Background
Hedge funds are private investment firms that trade a wide swath of financial assets (such as the stock and debt of publicly traded companies), aiming to make money when markets are both up and down.
Like mutual funds (1440 Topics: Mutual Funds), hedge funds pool money from investors and invest that sum on their behalf, but the similarities mostly end there. Hedge funds—with portfolios ranging from millions to tens of billions of dollars—buy and sell a wide range of assets, from bankrupt companies' debt to commodities like cattle. Mutual funds tend to buy and sell less complex assets, like stocks.
Hedge funds are now a multitrillion-dollar industry that impacts just about every corner of the economy. Yet, the SEC allows only “accredited investors,” such as family offices and university endowments, to invest in hedge funds due to their risky and complex strategies.
Minimum investments range from $100K to several million dollars. In 2024, global hedge fund assets hit a record $4.5T.
History
Alfred Winslow Jones—once a self-professed Marxist and financial journalist with little to no hands-on investing experience—launched the world’s first hedge fund in 1949.
Conventional investment strategies in the post-Great Depression era were simple compared to today’s complex standards. Traders relied on rudimentary data, often attempting the impossible—predicting the market.
Money managers followed a predictable playbook. For instance, they could purchase a stock in a railroad company or buy a soybean contract expecting either asset to appreciate. If the opposite happened and losses mounted, they’d sell.
Jones developed a simple, contrarian thesis that would forever change Wall Street—and the entire economy: Why can’t you make money both when stocks go up and when stocks go down?
He raised $100K from a handful of investors on the premise of what’s now known as a market-neutral portfolio. Market-neutral strategies share some similarities with the traders of Jones’ era: snapping up stocks you expect to rise, and selling before they fall.
But Jones added a twist. He established short positions as a “hedge” against when the stocks he thought would go up … didn’t go up.
Shorting a stock is a wager that the stock will decrease in value. To do so, a trader borrows a stock, sells it, and then buys back the stock at a lower price and returns it to the borrower—pocketing the price difference as profit.
How Hedge Funds Work
Hedge funds trade different types of assets. To get started, the fund markets its strategy to potential investors, showcasing its track record of success regarding the asset types it focuses on. For instance, a hedge fund specializing in corporate bonds would showcase high returns from buying and selling companies' debt.
Those institutional investors, such as pensions and endowments, evaluate that strategy while gauging its fit in their broader portfolio. An investor benefits when that debt strategy diversifies its existing portfolio of stocks, real estate, and private equity.
Hedge funds traditionally impose steep fees on investors with the “2 and 20” model. This means investors pay fund managers a 2% management fee, and the hedge fund keeps 20% of their profits (the 2% is imposed annually, irrespective of performance).
See the world’s top 10 hedge funds here.
Why Hedge Funds Matter
The largest investors—such as CalPERS, a California pension with $500B—rely on hedge funds to diversify their portfolios. Though hedge fund strategies can be risky, the diversification they provide is important for investors like pensions.
Retirees depending on pension plans and students counting on scholarships from university endowments benefit as hedge funds boost their returns, increasing overall funding for individual retirement funds and scholarships (see a detailed explainer).
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