Hedge funds are more loosely regulated than traditional mutual funds and tend to invest in different types of securities. This can mean higher returns, but it can also mean higher fees and greater risk of loss.
Hedge funds are like mutual funds, except that they’re designed to increase potential returns and hedge against market losses by investing in a wider array of assets. Hedge funds don’t experience the same regulatory scrutiny as mutual funds. This gives their managers more room to operate and take risk. That might mean shorting stocks, making leveraged investments and betting on foreign currencies and commodities.
This is one reason why hedge funds are restricted to accredited investors. These are investors who have the resources to withstand high fees and (potentially) heavy asset declines.
At its very core, a hedge fund is fairly simple. An investment manager manages a pool of money for limited partners. Often the limited partners are members of a wealthy family or business partners.
One of the most important characteristics of hedge funds is concentration. Whereas a usual ETF usually replicates the performance of hundreds of securities (e.g., an S&P 500 ETF replicates the 500 stocks in the index), a hedge fund is much more concentrated in the hopes of outperforming. For instance, some of the more classic hedge funds will often only own 15-30 stocks, but do rigorous amounts of research in selecting them.
The term hedge fund derives from the ability of the fund to “hedge” its investments. Often times, a portfolio manager will bet against stocks in addition to buying them. For example, the manager may invest in Amazon while simultaneously betting against brick and mortar retailers.
Hedge fund managers also have the ability to “lock in” money for as long as several years. This ensures that the manager can properly manage the investments without investors pulling out of the fund.