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What Is a Hedge Fund?

A Simple Explanation of What a Hedge Fund Is and How It Operates

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A hedge fund is simply a term used to describe an investment partnership setup by a money manager. It can take the legal form of a limited liability company or a limited partnership so that if the company goes bankrupt, the creditors can't go after the investors for more money than they've put into the hedge fund.

The manager of the hedge fund, typically the person that created it, is paid a percentage of the profits he or she earns on the money investors have deposited with his company. The term was originally used because the purpose of many of the first hedge funds was to make money regardless of if the market increased or decreased because the managers could either buy stocks or short them (shorting is a way to make money when a stock falls - for more information read The Basics of Shorting Stock). Today, the term hedge fund is a generic term used for any such arrangement.

A Fictional Hedge Fund to Help You Understand What a Hedge Fund Is

To make the idea easy to understand, let’s take an extreme example. Imagine that I setup a company called “Global Umbrella Investments, LLC” as a Delaware corporation. The operating agreement, which is the legal document that says how the company is managed, states that I will receive 25% of any profits over 4% per year and that I can invest in anything – stocks, bonds, mutual funds, real estate, startups, art, rare stamps, collectibles, gold, wine, or anything else of value.

Most hedge funds are structured as a limited partnership or limited liability company.

Along comes a single investor that puts $100 million into my hedge fund. He writes the company a check, I put it into our brokerage account, and invest the cash according to any guidelines that were spelled out in the operating agreement. Perhaps I use the money to buy up local restaurants. Maybe I start a new company. Either way, the point is that every day when I wake up and go to the office, my purpose is to put my investor’s capital to work at the highest rate possible (adjusted for risk, of course), because the more I make him, the more I get to take home.

For argument’s sake, image that I made an unbelievable investment the first year, doubling the company’s assets from $100 million to $200 million. Now, according to the company’s operating agreement, the first 4% belongs to the investor with anything above that being split 25% to me 75% to my investor. In this case, the $100 million gain would be reduced by $4 million for that “hurdle” rate, as it is often called on Wall Street (because you have to clear that “hurdle” as the hedge fund manager before you are ever paid a dime under an arrangement like this). The remaining $96 million is split 25% to me and 75% to my investor.

The net result is that I walk away with $24 million in compensation. My investor gets the $4 million hurdle earned and $72 million from the split to which they are entitled above that hurdle for a grand total of $76 million. The news headlines are going to say, “Hedge Fund Manager Earns $24 Million!” yet it doesn’t tell you that I earned my investors $76 million. If I were managing $10 billion, my compensation would have been $2.4 billion and I would have made my investors $7.6 billion. The newspapers would write articles about how I was earning ridiculous amounts of money, never once mentioning the massive payday I delivered to the people who entrusted me with their funds.

The Infamous 2 and 20 Hedge Fund Arrangement

If you ask the question, "what is a hedge fund?" then you are certainly going to need to know about the most famous compensation formula in the industry. It’s called the 2 and 20 and it is used by a large majority of hedge funds currently in operation according to some estimates.

The 2 and 20 formula basically means that the hedge fund’s operating agreement calls for the hedge fund manager to receive 2% of assets and 20% of profits each year. That means that even if they lose money, they are at least guaranteed the 2% return with little or no hurdle rate. So, a manager earning $1 billion might make $20 million even if the company did nothing but park the money in the bank. Obviously, with anemic returns like that, clients would defect before long so it really is in the best interest of the fund manager to maximize returns.

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