Understanding Hedge Funds: How Do They Work?

Hedge funds are investment vehicles that pool investors’ money looking for a positive return. These funds are subject to fewer rules than exchange-traded funds (ETFs) or mutual funds, so they have more flexibility in what methods they use to make money – using leverage, short-selling and speculative investment practices.

Hedge funds are riskier than mutual funds or ETFs because they aren’t as tightly regulated and are tougher to research. Due to their private nature, hedge funds provide limited public information about their portfolios, strategies, and performance.

This contrasts sharply with mutual funds and ETFs, which must disclose their holdings regularly, allowing investors to see exactly what they own.

Despite their risk, many investors are drawn to hedge funds because of their focus on absolute returns, diversification and their potential to avoid downside risk. Keep reading to learn more about hedge funds.

What are hedge funds in simple terms?

Hedge funds are private investment funds that typically pool money from high-net-worth individuals and/or institutional investors. They aim to achieve superior risk-adjusted returns.

As their name suggests, hedge funds often hedge their investments, taking both long and short positions. The latter means selling stocks they don’t own when they bet the prices are due to fall. This allows the overall fund to perform well whether markets go up or down.

However, the term hedge fund now applies to a broader set of private funds. These funds use a variety of investment strategies, some riskier than others. For example, some hedge funds focus less on hedging and more on making big, speculative bets.

Hedge funds, once just the exclusive domain of professional (accredited) investors, have become more popular with retail investors. According to the research firm HFR, the hedge fund industry grew by $12.6 billion in the first quarter to an estimated $4.53 trillion in assets under management.

Some examples of hedge funds

Here are some well-known hedge funds:

• Citadel: Founded in 1990 by Kenneth Griffin, the Miami-based hedge fund had more than $66 billion in assets under management at the end of 2024.
• Bridgewater Associates: Founded by Ray Dalio in 1975 from his New York apartment, the US hedge fund had $92.1 billion under management at the end of last year.
• Man Group: The world’s largest publicly traded hedge fund, trades on the London stock Exchange. It had $193.3 billion billion under management as of June 30, 2025.

---

Hedge fund managers – who they are and what they do

A hedge fund manager is an individual or financial firm that oversees all aspects of a hedge fund. They’re responsible for making all investment decisions, from choosing which assets to buy and sell to developing the overarching investment strategy.

Beyond just investments, they also manage the day-to-day operations of the fund. Hedge fund managers are highly paid, sometimes making $4 million a year or more.

To succeed, a hedge fund manager needs to carefully consider several key areas:

• Competitive advantage: How will their fund stand out and consistently outperform others in the market?
• Clearly defined investment strategy: What specific approach will they use to generate returns (e.g., long/short equity, global macro, event-driven)?
• Adequate capitalization: Is there enough money invested in the fund to execute the strategy effectively and weather market fluctuations?
• Marketing and sales plan: How will they attract and retain high-net-worth individuals and institutional investors?
• Risk-management strategy: What measures will they put in place to identify, assess, and mitigate potential financial risks?

---

Hedge fund investors – the type of investor using hedge funds  

In the US, hedge funds are primarily for institutional investors. This includes large organizations such as pension funds, endowments, foundations, and insurance companies.

Some individuals can also invest, but only if they are accredited investors. This means they meet specific financial or professional criteria, which suggests they can handle the higher risks that come with hedge funds and other complex investments.

Crucially, hedge fund investors are wealthy. They have significant assets or income. Hedge funds typically set high minimum investment amounts. While funds can set their own minimums, which vary based on their strategy, target investors, and demand, the bare minimum is usually around $100,000.

However, it’s common for larger or more popular funds to require $250,000 or more. For well-established funds that aren’t actively looking for new investors, minimums of $1 million or higher are not uncommon.

How do hedge funds work?

In this section, we cover exactly what hedge funds do, especially, how the scope of their activities differs from traditional investing, how their performance is measured, and how they are regulated.

What do hedge funds do differently?

Hedge funds distinguish themselves from traditional investment vehicles such as ETFs and mutual funds through their investment strategies, operational structures, target investors, fee models, and regulatory environment.

While ETFs and mutual funds primarily focus on long-only investments in publicly traded securities, hedge funds employ a broader, more aggressive, and often less transparent approach to generating returns.

Here’s a breakdown of what hedge funds do that other financial vehicles typically don’t:

Short selling 

Hedge funds frequently engage in short selling, which involves borrowing and selling securities with the expectation that their price will fall. They then aim to buy back the shares at a lower price, returning them to the lender and profiting from the difference. This allows them to profit in declining markets, a strategy generally not available to conventional mutual funds or ETFs.

Leverage

Hedge funds commonly use leverage by borrowing money to amplify their investment positions. This can significantly magnify returns if investments perform well, but it also increases the risk of substantial losses if they don’t. Mutual funds and ETFs have strict limits on their ability to use leverage.

