In 1949, Alfred Winslow Jones and four friends started a fund with $100,000. Jones bought shares he expected to rise. He also bet against shares he expected to fall, so a falling market would hurt the fund less. That protection is a hedge, which gave this kind of fund its name.
Hedge funds around the world managed $5.6 trillion at the end of June 2026, according to the data firm Hedge Fund Research (HFR). Here is how a hedge fund is set up, what it charges, who can invest and how it differs from a mutual fund or an index fund.
What is a hedge fund? A hedge fund is a private investment fund for wealthy and professional investors. It can bet on falling prices as well as rising ones, borrow to invest more and charge a share of its gains.
The classic fee is "2 and 20": 2% of the money each year plus 20% of the gains. The 20% is charged on the gain left after the 2%. So if $1 million earns 10% before fees, the fund takes $36,000 of the $100,000 gain.
In the US, investors usually must be accredited, for example with a net worth over $1 million, not counting their home. In the UK, hedge funds can be promoted only to professional investors and to certified wealthy or experienced individuals.
Average fees are now below 2 and 20. HFR put them at 1.32% a year plus 15.78% of gains in early 2026.
What is a hedge fund?
The US Securities and Exchange Commission (SEC) notes that the term has no agreed definition. A 2003 SEC staff report describes a pool of investments that is not sold to the public and not registered as a fund under US law.
The name comes from Jones. His fund used two tools that hedge funds still use:
Short selling. The fund sells borrowed shares, hoping to buy them back later at a lower price. It profits if the price falls.
Borrowing. The fund borrows money to invest more than it has. Gains and losses both grow.
Today, a hedge fund may or may not hedge, the SEC report notes. Hedge funds also trade bonds, currencies, futures and other contracts.
In April 1966, Fortune magazine reported that Jones's fund had gained 670% over the ten years to May 1965. The best mutual fund that ran through the whole decade, the Dreyfus Fund, gained 358%.
How a hedge fund is set up
A US hedge fund is usually a limited partnership, according to the SEC report. That means two kinds of partner:
The general partner runs the fund. This is usually the manager's own firm, which also acts as the fund's investment adviser.
The limited partners are the investors. They put in money but take no part in running the fund.
A limited partnership agreement sets out each side's rights, the fees and when investors can take money out. Many managers also run an offshore version of the fund, based outside the US, for foreign investors and US investors who pay no tax, such as pension funds.
So what do hedge fund managers do? They choose the investments, trade, borrow and manage the fund's risk. Banks lend them money and shares. Banks also settle their trades.
Hedge fund fees: how 2 and 20 works
Hedge funds charge two fees. The management fee is a yearly share of the money invested, typically 1% to 2%, according to the SEC's investor website. The performance fee is a share of the gains, typically 15% to 20%. "2 and 20" is the top of that range.
The table shows 2 and 20 on $1 million over one year. The management fee is 2% of the starting $1 million. The performance fee is 20% of what is left of the gain after the management fee.
Return before fees | Gain before fees | Management fee (2%) | Performance fee (20%) | Investor's gain after fees |
|---|---|---|---|---|
−10% | −$100,000 | $20,000 | $0 | −$120,000 (−12.0%) |
0% | $0 | $20,000 | $0 | −$20,000 (−2.0%) |
10% | $100,000 | $20,000 | $16,000 | $64,000 (6.4%) |
20% | $200,000 | $20,000 | $36,000 | $144,000 (14.4%) |
Source: YX Insights
At a 10% return before fees, the fund takes $36,000. That is 36% of the $100,000 gain. In a flat or losing year, the investor still pays the $20,000 management fee.
A high-water mark protects investors from paying twice for the same gains. The fund charges a performance fee only once an investor's money is above its previous high.
After the −10% year in the table, $1 million has fallen to $880,000. A 10% gain the next year takes it to $950,400 after the management fee. That is still below $1 million, so no performance fee is due.
Fees have come down. In the first quarter of 2026, the average management fee was 1.32% and the average performance fee 15.78%, according to HFR.
Hedge fund strategies
Source: HFR; YX Insights
The chart shows how much money each of HFR's four main strategies managed at the end of June 2026:
Equity Hedge: owns some shares and bets against others. It was the largest, with $1.76 trillion, or 31% of the total.
Event-Driven: trades around company events, such as takeovers, bankruptcies and new share issues.
Relative Value: bets that the price gap between two related investments, often bonds, will close.
