What Is a Hedge Fund?

Hedge funds are a way for wealthy individuals to pool their money together and try to beat average market returns. Managers often use aggressive strategies in an effort to produce positive returns for investors, and they typically get paid based on performance.

Hedge funds generally have similar legal structures, relatively comparable investment strategies, and charge about the same amount of fees to their investors. To really understand the definition of a hedge fund, though, we need to dig a little deeper.

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An infographic explaining how hedge funds work and what the "2 and 20" rule is. — Image source: The Motley Fool

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Two women in business suits talking. — Source: Getty Images

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Gross Expense Ratio

The gross expense ratio is the percentage of an investment that goes toward fees before discounts have been applied.

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The bottom line

Hedge funds offer access to a specific manager's investment strategy, but the price is very steep. Most individual investors are precluded from investing in hedge funds, and even those eligible to buy shares may be better off with a less expensive investing approach.

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About the Author

Adam Levy is a contributing Motley Fool stock market analyst covering technology, consumer, and financial stocks and how policy, economic, and consumer trends shape personal finance, Social Security and retirement savings. Before The Motley Fool, Adam was a financial advisor at Edward Jones. He studied finance and electrical engineering at Carnegie Mellon University.

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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Hedge fund strategies

Hedge funds can employ a number of strategies including:

Long/short equity: Fund managers will buy shares in stocks their research finds promising and short shares in stocks they think are overvalued. This strategy reduces market risk since the short positions offset the long positions. Provided the long positions as a group outperform the short positions, the fund makes money. For example, the manager buys Stock A and shorts Stock B. Stock A goes up 20% and Stock B goes up 15%, and the manager can sell Stock A, cover the short on Stock B, and still gain 5% on the trade. Likewise, if Stock A goes down 15% and Stock B goes down 20%, the trade still returns 5%.

Merger arbitrage: Fund managers will take advantage of opportunities where a merger or acquisition price isn't fully reflected in a security. They can do this by buying shares of the acquisition target and selling shares of the acquiring company based on the announced share-exchange ratio for the acquisition. The trade will succeed as long as the merger is successfully completed as planned, but there's risk that things could change or the deal faces regulatory roadblocks.

Event-driven: Managers will buy the senior debt of distressed companies or those that have already declared bankruptcy. As the company reorganizes, the manager expects to receive close to face value for the debt they buy while junior debt and equity holders may be completely out of luck in recouping any value.

Global macro: Hedge funds will analyze how global macroeconomic trends will impact basic financial systems and change exchange rates, interest rates, or commodity prices around the world. They then find investment opportunities most impacted by those changes, typically currency forwards.

Quantitative: Some hedge funds develop algorithms to analyze large sets of data to find trading opportunities. Oftentimes, the system automatically executes the trade, and management simply analyzes the performance of the algorithm and adjusts it as necessary. High-frequency trading is an example of quantitative trading in action.

Gross Expense Ratio

Related investing topics

How to Invest in Mutual Funds

How to Invest Money

IRA

Types of Stocks

The bottom line

About the Author

Our Guides

Premium Investing Services

How to Invest in Mutual Funds

How to Invest Money

IRA

Types of Stocks

How do hedge funds work?

How do hedge funds make money?

Differences between Hedge funds vs. mutual funds

Investment objectives

Fees

Shareholder requirements

Liquidity

Regulation

Trading strategies

Hedge fund strategies

Related investing topics

The bottom line

List of hedge fund companies