A hedge fund begins with the person who serves as the general, or managing, partner of the limited partnership that forms the structure of most hedge funds. This is the person who makes the actual investment choices and decisions for the fund.
They aretypically an established investment advisor with a proven track record in managing investments and/or a unique, appealing investment strategy. This individual, sometimes with the assistance of some of the initial investors, seeks out potential investors to persuade them to invest in the fund.
Once a fund has accumulated investment dollars it earns money based on assets under management (AUM) as well as on fund performance. The more investment money a hedge fund can accumulate, and the better it performs, the more money it makes for itself.
Key Takeaways
- Hedge funds seem to rake in billions of dollars a year for their professional investment acumen and portfolio management across a range of strategies.
- Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM).
- Funds typically receive a flat fee plus a percentage of positive returns that exceed some benchmark or hurdle rate.
- Hedge fund marketing is a key method of bringing in new investor dollars, which adds to the fund's bottom line.
How a Hedge Fund Raises Money
A hedge fund raises its capital from a variety of sources, including high net worth individuals, corporations,foundations,endowments,and pension funds. Hedge funds do not usually look for individual small investors such as the average person who purchases shares in a mutual fund, but instead seek out investors with large amounts of investment capital with whom to form a limited partnership.
A large part of raising investment funds for a hedge fund depends on the initial performance of the fund manager. To get the fund started and establish an investing track record, the fund manager usually invests a substantial amount of his or her own money into the fund. If the fund manager performs exceptionally well, showing excellent returns on investment, the fund then begins to attract the attention of large institutional investors who have substantial amounts of capital available to invest.
Good performance is also likely to elicit investment of additional capital from initial investors. The keys to raising investment capital for a hedge fund are for the fund manager to be able to find and convince some initial investors of his or her ability to manage the fund profitably, and then proceed to do just that so the fund attracts additional investors in the future.
Hedge Fund Fee Structure
Two and twenty (or "2 and 20") is a popular fee arrangement that is standard in the hedge fund industry and is also common in venture capital and private equity. Hedge fund management companies typically charge clients both a management and a performance fee. "Two" means 2% ofassets under management (AUM) and refers to the annual management fee charged by the hedge fund for managing assets.
"Twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark. While this lucrative fee arrangement has resulted in many hedge fund managers becoming extremely wealthy, in recent years thefee structurehas come under fire from investors and politicians for varying reasons.
Two and twenty is less so the norm in the industry thanks to hedge funds offering better arrangements. As well, robo-advisors charge as little as 0.25% of total assets for managing capital and no additional fees for profits gained.
Some hedge funds also have to contend with ahigh watermarkthat is applicable to their performance fee. A high watermark policy specifies that the fund manager will only be paid a percentage of the profits if the fund's net value exceeds its previous highest value. This precludes the fund manager from being paid large sums for poor performance and ensures that any losses must be made up before performance fees are paid out.
Hedge Fund Marketing
Hedge fund managers are hampered in their efforts to raise funds by regulations that prevent them from publicly advertising a specific fund. They can, however, do things such as set up aninformational website that explains their investment strategies and provides information on their backgrounds and experience as investors, investment advisors, or money managers. Fund managers often seek publicity by offering specific trading ideas on investment websites.
Hedge funds are often marketed by the fund manager who networkswith friends or business acquaintances or through third-party placement agents, who are individuals or firms that act as intermediaries for asset managers such as pension fund managers or investment managers for a foundation or endowment.
Sometimes fund managers offer "seed investment arrangements" to initial investors.In exchange for a substantial investment in the fund, the investor receives a discount on fund management fees or a partial ownership interest in the fund. These initial investors often do their own networking to solicit other investors.
Hedge fund managers mayproduce some basic marketing materials to give prospective investors. Such material, referred to as a "pitch book" or "tear sheet," contains information on the fund's strategy, the fund manager, and an outline of the terms for investing in the fund.
FAQs
A hedge fund raises its capital from a variety of sources, including high net worth individuals, corporations, foundations, endowments, and pension funds.
