Hedge Fund
A hedge fund is a private investment fund for wealthy and institutional investors that can use leverage, short selling and other flexible strategies. It faces fewer rules than mutual funds and usually charges a management fee plus a share of profits.
Hedge funds have a reputation for secrecy, star managers and enormous fees. The name comes from early funds that “hedged” their stock bets with short positions, but today it covers almost any private fund with flexible rules. This entry explains what makes a hedge fund different from a mutual fund, who can invest, how fees work and what the risks are.
- Category
- Trading Basics
- Reading time
- 4 min
- Also called
- Hedge funds, Private investment fund, Alternative investment fund
- Updated
Hedge funds in plain words
A hedge fund is a private, unregistered fund that pools investors' money and invests it in securities or other assets aiming for positive returns.1
They can use leverage, short selling and other speculative strategies that may increase the risk of losses.1
They are generally open only to individuals and institutions that meet certain wealth or sophistication criteria, and are not marketed to retail investors.1
How a hedge fund works, step by step
Qualified investors commit capital
Usually large minimums from wealthy people and institutions.
The manager runs a strategy
Long/short, macro, event-driven, arbitrage and more. See Market-Neutral Strategies.
Leverage and shorts are used
To amplify returns or hedge risk. See Leverage.
Fees are charged
A management fee plus a performance fee. See Two and Twenty.
Redemptions are limited
Lock-ups and notice periods restrict withdrawals.
Results are reported privately
Less public disclosure than registered funds.
Worked examples
Example 1 — Fees on a good year
Net ≈ 10.4%A $10 million investment earns 15% gross. Fees: 2% management and 20% of profits.
| Gross profit | $10m × 15% = $1.5m |
| Management fee | $10m × 2% = $200,000 |
| Performance fee | ($1.5m − $0.2m) × 20% = $260,000 |
| Investor keeps | $1.5m − $0.46m = $1.04m |
Here the performance fee is charged on profit after the management fee; exact terms differ by fund. See Two and Twenty.
Example 2 — Leverage cuts both ways
−30% on capitalA fund with $100m of capital borrows to hold $300m of assets. The assets fall 10%.
| Asset loss | $300m × 10% = $30m |
| Loss on capital | $30m ÷ $100m = 30% |
Borrowing increases exposure and risk at the same time.1 See Leverage.
Example 3 — A hedged position
+$250,000A fund buys $5m of stock A and shorts $5m of rival B. The sector falls 10%, but A falls only 5%.
| Long A | −$250,000 |
| Short B (−10%) | +$500,000 |
| Net | +$250,000 |
Pairing longs and shorts lets a fund profit from relative performance even when the market falls. See Pairs Trading.
Hedge fund vs mutual fund
| Aspect | Hedge fund | Mutual fund |
|---|---|---|
| Who can invest | Accredited or qualified investors | Anyone |
| Regulation | Lighter | Strict investor protections |
| Withdrawals | Often restricted | Daily at NAV |
| Fees | Management + performance | Expense ratio |
Why investors use hedge funds
Diversifying returns
Strategies that may not follow the stock market.
Downside protection
Short positions can cushion falls. See Hedging.
Access to specialists
Strategies are often grouped as event-driven, relative value, macro and equity hedge.2
Institutional portfolios
Hedge funds are open only to accredited and institutional investors such as pension funds and insurers.2
Advantages and disadvantages
Advantages
- Flexible strategies, including shorts and leverage.
- Can aim for returns in any market.
- Access to specialist managers.
Disadvantages
- High fees.
- Limited liquidity and transparency.
- Leverage can magnify losses.
- Only available to wealthy investors.
Going deeper
Read as far as you need. Each level builds on the one before it.
Who can invest
Beginner
To invest in a hedge fund you generally must be an accredited investor or a qualified purchaser.1 See Accredited Investor.
Fewer protections
Intermediate
Unlike mutual funds and ETFs, hedge funds are not bound by rules such as daily redemption at NAV, mandated disclosure or limits on leverage.1 See Mutual Fund.
Still bound by fraud rules
Advanced
Hedge funds remain subject to the same anti-fraud prohibitions as other market participants, and their managers owe a fiduciary duty to the funds they run.1
Common mistakes
Assuming "hedged" means safe
Many funds take large, leveraged risks.
Ignoring fees
Performance fees take a large share of good years.
Overlooking lock-ups
Money may be tied up for months or years.
Trusting past returns
Reported returns can suffer from survivorship bias. See Survivorship Bias.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Hedge funds are private funds for qualified investors.
- They can use leverage, shorts and complex strategies.
- They face fewer rules than mutual funds but still obey fraud laws.
- Fees are usually a management plus performance fee.
- Withdrawals are often restricted.
Frequently asked questions
Why are they called hedge funds?
Can ordinary investors buy hedge funds?
Do hedge funds beat the market?
Further learning
- Short Selling
A key hedge fund tool.
- Alpha
What investors are paying for.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Investor.gov (SEC). Hedge Funds (opens in a new tab) Checked .
- Corporate Finance Institute. Hedge Fund (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.