Most people don’t truly understand what a hedge fund is. They’re not familiar with some of the common investing terms associated with it, either.

For a primer, go download a free copy of my book, “An American Hedge Fund,” and you’ll learn the whole nine yards.

But in the meantime, here’s a basic rundown of the industry as a whole, sort of like a “Hedge Fund for Dummies” guide.

What Is a Hedge Fund?

Think of a hedge fund as group investing at an extremely high level. People with high net worths and institutions pool their money toward specific investments with the purpose of generating significant profits.

I started a hedge fund a few years after I made it big with penny stocks. It didn’t work out well.

However, knowing what a hedge fund is and how it works can make you become a better trader.

Key Characteristics of Hedge Funds

The goal of most hedge funds is to maximize return on investment. The name “hedge fund” is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market. Nowadays, hedge funds use dozens of different strategies, so it isn’t accurate to say that hedge funds just “hedge risk.”

Hedge Funds Risks and Returns

You’ve heard the phrase “high-risk, high-return,” right? It might as well have been coined specifically for hedge funds.

Many investors thrive on risk. They don’t mind investing a significant chunk of change even though they stand a good chance of losing it all. Hedge funds bring together these types of investors so they can pool their capital.

Hedge Fund Manager Fee Structure

Every hedge fund has a manager. This person is responsible for executing investments, dispersing dividends, and keeping everyone up-to-date on the hedge fund’s progress. In many cases, the hedge fund manager is also the founder.

Of course, managers don’t do all this work for free. They get paid.

Two and 20 is the most common hedge fund manager fee structure. The manager earns 2 percent of the fund’s total asset value as well as 20 percent off the top of any profits. It’s a pretty good deal as long as the fund does well.

Hedge Fund Accounting Basics

Many new investors confuse mutual funds with hedge funds. They’re completely different investment vehicles, though, with the only similarity being that they pool investors’ money.

A hedge fund doesn’t have to follow SEC guidelines or any other structured rules. That’s why investors in hedge funds can use leverage and other high-risk strategies to increase their earning potential.

In most cases, hedge funds are structured as limited partnerships. They also sometimes register as offshore corporations.

Hedge Fund Goals

A hedge fund’s primary — and often only — goal is to maximize return on investment. The manager and investors want to squeeze as much profit out of their investments as possible.

There’s no specific technique that can be applied to all hedge funds. As I mentioned before, the original goal was to hedge risk by purchasing conflicting positions on single or multiple stocks or otherwise mitigating risk while generating maximum profit. Today, a hedge fund can invest in any way it sees fit.

How to Pick a Hedge Fund

Do I recommend investing in a hedge fund? Not necessarily. However, if you have the capital and the desire to get involved with hedge funds, here are some tips on picking one that’s right for you.

Absolute Performance Guidelines

Think of absolute performance standard as an unattainable but highly desirable benchmark for a hedge fund. The term is used widely in finance and business as a way to boost quality control, reduce defects, and mitigate risk.

A hedge fund that uses absolute performance guidelines might prove less risky than one that doesn’t. Consider inquiring about this standard before you invest any money.

Relative Performance Guidelines

Some hedge funds use relative performance guidelines to evaluate specific investments, such as stock. Using this standard, they measure a stock’s or security’s performance against a standard of their choosing, such as an index.

Fund Size/Firm Size

Many hedge funds limit investors to 100 or fewer, and technically, two people can form a hedge fund. However, most funds have at least 100 investors and begin with between $10 and $20 million. The largest hedge funds might have $200 million or more in investment capital.

Track Record

You also want to consider the hedge fund’s track record as well as that of the portfolio manager. Has the fund traditionally experienced significant gains? Does the manager have the background and expertise necessary to effectively manage the fund?

Minimum Investment

How much money does the hedge fund require you to deposit in order for you to get a seat at the table? On average, a hedge fund will demand between $500,000 and $1 million of each investor.

Redemption Terms

Redemption means that you withdraw your investment from a hedge fund. Each fund has rules and regulations for when that’s possible, and those terms are designed to protect the health of the fund rather than your best interests.

