Hedge funds can be personally managed or leveraged using derivatives in domestic or international markets. These alternative investments use pooled funds to earn their investors active returns either on their absolute growth or on returns on investment in an active market.

They are a favorite diversification strategy due to their relatively low trade cost. However, only accredited investors can manage hedge funds due to how little they are regulated compared to other investments like mutual funds.

The Origin of the Hedge Fund

Hedge funds began in 1949 at A.W. Jones & Co. when Alfred Winslow Jones tried to minimize a large investment using a strategy of short selling. He buffed his returns with other leverage and was able to create a new investment structure that manages long/short equities over an extended period. So long as he started with a large initial investment, he could make this strategy pay off.

A few years later, he changed his tactics. Instead of using a general investment, he turned his fund into a limited investment, finalizing the modern model of the hedge fund. His strategy had four important features: a large initial investment, short selling other stocks, leveraging shared risk through a limited partnership, and compensating partners based on the fund’s market performance.

Hedge funds would continue to evolve, eventually outperforming mutual funds. They hit the spotlight in 1966 when Winslow’s strategy was covered by “Fortune” magazine.

How Do Hedge Funds Work?

Hedge funds can be separated by their investment style into categories that reflect the investor’s strategy. Different market opportunities require different styles of hedge funds, each of which comes with its own risk level and prospects.

Hedge funds require a sizable initial investment, as well as remaining illiquid for at least a full year. Hedge fund investors know this as the “lock-up,” where they cannot withdraw from the fund until a certain interval passes (it’s usually quarterly).

As limited partnerships, hedge funds are private investment opportunities overseen by the general partner, who shoulders more control but also more liability over the funds. As a result, hedge funds are not as regulated as other forms of investment.

Hedge Funds in Commercial Real Estate

Hedge funds invest in different industries depending on the investors’ strategy. Some hedge funds take on the risk of the real estate industry in the hope of outperforming mutual funds since hedge investments are uncapped and relatively unregulated.

In real estate, hedge funds deal mostly with public trading or acquiring underperforming properties. Investors more used to liquid funds may find real estate hedge funds too nontraditional. However, the examples of companies like Angelo, Gordon & Company, and The Praedium Group have shown that it can be done.

Hedge funds in real estate leverage publicly traded stocks or otherwise acquire properties for their investors. Property owners who lack liquidity can unload their property on investors who want to put those assets into a real estate hedge fund.

Some companies invest only in real estate using an altered form of hedge funds to pay out their income as dividends. These corporate entities are called real estate investment trusts or REITs. They use real estate hedge funds to support their investors in a pay structure similar to that of a mutual fund.