Hedge Funds - A Complete Institutional Reference

By EC Assets Research Team, Institutional Research · Published 14 May 2026 · Updated 16 October 2026

Hedge Funds: Hedge funds are actively managed investment vehicles for qualified investors, structured to use techniques unavailable to regulated long-only funds - short selling, leverage, derivatives, concentrated positions, and illiquid investments.

What Hedge Funds Are

The term goes back to Alfred Winslow Jones, whose fund, founded in 1949, combined long positions in stocks he expected to rise with short positions in stocks he expected to fall, hedging part of the market's direction. It was organised as a private partnership for a small number of investors and charged a 20 percent share of profits, a structure that has outlasted the original strategy.

Today the definition is structural rather than strategic. Hedge funds are privately offered pooled vehicles that may short sell, use leverage and derivatives, hold concentrated or illiquid positions and charge performance fees. In the US they generally rely on exemptions from registration under the Investment Company Act of 1940; in the EU and UK their managers are regulated under the alternative investment fund managers regime. Access is limited to investors who meet wealth or professional thresholds.

How It Works

The label covers strategies with little in common: long/short equity, market-neutral and statistical arbitrage, event-driven investing, relative value, discretionary global macro, systematic managed futures and multi-strategy platforms. Their return drivers, leverage, liquidity and risks differ more than those of many traditional asset classes.

Fung and Hsieh (1997) showed that hedge fund returns cannot be explained by standard asset-class exposures alone: many strategies behave like dynamic trading strategies with option-like payoffs, such as trend following resembling a long position in lookback straddles. Fung and Hsieh (2004) proposed benchmarks built from such risk factors, which separate exposures that could be replicated cheaply from returns that cannot.

Most funds use a master-feeder structure: an onshore partnership for taxable investors and an offshore corporate feeder for tax-exempt and non-US investors both invest in a single master fund that holds the portfolio. Large investors sometimes use separately managed accounts instead, gaining transparency and control at the cost of more operational work.

Fees, usually a management fee plus a performance fee above a high-water mark, take a substantial share of gross returns; the hedge fund fees entry works through the arithmetic.

Worked Example

The relevant question for an allocator is what a fund adds to an existing portfolio. A useful rule says that adding a small position in a fund raises the portfolio's Sharpe ratio if the fund's Sharpe ratio exceeds its correlation with the portfolio times the portfolio's Sharpe ratio.

Take an equity portfolio with an expected excess return of 5 percent and volatility of 16 percent, a Sharpe ratio of 0.3125. Fund C has an excess return of 4 percent, volatility of 8 percent and zero correlation, a Sharpe ratio of 0.50. Fund D has 6 percent, 10 percent and a correlation of 0.9, a Sharpe ratio of 0.60.

Hypothetical funds; returns are net of fees and in excess of cash.

Fund D has the higher standalone Sharpe ratio, but fund C improves the portfolio more, because 0.50 - 0 × 0.3125 = 0.50 exceeds 0.60 - 0.9 × 0.3125 ≈ 0.32. The ratio bench compares other combinations.

When It Applies (and Limitations)

Index returns are biased. Reporting to hedge fund databases is voluntary. Brown, Goetzmann and Ibbotson (1999) and Malkiel and Saha (2005) document survivorship bias, from failed funds that stop reporting, and backfill bias, from funds that add their good early history when they join.

Reported risk can be too low. Funds holding illiquid assets report smoothed returns. Getmansky, Lo and Makarov (2004) show that the resulting serial correlation understates volatility and correlation with markets.

Correlations rise in stress. Many strategies that look diversifying in calm markets lose with equities in crises, because they share leverage, liquidity and crowding risks.

Liquidity terms bind. Lock-ups, notice periods and gates mean that capital cannot always be withdrawn when needed.

Why It Matters for Institutional Investors

Diversification, not beating equities. The institutional case rests on returns with low correlation to the rest of the portfolio and access to strategies that require shorting, leverage or specialised skill, not on hedge funds outperforming equities in a rising market.

Manager dispersion. Results differ widely between managers in the same strategy, and skill, where it exists, is scarce and capacity-constrained. Manager selection and sizing matter as much as strategy choice.

Operational due diligence. Many hedge fund failures had warning signs in their operations rather than their strategies: valuation done by the manager, weak or unknown auditors, missing independent administration. Robust fund operations are a precondition for any allocation.

Cheaper substitutes for part of the return. Alternative risk premia products and hedge fund replication strategies offer exposure to systematic return sources, such as carry, trend or merger arbitrage, at lower fees. They set a benchmark that a fund charging full fees should beat.

Fees and terms. Fees, liquidity terms, transparency and capacity rights are negotiated, and they decide how much of a fund's gross return reaches the investor.

References

1. Fung, W., & Hsieh, D. A. (1997). Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds. Review of Financial Studies, 10(2), 275-302.
2. Fung, W., & Hsieh, D. A. (2004). Hedge Fund Benchmarks: A Risk-Based Approach. Financial Analysts Journal, 60(5), 65-80.
3. Brown, S. J., Goetzmann, W. N., & Ibbotson, R. G. (1999). Offshore Hedge Funds: Survival and Performance, 1989-95. Journal of Business, 72(1), 91-117.
4. Malkiel, B. G., & Saha, A. (2005). Hedge Funds: Risk and Return. Financial Analysts Journal, 61(6), 80-88.
5. Getmansky, M., Lo, A. W., & Makarov, I. (2004). An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns. Journal of Financial Economics, 74(3), 529-609.