Derivatives trading

Hedge funds extensively use complex financial instruments such as options, futures, and swaps. They employ derivatives for hedging, speculation, and arbitrage, allowing them to gain exposure to various assets or market movements with less capital upfront, or to profit from mispricing of assets.

Arbitrage

This involves exploiting price discrepancies between securities or markets. For example, a hedge fund might simultaneously buy and sell the same asset in different markets to profit from a small price difference.

Event-driven strategies

Some hedge funds invest based on specific corporate events such as mergers, acquisitions, bankruptcies, spin-offs, or restructurings. They aim to profit from the anticipated impact of these events on security prices.

Global macro strategies

Some hedge funds make investment decisions based on broad economic and geopolitical trends, taking large positions in currencies, commodities, interest rates, and equities across global markets.

Distressed securities

Other hedge funds may invest in the debt or equity of companies facing financial distress or bankruptcy, aiming to profit from their restructuring or turnaround.

Illiquid and alternative investments:

Unlike mutual funds and ETFs that focus on liquid, publicly traded assets, hedge funds sometimes invest in less liquid or alternative assets, such as private equity, real estate, or even unique collectibles, depending on their specific mandate.

Private offerings

Hedge funds are generally structured as private investment vehicles, exempt from many of the stringent disclosure requirements that apply to publicly offered mutual funds and ETFs. This means they don’t need to register their offerings with regulatory bodies such as the SEC in the same way.

“2 and 20” fee model

A common fee structure for hedge funds is the “2 and 20” model. This means they charge an annual management fee of about 2% of assets under management (AUM) and a performance fee of 20% of any profits generated above a certain hurdle rate. This performance fee aligns the manager’s incentives directly with the fund’s returns, a feature generally absent in mutual funds or ETFs, which primarily charge a fixed expense ratio based on AUM.

Lock-up periods

Many hedge funds have “lock-up” periods, during which investors cannot redeem their capital. These periods can range from a few months to several years, designed to allow managers to execute longer-term or less liquid strategies without worrying about sudden withdrawals.

Redemption gates

Even after a lock-up period, redemptions are often limited to specific windows (e.g.: quarterly or annually) and may be subject to “gates,” which limit the total amount of money that can be withdrawn from the fund at any given time.

Measuring hedge fund performance

Hedge fund performance metrics offer investors and managers a comprehensive view of a fund’s profitability, risk management, and overall success.

For managers, performance metrics reflect a fund’s investment philosophy and operational efficiency and allow them to refine their strategy. For investors, these metrics offer transparent insights into investment risks and rewards. Here are some key hedge fund performance metrics:

• Annualized return: This metric shows the geometric average amount an investment earns each year over a specific period, allowing for comparisons of investments held for different durations.
• Sharpe ratio: Developed by Nobel laureate William F. Sharpe, this ratio measures risk-adjusted performance. It calculates by subtracting the risk-free rate from the investment’s return and dividing the result by the investment’s standard deviation of returns. A higher Sharpe ratio indicates better risk-adjusted performance.
• Sortino ratio: Similar to the Sharpe ratio, the Sortino ratio distinguishes harmful volatility from total volatility. It uses the asset’s standard deviation of negative portfolio returns (downside deviation) instead of the total standard deviation of portfolio returns.
• Alpha: This metric measures a fund’s risk-adjusted performance. Alpha compares a hedge fund’s volatility (price risk) and risk-adjusted performance to a benchmark index. A positive alpha suggests the fund outperformed its beta prediction.
• Beta: Beta measures an investment’s volatility, indicating its relative risk. A beta of 1 shows the investment’s price moves with the market. A beta less than 1 means the investment will be less volatile than the market, while a beta greater than 1 indicates higher volatility.
• Maximum drawdown (MDD): This represents the largest observed loss from a portfolio’s peak to its trough before it reaches a new peak. MDD indicates downside risk over a specified period.
• Value at risk (VaR): VaR is a statistical technique quantifying the level of financial risk within a firm or investment portfolio over a specific timeframe. This metric estimates the maximum potential loss an investment portfolio could incur, based on statistical analysis of historical price trends and volatilities.
• Omega ratio: This performance measurement compares the probability of achieving a minimum acceptable return (MAR) to the probability of falling below that threshold. It is particularly useful when assessing the performance of hedge funds that do not have a normal distribution of returns.

Understanding and effectively using hedge fund performance metrics provides a comprehensive picture of a fund’s performance dynamics. It empowers managers and investors to make informed decisions, ensuring the fund’s objectives align with investors’ expectations and risk appetites.

---

Regulatory oversight

Multiple regulatory bodies oversee hedge fund operations across different regions, aiming to ensure transparency, manage risk, protect investors, and maintain financial stability.

