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What is a Hedge Fund?

A hedge fund is an investment company structured as a private partnership that typically invests money for sophisticated investors with the goal of maximizing returns or minimizing risk, while adding diversification to an overall portfolio. Hedge funds generally have greater latitude than a mutual fund to invest in a variety of strategies that the fund manager believes will earn a return and/or reduce the risk of the portfolio.

Because hedge fund investment strategies can be complex, there are many restrictions. No more than 100 individuals and entities can invest in any one fund. Often, the minimum investment amounts of hedge funds are anywhere from $250,000 to $1 million or more. Many hedge funds are also illiquid, requiring their investors to keep their money in the fund for a minimum period. Withdrawal periods are also limited.

Pension funds, banks, endowments, insurance companies and wealthy individuals are typical hedge fund investors. Due to the laws and regulations governing this industry, a hedge fund investor must qualify as an accredited investor. To be considered “accredited,” an investor must have an income greater than $200,000 each year for the past two years, or a net worth exceeding $1 million, excluding their personal residence.

Hedge funds are similar to mutual funds in that they charge an expense ratio, which is typically 2% of assets under management. Most hedge funds also have a performance incentive fee that can be 10% to 20% of profits. However, a manager only collects this fee if the fund’s profits exceed a previous peak in value.

Jemma Everyday Wisdom: For accredited investors, hedge funds have historically offered potential greater diversification in an overall portfolio due to their wide investment latitude.

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