What is a hedge fund, and how do they make money?
A hedge fund is designed for sophisticated investors or higher net worth individuals. As such there are usually higher entry costs, such as a minimum investment of $50,000 or $100,000 to get started in a fund.
The funds are usually aggressively managed to try to ensure maximum returns that should, in theory, significantly beat the index they are benchmarked against. Unlike mutual funds they may not specify a particular asset or investment style that they wish to stick to. This enables them to remain flexible and adopt any investing tactic that suits the current market conditions. At any given point a hedge fund may be:
- Long – betting the market or underlying assets will increase in value
- Short – betting the assets will decrease in value
- Highly Leveraged – meaning for every $1 they have in actual capital they may borrow $10 to maximize their returns, this is 10X Leverage
- Investing in Currencies, Property, Commodities, Stocks, ETF’s and other even more exotic instruments like Credit Default Swaps (CDS) or Collateralized Debt Obligations (CDO’s)
- High-Frequency Trading – using computers to arbitrage deals at a very high frequency. For example. If gold sells at $1600 an ounce in the U.S. and $1590 an ounce in Australia, they may choose to buy in Australia and sell the gold in the U.S. for a $10 per ounce profit.
As a reward for the aggressive investment, the Hedge fund will usually see a 2 and 10 cost structure. This means they will charge the investor a 2% annual charge on the entire investment you have made, and also keep 10% of the profits they have made with your money.