How do Hedge Funds Work? Part 2

Ray Dalio, the founder of Bridgewater, one of the biggest hedge funds in the world.
Ray Dalio, the founder of Bridgewater, one of the biggest hedge funds in the world.

Greater Flexibility

As hedge funds are made available only to certain sophisticated or accredited investors and cannot be offered or sold to the general public, they generally avoid direct regulatory oversight, bypass licensing requirements applicable to investment companies, and operate with greater flexibility than mutual funds.

Responsibility to Investors

While hedge funds may not be “regulated,” the hedge fund manager does have the responsibility of letting his or her investors know exactly how the fund is performing and what exactly it is investing in. As a result there are many types of charts, statistics, and numbers that every investor can expect to land on their desk, or more commonly these days, in their inbox. As a result, hedge fund managers hire administrators who keep track of all of the documents relating to the fund. This allows the manager to concentrate on running the hedge fund without having to spend time on administrative duties.

How Do Hedge Fund Managers Make Their Money?

Hedge fund managers such as Ray Dalio (pictured) get to charge a couple of very important fees in exchange for their services in running the fund. Firstly, they charge a management fee, which is independent of how the fund performs.This management fee is typically around 1 to 2% of assets under management, but can be higher depending on the individual hedge fund manager.

The second, and most lucrative fee, is the performance fee. This fee is usually 20% but may go as high as 40% or more, again depending on what the hedge fund manager likes to charge. So if a fund performs very well, the hedge fund manager stands to earn a very hefty amount in fees.

Closing Down Hedge Funds

The good

When it’s time to wind down a hedge fund, the assets are typically distributed among the investors, or may be transferred into a whole new hedge fund that is started by the same company. Things are not so straightforward in the event that the fund does not perform well.

The bad

In this case, whatever assets are left are generally distributed to investors. However, in scenarios such as these, managers will seek to avoid any kind of mad rush by investors, especially at a time when the liquidity is most probably not available. For this reason, when a hedge fund shuts down due to poor performance, the manager will often precede it by freezing investor redemptions.

Assets will tend to be frozen until market conditions improve. In either case, no one wants to shut down a hedge fund due to poor performance, and it’s very much considered a last resort. For managers it could be the deathknell as no one wants to be associated with a failed fund, while investors want anything but a negative return on their investment.


Other articles in this series:

How do Hedge Funds Work? Part 1