Macro: trades interest rates, currencies, commodities and share indices, based on views about the economy. It was the smallest, at $0.86 trillion.
Some managers decide by judgement, while others follow written rules. See Systematic vs Discretionary Investing and What Is Rules-Based Investing?
Hedge fund vs mutual fund vs index fund
A mutual fund pools money from the public. An index fund is a mutual fund or exchange-traded fund (ETF) that copies a market index, such as the S&P 500 index of large US companies. We explain it in What Is an Index Fund?
Source: HFR; Investment Company Institute; State Street; YX Insights
The chart shows one year's fees on $1 million, with the investments returning 10% before fees. A 2 and 20 hedge fund takes $36,000. At the average hedge fund fees, it takes $26,897.
The average actively managed share mutual fund charged 0.64% a year in 2025, according to the Investment Company Institute (ICI), the US fund industry body. That is $6,400 on $1 million. SPY (the S&P 500 ETF) charges 0.0945% a year, which is $945.
Mutual funds must let investors cash in daily, according to the SEC. They also face limits on borrowing and rules on what they disclose. Hedge funds do not.
Hedge funds typically let investors take money out four times a year or less, according to the SEC's investor website. Many also start with a lock-up. That is a period, often a year or more, when money cannot be taken out.
We compare mutual funds and ETFs in Mutual Fund vs ETF.
Who can invest in a hedge fund?
In the US, hedge funds are sold privately. Investors usually must be accredited investors under SEC rules. An individual qualifies with either of these:
Income over $200,000 in each of the past two years, or $300,000 with a spouse or partner.
Net worth over $1 million, not counting the main home.
Holders of some professional licences also qualify. Some funds require a higher test, called qualified purchaser status.
In the UK, the Financial Conduct Authority (FCA) sets the rules. A hedge fund that is not authorised for sale to the public is an unregulated collective investment scheme. The law bars firms from promoting these to the general public.
FCA rules allow some exceptions. These include professional clients and individuals certified as high net worth or as sophisticated investors. Since 27 March 2024, high net worth means income of £100,000 or more, or net assets of £250,000 or more.
Hedge fund risks
Hedge funds carry risks that index funds do not:
Borrowing. Borrowed money makes losses bigger, as well as gains.
Lock-ups. You may not be able to get your money back when you want it.
Less disclosure. Hedge funds are not bound by the disclosure rules that apply to mutual funds.
Returns after fees. Higher fees need higher returns to pay for them. In the first half of 2026, HFR's main index of more than 1,000 hedge funds gained 7.5% after fees. Over the same months, SPY returned 10.1% with dividends counted.
How to read a hedge fund's terms
A few checks help:
The fees. Check both fees and whether a high-water mark applies.
The exit terms. Check how often you can take money out. Check any lock-up too.
The comparison. Set the return after fees against a low-cost index fund over the same years.
A hedge fund is a private partnership that can bet against prices and borrow to invest. It is open only to wealthy and professional investors. Its fees are many times those of an index fund, so its return after fees is the number to judge it by.
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Common questions about hedge funds
What does a hedge fund do?
A hedge fund pools money from wealthy and professional investors and invests it with few limits. It can bet on prices falling through short selling, borrow to invest more and trade bonds, currencies and commodities. Hedge funds managed $5.6 trillion worldwide at the end of June 2026, according to HFR.
What do hedge fund managers do?
Hedge fund managers choose the fund's investments, trade, borrow and manage its risk. In a US fund set up as a limited partnership, the manager's firm is usually the general partner and investment adviser. The manager is paid a yearly fee on the money plus a share of the gains, classically 2% and 20%.
What is the difference between a hedge fund and asset management?
Asset management is the wider business of investing money for clients. An asset manager can run mutual funds, ETFs and hedge funds. A hedge fund is one type of fund: private, open only to wealthy investors and free to bet against prices.
What does 2 and 20 mean?
"2 and 20" is the classic hedge fund fee: 2% of the money invested each year, plus 20% of the gains. The 20% is charged on the gain left after the 2%. On $1 million that earns 10% before fees, the fund takes $36,000. The investor keeps $64,000. HFR put average fees at 1.32% plus 15.78% of gains in early 2026.
Can anyone invest in a hedge fund?
No. In the US, investors usually must be accredited, with income over $200,000 in each of the past two years or a net worth over $1 million, not counting their home. In the UK, promotion is limited to professional clients and to certified high net worth or sophisticated investors.
DISCLAIMER: This article is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.