What is a hedge fund?

In simple terms, a hedge fund is an investment fund that pools money from individuals and institutions and invests it in assets to generate positive returns. The profits are then divided between the investors and fund managers according to the agreed-upon terms.

Hedge funds have two main parties: the limited partners and the general partner. The limited partners are the individuals and institutions that provide the money. The general partner is the firm managing the money on behalf of its limited partners.

The four main types of hedge funds are: equity, global macro, relative value, and activist.

Equity funds invest directly in stocks, both in domestic and foreign equity markets. They also short stocks to hedge against equity downturns.

Short-selling involves borrowing shares and selling them immediately, with the intention of repurchasing them at a lower price later and profiting from the difference. For instance, a fund can borrow 10 shares of Company A, currently trading at $9, then sell them for $90 ($9 x 10 shares).

If Company A’s stock price falls to $5, the fund will buy back the 10 shares for $5 each, costing $50. It’ll return the 10 shares to the lender and retain the remainder, which is $90 minus $50, resulting in a $40 profit.

Short-selling is the opposite of the traditional ‘long’ position, where a fund buys a stock and expects to sell it for a higher price later.

Global macro funds are actively managed funds that primarily aim to profit from market fluctuations triggered by economic or political events.

For example, the recent tariff impositions by the U.S. government caused significant price swings in the global financial system, especially in emerging markets. Some assets fell sharply while others rose. Global macro funds aim to capitalize on such market movements.

Relative value funds focus on identifying and profiting from market inefficiencies. They exploit temporary price differences in related securities to earn profits.

For example, Company A can announce an agreement to buy Company B for $30 per share. In the meantime, Company B’s share price jumps from $20 to $29, but not to $30 because there’s always a risk, no matter how little, of the deal not closing.

A fund can buy Company B’s shares for $29, betting that the deal will close. If it eventually closes, the fund earns a $1 profit on each share it purchased. This figure might not sound like much, but if the fund bought millions of shares, it can generate millions of dollars in profits within a short period.

Activist hedge funds invest in businesses and take action aimed at boosting their share price. For example, a fund can invest in a company and encourage the board to divest from unprofitable divisions, focusing instead on the profitable ones.

Activist hedge funds employ seasoned professionals to identify undervalued companies that they can invest in.

A hedge fund is a registered legal entity comprising two main parties: the limited partners (LPs), who provide the funds, and the general partner (GP), which makes the investment decisions. LPs are usually accredited individual and institutional investors.

The LPs and GP sign a formal agreement with precise terms, including capital commitments, management fees, profit-sharing arrangements, lockup duration, and the hedge fund’s investment strategy. This agreement is legally binding, and failure to comply with it may result in legal action.

Below is a step-by-step process of how a hedge fund works:

Common hedge fund strategies include:

The late Julian Robertson (1932-2022) founded Tiger Management, one of the first global hedge funds, in the 1980s. Tiger Management became a highly successful hedge fund, returning 31.7% annually from 1980 to its 1998 peak in assets under management. The fund managed $22 billion in assets at its heyday.

Robertson closed Tiger Management in 2000 and pivoted to mentoring and seeding new, skilled traders, fondly known as “Tiger Cubs.” These cubs went on to build some of the best-performing hedge funds of this era, such as Tiger Global Management and Viking Global Investors.

Ken Griffin is America’s most prominent hedge fund manager. His multi-strategy fund, Citadel LLC, manages over $60 billion and is renowned for its stellar returns. Citadel gained 15% in 2024 alone and made $16 billion in profits after fees in 2022, the largest-known annual haul by a hedge fund.

Along with Citadel LLC, Griffin also runs a market-making firm called Citadel Securities. It posted a record $9.7 billion in trading revenue in 2024, cementing Citadel’s reputation as one of the most successful in hedge fund history.

Hedge funds typically follow the 2-20 compensation system, comprising an annualized management fee of 2% and a performance fee of 20%.

The 2-20 system is an average, but compensation can vary greatly depending on the fund. For example, RenTech once disclosed charging a 5% management fee and up to 44% in performance fees for its flagship, multi-billion-dollar Medallion Fund.
Many hedge funds charge significantly higher or lower than the standard 2-20 system, depending on their performance. Sometimes, different investors pay different fees. It all depends on the contract.

Hedge funds offer potential higher returns for investors but also have elevated risks. Their speculative investment strategies can yield substantial returns or backfire, resulting in sizable losses.

Professional investors often pair hedge fund positions with other investments, including mutual and index funds. This diversification reduces the risks involved in hedge fund investments.

Personal investing goals determine whether one should invest in a hedge fund, and it’s always advisable to conduct thorough research before doing so.