How Do Hedge Funds Work? Structure, Strategies, Fees and Who Can Invest

At the end of 2025, 9,858 hedge funds reported to the SEC on Form PF, with $14.4 trillion of gross assets on $6.0 trillion of net assets. The gap between those two numbers is borrowed money and short positions, and it is the first clue to how hedge funds work. In its May 2026 Financial Stability Report the Federal Reserve said hedge fund leverage sat near all-time highs in the latest Form PF data. This guide is the map for our 13-part series on the hedge fund playbook: the structure, who gets in, how the money is financed and locked up, and the strategies each later article takes apart. If you want the short, investable version first, start with hedge fund strategies for retail investors.

What is a hedge fund?

A hedge fund is a private pool of capital that can use leverage, short selling and derivatives and is sold only to wealthy individuals and institutions. The SEC’s Investor.gov describes hedge funds as pursuing “more flexible investments and strategies” than mutual funds and ETFs, and notes that they are not subject to the rules that protect fund investors, such as daily redemption at net asset value (NAV), conflict-of-interest protections and limits on leverage.

There is no single legal definition, but Form PF gives a practical one. For SEC reporting, a private fund counts as a hedge fund if any one of three things is true: the manager can earn a performance fee that takes unrealized gains into account; the fund can borrow more than half its NAV or run gross notional exposure above twice its NAV; or it can sell short. So “hedge fund” describes a legal wrapper and a toolset, not a promise to hedge. Some funds are far more volatile than the stock market; others are built to have almost no market exposure at all.

The industry is big and top-heavy. The ten largest hedge funds held 19.8% of all hedge fund gross assets in the fourth quarter of 2025, and the top 100 held 50.1%, according to the SEC’s Private Fund Statistics. The investors behind them are mostly institutions: in qualifying hedge funds (those with $500 million or more of net assets), other private funds owned 20.6% of NAV, non-profits 13.8%, US individuals 11.8% and state and municipal pension plans 11.0%.

How is a hedge fund structured: LP, GP and the service providers?

A typical US hedge fund is a limited partnership in which investors are limited partners and a general partner controls the fund. The general partner is usually affiliated with the investment management company that employs the portfolio managers and collects the fees.

• The fund. Usually a Delaware limited partnership or LLC. Managers that raise money from non-US and US tax-exempt investors often add an offshore company and run both through a master fund, the master-feeder structure. Because the fund is a partnership, US investors get a Schedule K-1 rather than a 1099.
• General partner and manager. The GP has legal control; the management company makes the investment decisions. Most sizable managers register with the SEC as investment advisers and file Form ADV.
• Prime broker. Lends cash and securities, executes and clears trades, and reports positions. More on its role below.
• Administrator. An independent firm that calculates NAV, processes subscriptions and redemptions and keeps the investor register, so the manager isn’t marking its own homework.
• Custodian and auditor. SEC-registered advisers must keep client assets with a qualified custodian. A fund can satisfy part of the custody rule by having an independent public accountant audit its financial statements and sending them to investors within 120 days of its fiscal year-end, under 17 CFR 275.206(4)-2.

How do hedge funds make money?

Hedge funds make money for investors by earning returns that don’t depend only on the market going up, and for managers by charging fees on both assets and profits. Those are two different businesses, and you should evaluate them separately.

For investors, returns come from three sources. The first is security selection: being long the stocks or bonds that do better and short the ones that do worse, as in long/short equity. The second is spreads: buying one asset and selling a closely related one when the gap between them looks too wide, as in statistical arbitrage or the Treasury basis trade. Spreads are small, so funds borrow to make them worth the effort. The third is directional bets on macro trends in rates, currencies and commodities, run by discretionary traders or by trend-following models.

Leverage is what turns small edges into meaningful returns, and it varies enormously by strategy. Here is the NAV-weighted average leverage of qualifying hedge funds in the fourth quarter of 2025:

For the manager, the money comes from fees. Investor.gov says hedge fund investors “typically pay an asset management fee of 1–2% of NAV” plus a performance fee of 15–20% of profits, often subject to a high-water mark and a hurdle rate. On a big fund, the management fee alone is a large, steady business; the performance fee is the upside. Our guide to hedge fund fees and 2 and 20 shows how much of a gross return those fees absorb.

Who can invest in hedge funds?

Only investors who meet the SEC’s wealth tests: accredited investors, and for many larger funds qualified purchasers. The limits come from how the fund avoids registering as an investment company.

• Section 3(c)(1) funds can have no more than 100 beneficial owners and cannot make a public offering. In practice they admit accredited investors: individuals with net worth over $1 million excluding their primary residence, or income over $200,000 ($300,000 with a spouse or partner) in each of the past two years, or holders of certain securities licenses.
• Section 3(c)(7) funds must be owned exclusively by qualified purchasers: generally individuals with at least $5 million in investments, or entities investing at least $25 million on a discretionary basis. In exchange there is no 100-owner cap, which is why the largest funds use this exemption.

