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What Is a Hedge Fund? - Definition, Structure & Example

Instructor: Monica Gragg

Monica has taught college-level courses in Tourism, HR and Adult Education. She has a Master's in Education and is three years into a PhD.

In this lesson, we discuss the nature of hedge funds, illustrate investment strategies, and reveal their appeal and controversy. We also make comparisons between a hedge fund and a mutual fund and present the overall structure of a hedge fund.

Definition of a Hedge Fund

When planning for our future, common advice is to invest, particularly in mutual funds. Mutual funds are very attractive for an individual. They diversify your portfolio because money is pooled into one fund that buys a wide variety of stocks, bonds, and other securities. Having a manager do the hard work for you is another incentive. Hedge funds have similar advantages, only the benefits are supersized. So if you're wondering why no one has recommended hedge funds as an investment, it's because hedge funds are for the super wealthy.

Like a mutual fund, a hedge fund is a managed, pooled fund that uses different strategies to invest. The fund could invest in stocks, bonds, commodities, or real estate.

Unlike a mutual fund, the investors must be accredited. In other words, the investors must have a minimum annual income (the amount depends on each country), have a net worth of at least a million dollars and have significant knowledge of investments. In the hedge fund world, these investors are known as 'sophisticated investors'.

Hedge funds are appealing because they are hardly regulated compared to other forms of investment, which is why you may have heard about them in the news. Do you remember Bernie Madoff? From the 1990s to 2008, he stole $50 billion from Ascot Partners, the limited partner firm he managed. This is a big deal because a limited partnership is the company (or hedge fund) that pools the funds of several investors. So essentially, he stole from many investors that trusted him to manage the hedge fund. We talk more about limited partner firms in the hedge fund structure below. There are hardly any restrictions on taxes, either. You may have heard politicians complaining about how hedge fund managers make billions of dollars every year but pay less tax than nurses and truck drivers in the U.S. In other words, hedge fund managers get a tax break because a portion of their income is based on the fund's performance. The funds performance is called the carried interest. There are lax laws on carried interest income.

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