Hedge Funds - How They Work

As a financial advisor with Emerson Equity, Darrach Bourke draws on more than 17 years of experience in finance. He comes to his role as a former executive vice president of Stella Capital, where he oversaw management of a fund of hedge funds.

Known for their exclusivity and complex nature, hedge funds function as pooled investments from experienced and well-resourced investors. The individual investors, often knowna s limited partners, provide the capital that a fund manager then distributes among a carefully selected portfolio of products. 

The fund manager, known as the general partner, seeks to distribute assets in a way that minimizes risk and maximize returns. This aim parallels that of more traditional vehicles, such as the mutual fund, though the hedge fund general partner has more opportunities for doing so.

Since a hedge fund is more limited in size and investor characteristics than other funds, it does not fall subject to regulation by the Securities and Exchange Commission. This means that fund managers may invest in almost any market instrument, including stocks and derivatives as well as real estate and currencies.

Hedge funds are also flexible in the techniques that they use to promote high returns and minimal risk. As their name indicates, such funds originally depended on hedging techniques, in which managers would invest long to benefit from rising prices, while also going short on some investments in case prices fell. Since then, managers have diversified their strategies. Some choose to invest in a way that takes advantage of pricing inaccuracies, while others will borrow money to increase investor returns.

Regardless of the strategy, however, investors must pay for these expanded opportunities with higher fees. The traditional fee structure has been 2 and 20, which translates to 2 percent of invested capital and 20 percent of profits. Some experts believe that this may change as the market shifts.