Question of the week: What is a hedge fund?

Hedge funds have been easy fodder for Hollywood over the years, frequently appearing in movies (Wall Street: Money Never Sleeps and The Big Short) and TV shows (Billions) that have some aspects of finance or wealth attached to the plot. The term hedge fund is bantered around a lot, but that doesn’t mean the average investor has any idea what they actually are. If their only introduction to a hedge fund is through the entertainment it’s highly likely they know very little about them at all.

A hedge fund in simple terms is an investment fund. A hedge fund may have different legal structures. This may sound like a mutual fund, but that’s where the similarities end.

Whereas a mutual fund is open to almost anyone to invest in it, a hedge fund is open only to accredited or qualified investors. This means they must have a certain net worth, typically in the millions, to be able to endure the increased risk that comes with investing in a hedge fund or an institutional investor such as a pension fund.

By limiting investors in a hedge fund to accredited investors, the hedge fund manager can use riskier investment strategies that are not allowed or restricted for mutual funds. This includes tactics such as short selling, leveraging, and derivatives.

Hedge funds are also open to a much wider net of investments than a mutual fund. A mutual fund is typically limited to investing in liquid investments such as stocks and bonds. A hedge fund is limited by its mandate, but can invest in almost anything, including land, real estate, stocks, bonds, and currencies.

Another major difference for hedge funds is the fee structure. In most hedge funds, there are two fees that are paid to the fund manager, a management fee and a performance fee. The ratios for these two fees can be any number, but most funds go by the 2-20 fee structure. Under this fee structure, the manager is paid a management fee of 2 per cent and a performance fee of 20 per cent. This means they receive two per cent of the fund’s assets and 20 per cent of any gains made by the fund. With millions of dollars invested in a hedge fund a fund manager can earn a lot of money if the fund is managed successfully.