Hedge funds manage trillions of dollars for wealthy investors and institutions, using strategies most investors never touch. Here’s how they work, how they charge, and why some have spectacularly collapsed.
A hedge fund is a pooled investment fund that uses a wide range of strategies to try to earn returns, whether markets are rising or falling.
The name comes from the idea of “hedging” bets, protecting against losses, although many modern hedge funds take large risks rather than reducing them.
How they differ from ordinary funds
Most managed funds and exchange-traded funds buy shares or bonds and hold them, aiming to match or beat the market.
Hedge funds have much more freedom. They can short sell shares, betting on prices falling. They can borrow heavily to increase the size of their bets, known as leverage. They can trade derivatives, commodities and currencies, and move money quickly between strategies.
Because they’re open mainly to wealthy individuals, family offices, pension funds and endowments, they face lighter regulation than funds sold to the general public, and often have rules limiting when investors can withdraw their money.
Common strategies
Long-short equity funds buy shares they expect to rise and short sell ones they expect to fall.
Global macro funds bet on big economic trends, such as interest rates, currencies and commodities. Investor George Soros famously made around US$1 billion betting against the British pound in 1992.
Event-driven funds invest around takeovers, bankruptcies and restructurings.
Quantitative funds use computer models and huge amounts of data to make trading decisions.
Activist funds buy stakes in companies and push for changes, such as new management or asset sales.
The fees
Hedge funds traditionally charged “two and twenty”: an annual management fee of 2% of the money invested, plus 20% of any profits. Fees have come down for many funds, but remain much higher than for index funds.
Top hedge fund managers can earn billions of dollars a year.
The risks
Hedge fund returns vary enormously. Some have delivered strong returns for decades, but research suggests many fail to beat a simple mix of shares and bonds after fees.
Because they often use leverage, losses can be magnified. In 1998, U.S. fund Long-Term Capital Management, which had two Nobel Prize-winning economists among its partners, collapsed so badly that the Federal Reserve organised a rescue to prevent wider damage to markets.
Hedge funds can also add to market turmoil when many are forced to sell at the same time.
In Australia, most people are only exposed to hedge funds indirectly, through their super funds, some of which allocate a small share of money to them.
