Understanding Hedge Funds: A Complete Guide to How They Work, Who Can Invest, and Why They Matter

In the world of investing, you may often hear the term “hedge fund” mentioned in discussions about high-risk, high-reward strategies or elite financial markets. Hedge funds have a reputation for being sophisticated, exclusive, and sometimes mysterious. They are often associated with wealthy investors, large institutions, and fund managers who use complex strategies to generate exceptional returns. While this image carries some truth, the core idea behind a hedge fund is actually straightforward: it is a professionally managed investment pool that uses advanced techniques to maximise returns, often with fewer regulatory restrictions than conventional funds.

To better understand hedge funds, it is useful to break down what they are, how they function, who can invest in them, and why they are considered both potentially profitable and risky. This article aims to provide a clear, human-friendly explanation of hedge funds so you can easily grasp the concept without any prior financial knowledge.

What Exactly Is a Hedge Fund?

A hedge fund is essentially a pooled investment vehicle, similar in structure to a mutual fund, but different in its approach to investing. Hedge funds collect money from a group of investors and invest that pooled capital across various asset classes. The main goal is to generate higher-than-average returns using innovative, aggressive, and sometimes unconventional strategies.

The term “hedge” originally referred to strategies used by early fund managers to protect or “hedge” their investments from market risk. Over time, hedge funds evolved, and today they focus more on achieving high performance than simply hedging risks. They may invest in stocks, bonds, currencies, commodities, derivative instruments, real estate, and even private companies.

One defining feature of hedge funds is the flexibility they enjoy. Compared to traditional mutual funds, hedge funds face far fewer restrictions, allowing managers to use leverage (borrowed money), short selling, arbitrage, and other advanced methods to pursue strong returns.

Who Can Invest in Hedge Funds?

Hedge funds are not open to the general public. They are designed exclusively for “accredited” or high-net-worth investors who meet certain income or asset thresholds.

There are several reasons for this exclusivity:

Hedge funds carry higher risks, and regulators want to ensure investors have the financial capacity to absorb potential losses.

The minimum investment amounts are usually high, often starting from tens of lakhs to several crores.

Sophisticated strategies require informed investors, meaning hedge funds assume their clients understand the nature of risks involved.

In short, hedge funds are not designed for everyday retail investors. They cater to individuals and institutions capable of making large investments and accepting higher volatility in pursuit of greater returns.

How Hedge Funds Invest: Strategies and Approaches

What sets hedge funds apart from mutual funds is their freedom to use a wide variety of investment strategies. While mutual funds typically follow a long-only approach (buying assets and holding them for long-term growth), hedge funds can bet on both rising and falling markets.

Here are some of the most common strategies hedge funds employ:

1. Long–Short Equity Strategy

In this approach, the fund buys stocks expected to rise in value (long positions) and simultaneously sells stocks expected to decline (short positions). This allows the fund to profit in both upward and downward markets.

2. Global Macro Strategy

This strategy involves making large bets on global economic trends — such as interest rate movements, currency fluctuations, or geopolitical shifts. Managers use research and forecasting to position the portfolio for big global changes.

3. Event-Driven Strategy

Here, hedge funds invest based on corporate events such as mergers, acquisitions, bankruptcies, or restructuring. The goal is to profit from price movements caused by such events.

4. Arbitrage Strategies

Arbitrage involves exploiting small price differences in markets. For example, buying a stock in one market and selling it at a slightly higher price in another. This requires speed, expertise, and advanced technology.

5. Use of Leverage and Derivatives

Many hedge funds borrow money to increase their investment capacity, which amplifies both gains and losses. They also use derivatives like options and futures to make strategic bets or hedge risks.

Because of this wide range of strategies, hedge funds can generate impressive returns during favourable conditions. However, these methods also bring significant risk, especially when leverage is involved.

Higher Fees and the Famous ‘2 and 20’ Model

One of the most distinctive aspects of hedge funds is their fee structure. Unlike mutual funds, which usually charge a simple management fee, hedge funds often follow the “2 and 20” model:

2% Management Fee: Charged on the total amount managed, regardless of performance.

20% Performance Fee: Charged on the profits earned beyond a certain benchmark or threshold.

This structure incentivises fund managers to aggressively seek profits, as they earn a part of the upside. However, it also makes hedge funds significantly more expensive than regular investment vehicles. For investors, this means they need strong returns just to offset the high fees.

Liquidity: Why Hedge Funds Are Less Flexible

Another important characteristic of hedge funds is limited liquidity. Unlike mutual funds, which allow investors to redeem units daily or weekly, hedge funds often impose lock-in periods ranging from a few months to several years. During this time, investors cannot withdraw their capital.

This is because hedge fund strategies often involve long-term commitments or illiquid assets. Limited liquidity allows managers to execute their strategies without disruption.

While this makes hedge funds more stable from an operational perspective, it also means investors need to be comfortable leaving their money locked away for extended periods.