What Are Hedge Funds? How Do They Work?

A hedge fund is a vehicle in which investors contribute capital to professional money managers who in turn devise and execute the investment strategy for the fund. 

That broad description applies to many investment funds, however. As we shall see, what separates a hedge fund from other investment vehicles is how the fund operates and invests.

The term “hedge fund manager” can apply to either a company or an individual. In the corporate sense, a hedge fund manager is the organization (usually a limited partnership) that operates a hedge fund, or multiple hedge funds. That organization will include investment professionals, accounting staff, as well as administrative and compliance employees.

In the individual sense, generally speaking a hedge fund manager is the person who leads and/or is the public face of the organization. 

For instance, Bridgewater Associates is one of the world’s largest hedge fund managers, with over 1,000 employees operating several funds. But Ray Dalio, the company’s co-chief investment officer, also is referred to as a “hedge fund manager”, since he has been at the top of Bridgewater since founding the company back in 1975. 

A hedge fund begins by attempting to raise funds from outside investors. Most often, they will target institutional investors, such as pension funds or non-profit endowments. But individual investors are eligible as well — as long as they are “accredited investors”, meaning they have to satisfy either wealth or income requirements. 

As of 2022, under U.S. Securities and Exchange Commission guidelines, an accredited investor must have a net worth over $1 million excluding the primary residence to satisfy the wealth criterion. Or, they need to have generated income over $200,000 (individually) or $300,000 (including significant other) in the previous two years, along with the expectation of hitting those targets again in the current year.

Hedge funds work hard — and often spend heavily — to bring on investors. In this way, hedge funds are essentially no different from any startup, which spends money upfront on marketing to attract customers. 

And once the capital is raised, hedge funds in many ways act like any other business. They hire employees to analyze investments, deal with investors, and satisfy regulatory and compliance needs. They look to grow their business, in this case by finding new investors and/or attracting more capital from existing ones.

Of course, as in any industry, there’s a great deal of variability among individual businesses. Some hedge funds are one- or two-person enterprises that manage only a few million dollars. The largest have hundreds of employees that run tens of billions in capital. 

Strategies can vary widely across numerous asset classes. Some hedge funds take a multi-year approach; others are closer to active traders than long-term investors. Each fund believes it has an “edge” in a given market, but what that edge is and in which markets varies wildly from fund to fund.

Both hedge funds and mutual funds are investment funds — but at that point, the similarities mostly stop. 

Mutual funds are available to the public; as noted, hedge funds are only available to accredited investors and institutions.

Mutual funds trade daily. Hedge funds don’t trade at all, and in many cases investors are restricted from withdrawing their capital except after a so-called “lockup” period and/or at predetermined times.

Owing to their public nature, mutual funds generally are lower-risk. They rarely borrow money, for instance, while some hedge funds (if the funding is there) might borrow multiples of their investor capital.

Hedge funds can be more aggressive because their investors often are looking for more risk — or, at least, the correct kind of risk. If a hedge fund fails, in most cases its experienced institutional investors will have understood the dangers well. In many cases the same trend causing the fund to decline or fail in fact boosted those investors’ other holdings. 

In contrast, a mutual fund failure — or simply a big decline — can be devastating for its investors’ finances. 

It’s commonly thought that mutual funds cannot sell stocks short, but that hedge funds can. This is not actually the case: mutual funds can and do make bearish bets. But few regularly execute that strategy because mutual fund investors and hedge fund investors simply have very different goals. For the latter, shorting stocks is part of a diversified return plan; for the former, it’s often too big a risk.

One other notable difference between hedge funds and mutual funds is in terms of regulation. 

Hedge funds do face regulatory requirements. Employees typically must register as investment advisers. Their investors must meet the “accredited” standard. Funds of a certain size must register with the U.S. Securities and Exchange Commission and disclose their holdings on a Form 13F. Those requirements aside, hedge funds are also subject to more general laws surrounding fraud, market manipulation, and other potentially criminal activities.

Still, the regulatory regime for hedge funds is far less onerous. Mutual funds have stricter regulation — because, again, they are meant for the public. The SEC presumes that mutual fund investors are not as experienced or as expert as hedge fund investors. And so mutual funds have far more onerous disclosure requirements relative to fees and risks, as well as greater restrictions on their investment activities.

The core difference between hedge funds and private equity, generally speaking, is that hedge funds own investments, while private equity funds own entire companies.

That’s not a hard-and-fast rule, to be sure; the lines can get blurred. A P-E firm might own a stake in a publicly traded company; a hedge fund in theory could own an entire business. But the core distinction still holds in most cases.

