Hedge Fund Characteristics
Now that you know what hedge funds are and who can invest, let's look at the features that define the hedge fund experience, from high minimums to the distinctive fee structure.
Minimum Investment
- Hedge funds typically require high minimum investments; ranging from $250,000 to $1 million or more
- This high barrier, combined with accredited/qualified investor requirements, makes hedge funds inaccessible to most retail investors
Exam Tip: Gotchas
High minimums ($250,000 to $1 million+) combine with the accredited/qualified investor rules to exclude retail investors. Expect a distractor claiming "any investor" can meet a hedge fund's eligibility standards.
Partnership Structure
Like Direct Participation Programs (DPPs), hedge funds use a partnership model:
- General partner (GP): the fund manager who makes all investment decisions
- Limited partners (LPs): investors who provide capital and share in profits and losses
- Pass-through tax treatment; investors receive a K-1 form
- The GP has a fiduciary duty to act in the best interests of investors
Exam Tip: Gotchas
Hedge fund investors receive a K-1, not a 1099. The partnership structure passes income, gains, and losses through to limited partners, which means the fund itself pays no entity-level tax.
The "2 and 20" Fee Structure
One of the most recognizable features in finance:
| Fee Component | Typical Rate | Charged On | When Paid |
|---|---|---|---|
| Management fee | 2% annually | Total assets under management | Regardless of performance |
| Performance fee | 20% of profits | Net gains above a benchmark or hurdle rate | Only when fund is profitable |
- The management fee is charged whether the fund makes money or not
- The performance fee (also called "carried interest" or "incentive fee") aligns the manager's interests with investors; the manager earns more when the fund performs well
- Some funds include a high-water mark; the manager only earns a performance fee on gains above the previous highest net asset value (NAV), preventing double-charging on recovered losses
Exam Tip: Gotchas
- The "2 and 20" fee structure means investors pay 2% of ALL assets every year regardless of performance, PLUS 20% of any profits. On a $1 million investment that gains 10% ($100,000), the investor pays $20,000 in management fees plus $20,000 in performance fees = $40,000 in total fees. That is 40% of the gain.
Private Equity Exposure
Some hedge funds invest in private equity; ownership stakes in companies that are not publicly traded:
- May include venture capital (early-stage companies), leveraged buyouts (LBOs), and distressed debt
- These investments have very long holding periods and are highly illiquid
- Returns depend heavily on the manager's ability to identify and improve undervalued companies
Exam Tip: Gotchas
Private equity holdings inside a hedge fund have very long holding periods and no active market. Expect a distractor claiming an investor can sell private equity positions quickly on a secondary market.
Illiquidity and Lock-Up Periods
Hedge fund investors face significant restrictions on accessing their money:
- Lock-up periods: investors cannot withdraw their money for a specified period, often 1 to 2 years (sometimes longer)
- After the lock-up period, redemptions may only be allowed during specific windows (quarterly or annually)
- Investors must typically provide advance notice (30 to 90 days) before redeeming
- There is no active secondary market for hedge fund interests
- Some funds may impose gates: limits on the total amount that can be redeemed in any period
Exam Tip: Gotchas
During a lock-up period, investors have no right to redeem. After the lock-up, redemption windows are limited (often quarterly), and gates can further restrict withdrawals during a stressed market. This illiquidity is a defining hedge fund risk.
Let's now look at the aggressive strategies hedge funds use; strategies unavailable to mutual funds.