Hedge Fund: Definition, Examples, Types, and Strategies (2024)

What Is a Hedge Fund?

A hedge fund is a limited partnership of private investors whose money is pooled and managed by professional fund managers. These managers use a wide range of strategies, including leverage (borrowed money) and the trading of non-traditional assets, to earn above-average investment returns.

A hedge fund investment is often considered a risky, alternative investment choice and usually requires a high minimum investment or net worth. Hedge funds typically target wealthy investors.

Key Takeaways

  • Hedge funds are actively managed funds focused on alternative investments that commonly use risky investment strategies.
  • A hedge fund investment typically requires accredited investors and a high minimum investment or net worth.
  • Hedge funds charge higher fees than conventional investment funds.
  • The strategies used by hedge funds depend on the fund manager and relate to equity, fixed-income, and event-driven investment goals.
  • A hedge fund investor's investment usually is locked up for a year before they may sell shares and withdraw funds.

Hedge Fund: Definition, Examples, Types, and Strategies (1)

Understanding Hedge Funds

Hedging Their Bets

The term "hedge fund" refers to an investment instrument with pooled funds that is managed to outperform average market returns. The fund manager often hedges the fund's positions to protect them from market risk.

They do so by investing a portion of the fund's assets in securities whose prices move in the opposite direction of the fund's core holdings. Theoretically, should the prices of the core holdings move down, the prices of the securities acting as a hedge should move up. 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 such as 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 securitiessuch as options and futures. Therefore, an investor in a hedge fund is commonly regarded as an accredited investor. This means that they meet a required minimum level of income or assets. Typical investors are institutional investors, such as pension funds and insurance companies, and wealthy individuals.

Investments in hedge funds are consideredilliquidas funds often require investors to keep their money in the fund for at least one year, a time known as thelock-up period.Withdrawalsmay also only happen at certain intervals such as quarterly or bi-annually.

Types of Hedge Funds

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.

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 theinvestment 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), include:

  • Bridgewater Associates: Founded in New York in 1975 and headquartered in Westport, Conn., global leader, with more than $124 billion in AUM.
  • Renaissance Technologies: Founded in 1982 and headquartered in East Satauket, N.Y., with mathematical- and statistical-based investment strategies, and over $106 billion in AUM.
  • AQR Capital Management: Founded in 1998 and headquartered in Greenwich, Conn., with applied quantitative research investment strategies, and over $94.5 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 that aimed to minimize the risk in long-term stock investing byshort-selling, now referred to as the long/short equitiesmodel.

In 1952, Jones converted his fund to alimited partnership,added a 20%incentive feeas compensation for the managing partner, and became the firstmoney managerto combine short selling, the use of leverage, and a compensation system based on performance.

Today, hedge funds employ a standard "2 and 20" fee system, which refers to a 2% management fee and a 20% performance fee.

The management fee is based on the net asset value 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 Fund vs. Mutual Fund

Hedge funds are not as strictly regulated by the Securities and Exchange Commission (SEC) as mutual funds are.

Mutual funds are a practical, cost-efficient way to build a diversified portfolio of stocks, bonds, or short-term investments. They are available to the general public and average investor.

Hedge funds normally will only accept money from accredited investors who include individuals with an annual income that exceeds $200,000 or a net worth exceeding $1 million, excluding their primary residence. These investors are considered suitable to handle the potential risks that hedge funds are permitted to take.

A hedge fund can invest in land,real estate, stocks,derivatives, and currencies while mutual funds use stocks or bonds as their instruments for long-term investment strategies.

Unlike mutual funds where an investor can elect to sell shares at any time, hedge funds typically limit opportunities to redeem shares and often impose a locked period of one year before shares can be cashed in.

Hedge funds employ the 2% management fee and 20% performance fee structure. In 2022, the average expense ratio across all mutual funds and exchange-traded funds was 0.37%.

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What to Consider Before Investing

As investors conduct research to identify 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 U.S., 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, the strategies of the fund, the location of the fund, and the risks anticipated by the investment.
  • Understand the level of risk involved in the fund’s investment strategies and whether they equate with your personal investing goals, time horizons, and risk tolerance.
  • Determine if the fund is using leverage or speculative investment techniques which will typically invest both the investors’ capital and the borrowed money to make investments.
  • Evaluate potential conflicts of interest disclosed by hedge fund managers and research the background and reputation of the hedge fund managers.
  • Understand how a fund’s assets are valued as hedge funds 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 to redeem shares.

