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.