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What is a Mutual Fund? – Definition, Types, Advantages & Examples

What Is a Hedge Fund? – Definition, Structure & Examples

Quiz & Worksheet – Hedge Fund Characteristics & Structure

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In this lesson, we will discuss the nature of hedge funds, illustrate investment strategies, and reveal their appeal and controversy. Well also make comparisons between a hedge fund and a mutual fund and present the overall structure of a hedge fund.

When planning for our future, common advice is to invest, particularly in mutual funds.Mutual fundsare very attractive for an individual. They diversify your portfolio because money is pooled into one fund that buys a wide variety of stocks, bonds, and other securities. Having a manager do the hard work for you is another incentive. Hedge funds have similar advantages, only the benefits are supersized; so if youre wondering why no one has recommended hedge funds as an investment, its because hedge funds are for the super wealthy.

Like a mutual fund, ahedge fundis a managed, pooled fund that uses different strategies to invest. The fund could invest in stocks, bonds, commodities, or real estate. Unlike a mutual fund, the hedge fund investors must beaccredited. In other words, the investors must have a minimum annual income (the amount depends on each country), have a net worth of at least a million dollars, and have significant knowledge of investments. In the hedge fund world, these investors are known as sophisticated investors.

Hedge funds are appealing because they are hardly regulated compared to other forms of investment, which is why you may have heard about them in the news. Do you remember Bernie Madoff? From the 1990s to 2008, he stole $50 billion from Ascot Partners, the limited partner firm he managed. This is a big deal because alimited partnershipis the company (or hedge fund) that pools the funds of several investors. So essentially, he stole from many investors who trusted him to manage the hedge fund. Well talk more about limited partner firms in the hedge fund structure in a bit.

There are hardly any restrictions on taxes in a hedge fund, either. You may have heard politicians complaining about how hedge fund managers make billions of dollars every year but pay less tax than nurses and truck drivers in the United States. In other words, hedge fund managers get a tax break because a portion of their income is based on the funds performance. The funds performance is called thecarried interest. There are lax laws on carried interest income.

With limited regulations, some investment strategies are less traditional, so there are more options on how to invest, and the risks are lower. An example of lower risks is hedge fund structuring. Hedge funds are structured on flexibility, while other funds are structured on a fixed income. As a result, hedge funds have a higherreturn on investment (ROI)than other forms of investment.

Lets quickly recap some similarities and differences between mutual funds and hedge funds.

Both types of funds are used to diversify a portfolio, and in both, a pooled fund invests in a variety of areas such as commodities, bonds, stocks, and derivatives. However, a mutual fund is heavily regulated, while a hedge fund is not. Anyone can invest in a mutual fund, while hedge funds are for so-called sophisticated investors. Finally, the managers of mutual funds are paid regardless of performance, while the managers of hedge funds are paid based on performance.

Lets look here at the structure of a hedge fund.

Alimited partneris a company that holds the funds of accredited investors. Ageneral partneris the hedge fund owner, and his or her company that manages the funds. The general partner grows the fund by making different investments. The general partner also makes money based on management fees and fund performance. Investors make money, orROI, off of performance.

Now lets look at some examples of hedge fund strategies.

, which means buying long stocks, or shares that are expected to increase in value, and selling short stocks, or shares that are expected to decrease in value.

. This is investing in emerging markets (developing countries) that are predicted to perform well in the global economy.

, or when a fund will invest on the prediction that two companies will or will not merge.

To recap, ahedge fundis a limited-partner company managed by a general partner, also known as a hedge fund manager. It uses traditional and unconventional methods of investing for significant growth. Investors of a hedge fund must beaccredited, meaning they must have a minimum annual income, a net worth of over a million, and significant knowledge of investing.

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