Hedge Fund

What makes a hedge fund different

A mutual fund sold to the general public operates under tight rules about what it can own and how much risk it can take. A hedge fund is the opposite arrangement: a private pool, open only to a restricted group of investors, whose manager is given wide freedom of strategy. That freedom typically includes short selling to profit when securities fall, leverage to amplify results with borrowed money, derivatives, and concentrated positions that a public fund would never be allowed to hold.

In theory, all this flexibility exists to earn returns that do not depend on the direction of the overall market. Some funds pursue that goal seriously. Others simply use the extra tools to take bigger swings.

The name is mostly historical

The original hedge funds paired long positions with short positions so their results did not hinge on the market rising: they were literally hedged. The label stuck, but the modern industry spans everything from cautious market-neutral strategies to aggressive concentrated bets. Many hedge funds today do not hedge in any meaningful sense, so the name describes the legal structure more than the behaviour.

The famous fee structure

The traditional arrangement is known as two and twenty: a management fee of about 2% of assets each year, plus a performance fee of about 20% of profits. That is far more than ordinary funds charge, and the drag compounds year after year.

Competitive pressure has softened the model over time. Many funds now charge less than the classic headline numbers, and large investors often negotiate their own terms. Even so, hedge funds remain among the most expensive investment products in existence.

Who can invest, and whether you should care

In Canada, hedge funds are sold under prospectus exemptions, which generally means investors must qualify as accredited investors by meeting income or financial asset thresholds set by securities regulators, or come in through other exemptions with meaningful minimum investments. The practical result is that the average Canadian cannot buy in, and that is less of a loss than it sounds.

Measured across the whole industry, hedge fund results after fees have generally been unremarkable compared with simply holding a low-cost index fund. A minority of managers do deliver something exceptional, but identifying them in advance is notoriously difficult, and the best funds are often closed to new money. For most investors, the sensible reaction is curiosity rather than envy.

For those who want a taste of these strategies inside a regulated wrapper, so-called liquid alternative mutual funds offer hedge-fund-like techniques with daily liquidity and low minimums, though usually in diluted form and still at above-average fees.