What Is a Hedge Fund?

By Adam Levy – Updated Mar 5, 2026 at 3:20 PM EST | Fact-checked by Parker Hicks

Key Points

Hedge funds are exclusive to accredited investors with aggressive investment strategies.
They often charge a "2-and-20" fee structure, now possibly lower post-2008 crisis.
Fund strategies include long/short equity, merger arbitrage, and global macro.

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.

Shareholder requirements

Anyone can invest in a mutual fund. Mutual funds may require a minimum investment of $100, $1,000, or more, but as long as you have the money, you can buy shares.

Hedge funds only accept accredited investors. On top of that, hedge funds usually have very high minimum investments, like $1 million. This puts a significant limit on the number of people who can invest in a hedge fund.

Liquidity

Investors can sell their shares in a mutual fund on any day. While their sell order won't execute until the end of the trading day, they can sell or buy more any day the stock market is open.

Hedge funds limit their investors to buying and selling during certain periods every quarter, half-year, or sometimes longer. Additionally, new investors must lock up their funds for a certain length of time, typically one year.

Regulation

Mutual funds are registered with the SEC. As such, they're required to comply with all agency regulations, including regular financial reporting.

Hedge funds don't have to register with the SEC, and, therefore, there's a lot less transparency. However, the SEC can still sue nefarious hedge fund managers on its investors' behalf in the case of corruption or misleading investors, such as in a Ponzi scheme.

Trading strategies

Mutual funds are limited in the strategies they can use to invest. For the most part, mutual funds stick to buying stocks, bonds, and other securities.

Hedge funds can invest in just about anything, and, therefore, can employ a wide variety of strategies. Managers can use derivatives to hedge or leverage positions, buy more illiquid assets such as art or private real estate, sell short, and use debt. These strategies are often more volatile than those available to mutual funds.

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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 because short positions offset 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 rises 20% and Stock B rises 15%; the manager can sell Stock A, cover the short on Stock B, and still gain 5% on the trade. Likewise, if Stock A falls 15% and Stock B falls 20%, the trade still returns 5%.

Merger arbitrage: Fund managers take advantage of opportunities where a merger or acquisition price isn't fully reflected in a security's price. 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 a 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 affect core financial systems and alter exchange rates, interest rates, and commodity prices worldwide. They then identify the investment opportunities most affected 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.

What Is a Hedge Fund?

Key Points