The tests matter if much of your wealth is in company stock: vested shares count toward net worth and investments, so many senior tech employees qualify on paper long before they have diversified. Our qualified purchaser guide walks through what counts.

What does a hedge fund prime broker do?

A prime broker is the bank that finances, clears and holds a hedge fund’s positions. It lends cash against long positions, borrows stock for the fund to sell short, settles trades executed through many brokers, and produces consolidated reports.

It is also one of the two main sources of hedge fund leverage. In December 2025, qualifying hedge funds reported $7.5 trillion of borrowings: $3.4 trillion through reverse repo (mostly financing Treasury and other bond positions), $3.2 trillion from prime brokers, $0.8 trillion of other secured borrowing and less than $0.1 trillion unsecured. Across all hedge funds, borrowings equaled 54.7% of gross assets. The lender sets the margin on each position and can raise it, which is why a funding squeeze can force a fund to sell even when its views haven’t changed. That is the mechanism behind degrossing episodes and crowded-trade unwinds, and why gross versus net exposure is the first number risk managers watch.

How do hedge fund lockups, gates and redemptions work?

You put money in on set subscription dates and can take it out only on set redemption dates, after notice, and often not at all during an initial lockup. Investor.gov says hedge funds typically limit redemptions to four times a year or fewer, often impose a lockup of one year or more, may charge a redemption fee, and may suspend redemptions in stressed markets.

The SEC’s Form PF data shows why. Qualifying hedge funds estimated they could liquidate 33.6% of their portfolios within a day and 76.2% within a year. But only 6.5% of investor capital could be withdrawn within a day, and 58.6% within a year. The gap is a buffer: it lets a manager hold positions through a drawdown instead of selling into it to meet withdrawals.

The fund documents also give the manager tools to slow withdrawals further. At the end of 2025, qualifying hedge funds with $3.3 trillion of net assets had the right to suspend redemptions, and funds with $2.1 trillion could impose gates. In practice the tools were little used: $128 billion was actually gated, $21 billion suspended and $113 billion held in side pockets, separate accounts for hard-to-value assets that investors can’t redeem until they are sold.

How are hedge funds regulated, and what do they disclose?

Hedge funds are exempt from the Investment Company Act’s registration rules, but most of their managers are regulated advisers. That means lighter disclosure to the public but substantial confidential reporting to regulators.

• Form ADV. The adviser’s registration form. Part 1 covers ownership, clients and disciplinary history; Part 2 is a plain-English brochure on fees and conflicts. Both are public on the SEC’s Investment Adviser Public Disclosure site.
• Form PF. A confidential report on fund size, leverage, liquidity and counterparties. Only SEC-registered advisers with at least $150 million of private fund assets file it; those with $1.5 billion or more of hedge fund assets report in more detail. The SEC publishes only aggregates, which is where every industry number in this article comes from.
• Form 13F. Managers with $100 million or more of US-listed equities disclose their long holdings quarterly, with a lag; see 13F filings explained.
• Offering documents. What you actually sign: a private placement memorandum, the partnership agreement and a subscription agreement. Fees, lockups, gates, side pockets and key-person terms all live here.

Anti-fraud rules apply in full, and the manager owes the fund a fiduciary duty. What you don’t get is a mutual fund’s daily liquidity, leverage limits and standardized reporting; our hedge fund vs mutual fund comparison lines them up rule by rule.

Which strategies do hedge funds use?

Hedge fund strategies fall into a handful of families that differ mainly in leverage and in how tied they are to the stock market. Each has its own article in this series.

1. Equity long/short. The largest family by assets: $1.6 trillion of qualifying-fund NAV. Funds buy stocks they like and short ones they don’t; see long/short equity and the risk dials in gross vs net exposure.
2. Quantitative relative value. Models trade baskets of related stocks back toward historical relationships; see statistical arbitrage.
3. Event driven. Bets on corporate events: merger arbitrage on announced deals, and activism, spin-offs and distressed debt in event-driven investing.
4. Fixed income and convertible relative value. The most leveraged family. Convertible arbitrage buys convertible bonds and shorts the stock; Treasury basis and swap-spread trades sit here too.
5. Global macro. Positions in rates, currencies, commodities and indexes based on economic views; see global macro.
6. Managed futures. Systematic trend following in futures markets; see managed futures and how those funds behaved in 2022’s crisis alpha.
7. Multi-strategy platforms. Many teams under one roof with central risk control and pass-through costs; see multi-strategy hedge funds.

Before any of the strategy pages, read the two cost-and-wrapper pieces: 2 and 20 fees and hedge fund vs mutual fund. If you can’t or don’t want to invest in a private fund, liquid alternative ETFs package several of these strategies in daily-liquid funds. To watch what the big funds are doing from the outside, the companion series starts at institutional money flow.

