A hedge fund is a private pooled vehicle that uses leverage, short selling, and derivatives to pursue absolute returns. The label "hedge" is historic; many strategies hedge little and amplify risk. Learn the features, the legal wrappers, and what actually drives return.
Hedge funds are private pools available only to accredited investors or qualified purchasers. Six features define them:
- Active, absolute-return mandate. The benchmark is cash or a fixed hurdle, not the S&P 500.
- Wide tool set. Long, short, leverage, derivatives, illiquid assets, and concentrated positions are all permitted.
- Restricted liquidity. Lock-ups of 1 to 3 years, quarterly redemption windows, advance notice periods (30 to 90 days), and gates that cap aggregate withdrawals.
- High minimums. Typically $500,000 to $1M, sometimes higher.
- Performance-heavy fees. Management plus carry, with hurdles and high-water marks.
- Limited transparency. Positions are disclosed selectively to avoid front-running.
KEY: Mutual funds are constrained by the Investment Company Act of 1940; hedge funds use exemptions (3(c)(1) up to 100 investors, 3(c)(7) for qualified purchasers) to escape those constraints.
Common mistakes
- Treating "hedge fund" as a single asset class. Strategies range from market-neutral to highly directional. Trap answer: "hedge funds always reduce portfolio volatility." Wrong; macro and short-bias funds add directional risk.
- Forgetting the high-water mark in performance fee math. After a drawdown, no carry until NAV recovers above the prior peak. Trap: charging 20% on every positive year regardless of cumulative position.
- Confusing master-feeder roles. The offshore feeder is a corporation that blocks UBTI for tax-exempt LPs. Trap answer: "the offshore feeder is a partnership for non-US investors."
Bottom line
- Hedge funds use leverage, shorting, and derivatives to chase absolute returns; minimums are high, liquidity is restricted, and investors must be accredited or qualified.
- Four strategy buckets: equity hedge, event-driven, macro/CTA, relative value. Multi-strategy and funds-of-funds combine them.
- Standard vehicle: limited partnership. Master-feeder structure routes US (onshore LP) and non-US/tax-exempt (offshore corp) capital into one master fund.
- Fees: "2 and 20" with a hurdle and a high-water mark. The high-water mark prevents charging performance fees twice on the same gain after a drawdown.
Exam shortcut
Anchor the four strategy buckets first (equity hedge, event-driven, macro/CTA, relative value). When fees appear, always check three things in order: hurdle type (soft vs. hard), high-water mark presence, and FoF layering. For master-feeder questions, remember the offshore feeder is a corporate UBTI blocker, while the onshore feeder is a pass-through LP.
The full lesson (about 2,163 words, 14 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- hedge funds
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