HEDGE FUNDS EXPLAINED: STRATEGIES, FEES, ACCESS, RISKS

A hedge fund is a pooled investment vehicle that employs a wide range of strategies to maximise investor returns. Unlike traditional mutual funds, hedge funds are generally open only to accredited or institutional investors due to their complex investment strategies and higher risk profile. They are managed aggressively and often make use of leverage, derivatives, and short selling to generate returns irrespective of broader market movements.

Hedge funds aim for “absolute returns”—that is, profits regardless of whether markets rise or fall. Since they are typically structured as private investment partnerships, hedge funds tend to operate with fewer regulatory constraints than mutual funds. This allows managers greater flexibility in crafting their strategies but also means reduced transparency and greater risk for investors.

Access to hedge funds is restricted. Individual investors often need to meet specific income or net worth thresholds to participate, limiting their availability to wealthy individuals, pension funds, endowments, and other institutional investors. Due to their exclusivity and potential for outsized returns, hedge funds have become emblematic of sophisticated financial investing—with all the accompanying complexity and scrutiny that status entails.

Understanding the fundamentals of hedge funds is crucial for those considering stepping into this segment of the investment world. The following sections elaborate on their most common strategies, fee structures, access limitations, and associated risks to provide a well-rounded overview.

Hedge funds use a broad variety of investment strategies tailored to secure returns in diverse market conditions. These strategies can be classified into several core categories, with many funds employing a combination to meet their investment goals.

Equity Long/Short

This strategy involves taking long positions in stocks expected to appreciate and short positions in stocks expected to decline. Fund managers aim to capitalise on price inefficiencies and offset loss through careful positioning. Net exposure to the equity market may vary significantly, with some funds maintaining market neutrality.

Global Macro

Global macro funds take large-scale positions based on trends or shifts in global economic and political conditions. These positions may include currencies, interest rates, commodities, or stock indices. Their broad focus allows these funds to navigate shifting economic tides with more agility than geographically bound counterparts.

Event-Driven

These strategies bank on corporate events such as mergers, acquisitions, restructurings, or bankruptcy proceedings. Merger arbitrage, for example, involves buying shares of a target company while shorting the acquirer’s stock to profit from pricing discrepancies during pending takeover deals. The approach relies on accurate predictions of deal outcomes and timelines.

Relative Value

Relative value funds aim to exploit price differences between related securities by analysing discrepancies that are expected to revert over time. Popular sub-strategies include fixed-income arbitrage, convertible arbitrage, and statistical arbitrage. These approaches often rely on quantitative models and demand precision and a robust risk management system.

Distressed Securities

Funds specialising in distressed debt invest in bonds or other instruments of companies undergoing financial hardship, often trading at deep discounts. If restructuring succeeds, such investments can yield significant returns. However, they require expertise in credit analysis and legal matters related to bankruptcy proceedings.

It is common for hedge funds to remain secretive around their strategic implementation in order to protect intellectual capital from competitors. Consequently, transparency to investors is more limited compared to traditional vehicles, though periodic reporting and due diligence do occur.

The strategies selected directly influence the risk-return profile of a hedge fund, along with its ability to weather economic downturns. Investors should possess a thorough understanding of how a manager’s approach aligns with their risk appetite and investment objectives.

Hedge funds are famously associated with high fees, justified by the complexity of their strategies and the promise—or at least the pursuit—of above-market returns. The most common fee structure is the “2 and 20” model, wherein investors pay a 2% annual management fee and a 20% performance fee based on fund profits.

Management Fees

The fixed management fee—typically 1% to 2% annually—is levied on the total assets under management (AUM), irrespective of fund performance. These fees ensure fund operations continue irrespective of market conditions and align remunerations for staff, research, and administration.

Performance Fees

These fees are variable and charged only when the fund achieves positive returns. They serve to incentivise managers to outperform the market. Some funds use benchmarks or high-water marks, ensuring performance fees are only collected when the fund reaches new profit levels beyond prior peaks. The employment of hurdles, i.e., a minimum required return, is also common.

Some newer hedge funds or those targeting a broader investor base may offer lower fees or introduce variations such as tiered performance rates. Still, the traditional “2 and 20” remains dominant among high-performing, elite funds.

Investor Access

Unlike mutual funds, hedge funds are typically restricted to high-net-worth individuals and institutional investors. Regulatory thresholds vary by jurisdiction but usually require substantial financial assets or annual income, categorising these investors as ‘accredited’ or ‘sophisticated.’

Initial investment minimums can range from £100,000 to over £1 million, depending on the fund’s reputation, strategy, and intended pool of investors. Many hedge funds are structured as private limited partnerships, with investors joining as limited partners who contribute capital while general partners manage the strategy.

Due to lower liquidity compared to public funds, hedge funds often feature lock-up periods that restrict redemptions for a predetermined length of time—ranging from months to several years. Redemption windows are typically quarterly or annually, and funds may impose notice periods to manage capital outflows and preserve stability.

This exclusivity contributes to the perception of hedge funds as elite and inaccessible for the average retail investor. However, some regions offer regulated funds of hedge funds, which provide diversified exposure to multiple hedge fund strategies, usually at lower minimums but with an additional layer of fees.

Understanding the fee structure and access conditions is essential for prospective investors. It enables them to evaluate cost-effectiveness, assess fund manager alignment with their interests, and plan around liquidity constraints.