What it is:
A hedge fund is an investment structure designed to allow management of a private, unregistered portfolio of assets.
How it works (Example):
The original concept of a hedge fund was to offer plays against the market using short selling, futures, and derivatives. Today, hedge funds follow any number of strategies and cannot be considered a homogenous asset class.
Hedge funds (as an asset class) use various strategies, including leverage, hedging, and macroeconomic bets on commodities, currencies, and interest rates. The common denominator of hedge funds is not their investment strategy but their search for absolute returns (as opposed to relative returns). Absolute return strategies focus on generating a positive return on investment (ROI) regardless of the direction of the financial markets.
Hedge fund managers seek freedom to achieve high absolute returns and wish to be rewarded for their performance. The compensation arrangement for the manager typically specifies considerable profit participation. The specific legal organization of hedge funds and the considerable fee structure expected by fund managers are probably the only uniform characteristics of hedge funds.
Only accredited investors are eligible to invest in hedge funds. The term accredited investor includes wealthy individuals and organizations like corporations, endowments, or pension funds. Accredited investors invest in hedge funds because they are looking for investments with negative correlation to the broad market.
Why it Matters:
Because they operate outside the realm of the public markets and are lightly regulated, hedge funds have been declared "off limits" to most individual investors. Some say the lack of oversight paired with the high-risk, high-return strategies employed by most hedge funds have resulted in some of the world's most catastrophic financial events, including the failure of Long-Term Capital Management in 1998 and the collapse of two Stearns hedge funds in 2007.
That being said, all investors, regardless of experience and sophistication, need to perform extensive due diligence before investing in any hedge fund. Before investing in a hedge fund, an investor needs to consider the correlation of the fund strategy to the rest of the investor’s portfolio, the reputation and success rate of the fund manager, the use of leverage, as well as the fee schedule.