A hedge fund is similar to other investment funds in the sense that it takes money from outside investors, invest their money to attempt to achieve returns expected by those investors, and charge management fees. However, that is where all the similarities end. It is hard to define hedge funds in a few short sentences, but here are 4 characteristics of Hedge Funds that differentiate them from other funds like mutual funds and money market funds:
Only Accredited Investors are allowed to invest in hedge funds:
- Has an individual net worth, or joint net worth with that person & spouse exceeding $1,000,000.
- Had an individual income in excess of $200,000 or $300,000 in joint income with spouse in each of the two most recent years, and likely to earn the same income level in the current year.
- Is the director, executive officer or general partner of the issuer of the securities being offered or sold.
Although few investors can invest in hedge funds, as of 2019, the total Assets Under Management (AUM) by hedge funds amount to a staggering $3 trillion dollars! If hedge funds were a country, it would be twice the size of Russia in terms of GDP!
- Since hedge funds are private firms and not subject to regulations by the authorities, they can invest in any type of financial products and employ different investment strategies that are not permitted in traditional investment funds. A hedge fund can also invest in risky financial products such as derivatives and shares of new private companies.
- In addition, hedge funds are permitted to use leverage to amplify returns on their investments. This allows them to outperform the market and traditional funds by a large margin, but also make investing much more risky.
Hedge Fund Managers invest their own money in the fund:
- Unlike managers of traditional funds, all Hedge Fund Managers put a substantial amount of their own money into the funds they manage. Moreover, whatever profit attributed to the manager from investing, a large part of it will be reinvested into the hedge fund.
High management fees:
- The "2 and 20" fee structure, which means they charge 2% of AUM as management fees, and 20% performance fees on the profits made.
- The "2 and 20" fee structure is not standard across all hedge funds, rather, it is close to the average fees charged by hedge funds. Some hedge funds that have a history of outperforming the market by double-digits, can charge management fees as high as 4% and performance fees as high as 50%!
For example, the hedge fund SAC Capital ran by Steve Cohen, is known to charge 3% management fees and 50% performance fees from 1992 to 2013. Even though the fees seemed ridiculous, during that period the average annual returns net of fees to the investors was 30%.
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