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

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  • 0:04 Definition of a Hedge Fund
  • 2:39 Mutual Fund vs. Hedge Fund
  • 3:41 Examples of Hedge Fund…
  • 4:11 Lesson Summary
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Lesson Transcript
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 will discuss the nature of hedge funds, illustrate investment strategies, and reveal their appeal and controversy. We'll 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 hedge fund 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 who trusted him to manage the hedge fund. We'll talk more about limited partner firms in the hedge fund structure in a bit.

There are hardly any restrictions on taxes in a hedge fund, 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 United States. In other words, hedge fund managers get a tax break because a portion of their income is based on the fund's performance. The fund's performance is called the carried interest. There are lax laws on carried interest income.

With limited regulations, some investment strategies are less traditional, so there are more options on how to invest, and the risks are lower. An example of lower risks is hedge fund structuring. Hedge funds are structured on flexibility, while other funds are structured on a fixed income. As a result, hedge funds have a higher return on investment (ROI) than other forms of investment.

Mutual Fund vs. Hedge Fund

Let's quickly recap some similarities and differences between mutual funds and hedge funds.

Both types of funds are used to diversify a portfolio, and in both, a pooled fund invests in a variety of areas such as commodities, bonds, stocks, and derivatives. However, a mutual fund is heavily regulated, while a hedge fund is not. Anyone can invest in a mutual fund, while hedge funds are for so-called 'sophisticated investors.' Finally, the managers of mutual funds are paid regardless of performance, while the managers of hedge funds are paid based on performance.

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