What Is a Hedge Fund?
A hedge fund is a private investment vehicle that raises money from accredited investors and institutions and invests it with far more flexibility than a mutual fund. Hedge funds can bet against stocks through short selling, use leverage to amplify positions, trade derivatives, and move across asset classes, all in pursuit of absolute returns rather than simply tracking a benchmark index.
The name comes from the original idea of hedging: pairing long positions in undervalued stocks with short positions in overvalued ones so the portfolio is protected against broad market moves. Today the label covers a huge range of strategies, including long/short equity, global macro, event-driven, credit, quantitative, and multi-strategy funds.
How Hedge Funds Make Money
Hedge funds traditionally charge 2-and-20: a 2% annual management fee on assets under management plus a 20% performance fee on profits, though fee pressure has pushed many funds below those headline numbers. Performance fees usually come with a high-water mark, meaning the manager only earns them on gains above the fund's previous peak value, so investors do not pay twice for recovering losses.
Unlike private equity funds, hedge funds are typically open-ended: investors can subscribe and redeem at set intervals rather than locking up capital for ten years. Because positions are often in liquid public markets, performance is measured continuously, and managers are judged on metrics like alpha, the return generated above what market exposure alone would explain.
Example
Consider a $5 billion long/short equity fund charging 1.5% and 20%. The management fee alone generates $75 million per year to cover salaries and operations. If the fund returns 12% gross, that is $600 million of gains, and the manager keeps 20% of the profit after the management fee, roughly $105 million, in performance fees.
A classic position might be going long an airline the manager believes is undervalued while shorting a competitor with weaker margins, so the trade profits from the spread between the two rather than from the direction of the overall market.
Why It Matters
Hedge funds are among the most sought-after exits for investment banking and equity research analysts, offering direct exposure to markets and pay tied closely to performance. Firms like Citadel, Millennium, and Bridgewater manage tens of billions and are major forces in daily market trading volume.
In interviews, especially for long/short roles, expect to pitch a long and a short idea and to explain how hedge fund incentives and fee structures differ from those of mutual funds and private equity.
