An aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.
A hedge fund is a private investment fund that charges a performance fee and is typically open to only a limited range of qualified investors. Hedge fund activity in the public securities markets has grown substantially as it constitutes approximately 30% of all U.S. fixed-income security transactions, 55% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, as well as 30% of equity trades. Hedge Funds dominate certain specialty markets such as trading in derivatives with high-yield ratings, and distressed debt. 
The assets under management of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage . Their sway over markets, whether they succeed or fail, is therefore potentially substantial and there is a continuing debate over whether they should be more thoroughly regulated.
As with other investment funds , the management fee is calculated as a percentage of the net asset value of the fund at the time when the fee becomes payable. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. Therefore, if a fund has $1 billion of assets at the year end and charges a 2% management fee, the management fee will be $20 million in total. Management fees are usually calculated annually and paid monthly.
Performance fees, which give a share of positive returns to the manager, are one of the defining characteristics of hedge funds. In contrast to retail investment firms, performance fees are prohibited in the U.S. for stock brokers . [ citation needed ] A hedge fund's performance fee is calculated as a percentage of the fund's profits, counting both unrealized profits and actual realized trading profits. Performance fees exist because investors are usually willing to pay managers more generously when the investors have themselves made money. For managers who perform well the performance fee is extremely lucrative.
Typically, hedge funds charge 20% of gross returns as a performance fee, but again the range is wide, with highly regarded managers demanding higher fees. In particular, Steven Cohen 's SAC Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons ' Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its flagship Medallion Fund before returning all investors' capital and running solely on its employees' money. [ citations needed ]
Managers argue that performance fees help to align the interests of manager and investor better than flat fees that are payable even when performance is poor. However, performance fees have been criticized by many people, including notable investor Warren Buffett , for giving managers an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark and sometimes by a hurdle rate . Alternatively, the investment manager might be required to return performance fees when the value of the fund drops. This provision is sometimes called a ‘claw-back.’
They do enormous research to find out where there is hidden value. Activists typically go into situations where the value isn't immediately clear and they press management to unlock that value (for instance, trying to get MCD to sell real estate holdings, etc).
They are typically long-term holders. Activists tend to take 5% or greater positions in a company. They aren't able to nimbly trade out of those positions.
They usually publish their research in 13D filings in order to convince shareholders to vote their way.
They use their own equity to invest (as oppose to LBO funds that use the target company to raise debt)
Often demand share buybacks (don’t like excess cash on the balance sheet)
Management time wasted on appeasing hedge fund managers not running the business
Increase leverage could effect cash flows, credit rating, ability to raise capital
Short term vs long term
For class discussion purposes only 2/7/2008
Source: Investments , leveraged buyouts Self made Age: 69 Marital Status: Married, 2 children, 1 divorce Hometown: New York, NY Education: Princeton University, Bachelor of Arts / Science Obsessive corporate raider up to old tricks with purchase of a small stake in Time Warner; trying to strong-arm media giant into dumping publishing assets and buying back $20 billion in stock. "Shareholder activist" grew up middle class in NYC's Queens. Studied psychology at Princeton, then NYU med school; dropped out because he didn't like working with corpses. Got job as stockbroker for Dreyfus & Co.; moved into securities arbitrage. Borrowed to buy NYSE seat 1968; bought firms, forced managers to improve, buy him out or spin off at profit. Big scores in 1980s with takeovers of Texaco, USX. Latest vehicle: hedge funds. Icahn Partners fund manages $2.5 billion in assets. Also owns Las Vegas' tallest casino, the Stratosphere, through stake in American Real Estate Partners; shares worth $2 billion #24 Carl Icahn Net Worth: $8.5 billion Source: Forbes For class discussion purposes only 2/7/2008
Who: Hedge fund manager, Pershing Square Capital Management Current Residence: New York, NY Spotlight: “Young people are bright people. They are not indentured to received wisdom Enemies: MBIA, the insurance giant. According to a story in The Edge Singapore, MBIA chairman Jay Brown summoned Ackman and other Gotham associates to a meeting after Gotham published a series of reports criticizing MBIA’s bookkeeping. Brown supposedly accused Ackman of manipulating the market and emphasized that MBIA had “friends in high places”. The meeting ended with Ackman offering a handshake and Brown recoiling. Soon after, the SEC began to investigate Gotham. Ackman bore out the investigations, which found nothing suspect, and eventually used the relationships he developed with the SEC to instigate an investigation into MBIA’s accounting practices. He later enjoyed the sweet, sweet taste of revenge when MBIA was forced to restate six years of earnings, reducing profits by $60 million. Quotable: “The truth wins out eventually. If I’ve got my idea and basic facts right, I’ll be fine. If nothing else, I’m a persistent cuss.” Never has pursuit of the truth been this (financially) rewarding. Zillowed: When Ackman isn’t living in a $26 million co-op on Central Park West in New York, he spends time in his home on 73rd street, a neighborhood with $4-5 million houses. Source: www.01138mag.com Bill Ackman For class discussion purposes only 2/7/2008
It was the $109,000 photocopying bill that hedge fund manager William Ackman says made him realize how much he'd read and underlined before betting against bond insurer MBIA Inc. in 2002.
His law firm charged him for copying 725,000 pages of financial statements and other documents, 140,000 of them about MBIA, to comply with a subpoena. Following New York and U.S. probes of his trading and reports, Ackman persisted in challenging MBIA's AAA credit rating for more than five years, based on his own research.