What Are Hedge Funds, Anyway?

Few of us have the savvy — or the scratch — to invest in hedge funds, but they are still key players in the world of investing. So, what are they, and why do they matter?

Here's the long and short of it: A hedge fund is a limited partnership of investors that uses advanced (often risky) methods, such as investing with borrowed money, in an attempt to realize large gains. They matter because they are a $3.2 trillion dollar industry. Anything that huge has the potential to make big waves in the global economy — for better or for worse.

Less Gamble, More Skill

Most hedge funds are, by design, limited partnerships. The hedge fund management group functions as the general partner, while third party investors, such as uber-wealthy individuals and banks and institutional investors, serve as limited partners.

It shakes out like this: The hedge fund management group invests the limited partner's pooled monies using a variety of clever tactics aimed at realizing big returns. Rather than solely relying on the movement of the stock market, however, profits are made due to the manager's skill.

The hedge fund was born out of the desire of large investment companies to mitigate market risks through exposure to alternative assets. For example, if the market were to take a dramatic plunge, hedge funds could minimize their losses by investing in assets that perform well in such an economic rut.

Hedge fund managers use a diverse set of investment vehicles, including investments in debt, stocks, bonds, commodities, and complex derivatives. Some hedge funds buy up shares in businesses, invest in crude oil, spend on collectables such as valuable art, or flip real estate. Sometimes a manager bets on these things, while at other times he or she might bet against them. In all cases, these investments are bought and sold to maximize returns.

Notably, most people don't qualify to invest in a hedge fund. Only those individuals who have an annual income above $200,000 or a net worth that tops $1 million, excluding a primary residence, can join as a limited partner. Many folks who meet these thresholds, however, might balk at the fees. Hedge funds typically charge limited partners about 20% of all gains and about 2% of assets.

Hedge Funds Are Big Business

Originally, hedge funds were almost exclusively the province of the uber-wealthy, but institutional investors have also been increasingly using hedge funds in the last 15 years. Many public pension funds, banks, endowments, and trusts now invest in hedge funds. The industry is ballooning, growing by more than $70 billion in 2015.

A whopping 60% of all hedge fund managers are based in North America, where New York City and Connecticut lead the way. Europe has 19% of the world's hedge fund managers, with the majority located in the UK. Asia-Pacific hedge fund managers constitute 17% of all firms within the industry, with major hubs in Hong Kong, Singapore, and Australia.

All this is to say that the hedge fund industry is big, it's global, and it has the potential to make investors huge gains in a short amount of time. Interestingly, the act of "hedging," which lends the industry its name, refers the minimization of risk. However, the aim of just about any hedge fund is to maximize returns on investment. And that usually requires relatively risky investment strategies.

Hedge Funds Today

Last year turned out to be a tough year for hedge funds, despite the fact that the industry made gains during the first five months of 2015. That winning streak was sharply reversed by four months of losses from June to September, the longest losing streak for hedge funds since 2008. Some of the best-known names in the industry lost their investors billions of dollars. Global events including declining oil prices, the collapse of commodity prices, and the Greek debt crisis are partially to blame.

Despite the industry's lackluster performance of late, the top hedge fund managers continue to take home billions of dollars. The 25 top-paid hedge fund managers earned a collective $13 billion in income last year, according to an annual ranking. Some of these top earners actually lost money for investors, but still personally profited.

Also notable is that David Tepper, the hedge fund billionaire behind Institutional Investor's Alpha, put the entire New Jersey state budget in peril this year when he moved out of the state to Florida, taking his hedge fund headquarters with him. Tax experts say his relocation could cost New Jersey hundreds of millions of dollars in lost payments.

It's just another example of how this powerful industry can affect all of us.

Anything we've missed? What are hedge funds, anyway?

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