What is a hedge fund
A hedge fund is a privately offered pooled fund that invests its investors' money using a wide range of strategies, often with leverage, short selling and derivatives.
Formal definition. A hedge fund is a collective investment vehicle, usually a limited partnership or offshore company. It is sold only to professional or wealthy investors, which exempts it from many rules that apply to public funds. Its manager has broad freedom over asset classes, leverage and position direction, and is paid both a management fee and a performance fee.
The word "hedge" is historical. Many hedge funds do not hedge at all and take concentrated, directional risk.
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How it differs from an ordinary fund
| Feature | Mutual fund | Hedge fund |
|---|---|---|
| Who can invest | General public | Professional or high-net-worth investors |
| Short selling and leverage | Limited by rules | Widely used |
| Fees | Management fee | Management fee plus a share of profits |
| Liquidity | Frequent redemptions | Lock-ups, notice periods, possible "gates" |
| Disclosure | Regular public reports | Limited, mainly to investors |
See open-end vs closed-end fund for how fund structures affect redemptions.
Common hedge fund strategies
- Long/short equity: buys shares the manager expects to outperform and short-sells shares expected to underperform.
- Global macro: takes positions in currencies, bonds, indices and commodities based on views about interest rates and economies.
- Event-driven: trades around mergers, restructurings or bankruptcies.
- Relative value and arbitrage: exploits price gaps between related instruments, often with high leverage.
- Managed futures (CTA): follows trends in futures markets using systematic rules.
- Quantitative: relies on statistical models and automated execution.
Worked example (hypothetical)
A long/short fund expects Bank A to do better than Bank B. It buys Bank A shares and short-sells Bank B shares of the same total value. Its net exposure to the banking sector is close to zero.
- If the whole sector falls, the loss on Bank A is partly offset by the gain on the Bank B short.
- If Bank A does better than Bank B, the fund profits whichever way the sector moves.
- If the view is wrong, both legs can lose at the same time. With borrowed money, those losses are multiplied.
The profit that comes from the manager's choice of stocks, rather than from the market's direction, is called alpha. Exposure to the market itself is measured by beta.
Edge cases experienced readers meet
- High-water mark: a performance fee is charged only on gains above the fund's previous peak value.
- Hurdle rate: a minimum return the fund must reach before the performance fee applies.
- Fund of funds: a fund that invests in several hedge funds, which adds a second layer of fees.
- Liquid alternatives: publicly sold funds that copy hedge fund strategies under stricter rules. They are not hedge funds in the legal sense.
- Prime broker: the bank that lends to the fund, holds collateral and acts as custodian. It is a key counterparty.
Where you see the term
- News: "hedge funds cut bets on the dollar" usually refers to positioning data or fund flows.
- Positioning reports: futures positioning data groups traders into categories such as "leveraged funds", which largely means hedge funds.
- Market commentary: "crowded hedge fund trades" means many funds hold the same position. If they all exit together, prices can move sharply.
Leverage works against a fund as fast as it works for it. Hedge funds have collapsed within days, and the same applies to individual traders using leveraged forex or CFDs. See risk management.
Related terms
Asset class · Correlation coefficient · Contrarian investing · Fat tails and tail risk · Trading glossary
Frequent questions
What is a hedge fund in simple words?
It is a private investment pool for wealthy or professional investors. Its manager can buy, short-sell and borrow across many markets.
Does a hedge fund always reduce risk?
No. The name comes from early funds that hedged market risk. Many modern funds take large directional positions.
How do hedge fund managers get paid?
They usually charge a yearly fee based on the money they manage, plus a share of profits, often limited by a high-water mark.
Can retail traders copy hedge fund strategies?
Some ideas, such as pairs trading, can be applied in personal trading. Retail traders, however, lack a fund's financing, data and risk controls, and leveraged trading can lose money quickly.