By Aash Shaw, Head of Investments – Summit Global Investments
At its core, a hedge fund is a private, pooled investment vehicle. Professional managers raise money from wealthy individuals and institutional investors (like pension funds or universities) and use that combined financial power to execute complex trading strategies. The name “hedge” comes from their original purpose: using specific financial tactics to protect (or hedge) an investment portfolio against market downturns, allowing the fund to make money whether the stock market goes up or down. Nowadays, the term “hedge fund” applies to many different aggressive investment strategies that may not have anything to do with hedging.
Four Core Features of a Hedge Fund
To truly understand what makes a hedge fund different from a standard mutual fund or your personal stock portfolio, look at these four distinct characteristics:
1. High Investment Minimums & Limited Access
Hedge funds are not available to the general public. Because they use aggressive financial strategies, regulators restrict them to accredited or qualified investors. Generally, this means individuals must have a net worth exceeding $1 million (excluding their primary residence) or an annual income over $200,000.
2. Massive Investment Flexibility
While a typical mutual fund is usually legally forced to just buy stocks or bonds and hold them, hedge funds have almost total freedom. They can invest in practically anything:
- Short Selling: Betting against companies, allowing them to profit when a stock price drops.
- Leverage: Borrowing huge sums of money to amplify their potential gains (which also amplifies their risks).
- Alternative Assets: Buying derivatives, currencies, real estate, commodities, or even private businesses.
3. The “Two and Twenty” Fee Structure
Hedge fund managers are highly incentivized by how they make money. While the exact percentages vary based on market conditions, the traditional standard is the 2 and 20 model:
- 2% Management Fee: Charged annually on total assets under management just to cover operating costs.
- 20% Performance Fee: The manager keeps 20% of all profits the fund generates. This is where hedge fund managers can make massive fortunes if they outperform the market.
4. Illiquidity (The Lock-Up Period)
Unlike regular stocks or mutual funds that you can sell at any second, hedge funds require investors to leave their money in the fund for extended windows. When you first invest, you frequently face a lock-up period of one to two years where you cannot withdraw your money. Even after that, you may only be allowed to pull money out once every quarter or once a year.
Hedge Funds vs. Mutual Funds
Hedge fund strategies vary wildly depending on what the manager excels at, but the industry generally groups them into four master categories.
1. Equity Strategies (Long/Short)
This is the oldest and most common hedge fund strategy. Instead of just buying stocks they like, the manager plays on both sides of the market.
- How it works: The fund goes “long” on undervalued stocks they expect to rise, and “shorts” overvalued stocks (or weak competitors) they expect to fall.
- The Goal: By balancing long and short positions, the fund attempts to reduce its vulnerability to overall stock market crashes. If the whole market takes a dive, the money made from the short positions acts as a cushion.
- Variant (Market Neutral): A sub-strategy where managers perfectly balance the dollar amount of long and short bets so the fund has zero net exposure to the stock market’s overall direction, profiting purely on individual stock picking.
2. Macro Strategies (Global Macro)
- Global Macro funds act like economic chess players, hunting for massive trends across global economies.
- How it works: Instead of staring at individual company balance sheets, macro managers analyze high-level economic indicators—interest rates, inflation, central bank policies, and geopolitical shifts. They trade anything liquid: government bonds, currencies, stock indexes, or commodities like oil and gold.
- The Goal: To cash in on structural economic changes. For example, a global macro fund might bet heavily against a country’s currency if they believe that country’s central bank is printing too much money.
3. Event-Driven Strategies
Event-driven managers look for corporate catalysts or legal “events” that create temporary, mispriced discrepancies in a company’s stock or bonds.
- How it works: The most famous example is Merger Arbitrage. When Company A agrees to buy Company B for $50 a share, Company B’s stock usually jumps to around $47 or $48. It doesn’t instantly hit $50 because there is always a tiny risk the deal will fall through. An event-driven fund will buy Company B at $48 and wait to pocket the $2 difference when the deal safely closes.
- Other events: Corporate restructurings, bankruptcies, spin-offs, or regulatory rulings.
4. Arbitrage Strategies (Relative Value)
Arbitrage is the act of buying an asset in one place and simultaneously selling it in another at a higher price, taking advantage of temporary price mismatches.
- How it works: In modern markets, these differences are mathematically microscopic. Funds use complex algorithms and high-frequency trading systems to find these gaps. Because the profit per trade is tiny, they use heavy leverage (borrowed money) to magnify the returns.
- Example (Convertible Arbitrage): Buying a company’s convertible bonds (bonds that can be turned into stock later) while simultaneously shorting the company’s underlying stock. If the math shows the bond is trading cheaper than the stock is worth, the fund locks in a risk-free spread.
According to data provider Hedge Fund Research, Inc. the average lifespan of a typical hedge fund is relatively short approximately 5 years. Historically, the hedge fund industry sees an annual “attrition rate”—funds that either permanently shut down or stop publicly reporting—of roughly 7% to 10% each year, of which half close due to investment losses and the remaining close due to other reasons. However, during crisis periods failure rates can be significantly higher.
For example, during the 2008 Financial Crisis an estimated 1,471 hedge funds shut down, the highest on record at the time. Then again in 2009 more than 1,000 funds closed, making it the second-highest year on record for liquidations. During this two-year period, half of hedge funds in existence globally closed.
Overall, annual closure rates have averaged 7%-10% in stable years to 20%-35% during periods of market stress. Smaller funds are disproportionately vulnerable due to fee pressures and difficulty raising capital. When comparing hedge fund performance, investors should recognize that the performance they may be comparing are of the successful surviving funds and not inclusive of the numerous failed funds which stopped reporting and disappeared.
