How do hedge funds work?

Table of Contents

Hedge funds

A hedge fund is a type of investment that does not have a fixed structure and makes investments by the method or strategy with which it can to achieve the best returns. Hedge funds are a high-risk investment due to its sophisticated and infrequent business practices. Hedge funds can invest in options or derivatives, resort to leverage, sell short-term commercial currencies, both domestic and foreign.

Investors must be accredited in order to be admitted to a hedge fund. They must meet certain monetary requirements, such as having an annual income of US $ 200,000 and a total net worth of at least US $ 1 million.

The objective of a hedge fund is exclusively to maximize profitability. Unlike traditional investments, such as investment funds, hedge funds aim to generate absolute returns. Traditional investments produce relative returns, which means that performance is assessed in relation to a benchmark. The absolute profitability generates a fixed amount of return per year, regardless of the market situation. Because of this, hedge funds can often decrease compared to other investments in bull markets and overcome them in bear markets. Due to the fact that hedge funds usually have a variety of investments, they have a very low correlation with the stock market.

Hedge funds are considered private entities, which allows them to avoid SEC regulation. Usually, they require a high minimum investment starting at around the US $ 200,000 and only a certain amount of investors are allowed in the fund. They are also prohibited from actively soliciting investors and only investors with a pre-existing relationship with the fund manager can enter the fund.

Most high-risk funds often use retirement outflows and blocking periods. Blocking periods are the amount of time an investor must wait after making an initial investment in the fund to make withdrawals. Withdrawals designate the percentage of the investment that you are allowed to withdraw.

Hedge funds often invest in non-liquid and hard-to-value securities, in which prices are not available every day. Most are valued monthly or quarterly. These assets can also make it difficult to calculate the true performance of the fund.

Fund of funds

Another way to invest in hedge funds is through a fund of funds. A hedge fund is a collection of hedge funds that are managed by an investment manager. There are usually between 10 and 30 funds of funds. The investment manager does the whole process and research on the funds, which takes part of the investor’s risk. A fund of funds is also less risky since there are many common funds together if it performs poorly or sinks, the overall return is not affected as much.

Fund funds are also much easier to enter for a retail investor. Since they are registered with the SEC, there are no minimum investment requirements. Your minimum investment is also quite low in comparison, usually around $ 20,000 to $ 30,000. These funds also allow additional diversification. Managers will normally choose funds that are complementary to each other in order to gain exposure to additional areas in hedge fund investments.


Commissions for hedge funds can be very high in relation to other investments. Usually, two commissions are paid, one is based on total assets and can be in the range of 1 to 3%, and the other is a performance commission that is based on all capital gains obtained by the fund and It can reach up to 40%. Fund managers trade frequently and in large volumes, which significantly increases the amount of taxes on capital gains paid by the investor.