WH A T D O E S AH E D G E F U N D D O ?M E L I S S A K O

O U T L I N E

In a nutshell

Structure

Fees Involved

Other

considerations

Hedge funds remain a mystery for many peopleoutside of the banking and financial realms. Ifyou’re miles away from a central exchange orbusiness center, you probably haven’t heard of theterm yet or didn’t care much to search it online.

The fact of the matter is, hedge funds can be anessential chunk of a well-diversified investmentportfolio and knowing what the underlying entitydoes and how it operates can help you make moreinformed investing decisions.

Hedge Fund in a NutshellHedge funds are similar to mutual funds, which isbasically an investment program that poolstogether investor capital to be traded indiversified markets. What’s different, however, isthe style of investing that each fund exercises aswell as the prerequisites for joining as an investor.Typically, hedge funds will only high net worthindividuals, such as those with at least $1 millionto invest in the fund. Hedge funds are alsonotorious for implementing very aggressivetrading strategies that take on greater levels ofrisk in exchange for higher payout potential.

Structure of a Hedge FundThe typical hedge fund will be divided into twotiers – a General Partner and a Limited Partner, orinvestors. As a rule of thumb, general/limitedpartnerships must comprise of at least oneGeneral Partner and one Limited Partner. Due toan SEC regulation, albeit, hedge funds can onlyhave a maximum of 99 investors.

More than that will require the hedge fund toregister with the SEC, which means more red tapeand more oversight of operations. The second tierof the structure is the general partnership, whichis structured as an LLC. The amount of investorrisk is limited to the amount of their capitalinvested in the fund. The general partner’s dutiesis to grow and manage the fund and perform anytasks necessary to keep the fund afloat.

Fees InvolvedHedge fund managers usually charge higher fees over timethan their mutual fund counterparts. In fact, their feestructure is one of the primary factors why talentedmanagers decide to start their own fund. Not only are themanagement fees higher for hedge funds, but they alsocharge investors additional fees, such as an Incentive Fee,

that mutual funds don’t even ask for. Incentive fees canvary between hedge funds, ranging from as low as 10percent of the fund’s yearly profits to as high as 50 percent.While this sounds ridiculous, the incentive fee is onlycollected if the manager is able to exceed the previoushigh, known in the industry as the High Water Mark.

Other Considerations

It’s important to note that hedge funds do not allow dailycapital withdrawal. Liquidity is limited compared to whatmutual funds offer its clients. Some hedge funds will havemonthly subscriptions and redemption dates while othersonly allow you to withdraw capital on a quarterly basis.

These strict pullout schedules are necessary to ensure thefund doesn’t get hit severely when a big investor decides towithdraw his/her capital.