Hedge funds are companies that invest in securities that are not federally registered investment firms. Hedge funds like mutual fund companies buy securities with money invested by corporations, financial companies and private investors. As with any investment, the fund's investors stand to gain or lose money based upon the performance of the securities in the fund. However, unlike managers of other types of funds, hedge fund managers get a share of the revenue that the fund generates.
When you invest in a hedge fund, the fund manager or management team get to keep a fixed percentage of your investment gains. While revenue sharing agreements vary from fund to fund, in most instances the fund managers get to keep 20 percent of your earnings. If your investment increases in value by $50,000 your fund manager gets to keep $10,000 of your earnings as a performance bonus. By comparison, mutual fund managers do not get performance related pay and although you may pay a commission to sell your shares, this normally amounts to 3 or 4 percent and goes to your broker rather than the fund operatives.
Hedge funds tend to attract extremely wealthy investors which means that fund managers stand to earn huge amounts of money if the fund grows in value. Hedge funds are not subject to the same kind of rules as mutual funds that prevent managers from buying certain types of securities. Hedge fund managers can invest in just about anything in the pursuit of growth. Hedge fund proponents argue that revenue sharing agreements provide managers with a powerful incentive to work hard because during down years the fund manager earns nothing.
Many people argue that hedge fund investors are exposed to undue levels of risk because fund managers may thrown caution to the wind when presented with opportunity to earn huge commissions. Since hedge funds are largely unregulated, instances of fraud are harder to detect and investors could lose everything if an unscrupulous individual takes control of the fund. Furthermore, nothing prevents a hedge fund from shutting down its operations during a down year so that the fund does not have to recapture its losses before fund managers can earn bonuses again.
While revenue sharing deals tend to attract the attention of investors, you also have to pay asset management fees when you invest in a hedge fund. These fees cover trade expenses and administrative costs and often amount to 1 or 2 percent of your investment. Many hedge funds actually contain shares in other funds in which case you pay two lots of fees because you pay fees on the underlying shares and fees to the fund that you directly invested in. High fees and a lack of transparency mean that hedge funds are far from ideal investments for many people even if you overlook the revenue sharing agreements.