Hedge Funds
What It Is
Hedge funds are pooled investment vehicles that use a wide range of strategies to generate returns. Unlike traditional mutual funds, they can take short positions, use leverage, invest in derivatives, and employ complex trading strategies. They are typically accessible only to institutional investors and qualifying high-net-worth individuals.
Caveat: Hedge fund strategy labels are broad and can mask very different underlying risk profiles. A “long/short equity” fund can be very different from another fund with the same label depending on net exposure, sector concentration, leverage, and liquidity of underlying securities.
Main Strategy Categories
Long/Short Equity: The manager buys (is “long”) securities expected to rise and simultaneously sells short securities expected to fall. The portfolio’s net exposure (longs minus shorts) determines how much market risk is retained. A fund with 80% long and 20% short has 60% net long exposure — still substantially exposed to equity markets.
Global Macro: Positions are taken on broad macroeconomic themes across currencies, interest rates, commodities, and equity indices. The manager forms views on central bank policy, economic cycles, and geopolitical events. Global macro funds can be highly directional and use significant leverage.
Credit: Strategies focused on corporate or structured credit instruments — buying undervalued bonds, shorting overvalued ones, or trading credit default swaps. Some credit hedge funds overlap substantially with private credit in terms of underlying instruments but with greater liquidity and shorter holding periods.
Event-Driven: Strategies that profit from specific corporate events — mergers and acquisitions, restructurings, spin-offs, or bankruptcy proceedings. Merger arbitrage buys the target and shorts the acquirer; distressed investing buys the debt of companies in financial difficulty.
Relative Value / Arbitrage: Profits from mispricings between related instruments (e.g., two bonds from the same issuer, convertible bonds vs the underlying equity). These strategies often use high leverage to amplify small per-unit returns.
Multi-Strategy: A single fund allocates capital across several strategy types, often with the ability to shift allocations dynamically. Multi-strategy funds seek diversification of return sources but add operational complexity.
Fee Structures: HWM, Hurdle, and Performance Fees
Hedge funds typically charge two layers of fees, though the specific terms vary by fund:
- Management fee – An annual charge (percentage of AUM) covering operational costs, paid regardless of performance
- Performance fee – A percentage of profits earned above a reference point, paid periodically (often annually)
High water mark (HWM): The performance fee is only charged on profits above the fund’s all-time NAV peak. If a fund loses value in one period, it must recover those losses before the manager earns any further performance fee. This protects investors from paying fees on recovered losses.
Hurdle rate: Some funds require performance to exceed a minimum return (the hurdle) before any performance fee applies. A hard hurdle means no performance fee on any returns below the hurdle; a soft hurdle means the performance fee applies to all gains once the hurdle is exceeded.
Caveat: “2 and 20” (2% management fee, 20% performance fee) is often cited as a typical hedge fund fee structure, but actual fee terms vary widely by fund, strategy, vintage, and investor relationship. Fees have generally compressed over recent years across the industry. Do not apply any single fee structure as representative without verifying the specific fund’s documentation.
Prime Brokerage and Leverage
Most hedge funds use a prime broker — typically a large investment bank — as a central services provider. The prime broker offers:
- Margin financing – Lending cash against the fund’s long positions to amplify purchasing power
- Stock lending – Facilitating short selling by borrowing securities that the fund then sells
- Custody – Holding fund assets (securities, cash) in segregated accounts
- Clearing and settlement – Processing trades across multiple exchanges and counterparties
Through prime brokerage, hedge funds can operate with gross exposures (total longs plus total shorts) that are a multiple of their NAV. This leverage amplifies both gains and losses. See Leverage Risk.
Short selling mechanics at a high level: To short a security, the fund borrows it from the prime broker (for a fee), sells it in the market, and must later repurchase it to return the borrowed security. If the price falls, the fund profits; if it rises, the fund incurs a loss. Short positions create theoretically unlimited loss potential (a price can rise without limit) and are subject to forced buyback (“short squeeze”) risk.
