A hedge fund is defined as a pooled investment vehicle that pursues absolute returns using strategies most traditional funds cannot or will not employ. Short selling, leverage, derivatives, and concentrated positions are all standard tools.
How Hedge Funds Work
Unlike private equity or venture capital funds, hedge funds typically invest in liquid markets and operate as open-ended vehicles. Investors subscribe to the fund and can redeem their capital according to the fund’s terms, usually with 30 to 90 days’ notice and quarterly or annual redemption windows.
Hedge funds are structured as limited partnerships or limited liability companies. The GP manages investments and earns fees. LPs provide capital and have limited governance rights. Many hedge funds also establish offshore feeder funds to accommodate tax-exempt and non-U.S. investors.
Common Hedge Fund Strategies
Hedge funds are not a single strategy. The label covers a wide spectrum:
- Long/short equity - Taking long positions in undervalued stocks and short positions in overvalued ones. The most common strategy by fund count.
- Global macro - Trading currencies, interest rates, commodities, and equities based on macroeconomic themes.
- Event-driven - Investing around corporate events like mergers, restructurings, or bankruptcies. Includes merger arbitrage and distressed debt.
- Quantitative - Using mathematical models and algorithms to identify trading opportunities. Often high-frequency or systematic.
- Multi-strategy - Running multiple strategies within a single fund to diversify return sources.
- Credit - Focused on direct lending, mezzanine, or structured credit, overlapping with private credit.
Each strategy has a different risk-return profile, correlation to public markets, and liquidity requirement.
Fee Structure and Economics
The traditional hedge fund fee model is “2 and 20”: a 2% management fee on assets under management (AUM) and a 20% incentive fee on profits. Unlike PE carried interest, hedge fund performance fees are typically subject to a high-water mark: the GP only earns incentive fees when the fund’s net asset value exceeds its previous peak.
Some funds also include a hurdle rate, requiring the GP to exceed a minimum return (often a cash or Treasury benchmark) before earning performance fees.
Who Invests in Hedge Funds
Hedge fund investors include institutional investors such as pension funds, endowments, and sovereign wealth funds, alongside family offices and high-net-worth individuals. Regulatory requirements under Regulation D and the Investment Company Act restrict access to accredited investors or qualified purchasers.
Raising a Hedge Fund
Hedge fund fundraising differs from PE in a key way: investors evaluate live performance, not just projected returns. A GP with a two-year audited track record showing consistent risk-adjusted returns has a materially easier fundraise than one launching on a thesis alone. Institutional allocators typically require at least $100 million in AUM before committing, creating a chicken-and-egg problem for emerging managers. Many new hedge fund GPs start with seed capital from a single anchor investor or family office, then scale through capital introduction programs offered by prime brokers.
Frequently Asked Questions
What is the difference between a hedge fund and a private equity fund?
The fundamental difference is liquidity. Hedge funds typically invest in liquid or semi-liquid instruments (public equities, bonds, derivatives) and offer periodic redemptions, often quarterly or annually. PE funds invest in illiquid private companies with capital locked up for 10 years or more. Hedge funds aim for consistent absolute returns. PE funds target higher absolute returns in exchange for the illiquidity premium.
How much money do you need to invest in a hedge fund?
Most hedge funds require minimum investments of $250,000 to $5 million. Funds operating under Rule 506(c) of Regulation D require investors to be accredited investors. Many top-tier funds restrict access to qualified purchasers, which requires individuals to hold at least $5 million in investments. Some funds have closed to new investors entirely.
What fees do hedge funds charge?
The traditional fee structure is '2 and 20': a 2% annual management fee on assets under management and 20% performance fee on profits. However, fee compression has pushed many funds to '1.5 and 15' or lower. Most hedge funds include a high-water mark, meaning the GP only earns performance fees on new profits above the previous peak NAV.
