There is no specific formula for how hedge funds work because different hedge funds employ a multitude of different strategies. However, there are some common characteristics that are present in most hedge funds. All hedge funds start with a hedge fund manager.
This manager brings a specific strategy or investment philosophy to the table. Maybe he chooses to use leverage, short-selling, or derivatives. Maybe he uses asset-backed lending or has a global-macro approach. Whatever strategy he uses, the accredited investor or qualified client believes that this strategy will garner them some healthy returns, and therefore invests with this manager. Their investment is in the form of a lot of cash, usually upwards of a half million dollars.
The hedge fund manager takes whatever initial capital he gets, whether it be from investors, family, friends, maybe even his own money, and invests accordingly. While hedge funds have limited regulation, the manager does have the responsibility of providing transparency to his investors. There is a wide range of statistics, numbers and charts that the investor will expect to receive on a regular basis. This is why the hedge fund manager must hire an administrator to keep track of all of the documents relating to the fund. This way, the manager can focus on running the hedge fund and not administrative duties.
So where do these multi-million dollar paychecks for the hedge fund manager come in? Fees, fees and more fees. First, the manager gets to charge a management fee. This is independent of how the fund performs. The management fee is usually one to two percent of assets under management. Then comes the performance fee, which if the fund performs well, can be very lucrative. The performance fee is generally 20% but may go as high as 40% depending upon what the hedge fund manager likes to charge. James Simon, who runs Renaissance Technologies and who has garnered massive returns for his investors, charges a management fee of 5% and a performance fee of 44%.
When it comes time to close the fund down, assets are generally distributed to investors or transferred into a new hedge fund started by the same company. If the fund does not perform well, things get a little trickier. Whatever assets that are left are usually distributed to investors. However, the shutting down of a fund due to poor performance is generally preceded by the manager freezing investor redemptions. This is to avoid a mad rush by investors when the liquidity is probably not available. Sometimes, assets are frozen to wait out undesirable market conditions in hopes that things will improve. In either scenario, shutting down the fund after a poor performance is usually the last possible resort. Managers don’t want the reputation that comes with a failed fund, and investors don’t want a negative return on their contribution.