A hedge fund is a vehicle that uses investor capital (and on occasion borrows) to make investments, hoping to sell those investments for a profit. A private equity fund uses heavy borrowings plus investor capital to buy entire companies — with hopes of selling those companies for a profit. 

Hedge funds make money by taking a piece of the invested capital, as well as a portion of the returns generated.

It’s commonly believed that the standard compensation for a hedge fund is what is known as “2 and 20”: each year. In a 2 and 20 model, the fund takes a management fee of two percent of the assets under management, used to pay expenses, and a performance fee equal to 20% of returns. (In some cases, the fund must clear a “hurdle rate”, a minimum acceptable return before it can then start charging the performance fee.) But that’s actually no longer the case. 

Almost without exception, hedge funds do charge both annual and performance fees. But over time, the average percentage generated has compressed, to something closer to 1.5% of AUM and 17% of net gains. 

That’s the average, however. The largest, most-established funds can do better. Some operate under a “3 and 30” model, in which they charge 3% of the assets and 30% of the upside. Those fees may sound exorbitant, but investors are willing to pay a premium for strategies they believe will outperform. Getting that outperformance, and giving a chunk of it back, remains preferable to paying lower fees and receiving middling performance.

What happens when a hedge fund loses money? Typically, those losses offset gains in future years; the fund must return to overall net gains — known as hitting the “high water mark” — before it can take a performance fee. But, as with the attributes of compensation more broadly, this can vary from fund to fund. And if a money-losing fund shuts down, it’s under no obligation to return previously generated performance fees. 

As a result of these factors, hedge fund managers have a massive range of outcomes. A manager who outperforms for several years may end up with a “2 and 20” model — or better — on several billion dollars’ worth of assets, which can drive tens of millions of dollars in annual fees. Should that manager underperform, however, they won’t make a dollar in performance fees, while their annual fee will go largely to covering costs. It’s possible to run a hedge fund for several years — and wind up with little or nothing to show for it.

Given these high fees, it’s fair to wonder why institutional investors choose hedge funds at all. That’s particularly true because many funds can lock up investor capital for months, if not years. To top it off, at least on average, the data shows that hedge funds don’t necessarily outperform the market as a whole. 

But it’s important to remember a key point: hedge funds are not attractive purely because they can “beat the market,” however that is defined. For institutional investors, a simple comparison of a hedge fund’s annual returns to the Standard & Poor’s 500 index is only a small part of the total consideration.

Hedge funds in theory should have lower risk. This is because they are allowed to sell stocks short, unlike many other investment vehicles. A long/short equity fund might lag the S&P in a bull market, as indeed most did during the 2010s. But when stocks turn south, a good long/short equity fund has the ability to drive positive returns in a way that traditional funds cannot.

Similarly, there’s the matter of correlation. A pension fund can diversify its investments across asset classes like equities or bonds — yet still run the risk of multiple classes moving in the same directions. Hedge funds offer the possibility of non-correlated returns. 

Event-driven funds, for instance, might be expert in merger arbitrage, or taking advantage of the spread between where a takeover target trades and where the takeover offer is valued. So-called “pod shops” offer access to traders who in theory should be able to navigate any kind of market conditions.

The name “hedge fund” comes from the fund’s ability to “hedge” against losses, whether by shorting stocks or by using derivatives. Not all asset classes, and not all portfolio managers, have that ability. Hedge funds give institutional investors the ability to minimize overall portfolio risk — and that is an ability for which those investors will pay dearly.

On top of that, the best hedge funds — and there are several with impressive multi-year track records — do have an apparent ability to beat the market. For an institutional investor, the combination of high returns and minimized risk simply isn’t available anywhere else.

One of the factors that defines a hedge fund, beyond its ability to hedge losses, is the ability to invest in essentially anything. 

Many hedge funds simply invest in equities. Most of those funds are long/short, meaning they own (are ‘long’) some stocks and sell short others. Some, however, are long-only. A few funds are short-only, a strategy attractive to institutions whose portfolios have significant overall risk from a declining market.

But hedge funds are not limited to equities. Hedge funds can invest in derivatives, ranging from simple call and put options to complex multi-factor bets placed with major investment banks. Many so-called “credit funds” play solely in the debt markets, investing in or betting against bonds and loans from governments, corporations, and even individuals (such as the mortgage-backed securities that became infamous after the 2008-2009 financial crisis). 