How does $1 million move through a hedge fund in a year?

Here is one illustrative year for a $1 million investment in a 2 and 20 fund with quarterly liquidity and a one-year lockup. The terms are typical of those Investor.gov describes; the returns are made up to show the mechanics.

Two things stand out. Fees took almost a third of the gain in a good year. And the money is not yours to move at will: from step 1 to step 7 you are a partner in someone else’s book.

What does the hedge fund playbook mean if your wealth is in one stock?

It means you can use the risk discipline without buying the fund. If most of your net worth sits in your employer’s stock, you already run a highly concentrated, single-name, long-only book, the exact position a hedge fund risk manager would cut first.

Three habits transfer directly. First, measure exposure before returns: know your net dollar exposure to one stock and one sector, the way a fund tracks gross and net exposure. Second, hedge the tail rather than predict it: protective puts and collars on concentrated stock do what a fund’s short book does, at a known cost and without a taxable sale. Third, earn carry on positions you already hold: selling covered calls above prices where you would be glad to trim turns a static position into an income stream, much as relative value funds harvest small spreads. Proflex’s options-income work is built on those three habits, applied to the mega-cap tech stocks our readers tend to own.

What doesn’t transfer is the leverage. Hedge funds borrow because their spreads are small and diversified across many positions; an individual with one large stock position has the opposite problem. For tactics you can run in your own account, see how to hedge a stock portfolio with options.

What should you check before investing in a hedge fund?

1. Confirm your status: accredited investor or qualified purchaser, and which one the fund requires.
2. Read the private placement memorandum and partnership agreement, not only the pitch deck.
3. Write down the fee terms: management fee, performance fee, high-water mark, hurdle and any pass-through expenses.
4. Map the liquidity: lockup length, redemption frequency, notice period, gates, side pockets and audit holdback.
5. Check the manager’s Form ADV for conflicts, disciplinary history and assets under management.
6. Ask who the prime broker, administrator, custodian and auditor are, and confirm the administrator is independent.
7. Understand the leverage: typical gross and net exposure, and how financing is secured.
8. Plan for K-1 timing at tax season and size the commitment so you never need to redeem early.

Frequently asked questions

Key takeaways

1. A hedge fund is a private partnership that can use leverage, shorts and derivatives; it trades investor protections for flexibility.
2. Access is limited to accredited investors or qualified purchasers, and a 3(c)(1) fund can have no more than 100 beneficial owners.
3. Managers earn a management fee plus a performance fee, typically 1–2% and 15–20% per Investor.gov.
4. Leverage is concentrated in relative value and macro funds: gross-to-net assets averaged 9.7x and 7.9x in Q4 2025, versus 1.9x for equity funds.
5. Large funds could sell a third of their portfolios in a day but let investors withdraw only 6.5% that fast; lockups and gates are the design, not a bug.
6. Prime brokers and repo lenders supply the leverage, so funding conditions can force hedge funds to sell at the worst time.
7. You can borrow the playbook without the fund: hedge concentrated stock, size by risk, and harvest option premium with rules.

Sources and method

1. SEC Division of Investment Management, Private Fund Statistics, Q4 2025 — fund counts, assets, borrowing, liquidity, gates and leverage by strategy from Form PF
2. SEC Investor.gov, Hedge Funds — definition, eligibility, fees, lockups, redemption limits
3. Federal Reserve, Financial Stability Report, May 2026: Leverage in the Financial Sector — hedge fund leverage near record highs, Q3 2025
4. 15 U.S.C. §80a-3 (Investment Company Act §3(c)(1) and (c)(7)) — the 100-owner and qualified purchaser exclusions
5. 15 U.S.C. §80a-2(a)(51) — qualified purchaser definition: $5 million / $25 million of investments
6. SEC, Accredited Investors — income and net worth tests
7. SEC Investor.gov, Form ADV — adviser registration and brochure disclosure
8. 17 CFR §275.206(4)-2 (custody rule) — qualified custodian and audited statements within 120 days
9. SEC, Frequently Asked Questions About Form 13F — 13F threshold and filing lag

Industry figures are from the SEC’s Private Fund Statistics for the fourth quarter of 2025 (Form PF and Form ADV data received through July 3, 2026). “Qualifying hedge funds” are funds with at least $500 million of net assets advised by advisers with at least $1.5 billion of hedge fund assets. Strategy leverage is the NAV-weighted average ratio of gross to net assets; a fund is assigned a strategy when more than half of its assets follow it, otherwise multi-strategy. The worked example and Chart 1 are illustrative Proflex constructions; the fees in the example use the 2% and 20% upper end of the Investor.gov ranges. Chart 3’s exposure and liquidity columns are Proflex judgments.