United States:

In the US, the Securities and Exchange Commission (SEC) primarily regulates hedge funds. All hedge fund managers with over $100 million in assets under management (AUM) must register with the SEC, which also oversees accredited investors — hedge funds’ primary clientele.

The Commodity Futures Trading Commission (CFTC) supervises funds trading in commodity futures, options, or swaps. The IRS ensures hedge funds and their investors comply with tax regulations.

European Union:

The EU established the Alternative Investment Fund Managers Directive (AIFMD) in 2011, shortly after the global financial crisis. This directive created a regulatory framework for hedge funds, emphasizing increased transparency, robust risk management, enhanced investor protection, and overall financial stability.

The AIFMD applies to hedge funds with over €100 million in AUM, or €500 million for unleveraged or closed-ended funds. It also requires hedge fund managers to invest a specific amount of their own capital to ensure fund stability.

United Kingdom:

The UK has three main regulatory bodies for the financial sector: the Financial Conduct Authority (FCA), the Bank of England (BoE), and the Prudential Regulation Authority (PRA).

The FCA acts as the primary regulator, requiring hedge funds to obtain authorization and adhere to business principles such as integrity and fair client treatment. The BoE and PRA monitor systemic risk in financial markets and oversee highly leveraged hedge funds due to their associated risks.

Hedge fund strategies

Hedge funds employ a wide array of strategies to generate returns, each with a distinct approach to the market. Here is a brief overview of five common types of hedge fund strategies:

Long/short equity

Long/short equity strategy involves taking long and short positions in stocks with the goal of profiting from the manager’s ability to pick individual stocks, regardless of whether the overall market is going up or down.

• How it works: A manager buys (goes “long”) stocks the manager believes are undervalued and will increase in price, while simultaneously selling short stocks the manager believes are overvalued and will decrease in price.
• Primary goal: To achieve “alpha,” or returns that are independent of the broader market’s movements. The strategy aims to profit from the stock-picking skill of the manager, not from the general market direction.

Global macro

The global macro strategy uses leveraged bets on global economic and political events. The managers analyze macroeconomic trends—such as changes in interest rates, government policies, or geopolitical shifts—and take large positions in a variety of markets to capitalize on their predictions.

• How it works: A fund manager might bet on a country’s currency weakening due to rising inflation, or take a position on a bond market he or she believes will rally after a central bank’s policy announcement. These bets often involve a wide range of assets, including currencies, commodities, futures, and bonds.
• Primary goal: To profit from major shifts in the global economy. This strategy is highly flexible and can generate significant returns in periods of market volatility.

Trend following

The trend following strategy, often run by Commodity Trading Advisors, is a rule-based approach. The strategy calls for following existing trends in various markets.

• How it works: Using quantitative models and technical analysis, the managers identify assets that are trending up or down. If a trend is identified, the fund will go long on an upward-trending asset or short on a downward-trending one, holding the position until the trend reverses.
• Primary goal: To capture gains from persistent price movements across a wide range of markets, including stocks, bonds, currencies, and commodities. This strategy can perform well during periods of prolonged bull or bear markets.

Relative value (arbitrage)

The relative value strategy aims to profit from temporary pricing discrepancies between two or more related assets. It’s based on the assumption that the prices of these assets will eventually converge.

• How it works: A manager might identify two similar bonds or two companies in the same industry where one appears undervalued relative to the other. They would then buy the undervalued asset and short the overvalued one, expecting to profit when the “spread” between their prices narrows.
• Primary goal: To generate low-risk, consistent returns that are largely independent of market direction. This is a market-neutral strategy that focuses on exploiting market inefficiencies.

Activist hedge funds

The activist hedge-fund strategy requires a more hands-on approach. The managers acquire a significant ownership stake in a company and then use that position to actively influence management or the board of directors to make changes they believe will increase the company’s stock value.

• How it works: An activist fund might push for operational improvements, demand the sale of certain assets, advocate for a new CEO, or pressure the company to return more cash to shareholders through dividends or stock buybacks.
• Primary goal: To unlock hidden value in an underperforming or undervalued company and profit from the subsequent increase in its share price. Unlike other funds, they create their own catalysts for value appreciation.

---

How do I know what assets hedge funds are buying or shorting?

That’s not always easy, as hedge funds are not as transparent as mutual funds or ETFs. However, in the US, the most common way to glimpse hedge fund holdings is through Form 13F filings with the SEC. In the case of larger hedge funds, 13F filings show these funds’ long positions, but not their short positions.

However, starting this year, the SEC’s form SHO means that institutional investment managers with significant short positions in certain equity securities (exceeding $10 million or 2.5% of a company’s shares outstanding) must file a form SHO on a monthly basis.

