Hedge Fund: Definition, Examples, and Strategies
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Key Takeaways
- Hedge funds are actively managed funds focused on alternative investments that commonly use risky investment strategies.
- Investing in a hedge fund is generally open to accredited investors with a high minimum investment or net worth.
- Hedge funds charge higher fees than conventional investment funds.
- Hedge fund strategies depend on the fund manager and relate to equity, fixed-income, and event-driven investment goals.
- A hedge fund investment is usually locked up for a year before shares can be sold.
What Is a Hedge Fund?
A hedge fund is an actively managed private investment fund whose money is pooled and managed by professional fund managers. These managers use a wide range of strategies, including leverage and the trading of nontraditional assets, to earn above-average investment returns. Investing in hedge funds is often considered a risky alternative investment choice and usually requires a high minimum investment or net worth. Hedge funds typically target wealthy investors.
Investopedia / Julie Bang
How Hedge Funds Work
Hedge funds pool money that’s managed to outperform average market returns. The fund manager often hedges the fund’s positions to protect them from market risk. Some of the assets are invested in securities whose prices move inversely to the fund’s core holdings. So, if their prices drop, the securities’ prices should rise. As a result, the hedge can offset any losses in the core holdings.
For example, a hedge fund that focuses on a cyclical sector, such as travel, may invest a portion of its assets in a non-cyclical sector like energy, aiming to use the positive returns of the non-cyclical stocks to offset any losses in cyclical stocks.
Hedge funds use risky strategies, leverage, and derivative securities like options and futures. Therefore, hedge fund investors are almost always accredited. This means they meet a required minimum level of income or assets. Accredited investors are typically institutional investors, such as pension funds, insurance companies, and wealthy individuals.
Investments are considered illiquid, as investors have to commit their money for at least one year, which is the lock-up period. Withdrawals may also only happen at certain intervals, such as quarterly or biannually.
Types of Hedge Funds
The four common types of hedge funds are:
- Global macro hedge funds: These are actively managed funds that attempt to profit from broad market swings caused by political or economic events.
- Equity hedge funds: These may be global or specific to one country, investing in lucrative stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices.
- Relative value hedge funds: These funds seek to exploit temporary differences in the prices of related securities, taking advantage of price or spread inefficiencies.
- Activist hedge funds: These aim to invest in businesses and take actions that boost the stock price, such as demanding that companies cut costs, restructure assets, or change the board of directors.
Fast Fact
The appeal of many hedge funds lies in the reputations of their managers, which stand out in the closed world of hedge fund investing.
Common Hedge Fund Strategies
Hedge fund strategies cover a broad range of risk tolerance and investment philosophies. They involve a large selection of investments, including debt and equity securities, commodities, currencies, derivatives, and real estate.
Common hedge fund strategies are classified according to the investment style of the fund’s manager and include equity, fixed-income, and event-driven investment goals.
- A long/short hedge fund strategy is an extension of pairs trading, by which investors go long and short on two competing companies in the same industry based on their relative valuations.
- A fixed-income hedge fund strategy gives investors solid returns with minimal monthly volatility and aims for capital preservation; it takes both long and short positions in fixed-income securities.
- An event-driven hedge fund strategy takes advantage of temporary stock mispricing, spawned by corporate events like restructurings, mergers and acquisitions, bankruptcy, or takeovers.
Examples of Hedge Funds
The most notable hedge funds, based on assets under management (AUM) as of 2025, include:
- Bridgewater Associates: Founded in New York in 1975 and headquartered in Westport, Connecticut, with approximately $124 billion in AUM
- Renaissance Technologies: Founded in 1982 and headquartered in East Setauket, New York, with mathematical- and statistical-based investment strategies as well as roughly $106 billion in AUM
- AQR Capital Management: Founded in 1998 and headquartered in Greenwich, Connecticut, with applied quantitative research investment strategies and about $99 billion in AUM
Hedge Fund Compensation
Australian investor Alfred Winslow Jones is credited with launching the first hedge fund in 1949 through his company, A.W. Jones & Co. Raising $100,000, he designed a fund to minimize the risk in long-term stock investing by short selling, now referred to as the long/short equities model.
As a limited partnership, he added a 20% incentive fee as compensation for the managing partner, and became the first money manager to combine short selling, leverage, and a compensation system based on performance.
Hedge funds now use a standard “2 and 20” fee system. This is a 2% management fee and a 20% performance fee:
- The management fee is based on the net asset value (NAV) of each investor’s shares, so an investment of $1 million garners a $20,000 management fee that year to cover the operations of the hedge and compensate the fund manager.
- The performance fee is commonly 20% of profits. If an investment of $1 million increases to $1.2 million in one year, $40,000 is the fee owed to the fund.