Liquidity Terms: Why They Matter More Than Strategy Labels
The liquidity terms of a hedge fund are as important as the investment strategy in understanding the real risk profile. Key terms:
| Term | Description |
|---|---|
| Lock-up period | Investors cannot redeem for an initial period after subscription (e.g., 1–2 years) |
| Notice period | Advance notice required before redemption is processed (e.g., 45–90 days) |
| Redemption gate | Cap on total redemptions per period (e.g., 10–25% of fund NAV per quarter) |
| Side pocket | Illiquid or hard-to-value positions segregated; investors cannot redeem this portion |
| Suspension | Manager may suspend all redemptions in exceptional circumstances |
A fund investing in liquid equities with daily NAV and monthly redemptions is operationally very different from a fund investing in illiquid credit with quarterly NAV and 1-year lock-up plus 90-day notice — even if both are described as hedge funds. Investors and operations teams should always understand the full liquidity profile before treating a “hedge fund” as liquid. See Open-Ended vs Closed-Ended Funds and Liquidity Risk.
NAV frequency does not mean liquidity: A fund with daily NAV is not necessarily daily liquid. The NAV is calculated daily but redemptions may only be processed monthly or quarterly with a notice period. Knowing NAV frequency tells you how often value is measured — not how quickly capital can be accessed.
Key Risks
- Leverage risk – Many strategies use significant leverage; losses can exceed stated NAV in extreme scenarios. See Leverage Risk.
- Liquidity risk – Gates, lock-ups, and side pockets can restrict access precisely when investors need capital most. See Liquidity Risk.
- Valuation risk – For illiquid or complex instruments, NAV depends on models and judgement. See Valuation Risk.
- Counterparty risk – Heavy use of derivatives and prime brokerage creates exposure to counterparty failure.
- Strategy opacity – Complex strategies may be difficult for investors to fully understand; factor exposure can be unclear.
Key Metrics
| Metric | Use |
|---|---|
| Volatility | Standard deviation of returns; measures variability of performance |
| Sharpe Ratio | Risk-adjusted return; common cross-strategy performance metric |
| Maximum drawdown | Largest peak-to-trough loss; a measure of downside risk |
| Alpha / Beta | How much return is skill-driven vs market-driven |
Operational Considerations
- Subscriptions and redemptions are processed at defined windows. See Subscriptions.
- NAV is calculated more frequently than PE — typically monthly or daily — but NAV frequency does not mean instant liquidity.
- Investor reporting typically includes monthly performance updates, risk reports, and factor exposure summaries.
- Prime brokerage relationships are central to hedge fund operations and must be managed alongside administrator relationships.
Related Concepts
- Leverage Risk
- Liquidity Risk
- Valuation Risk
- Volatility
- Sharpe Ratio
- Open-Ended vs Closed-Ended Funds
- NAV
Source Anchors
- AIMA Due Diligence Questionnaires — AIMA’s DDQ framework covers hedge fund strategy, leverage, liquidity, risk controls, governance, and operational infrastructure in a structured due diligence format
- SBAI Standards — SBAI operational and governance standards for alternative investment managers, including valuation governance, risk management, and liquidity management
Manual Review Notes
- The description of strategy categories is deliberately high-level. Each strategy category contains significant heterogeneity in practice; sub-strategies (e.g., statistical arbitrage vs fundamental long/short) can have very different risk profiles. A more detailed treatment would require per-strategy files.
- “High water mark” mechanics are more complex when a fund has multiple share classes, partial redemptions, or crystallisation at different dates. The description here is the conceptual framework; implementation details vary.
- The mention that hedge fund fees have “generally compressed” reflects industry observations as of the time of writing. This may change and should not be stated as a current fact without verification.
- Short selling creates unlimited theoretical loss (a position can rise without limit). This risk should be emphasised more strongly in any LP-facing material about short-selling strategies.