What is a hedge fund and how do they work?

For accredited investors, a hedge fund can offer greater returns – at a greater risk.

But what is a hedge fund and how does it work? Find out more below.

What is a hedge fund?

A hedge fund is a partnership of investors who pool their money with the aim of earning above-average returns.

Hedge funds are only available to accredited investors, and managers often use aggressive strategies like leveraging and investing in high-risk assets. 

How do hedge funds work? 

A hedge fund is structured like a limited partnership. Investors in a hedge fund become limited partners, while the company is a general partner. The company pools the partners’ money and invests it for them. 

Only accredited investors can invest in a hedge fund - you need to have a net worth of £1 million (excluding property) or an annual income of £200,000.

Hedge fund managers tend to use more aggressive investment strategies, including derivatives, leverage and short positions, to get higher returns.

They will also often invest in non-traditional assets such as property and currency, including cryptocurrency. 

What are the different types of hedge fund? 

Different types of hedge funds deploy different strategies.

Here are four of the most common: 

Event-driven funds 

These take advantage of pricing inefficiencies caused by a corporate event like a merger, acquisition or bankruptcy. 

Directional funds

These types of hedge funds take positions in the stock markets, taking advantage of their ability to ‘go short’, so can profit from falling markets as well as rising ones, reducing risk. 

Relative value funds

A relative value hedge fund takes advantage of short-term differences in the value of related securities. 

Global macro hedge funds

These are funds that aim to profit from large fluctuations in the market caused by significant global events. 

What are some examples of hedge funds? 

Here are some famous examples of British-based investment management firms offering hedge fund services: 

Man Group

Man Group manages over $143 billion for its clients globally, of which 79 per cent is contributed by institutional investors. 

Capula Investment Management LLP 

Established in 2005, Capula Investment Management is the fourth-largest hedge fund in Europe, managing assets of about $23 billion. 

Brevan Howard Asset Management 

With 12 offices and over 150 portfolio managers, Brevan Howard specialises in global macro and digital assets. 

How can I invest in a hedge fund? 

We recommend speaking to a financial adviser to find out which funds are currently accepting new investors.

You’ll also need to find out the minimum investment requirements and verify that you’re an accredited investor.

Different funds have different practices for verifying investors.  

You can find out more about meeting with a financial adviser here. 

How are hedge funds regulated?

Since the financial crisis in 2008, hedge funds in the UK have been highly regulated.

Hedge fund managers are regulated under the Financial Services and Markets Act 2000 and the Alternative Investment Fund Managers Directive (AIFMD).

Regulation and authorisation approval falls under the Financial Conduct Authority (FCA). 

How are hedge funds different from mutual funds?

Here are some of the key differences between hedge funds and mutual funds: 

• Mutual funds are available to anyone. Hedge funds are only available to accredited investors
• A mutual fund invests in stocks or bonds, while a hedge fund can invest in a range of assets including property, derivatives and currencies
• Hedge funds charge higher fees: typically a two per cent management fee and 20 per cent performance fee, whereas the fee for a mutual fund is around 0.4 per cent
• Investors in a mutual fund can access their money at any time, whereas hedge funds only allow investors to withdraw money at specified times 

How much tax will I pay on a hedge fund? 

Profits on a hedge fund are taxed at the long-term capital gains rate of 23.8 per cent. 

What are the advantages and disadvantages of a hedge fund? 

Advantages

• Increased returns: hedge funds often see higher returns on investment
• Skilled managers: hedge funds tend to attract talented fund managers
• Variety of investment styles: this means you can customise your investment strategy 

Disadvantages

• You need a large minimum investment: you’re typically expected to invest a substantial figure, ranging from around £100,000 to £2 million

• They charge high fees: you’ll typically pay an asset management fee of between one and two per cent, plus a performance fee of around 20 per cent on any profit 
• They are exclusive: only accredited investors with a high income or net worth can invest in a hedge fund
• They are high-risk: hedge fund investment strategies tend to be aggressive and high-risk
• They are illiquid: you may only be able to withdraw your money after a certain period, or at particular times of the year 

How do hedge funds make money?

Hedge funds take a management fee of between one and two per cent of the amount you invest.

In addition, the hedge fund manager will receive a performance fee (usually around 20 per cent on any profit). 

What types of investment strategies do hedge funds use? 

Hedge fund managers often use high-risk investment strategies with the goal of increasing the return on their investments.

These include the following: 

• Leveraging: this means using borrowed money to invest.
• Shorting stocks: this is when an investor sells shares and buys them back later at a lower price, in order to profit when the value of an asset falls.
• Taking a concentrated position: this is when one type of security represents a large percentage of an investor’s overall portfolio. 

Seek financial advice

If you’re an accredited investor and you’re ready to invest in a hedge fund, we can help you find the right one for you. 

We’ll put you in touch with a financial adviser with extensive knowledge and experience of hedge funds to guide you through the research and verification process.

Find your financial adviser now.