Takeaways
- Hedge funds are pools of capital invested to generate outsized returns.
- Hedge funds are actively managed and reserved for wealthy investors.
- Hedge funds have high investment minimums and long lock-up times.
- Hedge funds have high management fees relative to other fund structures.
- Hedge funds enjoy less regulation than other types of funds like index or mutual funds.
What Is a Hedge Fund?
A hedge fund is a pooled investment fund that uses a range of strategies to maximize returns for its investors and hedge risk. Unlike more traditional investment funds, like venture capital funds, mutual funds, or index funds, hedge funds use a wide range of trading techniques to reach their goals, including long-only investments, short selling, leveraging positions, momentum trading, and purchasing derivatives.
Most hedge funds are only available to a limited number of accredited investors and high-net-worth and ultra-high-net-worth individuals with high net worths to invest in the fund. Family offices, pension funds, and endowments also invest in hedge funds. This cohort of investors expects a much higher return on their investment because of the high risk associated with hedge fund investing strategies.
Hedge funds are well-known for their flexibility and can specialize in investing in a wide range of assets, from conventional stocks and bonds to commodities, futures, and real estate. The structure and investment strategies of hedge funds vary tremendously by industry, sector, and market focus. In most cases, they will try to deliver outsized investment returns regardless of the overall market performance.
Portfolio managers, analysts, and traders at hedge funds are usually highly educated in the industry or sector they invest in. For example, hedge funds focusing on investing in pharmaceutical, biotechnology, and medical device companies usually have teams of portfolio managers and analysts who are medical doctors or have doctorate-level research degrees.
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How a Hedge Fund Works
A hedge fund is formed by pooling capital from investors and investing it in accordance with the fund’s investment strategy. Hedge fund managers are highly experienced financial professionals who have made a name for themselves in the investment world and have the reach, pull, and chops to pool together millions of investment capital.
In some cases, the fund uses leverage to boost its buying power. Leverage is implemented by borrowing money to increase the size and scale of an investment or stacking various positions so that if a catalyst event occurs, the fund gets outsized returns. Funds also try short selling, where investors make money when a stock loses value.
Hedge funds are not confined to investing in one asset but can invest in a wide range of assets, from traditional bonds to commodities. This flexibility allows them to place complimentary bets in many markets. For example, suppose a fund is bullish on the real estate market in the Southeast. In that case, they might buy many real estate investment trusts (REITs) that hold residential and commercial properties in this area and invest in publicly traded stocks in construction and homebuilding companies here, too.
Hedge funds are unencumbered by regulations covering larger investment vehicles and can be highly flexible in their investing approach.
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There are 3,872 hedge funds in the U.S. as of the end of 2023.[1]
Where Do Hedge Funds Invest?
Hedge funds are flexible vehicles and can invest in a wide range of assets across multiple asset classes, deploying numerous investment strategies. While the investment thesis for each hedge fund varies, here is a look at some of their most common investments:
- Stocks: One of the biggest ways hedge funds invest in publicly traded companies is through purchasing common stock. Some hedge funds specialize in investing in private companies about to launch an initial public offering (IPO). Others take a long-only approach to public stocks and hold the investment through an inflection point.
Funds have dedicated pools of capital to trading based on recent market news, stock price momentum, or industry trends. Unlike individual retail investors, hedge funds make large and fast orders. They sometimes enter and exit a large position intraday or hold it for only a few days.
- Bonds: In addition to stocks, hedge funds invest in bonds and other fixed-income instruments. They might try to take advantage of interest rate arbitrage or credit strategies, which exploit differences in credit risk and bond prices.
Most investors don’t know how to implement these strategies or have enough investment capital to make these trades meaningful. That’s where the power of an outsized capital pool can significantly exploit small advantages.
- Derivatives: Hedge funds also focus on investing in derivatives, which are investments like options and futures contracts. These are contracts and financial instruments derived from an underlying asset, such as marketable securities, cash, or commodities.
Derivatives allow hedge funds to manage risks and boost returns by implementing an investment thesis and speculating on future price movements.
- Commodities: Hedge funds are also commonly known to invest in commodities, which are physical materials like gold, oil, timber, soybeans, and natural gas. This is another area where hedge fund analysts' specialized industry knowledge comes into play.
By hiring former executives and conducting research in these industries, hedge funds can gain a huge informational and knowledge edge over the rest of the market. They can also develop highly sophisticated models to exploit price fluctuations or trends.
- Real Estate: Like other investors, hedge funds invest in real estate. However, hedge funds invest differently than private equity groups and venture capital funds, which have a much longer time horizon.
Hedge funds invest directly and indirectly in real estate. Direct investments can include buying specific commercial properties with the expectation of having the property acquired quickly. Indirect investment methods, on the other hand, include investing in publicly traded real estate investment trusts (REITs).
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How to Invest in a Hedge Fund
Not just anyone can invest in a hedge fund. To invest in a hedge fund, you need to be an accredited investor, which means that you meet specific criteria defined by the Securities and Exchange Commission. Becoming an accredited investor means building a high net worth or earning a high income.
Accredited investors have: [2]
- Over $1,000,000 in net worth (excluding your primary residence)
- Earn over $300,000 with your spouse or partner or $200,000 individually for two years and currently make that much.
Even if you can invest in a hedge fund, you will need to research funds that align with your financial goals and risk tolerance. Once you find a fund that looks like a good fit, you will have to go through a formal application process.
Many hedge funds have high minimum capital contributions that most beginner investors cannot afford. Before investing, make sure you are aware of the management and performance fees, which are both standard in the industry.
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Smart Summary
Hedge funds are pools of highly sophisticated investment capital run by elite finance professionals with a dedicated investment strategy. These funds are invested across a spectrum of asset classes and have millions or billions of assets under management. Hedge funds are known for their outsized market returns, ability to navigate bull and bear markets, and ability to make asymmetric risk and reward trades. Accredited investors invest in hedge funds to access the promise of high investment returns.
Frequently Asked Questions
Hedge funds are created each year with the promise of generating high returns. However, many funds fail and return investor capital (or what is left of it) to their shareholders. Other funds are tremendously successful and can produce investment returns multiples above the average market return. Picking a successful hedge fund can be like choosing a successful stock.
Hedge funds are regulated by the SEC and have much more flexibility than other fund types, such as mutual funds, index funds, and exchange-traded funds.
The funds you invest in a hedge fund are usually locked up for a minimum amount of time, ranging from 5 to 10 years.
(1) IBIS World. Hedge Funds in the U.S. – Number of Businesses. Last Accessed January 14, 2025.
(2) SEC.gov. Accredited Investor. Last Accessed January 14, 2025.