Most Common Hedge Fund Terms to Know

Here are some of the most common terms you’ll encounter when investigating hedge funds.

Absolute Return

The goal is to have a positive return, regardless of market direction. This is the return that an asset achieves over a certain period of time.

Accredited Investor

This is a term used by the Securities and Exchange Commission (SEC) under a rule known as “Regulation D” to refer to investors who are financially sophisticated and have a reduced need for the protection provided by certain government filings. Individuals, banks, insurance companies, employee benefit plans, and trusts can all be considered accredited investors.

Alpha

The return to a portfolio over and above that of an appropriate benchmark portfolio (the manager’s “value added”) is considered alpha. This is where the website “Seeking Alpha” gets its name.

Asset Mix

The classification of all assets within a fund or portfolio constitutes its asset mix. They are assigned to one of the core asset classes: equities, fixed income, cash, and real estate. Other categories that are sometimes considered asset classes are commodities, international investments, hedge funds, and limited partnership interests.

Beta

A measure of systematic (i.e. non-diversifiable) risk is beta. The goal is to quantify how much systematic risk is being taken by the fund manager vis-à-vis different risk factors, so that one can estimate the alpha or value-added on a risk-adjusted basis. If XYZ has a beta of 1.5, it will supposedly move 1.5 percent for every 1 percent shift in the market.

Correlation

A measure of how strategy returns move with one another, in a range of –1 to +1, is considered its correlation. A correlation of –1 implies that the strategies move in opposite directions — and vice versa.

Hurdle Rate

The hurdle rate is the return at which the manager begins to earn incentive fees. If the hurdle rate is 5 percent, and the fund earns 15 percent for the year, then incentive fees are applied to the 10 percent difference.

Leverage

This is when someone borrows money to increase their position in a security. If one uses leverage and makes good investment decisions, leverage can magnify the gain. However, it can also magnify a loss. Be careful.

Risk Arbitrage

Investopedia provides three types of risk arbitrage.

First, there is merger and acquisition arbitrage – the simultaneous purchase of stock in a company being acquired and the sale (or short sale) of stock in the acquiring company.

Second, there is liquidation arbitrage – the exploitation of a difference between a company’s current value and its estimated liquidation value.

Lastly, there is pairs trading – the exploitation of a difference between two very similar companies in the same industry that have historically been highly correlated. When the two companies’ values diverge to a historically high level, you can take an offsetting position in each (e.g. go long in one and short the other) because, as history has shown, they will inevitably become similarly valued.

Run on the Fund

This is when a hedge fund faces a growing amount of redemption requests. SAC experienced this earlier in the year.

R-Squared

This is a measure of how closely a portfolio’s performance varies with the performance of a benchmark, and thus a measure of what portion of its performance can be explained by the performance of the overall market or index. Hedge fund investors want to know how much performance can be explained by market exposure versus manager skill since they are most likely paying a large fee to have their money in the fund.

Value at Risk

This is a technique that uses the statistical analysis of historical market trends and volatilities to estimate the likelihood that a specific portfolio’s losses will exceed a certain amount. Value at risk is used by risk managers in order to measure and control the level of risk that the firm undertakes. The risk manager’s job is to ensure that risks are not taken beyond the level at which the firm can absorb the losses of a probable worst outcome.

Trading Challenge

Are you interested in learning more about the stock market? Consider applying to join many others like you in the Trading Challenge. I’m always on the hunt for my next success story.

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How Are Hedge Fund Profits Taxed?

In most cases, profits from hedge funds are considered short-term capital gains. For that reason, they’re typically taxed at the same rate as any other form of income.

The Bottom Line

Hedge funds aren’t for the faint of heart. In fact, they can be downright risky. Firms and high-net-worth individuals, however, have used them for years to maximize their capital gains.

If you’re interested in hedge funds, do your research. Figure out your options, determine what kind of investment you’re willing to make, and get to know potential managers well.

Have you ever invested in a hedge fund? How did it work out?