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 Morningstar to identify a universe of funds using similar strategies.

How Do Hedge Funds Compare to 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 the markets, or some sector or index of the markets. They take the greatest risks while trying to achieve these returns. In addition, 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 invest in.

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 that investors can 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.

Hedge funds are loosely regulated by the SEC and earn money from the 2% management fee and 20% performance fee structure.

Hedge Fund: Definition, Examples, Types, and Strategies (2024)


Hedge Fund: Definition, Examples, Types, and Strategies? ›

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.

What is a hedge fund and its types? ›

A hedge fund is a limited partnership of private investors, whose money is actively managed by professional fund managers. Fund managers may use leverage or trading of non-traditional assets, in order to maximise returns.

What are the different types of strategies created by hedge funds with examples? ›

Different types of hedge fund strategies
  • Long/Short Equity or Hybrids.
  • Credit Risk Strategies.
  • Vulture Funds & Distressed Debt.
  • Fixed Income Arbitrage.
  • Convertible Arbitrage.
  • Arbitrage on relative value.
  • Corporate Event Strategies.
May 23, 2024

What is a hedge fund example? ›

Some examples of hedge funds include names like Munoth Hedge Fund, Forefront Alternative Investment Trust, Quant First Alternative Investment Trust and IIFL Opportunities Fund. There are others such as Singlar India Opportunities Trust, Motilal Oswal's offshore hedge fund and India Zen Fund.

What is the most common type of hedge fund? ›

Long-short equity funds are probably the most common type of hedge fund. These funds go long (i.e., buy) stocks they think will appreciate in value and short (borrow and sell) stocks they think will fall in price.

What is the main purpose of a hedge fund? ›

Hedge funds pool money from investors and invest in securities or other types of investments with the goal of getting positive returns.

How do hedge funds work for dummies? ›

Hedge funds use pooled funds to focus on high-risk, high-return investments, often with a focus on shorting—so you can earn profit even when stocks fall.

What is an example of a hedging strategy? ›

For example, if you buy homeowner's insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters. Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks.

What is a hedge fund vs private equity? ›

Hedge funds are alternative investments that use pooled money and a variety of tactics to earn returns for their investors. Private equity funds invest directly in companies, by either purchasing private firms or buying a controlling interest in publicly traded companies.

What is the most popular hedge fund strategy? ›

#1 – Long/Short Equity Strategy

In this type of Hedge Fund Strategy, the Investment manager maintains long and short positions in equity and equity derivatives. Thus, the fund manager will purchase the stocks they feel are undervalued and Sell those who are overvalued.

How do hedge funds get paid? ›

Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM). Funds typically receive a flat fee plus a percentage of positive returns that exceed some benchmark or hurdle rate.

What the heck is a hedge fund? ›

Hedge Fund is a type of Investment Partnership. If you want to co-invest with other people, you need an entity that can combine your capitals. Depending on what this entity invests into, and who is allowed to join it, various types of investment partnerships are possible.

What makes a company a hedge fund? ›

A hedge fund is a pooled investment fund that holds liquid assets and that makes use of complex trading and risk management techniques to improve investment performance and insulate returns from market risk. Among these portfolio techniques are short selling and the use of leverage and derivative instruments.

What is a hedge fund strategy? ›

Hedge funds are versatile investment vehicles that can use leverage, derivatives, and take short positions in stocks. Because of this, hedge funds employ various strategies to try to generate active returns for their investors. Hedge fund strategies range from long/short equity to market neutral.

What is the most successful hedge fund of all time? ›

Citadel has generated roughly $74 billion in total gains since its inception in 1990, making it the most successful hedge fund of all time.

How does a hedge fund make money? ›

Hedge fund strategies involve investing in debt and equity securities, commodities, currencies, derivatives, and real estate. Hedge funds are loosely regulated by the SEC and earn money from the 2% management fee and 20% performance fee structure.

How much money is needed to start a hedge fund? ›

With respect to establishing a U.S. hedge fund, average hedge fund startup costs range from $50,000 to $100,000, and first- year operational costs usually total $75,000 to $150,000.

Are hedge funds legal? ›

Are Hedge Funds Legal? Yes, they are legal. That is, if they are doing the right thing. The usual problems that present are insider trading and market manipulation.

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