a hedge fund lose all my money?

Yes. Hedge funds use leverage and short-selling, which means losses can exceed the original investment in some cases. This is why the SEC only allows accredited investors to invest in them. If you cannot afford to lose your entire investment, you should not invest in a hedge fund.

Do hedge funds always make money?

No. Hedge funds can and do lose money, sometimes significantly. Some hedge funds have lost 50 percent or more of investor money in bad years. The fact that a manager is skilled does not may provide returns, especially in volatile markets.

Why would anyone pay 2 and 20 fees?

Investors pay high fees because they believe the hedge fund manager can earn returns that are high enough to justify the cost. If a hedge fund earns 15 percent per year and charges 2 and 20, the investor still comes out ahead compared to a mutual fund earning 8 percent and charging 0.75 percent. However, this only works if the hedge fund actually delivers those higher returns consistently.

Is a hedge fund the same as a private equity fund?

No. A hedge fund buys and sells stocks, bonds, and other liquid assets that can be sold quickly. A private equity fund buys entire companies or large stakes in companies, holds them for years, and then sells them. Private equity is even less liquid and even more restricted to wealthy investors than hedge funds.

Can I invest in a hedge fund through my 401(k)?

Typically no. Most 401(k) plans offer mutual funds and index funds, not hedge funds. Some very large 401(k) plans have added hedge fund options, but this is rare. If you want to invest in a hedge fund, you would do so with personal money outside of a retirement account.