Hedge funds explained

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Typically used by financial institutions, hedge funds are a common investment vehicle for wealthy investors. On this page, you’ll learn everything you need to know about hedge funds, their key characteristics, how they’re taxed and what you may need to consider when choosing a hedge fund.

Key takeaways
  • Hedge fund managers can invest in anything they think will return a profit, based on the performance of the stock market

  • Hedge fund managers only accept investments from wealthy and qualified investors with a high annual income to ensure the investor can weather the potential risks involved

  • Hedge funds are handled by a fund manager who makes investment decisions for the fund, specialising in any type of asset as long as there is evidence of returns

What is a hedge fund?

A hedge fund is a pooled investment fund that usually trades in liquid assets. This allows for more complex trading along with risk management options that can help reduce the risks of investment. These techniques can include leverage and short selling, among others.

Hedge funds are managed by financial institutions, with hedge fund managers facilitating complex investment strategies. These fund managers invest in any asset that they believe will make a profit. They don’t focus or measure their performance against an index. Instead, they try to find profitable returns from whatever the stock market is doing at the time. Hedge funds are handled by one manager who will invest in any asset, including shares, bonds, futures and options.

How do hedge funds work?

Hedge funds* work in different ways because every hedge fund manager has their own strategy for earning profit. However, there are a few things every hedge fund has in common, including the following:

  • Hedge fund managers will use various financial tools, which are known as derivatives, to help them make their decisions.
  • When you invest in a hedge fund, you’re relying on the fund manager to make good decisions. Even if the hedge fund you choose specialises in a particular asset, there’s no guarantee of good performance.
  • Most hedge fund managers will charge based on the manager’s performance fee, and an annual fee based on the value of the hedge fund.
  • Hedge funds can specialise in just about any type of asset, as long as the fund manager sees an opportunity to earn a profit.

Why do hedge funds have a bad reputation?

Several hedge funds have been the subject of various insider scandals since 2008, and this seems to have given rise to a general ill feeling towards hedge funds themselves.

One of the most high-profile cases involved the Galleon Group, which was managed by Raj Rajaratnam**. Rajaratnam was caught obtaining insider information from Rajat Gupta, who was a board member of Goldman Sachs. Gupta allegedly passed on information that Warren Buffet would be making investments into Goldman Sachs. On the day this information was passed on, Rajaratnam bought a substantial amount of Goldman Sachs stocks and made a huge profit.

Due to this type of potential insider trading, some people believe that hedge fund managers utilise insider trading, and leak information to gain profits.

Are hedge funds regulated?

Known as the ‘1%ers’ of the investment world, in the UK, hedge funds are regulated by the Alternative Investment Fund Managers Directive (AIFMD).*** Hedge fund managers have to be transparent about their dealings, and hedge fund founders have to adhere to stringent regulatory requirements.

Hedge funds are more strictly regulated in the UK than they are in the US, although the Securities and Exchange Commissions (SEC) is beginning to pay closer attention to hedge funds over the pond because of potential breaches, such as insider trading and fraud.

In the US, the Jumpstart Our Business Startups Act (JOBS Act) allows hedge funds to create private offerings and advertise to whomever they want. However, they should still only accept accredited investors. Hedge funds are key suppliers for startups and small businesses because of their wide investment latitude.

What are the key characteristics of hedge funds?

The following are common characteristics of a typical hedge fund:

  • Only open to accredited or qualified investors: hedge funds are only available to wealthy or qualified investors who earn an annual income of at least $200,000 and have done so for at least two years. They must also have a net worth of over $1 million. This is for securities and exchange commissions and ensures that the investor can handle the potential risks of their investments.
  • Offers wider investments than other funds: a hedge fund investment portfolio is extremely diverse, and will only be limited by the hedge fund manager. Hedge fund managers invest in anything from land, real estate and fine art, to stocks, derivatives and even currencies.
  • The use of leverage: hedge funds often use large amounts of borrowed money to increase their potential returns.
  • Fee structure: hedge fund managers don’t just charge on commission; they charge on both the expense ratio and performance fee. Fees are typically structured as what’s known as a ‘two and twenty’, because 2% goes to the management, and 20% is the cut of any gains the fund generates.
  • Private investment vehicles: Hedge funds are private investment vehicles, which means the key characteristics can differ per hedge fund. Hedge fund managers can do anything they want with their investments, as long as they disclose the fund strategy.

What’s an example of a hedge fund?

The following is an example of how a new hedge fund might work from the perspective of a hedge fund manager. Let’s say you set up a new company called “Divine Investments, LLC.” The operating agreement, or the agreement on how to manage your company, states that you’ll receive 20% of any profits over 2% each year. You can invest in anything you want, so long as you reach the 2% return mark before payment of your profit.

You then receive an investment of £10 million into your hedge fund, and you deploy the capital according to your operating agreement. No matter where you use the money, your goal is to always invest at the highest rate possible, because the more money you make for your investor, the more money you’ll receive.

Imagine you’ve made a great investment, and doubled Divine Investment, LLC’s assets from £10 million to £20 million. The first 2% would be paid to the investor, meaning the £10 million gain will reduce by £200,000. The remaining £9.8 million would then be split, with 80% going to your investor and 20% to you.

That means you’ll receive £1,960,000 as compensation, or a 20% cut, and your investor receives the 2% mark of £200,000, plus £7,840,000 from the split, bringing your investor’s cut to a total of £8,040,000.

Who can invest in hedge funds?

Hedge funds are typically aimed at professional investors rather than the general public. They only accept wealthy, experienced investors who are comfortable with taking high risks, and are capable of paying high fees. If you’re unsure about your investments, it’s always best to seek independent financial advice.

Do I have to pay to invest in a hedge fund?

Once you’re in a hedge fund, the fee you’ll likely pay is the ‘two and twenty fee‘, which means a 2% management fee and a 20% performance fee. Performance fees are paid to the fund manager for the investment gains made during the year.

How are hedge funds taxed?

Investors in a hedge fund are taxed on the shares of the partnership profits as if they hold the underlying investments. UK investors are liable for tax on all hedge fund income that’s distributed and reported to them, regardless of whether they’ve received it or not. UK bond fund rules also mean that distributions to UK investors from funds primarily invested over 60% in debt-like assets are treated as interest, which is taxable.

Some hedge funds establish themselves in tax-efficient locations and structure themselves as off-shore partnerships or companies. Off-shore corporate vehicles that are tax-resident exclusively in that location, without any permanent establishments on-shore, are only tax liable in the off-shore location. Typically, off-shore tax regimes impose profit tax at a zero rate.

What to consider when choosing a hedge fund

Before considering a hedge fund, first, you need to understand what you’re looking for to narrow down your choices. You should consider the risks of the hedge fund based on the strategies the hedge fund manager uses.

You’ll also need to identify the metrics that you find important and the results you want to see in each metric. This can mean looking at a hedge fund’s values, such as their annual returns, including previous years. You could also check the hedge fund ranking or the list of the current top hedge fund firms, and it’s a good idea to consider which hedge fund performs well in the specific investment category that appeals to you

Should I consider a savings account instead?

If you don’t want to take any risks on your investments but want guaranteed returns, then choosing a savings account such as a fixed rate bond may be a better option for you. A fixed rate bond offers a competitive interest rate that doesn’t change from the day you open the account until the end of your fixed term, so you’re guaranteed a return on your savings.

You can quickly and easily open a savings account with Raisin UK by registering and applying today. Opening an account with Raisin UK is free, and offers competitive interest rates from a range of UK banks.