Simply put, a hedge fund groups partners together to create enough money for the fund to make high-risk investments. The large financial base of a hedge fund creates the flexibility of participation in a larger assortment of investments and financial undertakings than other funds. However, hedge fund participation is typically regulated strictly and limited to specified types of investors. Because hedge funds are so high risk regulators specify that pension funds, endowments, institutions, and individuals whose capital net worth is very high. These types of investors are usually well-versed in the risks posed by the very nature of these types of investment funds.
Hedge fund investment value (what a person or organization’s share of the return) is determined by a share of the funds’ net value. Most often a hedge fund is set up to be open-ended so that investors may withdraw money at regular interims. This means that when the fund value fluctuates the investment value does as well. This is reflected in the amount of capital available for withdrawal. In other words, larger withdrawals can be made when a fund is performing well and smaller amounts can be withdrawn when funds are performing poorly.
Hedge fund management is known for high-risk strategies that strive to reach a positive return no matter how the markets are performing at any given time. A hedge fund manager is most often paid fees based upon a percentage of the funds’ value and a management firm is paid both management fees and performance fees. When a fund performs well the manager receives an accordingly higher payout. Hedge funds are not public investments and as such have far fewer restrictions than some other financial funds. Fees can run anywhere from 10% to 50% of annual fund profits, allowing performance fees to add up to large dividends.
High water marks create provisions that fund managers are only paid fees if there are net profits (over time) so managers have high incentive to work toward gains. These provisions prevent fund managers from profiting after poor performance. Some managers will bypass this provision by closing a fund instead of trying to recoup severe losses. Another possible provision is a hurdle. A hurdle is set up to pay performance fees only if a fund performs above previously specified levels. Fees with a soft hurdle are then figured by calculating all returns for the fund if the hurdle has been surpassed. Fees for a hard hurdle are percentage based on returns above and beyond the specified hurdle rate. This serves to guarantee that poor decision making on the part of a fund manager does not lead to profit.
Like many other types of investments there are often fees or penalties for withdrawals made before a specified date from the funds’ establishment. These may also apply if a withdrawal is more than a specified percentage of the initial investment. This reduces the chance of short-term investors and large withdrawals during times of poor return or after losses.
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