Definition
of Hedge Funds
What
is a Hedge Fund?
A
hedge fund is a private investment limited partnership that invests
in a variety of securities. There are two types of partners in a
hedge fund, a general partner and limited partners. The term hedge
fund is misleading in that a hedge fund does not necessarily have
to hedge. The term "hedge fund" now means any type of
private investment partnership.
The
general partner is the individual or entity who
started the hedge fund. The general partner also handles all of
the trading activity and day to day operations of running a hedge
fund. The limited partners supply most of the capital
but do not participate in the trading or day to day activities of
running the hedge fund.
Hedge
Funds are pooled investments, all the partner's capital amounts
are pooled together for the purpose of trading in securities. All
hedge funds follow some sort of trading strategy and are pretty
much free to use any financial instrument they wish. Some hedge
funds do not utilize leverage and the rest utilize leverage at an
average of 2:1. In rare cases, hedge funds like
Long-Term Capital Management manage to exceed the 2:1 ratio.
How
does the general partner get compensated and how are
gains/losses and expenses allocated to all the partners?
For
all the services that the general partner provides, he/she will
normally receive an incentive fee. The incentive fee is usually
20%of the net profits of the partnership. The incentive
fee determination will vary from hedge fund to hedge fund. Determination
of the incentive is dictated by the partnership agreement.
The general partner will also normally charge an administrative
fee, this fee is usually 1% of the year's net asset value.
This fee is also dictated by the partnership agreement. Hedge fund
managers are only rewarded for performance. If they make money they
do well, if they are flat or lose money they will receive little
or no money. The management fee will usually not cover the expenses
of operating a hedge fund.
The remainder of the profits/losses are allocated to all the partners
in the partnership based on their percentage ownership.
Hedge
Funds are prohibited from advertising, that's why there is little
information about particular hedge funds. Hedge funds will
raise money through the use of consultants or word of mouth, the
consultants will have accredited or qualified purchaser clients
that they solicit various hedge funds to. The consultants in some
cases will conduct background checks as well as due diligence for
their clients on the hedge fund managers. this means that on behalf
of the potential investors, the consultant will visit the hedge
funds, gather background information, gather references, collect
performance data, conduct statistical and analytical reviews of
the funds. They will then have a database of reviewed funds that
they can present to their clients.