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PitchBook has been covering alternative assets for over a decade, collecting extensive data and publishing comprehensive reports that detail everything an investor needs to know. Operating in the private markets has been historically opaque, and it’s our mission to shed light on the inner workings. In this 101 article, we’ll break down the basics of hedge funds—including how they make money, the types of strategies they use and how they differ from other fund types like mutual funds or private equity.

What is a hedge fund?

Hedge funds are alternative investment funds. They pool money from professional investors and invest it with the intent of making a profit, also known as realizing a return on their investment. Hedge funds are typically managed by institutional investors who utilize a wide array of nontraditional investment strategies with the primary goal of mitigating risk.

This type of investment is designed to generate returns, regardless of whether the market is up or down. As such, hedge funds are touted by some as immune to market forces, though analysis of performance shows that this may not be the case.

Why are they called hedge funds?

Hedging in finance can be similar to actual garden hedges—growing them to outline a yard is an alternative to traditional fencing but still creates a barrier, often for security and privacy. Hedging in finance means to limit or reduce exposure to risk, in the hope to make an investment more secure and successful despite market instability. To offset risk, hedge funds will deploy various financial instruments or market strategies. The idea is that by diversifying the investments which make up their investment portfolio, they are at less risk because they’re not completely dependent upon one asset class.

How do hedge funds work?

Hedge funds can invest capital anywhere in the market and through just about any strategy—making it difficult to generalize what the “typical” hedge fund looks like. However, there are some characteristics that apply to most of them: a preference for public market investments (as opposed to private equity investments that are relatively illiquid) and a tendency to use more uncommon trading techniques such as derivatives or short selling.

How do hedge funds make money?

On top of charging management fees, hedge funds also collect performance fees. These can vary from fund to fund, but the typical fee structure follows the 2-and-20 rule:

Management fees

Calculated as a percentage of assets under management or AUM, typically around 2%. These fees are intended to cover daily expenses and overhead and are incurred regularly.

Performance fees

Calculated as a percentage of the profits from investing, typically around 20%. These fees are intended to incentivize greater returns and are paid out to employees to reward their success.

In recent years, fund managers have faced mounting pressure to reduce management fees and step away from the traditional approach. The COVID-19 pandemic may have accelerated the upending of the 2-and-20 fee structure. 

Hedge funds vs mutual funds

The two biggest differences between hedge funds and mutual funds are 1) who can invest in the fund and 2) how they collect fees. Even though both funds tend to invest largely in public company stock, they pool money from different sources. Mutual funds can raise capital from anyone in the general public, whereas hedge funds are restricted to institutional investors and limited partners. Because mutual funds follow the Investment Act of 1940, they are only allowed to collect management fees. Hedge funds, which do not follow the act, charge both management as well as investor performance fees. 

Hedge funds vs private equity funds

Hedge funds and private equity (PE) funds are both considered alternative assets and are restricted to qualified, institutional investors. The two biggest differences between a hedge fund and a PE fund are fund structure and the types of companies that they invest in.

Hedge funds are open-end funds, whereas PE funds are closed-end. As the name would suggest, open-end funds do not have to close, which allows investors to contribute to or pull their money out of the fund at any point in time. In closed-end funds, the fund will be locked and the capital that was raised will get invested in long-term investments, where the money will be tied-up until it’s released by the fund manager, which could easily be a decade from when it was first invested. The difference in fund structure is largely because of the types of companies they’re investing in; hedge funds are mostly public market investments, while PE funds invest in the private markets. 

What are some criticisms of hedge funds?

Even though hedge funds are open-end funds, the fund manager may not always accept new subscriptions—which could limit investors from getting in on a hedge fund that’s doing well. Fund managers can also temporarily prevent investors from taking redemptions regardless of when they subscribed. This move is called “gates” and was used during the 2008-2009 Global Financial Crisis, when the market downturn shrunk their portfolios and LP redemptions may have taken the entire fund down.
 

What are the largest hedge funds?

According to PitchBook’s data, these are some of the top hedge funds around the world based on AUM as of January 2022:

Alpinum Investment Management

Alpinium Investment Management is an asset manager based in Zurich, Switzerland. They are a alternative investment firm that specializes in credit investments, direct lending, private markets and hedge funds.

Geode Market Capital

Founded in 2001, Geode Capital Management is a global asset manager based in Boston, Massachusetts. This firm uses quantitative techniques and a team-based approach in order to create a risk-managed investment process.

Asset Management One International

Founded in 1979, Asset Management One International is a money management firm based in London, United Kingdom. This subsidiary of DIAM International primarily operates within the EMEA region and employs Japanese and Asian investment strategies and liquidity solutions.

Eurizon SLJ Capital

Eurizon SLJ Capital is a global macro hedge fund manager based in London, England. They specialize in investment advisory, forex trading and fund management, guided by extensive research into global policy and macroeconomics.

Mellon

Founded in 1933, Mellon is the hedge fund management arm of BNY Mellon based in Boston, Massachusetts. The firm employs macro, credit, and equity multi-strategy investment strategies alongside fund of fund equity and risk parity investment strategies with a focus on mid-cap, small-cap, large-cap and value style investing.

Nikko Asset Management

Founded in 1959, Nikko Asset Management is a multi-strategy hedge fund manager based in Tokyo, Japan. The firm implements equity fundamental, equity market neutral, equity sector-oriented, macro multi-strategy credit fundamental, credit multi-strategy and credit sector-oriented investment strategies.
 

What are the types of hedge fund strategies?

There are many different investments strategies and substrategies within hedge funds. We’ll break down the four most common strategy types.

Equity

The most common hedge fund strategy. Equity hedges balance long and short positions in the public markets in order to drive higher return and reduce risk. There are three popular subcategories: market neutral, long-short and short-long.

Event driven (or equity-driven)

Event-driven hedge funds mostly invest in stock and make investment when they believe a one-time event in a company’s history will radically affect security prices. This could be an acquisition or a bankruptcy. Popular event driven substrategies include merger arbitrage and distressed funds.

Macro

These funds invest in a much wider view of securities, from stocks, bonds, commodities and derivatives. The play here is to predict how global forces (e.g., weather, politics, warfare) might cause a shift in the financial markets.

Relative value

A newer strategy that requires access to market data and looks for inconsistencies and errors in how the market is pricing individual securities. It focuses more on market behavior rather than a company. Popular substrategies within the umbrella of relative value include convertible arbitrage and volatility arbitrage.

Other hedge fund strategies are credit, risk parity, risk premia and fund of funds.

How to track hedge funds with PitchBook

We track thousands of hedge funds, including detailed information on performance, strategy and substrategy, net asset value, geographic focus and more. All of our data is verified and vetted before it enters our platform, ensuring you have access to high-quality information—all in one place.