Most regular mutual funds have one simple task: To buy stocks that they hope will rise in value. If the entire stock market crashes, a regular fund will almost always crash with it. A hedge fund, on the other hand, is built to be able to make money (or at least protect the money) no matter what happens in the world.
The word hedge means to protect oneself. Historically, these funds were created to protect investors against losses in bad times. Today, however, many hedge funds are known for taking extremely high risks to achieve astronomical returns.
"You will be a master of circumstances if you do not let circumstances become your master."
— Florence Scovel Shinn
The quote hits the core of what a hedge fund manager tries to do. They refuse to be controlled by whether the stock market is in a boom or a bust; they create their own strategies to master the market regardless of circumstance.
How do they differ from regular funds?
- Exclusivity: You usually cannot invest a thousand kroner in a hedge fund. They often require you to enter with many millions, and they are closed to regular small savers.
- Freedom: Regular funds have strict rules about what they are allowed to do. Hedge funds are almost entirely free to use leverage, short selling (betting that stocks will fall in value), and advanced derivatives.
- The 2 and 20 fee model: Hedge funds are notorious for being expensive. A classic model is that they take 2 percent of your money in a fixed annual fee, plus a full 20 percent of all the profits they generate.
Myth vs. reality: Although the most famous hedge funds are often in the news for making billions on spectacular bets, statistics show that the average of all hedge funds often struggles to beat a completely normal and cheap global index fund over time.
Pros and cons
Advantages
- They can make money even in deep financial crises by betting against the market (short selling).
- Managed by some of the sharpest (and most expensive) minds in the financial world.
- Helps to diversify a portfolio for those who already have a lot of money.
Disadvantages
- The high fees eat up a huge portion of the return.
- Many of the strategies involve extreme risk that can lead to the loss of the entire investment.
- The funds are often not very transparent; you rarely know exactly what your money is invested in from day to day.