Hedge Fund: Definition, Examples, Types, and Strategies

Key takeaways

• A hedge fund is a privately managed investment pool that uses active, often complex strategies to seek above-average returns.
• Hedge funds commonly accept only accredited investors and impose high minimums and lock-up periods.
• They employ leverage, derivatives, and alternative assets, and typically charge a “2 and 20” fee (management fee + performance fee).
• Strategies vary widely—equity, fixed-income, relative-value, event-driven, and global macro are common approaches.

What is a hedge fund?

A hedge fund is a private investment vehicle that pools capital from qualified investors and is managed by professional fund managers. Unlike mutual funds, hedge funds can use a broad range of techniques—short selling, leverage, derivatives, and investments in nontraditional assets (commodities, currencies, real estate, private equity)—to pursue higher returns or protect against market declines.

Hedge funds are less regulated than mutual funds and are designed for investors who can tolerate greater risk and reduced liquidity.

How hedge funds work

Fund managers build portfolios using multi-asset strategies and may “hedge” exposures—taking positions expected to move opposite to core holdings to offset losses. For example, a fund heavy in cyclical travel stocks might hold defensive energy positions to reduce volatility.

Key operational features:
* Accredited investors: participation is typically limited to individuals or institutions meeting financial thresholds (e.g., certain income or net-worth requirements).
* Lock-up and redemption: investments are often illiquid for a minimum period (commonly one year), with redemptions allowed only at set intervals (quarterly, biannually).
* Use of leverage and derivatives increases both return potential and risk.

Common types of hedge funds

• Global macro: trade across countries and asset classes to profit from macroeconomic or political shifts.
• Equity hedge: take long and short positions in stocks, often hedging overall market exposure.
• Relative value: exploit pricing inefficiencies between related securities (price or spread differentials).
• Activist: acquire stakes in companies and push for operational or governance changes to increase shareholder value.

Common strategies

• Long/short equity: buy undervalued stocks and short overvalued peers, often using pairs trading to isolate relative performance.
• Fixed-income arbitrage: take long and short positions in bonds or interest-rate instruments to profit from mispricings while aiming for low volatility.
• Event-driven: invest around corporate events—mergers, restructurings, bankruptcies—where temporary mispricing can occur.
• Quantitative and systematic: use mathematical, statistical, or algorithmic models to identify and execute trades.
• Multi-strategy: combine approaches to diversify sources of return and risk.

Examples of notable hedge funds

• Bridgewater Associates — known for macro strategies and large scale.
• Renaissance Technologies — renowned for quantitative and statistical models.
• AQR Capital Management — uses applied quantitative research across strategies.

Compensation and fee structure

The modern hedge fund fee model traces back to Alfred Winslow Jones in the 1940s–1950s, who combined long/short techniques with performance-based compensation. Today the standard remains:
* Management fee: typically around 2% of assets under management, intended to cover operating costs.
* Performance fee: typically around 20% of profits, aligning manager incentives with returns.
Many funds also use high-water marks and hurdle rates to calculate performance fees.

Hedge funds vs. mutual funds

• Investor eligibility: Hedge funds are usually limited to accredited or institutional investors; mutual funds are available to the general public.
• Regulation: Mutual funds are more tightly regulated and offer greater investor protections; hedge funds operate with fewer constraints.
• Liquidity: Mutual fund shares can usually be redeemed any time; hedge funds often impose lock-ups and scheduled redemption windows.
• Investment scope: Hedge funds can access derivatives, leverage, and esoteric assets that mutual funds typically avoid.
• Fees: Hedge funds generally charge much higher management and performance fees than mutual funds.

What to consider before investing

Investigate these aspects before committing capital:
* Strategy fit: Does the fund’s strategy align with your objectives, time horizon, and risk tolerance?
* Track record and longevity: How has the fund performed across market cycles and how long has it operated?
* Fees and structure: Understand management and performance fees, as well as any incentive fee mechanics (high-water marks, hurdles).
* Liquidity and redemption terms: Know lock-up periods, notice requirements, and redemption schedules.
* Use of leverage and derivatives: Higher leverage increases both return potential and downside risk.
* Valuation methods: How are illiquid holdings priced and how can valuation affect reported performance and fees?
* Conflicts of interest and transparency: Review disclosures and manager backgrounds.

Practical due diligence steps:
* Read offering documents and agreements carefully.
* Verify manager experience, reputation, and regulatory history.
* Assess whether reported performance reflects realized cash returns or manager estimates.

Measuring and comparing performance

Investors typically evaluate hedge funds by annualized returns, risk-adjusted metrics (Sharpe ratio, Sortino ratio), drawdown history, and correlation with other assets. Analytical platforms and research providers can help identify fund universes and benchmark strategies.

Why investors use hedge funds

Wealthy individuals and institutions may allocate to hedge funds to:
* Pursue absolute returns or outperformance versus benchmarks.
* Access specialized strategies or asset classes not available through mutual funds or ETFs.
* Diversify portfolios with low-correlation return streams (depending on strategy).

Bottom line

Hedge funds are private, actively managed investment vehicles that pursue returns through a wide array of strategies, including leverage and derivatives. They are designed for accredited or institutional investors who accept higher risk, lower liquidity, and higher fees in exchange for the potential of outsized or uncorrelated returns. Thorough due diligence on strategy, fees, liquidity, valuation, and manager track record is essential before investing.