What is a hedge fund & how do hedge funds work?

What is a hedge fund in simple terms?

A hedge fund is a professionally managed pool of money that can invest across a wide range of markets using advanced techniques designed to generate profits whether prices are rising or falling.

This flexibility is what separates hedge funds from traditional mutual funds or ETFs, which typically operate under tighter regulatory constraints. 

Most hedge funds are structured as private investment vehicles available primarily to accredited or institutional investors, and they have broad freedom to allocate capital across asset classes such as equities, bonds, commodities and currencies. Managers can also use tools like leverage, derivatives and short selling to enhance returns, with the goal of achieving positive performance - known as absolute returns - rather than simply tracking or modestly outperforming a market index. 

How do hedge funds work?

Understanding how hedge funds work starts with how they’re structured.

Investors commit capital to a fund, which is managed by team of fund managers. The managers then allocate that capital across different opportunities according to a defined strategy.

The typical process broadly follows these steps:

1. Investors contribute funds
2. The hedge fund manager selects investments
3. The fund may trade equities, bonds, commodities, currencies or derivatives
4. Profits and losses are distributed after fees

Unlike traditional funds, hedge funds can:

• Profit from falling prices through short selling
• Borrow money to increase exposure (leverage)
• Concentrate investments rather than diversify widely
• Trade complex instruments

This freedom allows hedge funds to pursue opportunities unavailable to most retail funds.

You can find out more about short-selling and how it works here.

What does a hedge fund do?

At its core, a hedge fund seeks to deliver strong, risk-adjusted returns for investors regardless of market direction.

Many aim for “absolute returns,” meaning positive performance even when stock markets fall.

To achieve this, hedge funds actively manage positions rather than simply holding assets long term. Some trade frequently, while others invest in longer-term opportunities. 

However, investing in hedge funds is a highly risky strategy, with the potential for substantial financial losses. We cover those in more detail later in the article.

How hedge funds seek to make money

Understanding how hedge funds make money involves two parts: investment performance and management fees.

Investment returns

Funds generate profits through successful trades, investments or arbitrage opportunities. These may come from rising or falling asset prices, interest income, pricing inefficiencies between markets or major economic trends.

Fees charged to investors

Most hedge fund companies use a performance-based model, traditionally known as “2 and 20”: roughly a 2% annual management fee plus around 20% of profits as a performance fee. Fee structures vary today as institutional investors push for better value. It’s worth noting that these fees can significantly erode returns for investors – particularly relevant for retail investors.

Common hedge fund strategies

There is no single approach, as hedge fund strategies vary widely depending on expertise and market conditions.

Long/short equity

Long/short equity is one of the most common and widely understood hedge fund strategies. Managers take “long” positions by buying stocks they believe are undervalued and likely to rise, while simultaneously taking “short” positions, i.e.: selling borrowed shares, in companies they believe are overvalued or facing decline. The aim isn’t simply to bet on the overall direction of the stock market, but to profit from the relative performance between strong and weak companies.

By balancing long and short positions, the fund can reduce its exposure to broad market movements and focus on stock-picking skill. For example, a manager might go long high-quality businesses with strong earnings growth while shorting competitors struggling with debt or falling demand. If the chosen winners outperform the losers, the strategy can generate returns even if the wider market moves sideways or falls.

However, long/short equity still carries risk. Poor stock selection, sudden market shifts or short squeezes can lead to losses on either side of the portfolio. Skilled risk management and deep fundamental research are therefore central to making this approach work consistently.

Global macro and macro hedge funds

Global macro is a broad hedge fund strategy focused on large-scale economic forces rather than individual companies. Macro hedge funds analyse trends such as interest rate cycles, inflation, central bank policy, currency movements and geopolitical developments, then position their portfolios to benefit from those shifts. Instead of stock picking, the emphasis is on how entire economies and financial systems are likely to move.

To express these views, managers typically trade highly liquid markets including stock indices, government bonds, commodities and foreign exchange. Positions can be long or short and may change quickly as new economic data or policy decisions emerge. Because macro strategies are not tied to a specific sector or region, they can adapt to changing conditions. But they also depend heavily on accurate interpretation of complex global events.

Event-driven

This is a hedge fund strategy that centres on major corporate developments that can materially affect a company’s value. Managers analyse situations such as mergers and acquisitions, takeovers, spin-offs, restructurings or bankruptcies, aiming to profit from the price movements that often occur before, during or after these events. For example, when a takeover is announced, the target company’s share price typically moves toward the agreed purchase price, creating potential opportunities for investors who can assess the likelihood of the deal completing.

These strategies rely heavily on legal, financial and industry analysis, as well as careful timing. Returns can be attractive if events unfold as expected, but outcomes are uncertain. Regulatory obstacles, financing issues or shareholder opposition can derail deals and cause sharp price reversals.

Relative value / arbitrage

Relative value, often called arbitrage, involves exploiting pricing discrepancies between related securities that should theoretically move in tandem. Managers look for situations where two assets, such as different classes of the same company’s shares, closely linked bonds, or securities tied to the same underlying exposure, have temporarily diverged in price. The fund then takes offsetting positions designed to profit if prices converge back to a more normal relationship.

Because both sides of the trade are connected, this approach can reduce exposure to broad market movements and focus on pricing inefficiencies instead. However, these opportunities are often small and short-lived, requiring sophisticated modelling, rapid execution and significant capital. Unexpected market stress can also cause relationships to break down for longer than anticipated.

Fixed income strategies

Fixed income hedge funds concentrate on bond markets and other interest rate-sensitive assets. This includes government and corporate bonds, credit instruments, mortgage-backed securities and derivatives linked to interest rates. Managers attempt to profit from changes in yields, credit quality, inflation expectations or the shape of the yield curve, which is the difference between short and long-term borrowing costs.

