What Are Hedge Funds? (2024)

Hedge fund is a fancy name for aninvestment partnership with freer rein to invest aggressively in a wider variety of financial products than most mutual funds. Ahedge fund's purposeis to pool funds, maximize investor returns, and eliminate risk with hedging strategies. If this structure and these objectives sound a lot like those of mutual funds, they are, but that's where the similarities end. Hedge funds are generally considered more aggressive, risky, and exclusive than mutual funds.

The hedge fund industry has grown tremendously since its inception. There are trillions of dollars of assets under management, more than 8,800 hedge fund managers, and over 27,000 funds globally.

Hedge Fund History

Former writer and sociologist Alfred Winslow Jones' company,A.W. Jones & Co.,launched the world's first hedge fund in 1949. Jones was inspired to try his hand at managing money while writing an article about investment trends earlier that year. He raised $100,000 (including $40,000 out of his pocket) and tried to minimize the risk of holding long-term stock positions byshort-sellingother stocks.

This investing innovation is now called the classiclong/short equitiesmodel. Jones also employedleverageto enhance returns. In 1952, he altered the structure of hisinvestment vehicle, converting it from ageneral partnershipto alimited partnershipand adding a 20%incentive feeas compensation for the managing partner.

Jones was the firstmoney managerto combine short selling, leverage, and shared risk by partnering with other investors. For this innovation, and by implementing a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.

Hedge funds took off in the 1990s when high-profile money managers deserted the mutual fund industry for fame and fortune as hedge fund managers.

Hedge Fund Industry at a Glance

• The industry had $4.18 trillion in assets under management in 2022, according to the PreqinGlobal Hedge Fund Report for the year.
• Therewere more than 8,800 hedge fund managers at the end of 2022.
• In the final quarter of 2022, money flowed out of hedge funds for the third quarter in a row to the tune of $7.4 billion. For the year, there was a total of $62.4 billion in net outflows. This is significant because it shows investors were interested in other investments in 2022.

Notable Hedge Funds

Notable hedge funds today include Renaissance Technologies (also known as RenTech or RenTec), founded by the mathematical genius Jim Simons. Renaissance specializes in systematic trading using quantitative models derived from mathematical and statistical analyses.

Pershing Square is a highly successful and high-profile activist hedge fund run by Bill Ackman. Ackman invests in companies he feels are undervalued with the goal of taking a more active role in the company to unlock value. Activist strategies typically include changing the board of directors, appointing new management, or pushing for a sale of the company.

Carl Icahn, a well-known activist investor, leads a prominent and successful hedge fund. In fact, one of his holding companies, Icahn Enterprises (IEP), is publicly traded and gives investors who can't or don't want to invest directly in a hedge fund an opportunity to bet on Icahn's skill at unlocking value.

Hedge Fund Regulation

Hedge funds face little regulation from the Securities and Exchange Commission (SEC) compared to other investment vehicles. The SEC only requires hedge funds to register if they have more than $150 million in private funds and manage one or more funds. However, hedge funds operate in many countries besides the U.S., and will follow the regulations of their home country.

Funds with assets under management of $500 million or more must file quarterly and report the details of their liabilities and assets.

Significant Regulatory Changes

In May 2023, the SEC adopted measures to force large hedge funds to disclose more information via its Form PF, the form used for confidential event reporting.

The Bottom Line

A hedge fund is an official partnership of investors who pool money together to be guided by professional management firms—just like mutual funds. But that's where the similarities end. Hedge funds aren't regulated as much and operate with far less disclosure. They pursue more flexible and risky strategies in the hopes of netting big gains for investors, which, in turn, result in big profits for fund managers. But perhaps what sets them apart from mutual funds the most is that they have much higher minimum investment requirements.

The majority of hedge fund investors are accredited, meaning they earn very high incomes and have existing net worths in excess of $1 million. For this reason, hedge funds have earned the dubious reputation of being a speculative luxury for the rich.