Hedge Funds

Section: Hedge Funds Estimated study time: 45 minutes Content: Hedge funds are privately organized investment vehicles that pool capital from institutional investors and high-net-worth individuals to pursue a broad range of investment strategies, typically with significant flexibility in instruments, leverage, and shorting. Unlike mutual funds, hedge funds are largely unregulated (exempt from the Investment Company Act in the U.S.), allowing them to use derivatives, leverage, and short selling without the constraints that apply to registered investment companies. The term "hedge" is a historical misnomer — most modern hedge funds do not simply hedge risk but rather pursue alpha-generating strategies using a wide toolkit. Investors accept limited liquidity (lock-up periods of 1-3 years are common) in exchange for access to uncorrelated returns and manager skill (alpha). The fee structure of hedge funds is typically "2 and 20": a 2% annual management fee on assets under management plus a 20% performance fee (incentive fee) on profits above a hurdle rate (the minimum return before the performance fee kicks in). Many funds also employ a high-water mark provision — the performance fee is only paid on profits that exceed the fund's previous peak NAV, preventing managers from being paid twice on the same gains after recovering from losses. Fee structures have compressed in recent years due to competitive pressure, with many funds now offering "1 and 10" or customized terms for large institutional allocations. The performance fee creates significant manager incentive alignment but also potential for risk-taking beyond the optimal level for investors. Hedge fund strategies span a wide spectrum of risk-return profiles. Long/short equity funds simultaneously hold long positions in stocks expected to outperform and short positions in stocks expected to…