What is a hedge fund?
An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).
Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.
Hedge fund explained?
For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.
It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.
History of hedge funds
The first hedge fund was started by Alfred W. Jones in 1949. He attempted to offset the risks of buying stock by selling short the shares of the stocks he determined would drop in value if the stocks he purchased appreciated. He also increased the leverage of his portfolio. Leverage and short selling are hallmarks of the modern hedge fund.
Jones is also credited with pioneering the hedge fund fee schedule. He set his hedge fund up as a limited partnership to avoid the requirements of the Investment Company Act of 1940 and he charged the fundholders a twenty percent performance fee on the annual profitability of the fund. If the fund didn't make a profit, Jones received no compensation.
Modern hedge funds still limit the number of investors in the fund for the same reason. By limiting the number of investors, they avoid many of the regulations that typical mutual funds must abide by. Additionally, today's hedge funds use a compensation scheme similar to Jones' performance-based fees, but they've added fixed management fees to the total fees. The most common fee structure in today's hedge funds is known as "2 & 20"; a 2 percent management fee and a 20 percent performance fee.