How do hedge funds get their money? ›
Hedge fund strategies involve investing in debt and equity securities, commodities, currencies, derivatives, and real estate. Hedge funds are loosely regulated by the SEC and earn money from the 2% management fee and 20% performance fee structure.
Who raises capital for hedge funds? ›
How does a hedge fund raise money? Hedge funds raise money by targeting institutional investors like pension funds, endowments, foundations, and sovereign wealth funds.
Where do hedge funds borrow money from? ›
Investing in securities using credit lines follows a similar philosophy to trading on margin, only instead of borrowing from a broker, the hedge fund borrows from a third-party lender. Either way, it is using someone else's money to leverage an investment with the hope of amplifying gains.
Where do hedge funds recruit from? ›
Headhunters: Headhunters are very active in recruiting for hedge funds. Most multi-manager hedge funds use headhunters, and some single Profit & Loss (P& L) funds do as well. A headhunter is simply an informal name for an employment recruiter (sometimes referred to as executive search or executive placement).
Why are hedge fund owners so rich? ›
Hedge funds seem to rake in billions of dollars a year for their professional investment acumen and portfolio management across a range of strategies. Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM).
How does the world's largest hedge fund make its money? ›
According to a person briefed on the investigation, what they concluded, in part, was that the world's biggest hedge fund used a complicated sequence of financial machinations — including relatively hard-to-track trading instruments — to make otherwise straightforward-seeming investments.
Who controls hedge funds? ›
Hedge fund management firms are often owned by their portfolio managers, who are therefore entitled to any profits that the business makes. As management fees are intended to cover the firm's operating costs, performance fees (and any excess management fees) are generally distributed to the firm's owners as profits.
Why are hedge funds so profitable? ›
One possibility is the nature of the hedge fund industry – very little regulation, huge pools of equity capital, strategic flexibility, and tremendous liquidity – allows funds to move more quickly to capture value than its primary competitors: the massive, highly regulated, and somewhat stodgy mutual fund industry, or ...
Is BlackRock a hedge fund? ›
BlackRock manages US$38bn across a broad range of hedge fund strategies. With over 20 years of proven experience, the depth and breadth of our platform has evolved into a comprehensive toolkit of 30+ strategies.
Hedge funds use two types of data to generate outsized returns: traditional data and alternative data. Traditional data comprises standard sources like SEC filings and government economic data, known for their accuracy and reliability.
Can anyone start a hedge fund? ›
Starting a hedge fund requires more than just an impressive track record of consistently beating the market. There are registration and regulatory requirements that you're expected to meet to ensure your fund is operating legally.
Where are most hedge funds headquartered? ›
Greenwich, CT
This area, known for investment firms and financial activity, is home to seven of the world's top one hundred hedge funds, according to recent surveys.
What is the best school for hedge funds? ›
The reigning champion for New York large-cap private equity is without a doubt, the University of Pennsylvania, which is home to Wharton. Wharton isn't just a private equity powerhouse – they're quite likely the best school for any buyside job, including hedge funds and possibly venture capital.
What broker do hedge funds use? ›
Prime brokerages, at times referred to as prime brokers, are generally larger financial institutions that have dealings with other large institutions and hedge funds.
What percentage of profits do hedge funds take? ›
Hedge funds typically charge an annual asset management fee of 1 percent to 2 percent of assets as well as a “performance fee” of 20 percent of a hedge fund's profit. These fees are typically higher than the fees charged by a mutual fund.
What happens if a hedge fund loses your money? ›
Regulatory bodies are under obligation to investigate the fund and the manager in question. Depending on the extent of the losses, investors may lose all their money, or recover a portion of their investment. On top of investment losses, investors may be obliged to pay tax on realized losses.
How do hedge fund traders get paid? ›
They earn money from a management fee, based on a small percentage of assets under management (AUM), and a performance fee, based on a percentage of annual returns. Traditionally, hedge funds charged “2 and 20,” meaning 2% of AUM for the management fee and 20% of the returns for the performance fee.
How do hedge funds make money from failing companies? ›
Hedge funds are able to purchase distressed debt (usually in the form of bonds) at a very low percentage of par value. If the once-distressed company emerges from bankruptcy as a viable firm, the hedge fund can sell the company's bonds for a considerably higher price.