These strategies may involve both directional bets, such as anticipating rate cuts or rises, and relative trades between different parts of the bond market. While bonds are often seen as lower risk than equities, fixed income markets can be highly sensitive to central bank policy and economic shifts, meaning positions can move sharply during periods of volatility.

Quantitative strategies

Quantitative strategies - often known as “quant” investing- rely on mathematical models, large datasets and automated systems to identify and execute trades. Instead of human intuition or discretionary decision-making, algorithms analyse patterns in market prices, economic indicators, news flows or alternative data sources to detect opportunities that may not be visible to traditional investors.

Many quantitative funds trade at high speed and across multiple markets simultaneously, adjusting positions as new data arrives. Advances in computing capabilities and AI have accelerated the growth of this approach in recent years. While quant strategies can remove emotional bias and process vast amounts of information, they also depend on the accuracy of their models, which may struggle during unprecedented market conditions.

Hedge funds vs traditional funds – key differences

The table below illustrates some of the differences between hedge funds and traditional ones such as ETFs or mutual funds. It’s not always the case, but should give a good indication of how hedge funds are perceived to differentiate themselves from other vehicles.

Who oversees a hedge fund?

A hedge fund manager is responsible for making investment decisions and managing risk within the fund.

Top managers often have backgrounds in:

• Investment banking
• Asset management
• Proprietary trading
• Economics or quantitative finance

Their compensation is closely tied to performance, meaning strong returns can lead to very high earnings - while poor performance can quickly damage reputation and investor confidence.

How to become a hedge fund manager

There’s no single or simple path to becoming a hedge fund manager. Whichever one you choose, competition is intense.

Typical steps include:

• Having a strong academic background in finance, economics, maths or similar
• Experience in trading or portfolio management
• A proven performance track record
• Professional qualifications (e.g. CFA)
• The ability to attract investor capital

Many managers launch funds after building credibility at banks or asset management firms.

Hedge fund companies and the industry today

Large hedge fund companies manage billions - sometimes hundreds of billions - in assets.

Elements shaping the landscape today are debated across the investment world, but we do see some broad trends emerging:

• The growth of data-driven and AI-led strategies
• Increasing dominance of institutional investors
• Expansion into private credit and alternative assets
• Pressure on fees and transparency
• Greater regulatory oversight

Despite competition from low-cost index funds, hedge funds remain influential because of their flexibility and specialised expertise.

How to invest in hedge funds

Direct access is usually restricted, which raises a common question: how to invest in hedge funds. IG, it should be said, does not offer direct access to hedge fund investments.

Most require investors to meet wealth thresholds and commit capital for extended periods.

There are, however, some indirect routes:

Fund of hedge funds

A fund of hedge funds invests capital across a selection of underlying hedge funds rather than backing a single manager or strategy. This approach aims to diversify risk by spreading exposure across different investment styles, asset classes and management teams, potentially smoothing returns over time. However, this extra layer of diversification also comes with additional fees, as investors effectively pay both the underlying funds’ charges and the fund-of-funds manager’s costs.

Listed alternatives

Listed alternatives are publicly traded vehicles, often investment trusts or specialised funds, that seek to deliver hedge-fund-like returns while remaining accessible on stock exchanges. Because they can be bought and sold like shares, they offer greater liquidity and transparency than private hedge funds. However, their strategies may be more constrained by regulation, and market pricing can diverge from the underlying asset value, meaning investors should assess both performance and structure carefully.

Institutional vehicles

Large institutions such as pension funds, insurers and sovereign wealth funds frequently allocate part of their portfolios to hedge funds to enhance diversification and pursue returns not closely tied to traditional markets. Individual savers may gain indirect exposure through these vehicles without investing in hedge funds themselves. However, allocations must be weighed against higher costs, complexity and potential liquidity limits, which can affect how quickly capital can be accessed if market conditions change.

Examples of hedge funds and listed alternatives

These firms have been selected for their large size and influence within the hedge fund industry. They are not recommendations, and past performance is not an indicator of future results.

One of the world’s largest hedge funds is Bridgewater Associates, known for its global macro strategies that analyse economic trends such as inflation, interest rates and currency movements.

For investors looking at listed firms connected to hedge fund strategies, Man Group is one of the largest publicly traded alternative asset managers. The company runs both quantitative and discretionary hedge fund strategies across equities, bonds and commodities. 

Another example is Pershing Square Holdings, a listed investment vehicle managed by hedge fund manager Bill Ackman. The trust runs a concentrated portfolio strategy similar to some activist hedge funds.

Risks associated with hedge funds

Higher flexibility means higher risk. There’s the potential for large losses due to leverage, and complex strategies are often difficult to properly evaluate. Hedge funds are notorious for being untransparent, with lock-up periods restricting withdrawals. And most importantly of all, whilst having a hedge fund manager overseeing things is a big draw for investors looking to have somebody else manage their dealings, returns are very much dependent on the skill of individual managers.

Even sophisticated investors typically treat hedge funds as one component of a diversified portfolio.

Hedge funds summed up

• A hedge fund is a private investment fund using flexible strategies to pursue strong returns, though with significant risks attached
• Understanding what a hedge fund is in simple terms helps to cut through industry jargon
• Core fundamentals revolve around pooled capital managed by professional fund managers
• Hedge fund strategies range from stock picking to global macro trading
• Hedge funds make money by combining both management ad performance fees (the “2 and 20” model)
• Access is usually limited to high net worth or institutional investors, though indirect options do exist.