Hedge Funds vs. Mutual Funds
Hedge Funds
A hedge fund can invest in land, real estate, stocks, derivatives, and currencies. It’s normally only open to accredited investors or those with either an annual income over $200,000 or a net worth exceeding $1 million. They’re seen as capable of dealing with the risks that hedge funds can take. Hedge funds also aren’t as strictly regulated by the Securities and Exchange Commission (SEC) as mutual funds are.
Hedge funds typically limit opportunities to redeem shares and often impose a locked period of one year before shares can be cashed in. They typically employ the 2% management fee and 20% performance fee structure.
Mutual Funds
Mutual funds use stocks or bonds as their instruments for long-term investment strategies. They’re a practical, cost-efficient way to build a diversified portfolio of stocks, bonds, or short-term investments. They’re available to the general public and the average investor.
Unlike hedge funds, mutual fund investors can sell their shares at any time. The average expense ratio for equity mutual funds was 0.40% in 2024.
| Hedge Funds | Mutual Funds | |
|---|---|---|
| Investments | Varies, including land, real estate, stocks, derivatives, and currencies among others | Varies, including stocks, bonds, indexes, commodities, and currencies among others |
| Investor Profile | Accredited investors | Open to all |
| Risk | Risky | Low-risk |
| Holding Period | Generally one year | Can sell at any time |
| Fee Structure | 2% (management) and 20% (performance) | Expense ratio based on fund |
Tip
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What to Consider Before Investing
As investors research hedge funds that meet their investment goals, they often consider the fund or firm’s size, the track record and longevity of the fund, the minimum investment required to participate, and the redemption terms of the fund. Hedge funds operate in many countries, including the United States, the United Kingdom, Hong Kong, Canada, and France.
According to the SEC, investors should also do the following when deciding whether or not to invest in a hedge fund:
- Read the hedge fund’s documents and agreements, which contain information about investing in the fund, its strategies, location, and the anticipated risks.
- Understand the risk involved in its investment strategies and whether they align with your investment goals, time horizons, and risk tolerance.
- Determine if the fund uses leverage or speculative investment techniques, which will typically invest your capital and the borrowed money to make investments.
- Evaluate potential conflicts of interest disclosed by hedge fund managers, and research their backgrounds and reputations.
- Understand how a fund’s assets are valued, as they may invest in highly illiquid securities, and valuations of fund assets will affect the fees that the manager charges.
- Understand how a fund’s performance is determined and whether it reflects cash or assets received by the fund as opposed to the manager’s estimate of the change in the value.
- Understand any limitations to time restrictions imposed on redeeming shares.
Explain Like I’m 5
A hedge fund is a private investment pool (i.e., capital collected from several investors) that’s actively managed by a professional fund manager. These funds can invest in stocks as well as nontraditional assets like land and currencies. Their investors don’t benefit from the same federal and state law protections as mutual funds. This is why hedge funds are often restricted to wealthy investors.
Hedge funds use complex strategies to outperform average market returns. To hedge against market risk, some of a fund’s assets are invested in securities that move counter to its core holdings. Its investments are also typically locked in for a minimum of one year before shares may be sold.
Fund managers are usually compensated by charging a 2% management fee as well as a 20% performance fee. The former is based on the NAV of each investor’s shares in the hedge fund, while the latter is typically tied to its profits.
What Tools Do Investors Use to Compare the Performance of Hedge Funds?
Investors look at the annualized rate of return to compare funds and to reveal funds with high expected returns. To establish guidelines for a specific strategy, an investor can use an analytical software package, such as those offered by Morningstar, to identify a universe of funds using similar strategies.
How Do Hedge Funds Compare with Other Investments?
Hedge funds, mutual funds, and exchange-traded funds (ETFs) all pool money contributed by many investors and attempt to earn a profit for themselves and their clients.
Hedge funds are actively managed by professional managers who buy and sell certain investments with the stated goal of exceeding the returns of either the markets or some sector or index of the markets. They take the greatest risks while trying to achieve these returns. Additionally, hedge funds are more loosely regulated than competing investments, and they can invest in options and derivatives as well as esoteric investments that mutual funds cannot access.
Why Do People Invest in Hedge Funds?
A wealthy individual who can afford to diversify into a hedge fund might be attracted to the high-performance reputation of its manager, the specific assets in which the fund is invested, or the unique strategy that it employs.
The Bottom Line
Hedge fund investing is considered a risky alternative investment choice and requires investors to make a large minimum investment or have a high net worth. Hedge fund strategies involve investing in debt and equity securities, commodities, currencies, derivatives, and real estate. These funds are loosely regulated by the SEC and earn money from the 2% management fee and 20% performance fee structure.
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