A reader asks, "what are these hedge funds I read about in the news? It seems like the managers make millions, hundreds of millions or even billions."
A hedge fund is simply an agreement between a manager and investors. It can take several legal forms such as limited partnerships (perhaps the most common) or limited liability corporation.
The term hedge fund is really a generic description for the arrangement. There is no formal structure they all must follow.
Two things to know about hedge funds:
- Each one is defined by a legal agreement between the money manager and investors that describes how the money manager is compensated.
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Secondly, hedge funds are often give broad and maybe unlimited authority to invest in any type of security (or even non-securities such as real estate), use any type of investing strategy and employ sophisticated trading strategies.
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Basically, the purpose of the hedge fund is to make money for investors regardless of market conditions or the economy. When they meet this goal, the money manager is often rewarded handsomely.
For example, the hedge fund agreement may spell out the compensation like this:
The manager gets a percent of the total assets in the fund regardless of whether it makes a profit or not and a percentage of the profits.
One of the more popular arrangements gives the money manager 2% of the total assets under management annually. In addition, the money manager gets a percentage of the profits (20% for example).
Another compensation model sets a threshold for the investors and a percentage of the profits after the threshold is reached.
For example, the threshold might be 3%, which means the first 3% of the profits go to the investors. After that has been paid, the money manager might receive 25% or more of the profits.
As you can see, if a hedge fund has $500 million in assets, the money manager stands to make a tidy commission if the fund is profitable.
Thinking about getting in a hedge fund? Many hedge funds require a huge investment (often in the millions).
