A hedge fund is a private investment vehicle typically open to only a very limited range of qualified investors. In the United States, hedge funds are open to accredited investors only. Because of this restriction, they are usually exempt from any direct regulation by the SEC, NASD and other regulatory bodies. Because they are largely unregulated, hedge funds are free of the restrictions that keep most mutual funds from investing in non-traditional strategies like selling short and investing in complicated derivatives.
However, hedge funds typically become subject to greater regulation once they have more than a small number of investors, so they are generally limited to a few very wealthy individuals.
A hedge fund manager receives a significant portion of its compensation from incentive fees tied to the fund's performance - typically 20 percent of annual gains over a certain hurdle rate, along with a management fee equal to 2 percent of assets (often referred to as "two-and-twenty"). The funds, often organized as limited partnerships, typically invest on behalf of high-net-worth individuals and institutions.
Their primary objective is often to preserve investors' capital by taking positions whose returns are not closely correlated to those of the broader financial markets. Such vehicles may employ leverage, short sales, a variety of derivatives and other hedging techniques to reduce risk and increase returns.