What Is a Hedge Fund?

If you’re not deeply involved in investing or the finance world, the term “hedge fund” can sound intimidating, or easy to confuse with concepts like private equity and venture capital. In simple terms, a hedge fund is a pooled investment vehicle managed by professionals who use a range of strategies to generate strong returns for their investors. Whether you’re just starting out or already an experienced trader, a financial advisor can help you understand how hedge funds work and whether they fit into your broader investment strategy.

How Hedge Funds Work

A hedge fund is a pooled investment vehicle that uses a wide range of investing techniques to generate astronomical rates of return. Hedge funds are usually limited liability companies or limited partnerships.

They can work with many different kinds of assets, including stocks, bonds, futures, options, real estate, commodities, currencies and a wide variety of derivatives such as delta-neutral investing and collateralized debt obligations. Normally, they’re used by institutions and high-net-worth individuals.

The minimum balance is far greater than an average retail investor can afford. A million dollars is not unusual. Sometimes the entry fee is far greater, and it’s not unheard of for hedge funds to even reject applicants who have a fortune of assets to invest.

Once investors (or limited partners) add their money to a hedge fund, the manager picks the strategy that he or she thinks will yield the most money. Besides the broad array of securities that hedge fund managers can invest in, they have far more discretion of where to put their clients’ money, including what percentage of a portfolio can be in cash, than other fund managers.

The government agency responsible for overseeing the investment market in the U.S., the Securities and Exchange Commission, does not regulate hedge funds in any capacity. In other words, prospective clients should take special precautions to ensure that they fully understand and feel comfortable with a fund’s managers and investment strategy before coughing up any cash.

Types of Hedge Funds

There are many different kinds of hedge funds and each one uses a unique investment strategy. Here are a few popular hedge fund classes:

1. Long-Short Funds

A long-short equity position is a strategy that involves investing in stocks but it mirrors similar practices used often by options and futures traders.

In this trading scheme, the investor takes a combination of long and short positions in a single portfolio. They take long positions (buying shares to profit off price gains) in stocks that they believe are undervalued and poised for growth. They take short positions (borrowing shares to sell and profit off price decreases) in stocks they believe are overvalued and poised to decline.

2. Market-Neutral Funds

Market-neutral funds are a type of long-short fund. What distinguishes this type of fund from others is that market-neutral fund managers seek to protect their portfolios from the rise and fall of prices in the general market. Your strategy would be to either invest in an equal number of securities in long and short positions or take steps to bring your relative risk level closer to zero.

While traditional funds such as mutual funds strive to generate income for investors or profit from capital appreciation, the goal of market-neutral funds is more singular: to stay neutral in the face of market volatility.

3. Event-Driven Funds

With event-driven funds, you’re trying to profit off of specific events that could affect the whole market. For instance, if you think that the price of a security will rise following a major earthquake, you might decide to buy into a stock and sell it later on. You could use the same strategy if there’s political instability or economic turmoil that leads to mergers and company buyouts.

A free, easy-to-use inflation calculator can give you a quick read on how much buying power your money will have 10, 20 or 30 years from now.

How Hedge Funds Differ from Mutual Funds and Private Equity

A seedling growing up through a pile of money.

Hedge funds, mutual funds and private equity funds all pool money from investors, but they operate in very different ways. The main distinctions lie in strategy, risk, liquidity and accessibility.

Mutual funds are the most familiar to everyday investors. They’re highly regulated by the Securities and Exchange Commission, offer daily liquidity and aim to grow by investing in diversified portfolios of stocks, bonds or other securities. Investors can buy or sell shares at the fund’s net asset value at the end of each trading day, making mutual funds relatively transparent and accessible.

Hedge funds, by contrast, are private investment vehicles open primarily to accredited investors and institutions. They use more complex and flexible strategies such as short selling, derivatives and leverage to seek higher returns. Hedge funds are also less liquid, often locking up investor capital for months or years, and they’re subject to less regulatory oversight. This freedom allows hedge fund managers to pursue aggressive opportunities but also exposes investors to greater potential risk.

Private equity funds take a different approach altogether. Instead of trading public securities, they invest directly in private companies, often acquiring, restructuring or scaling them before selling for a profit. These investments typically require long holding periods, sometimes 7–10 years, but can deliver substantial returns when successful.

Hedge Fund Fees

Hedge fund fee schedules ordinarily include two distinct charges: a management fee and an incentive fee.

Management fees are applied to the entirety of your assets under management, and they generally reside around a 2% annual rate. While this might seem tolerable, incentive fees can be much more significant at 10% to 20%. These are not necessarily consistent charges, though, as they are only added on if your portfolio generates profits. So if your portfolio sees a 10% return, and the incentive fee is 15%, you’ll receive an 8.5% net return.

Pros and Cons of Hedge Fund Investing

Many hedge funds use leverage when conducting trades, which means that they make investments using borrowed money. What’s appealing about this move is that it has the potential to leave investors with higher rates of return. The absence of SEC oversight is another appealing feature of hedge funds because of the flexibility it affords managers.

Using leverage has the potential to create huge returns. But if a leveraged investment doesn’t perform well, the fund (and its investors) could face enormous losses. Hedge funds are also less liquid than mutual funds, meaning that your money could be locked up in the fund for a longer period of time than it would be in a mutual fund or exchange-traded fund.

Bottom Line

Hedge funds can be powerful investment vehicles, offering the potential for outsized returns through sophisticated and flexible strategies. However, that same freedom gives fund managers broad discretion across markets, asset classes and risk levels, which can lead to significant volatility. For that reason, hedge funds aren’t suitable for every investor. Even those who qualify as accredited investors should approach them cautiously and maintain a diversified portfolio that includes more stable, transparent investments such as mutual funds or ETFs.

Tips on Investing

Consider talking to a financial advisor about how to best handle your financial assets. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s financial advisor matching tool matches you with vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
One of the quickest ways to get a good estimate of how your investments will grow is to take advantage of a free, easy-to-use investment calculator.