---

Pros and cons of investing with a hedge fund

Investing with a hedge fund is more complicated than investing in an index fund, or an index-related ETF or mutual fund. Hedge funds have a lot more flexibility in how they invest. Here are the pros and cons of investing in hedge funds:

Pros

• Potential for high returns: Hedge funds often use sophisticated and aggressive strategies, including leverage, derivatives, and short selling, that aim to generate substantial returns, potentially outperforming traditional investments, especially in volatile or down markets.
• Diversification and reduced volatility: Many hedge fund strategies are designed to have low correlation with traditional asset classes such as stocks and bonds. This can help diversify an investor’s portfolio, potentially reducing overall portfolio volatility and providing more consistent returns, even during market downturns.
• “Absolute return” focus: Unlike many traditional funds that aim to beat a benchmark (such as the S&P 500), many hedge funds strive for “absolute returns,” meaning they aim to generate positive returns regardless of overall market conditions. This is often achieved through strategies that can profit from both rising and falling markets.
• Access to unique strategies and asset classes: Hedge funds have greater flexibility in their investment mandates. This means they can invest in a broader range of assets (e.g., private investments, distressed debt, commodities) and use complex strategies (e.g.: market neutral, event-driven, global macro) that are generally not available to the average investor through mutual funds.
• Expert management: Hedge fund managers are typically highly skilled and experienced professionals who actively manage the fund’s portfolio. Their expertise and ability to adapt to changing market conditions can be a significant advantage.
• Downside protection: Some hedge fund strategies specifically focus on capital preservation and mitigating losses during bear markets, which can be appealing to risk-averse investors seeking to protect their capital.

Cons 

• High fees: Hedge funds typically have a “2 and 20” fee structure, meaning a 2% annual management fee on assets under management (regardless of performance) and a 20% performance fee on profits generated. These fees are significantly higher than those charged by mutual funds and can eat into net returns.
• Limited liquidity: Hedge funds often impose “lock-up periods” during which investors cannot withdraw their money, or they may have “gates” that limit how much an investor can redeem at a given time. This illiquidity can be a major disadvantage if an investor needs quick access to their capital.
• Lack of transparency: Hedge funds are less regulated than mutual funds and are generally not required to disclose their holdings or strategies to the same extent. This lack of transparency can make it difficult for investors to fully understand what they are invested in and the risks involved.
• Complexity and risk: The sophisticated strategies employed by hedge funds, including leverage and derivatives, can be complex and inherently risky. While these tools can amplify gains, they can also significantly magnify losses.
• High minimum investments: As discussed, hedge funds typically require very high minimum investments, often $100,000 or more, making them inaccessible to most individual investors.
• Regulatory risk: While less regulated, changes in financial regulations can still impact hedge fund operations and performance, adding another layer of uncertainty.

---

A summary of the benefits and drawbacks of hedge-fund investing

---

The difference between hedge funds and mutual funds

Hedge funds and mutual funds differ significantly in their structure, strategies, and the types of investors they attract. Understanding these distinctions helps you choose the right investment based on your risk tolerance, current wealth, and investment knowledge.

Investor access and requirements

Hedge funds are exclusively available to accredited investors, individuals who meet specific income or net worth criteria. This exclusivity allows hedge funds to pursue riskier investment strategies. In contrast, mutual funds cater to the general public, enabling individuals with less capital to invest and access professional management.

Investment strategies

Hedge funds employ a wide range of aggressive strategies, including leverage, derivatives, and short selling, to generate high returns. They often aim for absolute returns regardless of market conditions. Conversely, mutual funds focus on long-term growth through diversified investments in stocks, bonds, or other securities. These funds face more regulation, generally avoiding high-risk strategies and prioritizing consistent, steady returns.

Regulation and transparency

The SEC heavily regulates mutual funds to ensure transparency and protect investors. Mutual funds regularly disclose their holdings, strategy, and performance. Hedge funds, however, operate with significantly less regulatory oversight, giving them more freedom to make quick investment decisions. But this reduced oversight also means less transparency for investors.

Risk and return profile

The potential risk and return vary considerably between these two investment vehicles. Hedge funds pursue higher returns through aggressive tactics, which inherently increases their risk, including the possibility of substantial losses. Mutual funds are generally considered safer because they emphasize diversification and lower-risk strategies, making them suitable for a broader range of investors.

Fees

Hedge funds are known for their “2 and 20” fee model, which includes both management and performance fees. Mutual funds typically have lower fees, often a flat management fee or expense ratio, making them more cost-effective for average investors.

Other differences

The objectives and performance of mutual funds versus hedge funds are generally another key differentiator. Hedge funds often generate high returns in any economic environment, including recessions or market downturns. Since many hedge funds take a more defensive approach, their returns might not be as high as some mutual funds during a bull market.

---

Hedge fund FAQs