Hedge Funds Basics

Hedge funds are pooled investment vehicles that use a wide range of strategies, including leverage, short-selling and derivatives. They are typically aimed at institutions and wealthy individuals, and are often less regulated than mutual funds or publicly offered investment products.

This page explains what hedge funds are trying to do, the main types of strategies they use, how fees work and the key risks to understand before considering hedge fund style investments or products that mimic them.

What makes a hedge fund different?

There is no single legal definition of a hedge fund that covers every country, but many hedge funds share characteristics such as:

• Restricted to accredited or qualified investors.
• Use of leverage and derivatives to amplify or hedge exposures.
• Flexible mandates that allow both long and short positions.
• Compensation structures that include performance fees.

Historically, hedge funds promoted themselves as a way to “hedge” risk and generate positive returns regardless of market direction, though in practice results vary widely.

Common hedge fund strategies

Hedge funds use many approaches, but a few broad strategy groups are frequently discussed:

• Long/short equity: buying stocks expected to rise and shorting those expected to fall, aiming to profit from relative performance.
• Global macro: trading currencies, bonds, commodities and stock indices based on macroeconomic themes and policy views.
• Event-driven: focusing on mergers, restructurings, spinoffs or other corporate events that may change valuations.
• Relative value / arbitrage: seeking small price discrepancies between related securities, often using leverage.
• Managed futures / trend-following: using systematic rules to ride medium- term trends across many futures markets.

Many funds combine elements of several strategies, and styles can evolve over time.

Hedge fund fee structures

A classic hedge fund fee structure is often described as “2 and 20”:

• Management fee: for example, 2% per year of assets under management.
• Performance fee: for example, 20% of profits above a certain benchmark or high watermark.

Actual fee levels differ by fund, and some may charge lower management fees but maintain performance fees. High fees mean that even strong gross performance may translate into more modest net results for investors.

Risks and considerations

Investing in hedge funds or hedge-fund-like products involves several specific risks:

• Strategy risk: complex strategies may behave unexpectedly in stressed markets.
• Leverage risk: borrowing to expand positions can magnify losses.
• Liquidity risk: some funds restrict redemptions or invest in illiquid assets.
• Transparency: positions and risk measures may not be fully disclosed.
• Manager risk: results can depend heavily on one team or individual.

Because of these factors, hedge funds are generally considered alternative investments suitable only for investors who can handle additional complexity, illiquidity and risk.

Hedge fund style investing for individuals

Even if you cannot or choose not to invest directly in hedge funds, some public vehicles offer “hedge fund style” exposures, such as:

• Liquid alternative mutual funds and ETFs that use long/short or macro strategies.
• Managed futures funds accessible through regular brokerage accounts.
• Structured products that reference hedge fund indices.

These products may come with higher fees and added complexity compared with simple portfolios of mutual funds, bonds and diversified stock holdings. It is important to read the prospectus and understand how returns are generated.

Do you need hedge funds in a portfolio?

Some investors use hedge funds in an attempt to:

• Reduce volatility through diversifying strategies.
• Seek returns that are less tied to broad stock or bond indices.
• Access specialised trading approaches they cannot implement themselves.

For many individuals, however, a well-diversified portfolio of low-cost stock and bond funds may be simpler, more transparent and good enough to reach long-term goals. Hedge funds and alternatives should generally be considered only after the basics are in place.

To understand how hedge funds compare with other vehicles, see our pages on mutual funds, options, futures and forex.