A hedge fund is an investment entity that pools capital from third-party investors, and a professional investment advisor manages those funds.
Individual and institutional investors will often invest in hedge funds because they are looking for a professional money manager to earn them a return on investment (ROI) that exceeds the market rate of return.
Hedge funds will invest in commonly traded assets like publicly traded stocks, bonds, and commodities, but they also invest in alternative investments that are otherwise unavailable to the traditional investor. For example, a hedge fund will have the necessary capital and expertise to invest in products like a Credit Default Swap (CDS) or Insurance Linked Securities (ILS). In contrast, a typical individual investor can only purchase publicly traded stocks and bonds in their brokerage account and cannot access the CDS or ILS markets.
The hedge fund manager organizes the hedge fund as a master-feeder fund structure. Investors invest in a hedge fund through a feeder fund, which is typically a domestic limited partnership (LP) or a foreign corporation in a tax-free jurisdiction. The investor contributes capital to the LP in exchange for a limited partnership interest in the entity.
The feeder funds invest all of their capital into the master fund, which is ultimately managed by the hedge fund investment manager. The hedge fund manager generally charges a management fee based on assets under management (AUM) and a performance fee on the fund’s profits, if any.