What is a Hedge Fund?

Hedge funds arose when one man developed one simple concept: market neutrality. Alfred Jones bought assets he believed would rise in value relative to the overall performance of the market, and sold short assets whose price he expected to decrease. This led to a multi-trillion dollar industry with opportunities to invest across sectors and achieve positive returns, regardless of market direction. We'll delve into the world of hedge funds in these lessons, looking at the industry growth, key strategies, why investors allocate, and the performance of this asset class.

The term ‘hedge fund’ originally derives from the investment strategy of ‘hedging’ against market movements, maximizing returns and eliminating risks by choosing either long (buy) or short (sell) positions within the market – the aim being to profit regardless of market direction. 

Nowadays, with a total AUM of $3.61tn, the modern hedge fund sector encompasses a diverse group of strategies that can invest in an unconstrained manner to meet a variety of portfolio needs. Providing a single definition is therefore challenging. In fact, one of the simplest ways to define hedge funds is to look at what hedge funds are not:

• Hedge funds are not a single asset class. With their light levels of regulation, hedge funds can invest across a wide range of asset classes and instruments, without the constraints that many public or mutual funds must adhere to.
• Hedge funds do not invest in a consistent way. Investment strategies differ considerably, with varying methods of portfolio construction and risk management techniques.

Historically, hedge funds have been largely unregulated, but this is beginning to change. The Global Financial Crisis (GFC), some high-profile hedge fund collapses, and the changing investor audience have all helped create this shift toward regulation. Previously, only the most sophisticated (accredited) investors were able to invest in hedge funds. Over the past few years amendments on traditional products, for instance UCITS or alternative mutual funds, have made hedge fund investment more accessible for smaller and retail clients. UCITS and alternative mutual funds are explored in more detail in Hedge Fund Structures, Fees, and Returns.

The structure of hedge funds is becoming more varied: funds are often available as pooled vehicles through limited partnerships or limited liability companies, but are increasingly offered as separately managed accounts, or via platforms. Hedge funds tend to be open ended, with all capital invested at the start of a relationship. This is unlike other alternative asset products (such as private equity), where an investor may be called upon to provide capital at intervals throughout the investment relationship. Investors can periodically withdraw capital or increase their subscription.

Hedge funds have often been characterized by the high fee structure they charge. Historically, this is a 2% management fee (based on net asset value), plus a 20% performance fee – a ‘2/20’ fee structure – although in recent years these numbers have fallen on average.

As the industry itself has evolved over time, so too have the reasons for investing in hedge funds. In the 1980s, hedge fund investors – commonly private individuals and families – were mostly looking for high absolute returns. Today, with the capital invested in hedge funds predominantly coming from institutional investors, there are a range of possible motivations including volatility reduction, reduced correlation to public markets, and improvements to returns on a risk-adjusted basis. We explore the history of hedge funds in the next lesson.

The chart below shows why investors invest in hedge funds, as per a survey we conducted.



The benefits of investing in hedge funds vary by strategy. For example, equity strategies can provide high returns that are driven by a manager’s ability to pick stocks, with lower exposure to market risks. By contrast, macro strategies offer investors diversification benefits as managers operate across multiple markets. We explore these strategies and their risk/return profiles in the following lessons.

In this lesson, we introduced you to the world of hedge funds. As the concept of ‘hedging’ against market movements grew to become its own asset class, the structure and how it operates have grown over time too. We covered the general hedge fund structure, how it works, and why investors choose to allocate to hedge funds within their portfolios.