Hedge Fund Firms and Funds Key Terms

Demystify institutional investing by learning hedge fund firms and funds key terms

To the average investor, hedge fund firms and funds key terms may seem daunting and even mystical. Once you familiarize yourself with the basic terminology used by hedge fund companies, however, you'll gain a good understanding of how they work, putting you one step ahead of many other investors.

Although hedge fund firms employ a wide variety of different investment strategies to beat the market, they have a few things in common. Most importantly, as their name implies, they try to neutralize their financial risk by hedging their investments. Hedging is often what allows firms for hedge funds to post good returns, even during economic downswings. Hedge funds also have the following characteristics in common:

1. Hedge fund organizations typically hedge their investments with a variety of techniques, including short-selling.

2. Hedge funds charge two important kinds of fees: management fees and performance fees.

3. Hedge fund managers often use high-water marks and hurdle rates to determine their fees.

 

Learn about the different investing strategies used by hedge funds

Two important techniques hedge fund managers use to earn profits are short-selling and leveraging. When combined with traditional position trading, short-selling, or borrowing and then selling stocks whose price is about to fall, allows hedge funds to generate returns in uncertain or volatile market climates. Many funds also use leveraging to magnify their profits, although this exposes them to a greater degree of risk.
Try: Before investing any money in hedge funds, read the Securities and Exchange Commission's definition of hedge funds and funds of hedge funds. Also, you can read up on different hedge fund management strategies at HedgeFund.net.

Research fees before investing in a hedge fund firm

Hedge fund managers generally charge their investors two types of fees. The first, called the management fee, is usually a small portion (1% to 2%) of the client's total invested assets. The second, called the performance fee, is much larger (about 20%) and comes out of the profit earned by the investment. It's very important to evaluate both of these fees before tying your business' money up in a fund.
Try: Morningstar and Hedge Fund Blogger.com both publish an extremely thorough hedge fund directory that includes detailed information on the fees, returns and net assets of funds around the world.

Check hedge funds for high-water marks and hurdle rates

Although many hedge funds do not offer them, especially when demand for their investment services is high, high-water marks and hurdle rates can protect investors from risky management decisions. Before a hedge fund manager receives performance fees on a fund with a high-water mark, the value of that fund's assets must exceed its previous greatest value. A hurdle rate is the minimum return an investor must receive before paying the performance fee. Occasionally, funds operate with both regulations in place.
Try: TheManager.org has published a brief but informative primer on high-water marks, hurdle rates and other regulatory features of hedge funds. It can also be helpful to compare a fund's hurdle rate or high-water mark to its history of returns. HedgeCo.net operates a hedge fund database that allows you to do this.

 

• Remember that hedge funds are private investment organizations and the SEC generally doesn't regulate them. Always research the history of a fund and its manager before investing.

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