A hedge fund is a pooled investment fund that holds liquid assets and that makes use of complex trading and risk management techniques to improve investment performance and insulate returns from market risk. Among these portfolio techniques are short selling and the use of leverage and derivative instruments.
While most modern hedge funds are able to employ a wide variety of financial instruments and risk management techniques,[5] they can be very different from each other with respect to their strategies, risks, volatility and expected return profile. It is common for hedge fund investment strategies to aim to achieve a positive return on investment regardless of whether markets are rising or falling ('absolute return').
Hedge funds are considered alternative investments. Their ability to use leverage and more complex investment techniques distinguishes them from others. Other than a fund's regulatory status, there are no formal or fixed definitions of fund types, and so there are different views of what can constitute a 'hedge fund'.
A hedge fund usually pays its investment manager a management fee (typically, 2% per annum of the net asset value of the fund) and a performance fee (typically, 20% of the increase in the fund's net asset value during a year). Hedge funds have existed for many decades and have become increasingly popular. They have now grown to be a substantial portion of the asset management industry, with assets totaling around $3.8 trillion as of 2021.[7] Hedge fund managers can have several billion dollars of assets under management (AUM).
Hedge fund strategies are generally classified among four major categories: global macro, directional, event-driven, and relative value (arbitrage). Strategies within these categories each entail characteristic risk and return profiles. A fund may employ a single strategy or multiple strategies for flexibility, risk management, or diversification. The hedge fund's prospectus, also known as an offering memorandum, offers potential investors information about key aspects of the fund, including the fund's investment strategy, investment type, and leverage limit.
The elements contributing to a hedge fund strategy include the hedge fund's approach to the market, the particular instrument use, the market sector the fund specializes in (e.g., healthcare), the method used to select investments, and the amount of diversification within the fund. There are a variety of market approaches to different asset classes, including equity, fixed income, commodity, and currency. Instruments used include equities, fixed income, futures, options, and swaps. Strategies can be divided into those in which investments can be selected by managers, known as 'discretionary/qualitative', or those in which investments are selected using a computerized system, known as 'systematic/quantitative'. The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager, or a combination.
Sometimes hedge fund strategies are described as 'absolute return' and are classified as either 'market neutral' or 'directional'. Market neutral funds have less correlation to overall market performance by 'neutralizing' the effect of market swings whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.