What Are Hedge Funds and How Do They Work? Definition, Purpose & Types
Hedge funds aim to outperform the market by a significant margin—that's part of why their fees are so high.
What Is a Hedge Fund in Simple Terms?
Hedge funds are sort of like mutual funds for the ultra-wealthy—they pool the money of their clients (mostly institutional and accredited investors) and then invest it in a variety of securities. Unlike most mutual funds, however, they make use of advanced trading strategies like hedging, shorting, and using leverage with the goal of generating very high returns for their wealthy clients while minimizing risk.
Because they are very actively managed by experienced professional traders and seek to produce higher-than-average returns using sophisticated trading strategies, they charge much higher fees than the mutual funds and ETFs available to retail investors. Additionally, most have very high investment minimums, keeping them well out of reach of the average investor.
In general, hedge funds are considered alternative investments, meaning they don’t fit neatly into the equity, fixed-income, or derivative security categories. Each fund is different, and since they are subject to less regulation than traditional pooled investment vehicles like mutual funds, the assets they buy and the strategies they employ can vary widely.
How Do Hedge Funds Work? What Do They Do?
In general, the goal of a hedge fund is to employ trading strategies that allow it to generate positive returns regardless of market conditions. In other words, hedge funds aim to profit whether equities and other assets are going up or down in value so that their wealthy clients can profit during bull markets and bear markets alike.
Most hedge funds buy (and/or short) publicly traded stocks, but they can also make use of alternative assets—like fine art, real estate, currencies, crypto, and even patents—in their money-making strategies. Different funds have different goals and employ different techniques, but all aim to produce standout returns for their clients while attempting to minimize risk.
Hedge funds’ namesake comes from the way they minimize risk—many hedge funds “hedge” their bets by taking offsetting positions in assets they are long on. This could mean buying put options, selling stocks short, or even investing in assets that tend to outperform at different times in the economic cycle than their primary holdings. In doing so, they can minimize their losses to some degree should the assets they are long on fall in value.
What Sorts of Investors Can Invest in Hedge Funds?
Unlike similar open-ended funds (like mutual funds and ETFs), hedge funds aren’t accessible to most retail investors. Generally, only institutional investors, accredited investors, and high-net-worth individuals—and these three categories have quite a bit of overlap—can buy into hedge funds.
To be considered an accredited investor, an individual must have a net worth of over $1 million, make over $200,000 a year, or be a licensed investment professional. Most hedge funds have investment minimums of between $25,000 and $1 million.
4 Common Types of Hedge Funds
There are many different types of hedge funds, and different funds have different goals and focuses. A few common types are described below.
Long-Short Equity Hedge Funds
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. This strategy helps minimize exposure to market volatility by maintaining positions that can generate returns in both bull and bear climates.
Different funds go long and short in different proportions—some devote 60% of their funds to long positions and 40% to shorts. Others do the opposite. Many funds strategically employ a “market neutral” strategy by going long and short in equal proportions.
Global Macro Hedge Funds
Global macro hedge funds are those that aim to capitalize on changes in macroeconomic factors like market shifts that occur due to international economic and political events. Macro funds rely on research and make trading decisions based on fluctuations in things like interest rates, national and international policies, indexes, and currency values.
Funds like these are usually highly diversified and tend to use a lot of leverage to maximize returns. For this reason, macro funds are considered risky, and many notable funds—like Long-Term Capital Management, which had to be bailed out in 1998 due to its dismal performance—have failed.
Relative Value Arbitrage Hedge Funds
Relative value funds aim to profit from the price differences of closely related securities. To do this, they attempt to determine which securities are undervalued compared to their peers and which are overvalued, then buy long and sell short accordingly. These sorts of funds often use leverage and buy on margin.
Distressed Hedge Funds
Distressed hedge funds invest in promising distressed securities—like junk bonds of companies that are in financial trouble but have a path to recovery. Bonds like these are cheap for their yields due to the high level of risk they carry. Distressed funds also invest in things like loan payouts and restructurings.
What Sorts of Fees Do Hedge Fund Managers Charge Investors?
Traditionally, many hedge funds charged clients “2 and 20”—that is, a 2% management fee and a 20% performance fee.
Management Fee
The management fee is 2% of the fund’s net asset value annually and can be thought of as similar to the expense ratio of a mutual fund or ETF; it covers the expenses associated with the management of the fund (e.g., office space, employee salaries, etc.).
Performance Fee
The much steeper 20% performance fee, however, only comes out of the fund’s profit—not its total assets. This is the fee clients pay the fund manager for (ideally) beating the market by a large margin via their careful research and trading decisions. If the fund doesn’t make a profit, this fee isn’t charged, but 2% of each client’s investment is still paid to the fund’s manager annually regardless.
Note: While “2 and 20” are the traditional fee levels for hedge funds, actual fees tend to be lower in the modern day. According to CNBC, the average hedge fund management fee was 1.37%, and the average performance fee was 16.4% as of 2020.
How Are Hedge Funds Regulated?
While larger hedge funds (those with over $100 million worth of assets under management) are registered with the SEC like mutual funds and ETFs, smaller funds and those that qualify as private equity advisors are not. Those that are not required to register with the SEC are subject to far fewer and have less oversight.
Even larger funds that are registered with the commission are not required to maintain the same level of transparency as mutual funds and ETFs, and they are also subject to less oversight. This is one of several reasons why hedge funds are restricted to accredited and institutional investors—these groups are seen as both wealthy enough to weather a substantial financial loss and sophisticated enough to research and understand what they are investing in.
What Are Some of the Largest Hedge Funds?
- BlackRock
- Renaissance Technologies
- Bridgewater Associates
- Man Group
- Citadel
- D.E. Shaw Co.
- AQR Capital Management
- Millenium Management
- Elliot Asset Management
- Two Sigma