What is a hedge fund — in simple terms?

Let’s be honest, most of us aren’t bringing up hedge funds around the lunch table. But that shouldn’t stop you from learning about a major part of the financial system. After all, hedge funds are pretty influential. In 2023, the total value of assets managed by hedge funds worldwide exceeded five trillion U.S. dollars!

But what is a hedge fund, in simple terms? And how can they help you learn about investing and developing a future financial strategy? Let’s break hedge funds down (minus the financial jargon) and go over some real-world examples to illustrate how they operate.

Hedge funds in simple terms

Hedge funds are used by wealthy investors to pool their money and make high-risk, high-reward investments. Their primary purpose is to generate as much profit as possible, but they may use hedging strategies to lower the overall risk.

Here’s a quick and easy breakdown of the most common hedge fund characteristics:

• Invest in a wide range of assets

• Often use high-risk investment strategies

• Only available to “accredited investors” with a high net worth

• Actively managed by hedge fund managers

• High fees, including a performance fee of 20% on profits 

• Can short-sell stocks

Hedge funds explained

Since hedge funds aren’t regulated as closely as other types of funds, they have a reputation for being risky investments with a high failure rate. Some spectacular collapses have happened, like in 1998 when a hedge fund called Long-Term Capital Management lost $4.6 billion in less than four months.¹ 

If they're so risky, then why would anyone invest in a hedge fund?

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Because when risky investment strategies work, they can pay off in a huge way. Last year, investors in Citadel, one of the world’s best-performing hedge funds, gained $16 billion in profits.

Hedge funds are capable of generating huge profits precisely because they’re willing to risk it all on unpredictable investments, known as speculative or alternative investments. These funds may use a variety of strategies to achieve profitability. For instance, some funds rely on big data and complex statistical models to crunch the numbers and make automated trading decisions. These are known as quantitative hedge funds. 

On the other end of the spectrum, global macro hedge funds prefer to take a look at the big picture. Their strategy is to analyze political and economic trends to make predictions on where the market is heading. Then they use this information to invest in a portfolio of assets that will increase in value if their predictions turn out to be right.

Another risky strategy that can have big returns is short-selling. This is when you sell stocks you don’t own because you plan to buy them later when they decrease in value. Instead, you borrow them from stockbrokers for a fee.

If the stock does drop in value, you can buy back the shares you borrowed and turn a profit. But if the price goes up, you’ll have to return the stocks to the broker at a higher cost than you paid for them initially. Since it’s hard to predict how the market will move, there’s a chance you could lose a lot of money.

There are other strategies that hedge funds use to make profits, but they always have a high ratio of risk to reward.

Why is it called a hedge fund?

Just like a hedge that surrounds a garden for protection, hedge funds were initially created to protect investors from risk.

In terms of finance, “to hedge” means that you try to reduce your chances of losing money on an investment by making a similar investment on the opposite outcome. In other words, you’re betting on both sides so that you don’t lose too much money no matter which way the numbers go.

But didn’t we just say that hedge funds are considered riskier than other types of funds? Yes. Let’s clarify.

Despite sticking with the same name, hedge funds have evolved over the years to become more focused on earning big returns than lowering risk.

Exploring hedge funds

There are several things that set hedge funds apart from other options. Two of the most significant factors are the approach towards risk and the level of accessibility. In other words, what are their strategies for making money, and who is allowed to participate?

High-risk, high-reward

Hedge funds take on high levels of risk and have more flexibility when it comes to investment strategies than other types of funds. This requires hedge fund managers to actively manage the fund and look for aggressive trading opportunities. Hedge funds frequently invest in liquid assets like stocks, currencies, real estate, and derivatives.

In contrast, other types of funds may be low-risk and low-reward. For example, mutual funds use more conservative strategies to invest in diversified portfolios of stocks, bonds, and other securities. Instead of betting on high-risk, high-reward market movements, mutual funds aim for long-term growth and steady returns.

You’ve got to pay to play

The other main difference between hedge funds and mutual funds is their accessibility level. Hedge funds aren’t open to the general public. Since they require you to meet certain financial requirements, they are usually only open to accredited investors or institutions.

To be an accredited investor, you must fall into one of these categories:

• Have a liquid net worth of over $1 million

• Earn over $200,000 per year

• Be a licensed investment professional

In addition, most hedge funds ask for minimum investments of between $100,000 and $1 million. This requirement, plus extra management and performance fees, means that most retail investors don’t invest in hedge funds.

Real-world examples of hedge funds

To better understand how hedge funds work, let's look at some real-world examples.

Citadel is a hedge fund run by Kenneth Griffin, who started his trading journey as a 19-year-old student in his Harvard dorm room. He founded Citadel in 1990 and has since grown the fund into one of the largest in the world. It focuses on various high-yield strategies that place it near the top of the list when it comes to turning a profit.

Continuing the theme of launching hedge funds from your bedroom, well-known investor Ray Dalio founded Bridgewater Associates in 1975 from his apartment in New York. Another top hedge fund, they primarily provide services to institutional investors like governments, central banks, universities, charities, and pension funds.

If you’re interested in numbers, read up on Renaissance Technologies. Founder Jim Simons revolutionized hedge fund management by using mathematical analysis to develop quantitative models that drive its automated trading strategies.

For young investors trying to shake up the business world, look into Pershing Square. Known for its successes and failures as an activist hedge fund, Pershing Square and founder Bill Ackman try to unlock value in undervalued companies.

If you want to learn more about real hedge funds and how they work, here’s a list of some of the other largest funds today:

• BlackRock

• Man Group

• D.E. Shaw Co.

• AQR Capital Management

• Millennium Management

• Elliott Investment Management

• Two Sigma

So, where does that leave young investors?

Well, unless you have a net worth of over $1 million or make more than $200,000 per year, you won't be investing in any hedge funds just yet. But that doesn't mean you've spent all this time learning for nothing.

Understanding how hedge funds work brings you one step closer to putting together the larger financial puzzle. By learning about all the different pieces that make up the fascinating world of finance, you're investing in yourself to achieve financial success in the future. Think of it as a low-risk, high-reward strategy — the best of both worlds!

While you might not be able to invest in hedge funds directly right now, you can still familiarize yourself with the strategies they use to maximize returns and minimize risk. Consider how you can use this knowledge to develop your own investment strategy that aligns with both your short-term needs and long-term goals.

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¹Ferguson, N. (2008). The Ascent of Money: A Financial History of the World. London: Allen Lane.