What Exactly Is A Hedge Fund?

A pretty damn good way to either make or lose a lot of money!  Hedge funds are a form of pooled capital, such as a mutual fund.  However, compensation structures are vastly different!

Mutual funds typically charge a fixed management fee - usually in the range of .50% to 1% of assets annually.  They also carry administrative fees which are normally very near .25% per year.  Some have fees for their sales, called "loads".  These fees can be quite expensive - as much as 5% up front!  But, loaded funds are relatively few.  I advise that you NEVER buy a loaded fund!

Hedge funds are all about compensation!  I should know.  I ran a series of hedge funds for years.  Typically, the management fee runs 2% per year in addition to some sort of reimbursement for expenses, which is highly variable, but not usually less than 1% annually.   The way that hedge funds produce exorbitant riches for their sponsors is through a "performance fee" assessed by scooping a portion of the fund's profits.  Performance fees are typically 20% of the fund's profit minus a benchmark such as the T-Bill rate.

One problem with hedge funds is, that while they charge you for winning, they don't "eat it" for losing!  Unless they contain a provision known as a "highwater mark".   That feature allows investors to recapture losses, but only after profits have been made.  For example, if a fund's performance fee is $1 million, it will discontinue earning addition performance fees until the highwater mark of $1 million has been exceeded.  In NO circumstances, that I'm aware of, do hedge funds ever return MORE than the highwater mark.  Said differently, performance fees can NEVER drop below zero on a cumulative basis.

Because of the nature of performance fees, hedge funds are highly incentivized to take excessive risk.  "Heads I win... Tails I win!

I've never heard of a mutual fund going belly up, yet, hedge funds are famous for a variety of scandals, sometimes resulting in a complete and total loss to investors.  The most recent and notorious example is the Bernie Madoff caper.  But, there have been many, many others!

Finally, the term "hedge fund" is a misnomer as many, if not most funds, do no hedging at all!  A "hedge" involves taking some sort of position designed to partially offset another position.  For example, a hedge might consist of buying certain stocks, while simultaneously offsetting the risk via the short sale of other stocks, but not the same stocks.

Tomorrow, we'll put a "shine" on the Gold and Silver Market.

Marko's Take