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What Are Hedge Funds and How Do They Work?

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If you've recently started to dip a toe into the world of investing, it's highly likely that you've heard of hedge funds. But their name doesn't give much away. So what exactly are these investment relationships? Put simply, a hedge fund is a financial partnership in which members pool their funds and earn active returns through a variety of different investment strategies — but that's not all they do. To boost your understanding of what hedge fund investments involve, take a deeper dive into how hedge funds got started, how they work and how they're structured.

The History of Hedge Funds

Hedge funds are a relatively new idea; they've only been around since 1949. The first type of this fund was launched by a former Fortune magazine writer and sociologist named Alfred Winslow Jones with his company, A.W. Jones & Co. Having been inspired by an article he was writing about investment trends, he decided to see if he could create an investment portfolio that was market neutral, meaning it could offset the risk of some investments to limit potential losses. Jones was able to pool together $100,000 to invest with, $40,000 of which he put up himself.

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Throughout the next few years, Jones pioneered what's now commonly known as long/short equity investing. This meant he invested some of the group's money into stocks that had a good possibility of making money in the long run. While he was waiting on that money to generate returns, he made short-term money by short-selling other stocks for a quicker profit.

By using such techniques, Jones was able to "hedge" the group's money against potential surprises in the stock market. In other words, he found a way for the fund to profit regardless of whether the stock market went up or down, thus minimizing risk. This investment strategy is where hedge funds got their name.

Jones also used leverage, an investment strategy involving the use of borrowed money, to increase return on investments. Then, in 1952, he converted his hedge fund into a limited partnership and added a 20% incentive fee for the managing partner. This was sort of like a commission that the managing partner would get from the profits of investments that did well.

Not only did Jones prove that a hedge fund could work, but he also demonstrated that it could be a very profitable concept with the right experts behind the wheel. Hence, Jones went down in history as the father of the world's first hedge fund.

How Does a Hedge Fund Work?

A hedge fund is made up of a professional fund manager, also known as a general partner, and high-profile investors, who are sometimes known as limited partners. The goal of this setup is to pool a large amount of money — larger than what the individual investors would have access to otherwise — which is then invested with the hope of maximizing the returns of all the investments while simultaneously minimizing risk.

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While this may sound a lot like a mutual fund, there are several key differences. You can only participate in a hedge fund if you're what's known as an "accredited investor." This designation has traditionally been based almost entirely on financial status.

To become an accredited investor, you have to have made an annual income of over $200,000 (or $300,000 worth of joint income) in each of the previous two years and must expect to earn at least that much or more in the current year. If you don't meet these qualifications, then you need to have at least a $1 million net worth. A new change in 2020 made it possible to qualify if you have a certain level of professional or financial knowledge, such as having passed certain exams or earned certain licenses, as outlined by the SEC.

These laws were made to protect investors whose finances couldn't necessarily withstand losing as much money as the average accredited investor. A hedge fund's goals are to maximize profits, but anyone who has ever participated in investing at any level knows that markets and financial products can be risky, fickle and unpredictable.

This is especially true for hedge fund investors, even though "hedging" was created to minimize some of the risk. While only accredited investors are allowed to participate in a hedge fund, these types of funds are far less regulated than mutual funds and provide access to a wider array of investment opportunities. Many of the investments they participate in are very risky and aggressive. Consequently, they can either pay off in a big way — or not.

Common Hedge Fund Tactics

Hedge funds continued to grow in popularity through the 1960s, when they managed to outperform even some of the best mutual funds. As more hedge funds continued to pop up, many investors began to employ new and more aggressive techniques than those that Jones first pioneered. While some of them paid off, others led to disastrous results by the end of the 1960s and the beginning of the '70s.

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Hedge funds once more soared into the spotlight in the 1980s as fund managers began touting the returns promised by tactics such as futures and options. Futures are, in general terms, financial contracts in which a fund agrees to buy an asset at a future date for a predetermined price. The idea of this type of arrangement is that the buy will go through regardless of the asset's price on the stock market at the time, whether it ends up being higher or lower than the agreed-upon price.

Options are similar in that they allow the investor to buy or sell an asset at an agreed-upon price within a certain time frame. The biggest difference between options and futures is that, with an option, the holder only has to buy or sell if they want to within that time frame if they choose to. Hence, they have an "option."

During the late 1990s and through the early 2000s, hedge funds largely experienced near-catastrophic losses. In more recent history, they've made a comeback, with over 3,600 hedge funds operating in the United States. Today, there's a variety of different types of hedge funds that invest in different industries.

These investments can include anything from stocks and derivatives to land, real estate and currencies. Some hedge funds stick to very specific investment strategies, while others invest using a variety of different techniques. Aside from the tactics already mentioned, other common hedge fund techniques include:

Merger Arbitrage: Buying and selling the stocks of two merging companies at the same time
Global Macro Strategy: Choosing investments based on the overall economic and political climates of various countries
Volatility Arbitrage: A strategy based on the difference in the forecasted and implied volatility of an asset
Convertible Bond Arbitrage: Attempting to profit from the mispricing of a convertible bond and its stock