Some cross asset classes, focusing on distressed investments, whether equity or bonds. Others focus on arbitrage, whether of convertible bonds (which are convertible into stock), or between theoretically similar instruments. This latter strategy was at the core of Long-Term Capital Management, which posted several years of hugely impressive returns before requiring a multi-billion-dollar bailout in 1998.

Hedge funds can trade short term; they can hold positions for years. Hedge funds are about much, much more than just stocks.

Unsurprisingly, hedge funds have been created to take advantage of the rise in cryptocurrency as well.

Crypto makes perfect sense for hedge funds. They have the latitude to invest in the space. They can use their trading acumen, and take advantage of the higher volatility in cryptocurrencies relative to equities or bonds. (The more a price moves, the more opportunities there are to take advantage.)

Some funds have been created solely to invest in and/or trade crypto, in part because institutional investors may have impediments to doing so directly. But most of the hedge fund activity in the category appears to come from multi-strategy funds, who add crypto strategies to their other core competencies.

As noted, hedge funds do invest in real estate, and notably did so during the first decade of this century. But what has changed of late is that hedge funds are not buying just real estate investment trusts or mortgage-backed securities, but actual houses.

How big that trend is remains unclear. Coverage of “hedge funds” buying houses often appears to conflate hedge funds with large asset managers like BlackRock, or private equity funds (which are a different type of fund). But it does seem from reporting in the financial press that hedge funds have moved into actual home ownership, in a bid to boost returns for their investors.

Again, only accredited investors are allowed to invest in a hedge fund. But even with that qualification, it’s hardly as simple as picking a fund and sending a check.

Individual investors in particular can’t simply choose a fund. Many of the best hedge funds won’t be open to new money at all, or will focus solely on institutional investors like pension funds. Those that will accept individual investors often have high minimum investment requirements, which can often be in the millions of dollars. 

And because hedge funds are higher-risk, even a lower minimum investment can deter high net worth individuals. Many hedge funds are designed to invest only a portion of an investor’s capital as part of a broader portfolio strategy. Should a fund have a minimum investment of, say, $1 million, in many cases that level of capital is only suitable for individuals with liquid net worth of $10 million or more. 

Some smaller and/or newer funds are open to individual investors. But those funds often lack a long track record, making it difficult to assess their attractiveness or ability to manage different market environments. Those funds too may run niche strategies, which don’t provide the diversification individuals require.

All told, in theory any accredited individual investor can invest in a hedge fund. But simply meeting the bare requirements of net worth or income isn’t enough to make hedge fund investing a wise choice in practice.

Certainly, investors can’t invest in the biggest, best-known hedge funds. But those funds still attract plenty of attention for their impressive track records and ability to seemingly defy gravity.

Most top hedge fund companies are not equity funds — at least in the way that many finance outsiders might think. Rather, many of the biggest funds have found their success through advanced, quantitative methods as opposed to more traditional single-stock fundamental analysis.

Among the best at this are AQR Capital Management, Ray Dalio’s Bridgewater Associates, and Renaissance Technologies. AQR is a behemoth that regularly leads the industry in terms of assets under management. Bridgewater has driven years of above-market returns. 

Renaissance might well be the best hedge fund ever. Over three decades, the flagship Medallion fund reportedly returned an incredible 66% per year. RenTech, as it’s often known, and led by former Massachusetts Institute of Technology professor James Simons, inspired a book titled The Man Who Solved The Market. 

But there are hedge funds with strategies more akin to traditional equity investing. Elliott Asset Management is known for its “activist” efforts, in which it works with — and sometimes against — underperforming corporate management teams. In more recent years, Bill Ackman’s Pershing Square, David Einhorn’s Greenlight Capital, and David Tepper’s Appaloosa Management have put in impressive track records and brought in tens of billions of dollars in assets apiece.

All of these managers — even RenTech, at least outside of the Medallion fund — have had blips of underperformance. Overall, however, there usually is good reason why these hedge funds are the biggest: they’re considered among the best.

One way to begin the journey toward being the biggest and the best is to start an incubator hedge fund. Incubator hedge funds are a somewhat new concept in which a prospective fund manager contributes their own capital and then begins to trade, usually for a period of six to twelve months.

The idea of an incubator hedge fund is to get around the core marketing problem for new hedge funds: the lack of a track record. Ostensibly, a fund manager could claim to have driven outstanding returns for many years, but there’s no real way to verify that claim. 

An incubator hedge fund thus aims to simulate the process of running an actual hedge fund — except without the capital from outside investors. Assuming that the incubator posts strong returns, it gives the manager a leg up in trying to acquire that capital, and moving on to running the real thing.