By Jen Saarbach & Kristen Kelly, Co-Founders of The Wall Street Skinny
This recent WSJ article caught our attention: after a decade of underperformance, hedge funds just had their best year since 2013. In 2025, per the article, the top decile of funds returned nearly 30%. According to Goldman Sachs, more institutional investors plan to increase hedge fund exposure in 2026 than ever before. For an industry that spent most of the 2010s stuck in what JPMorgan called an “alpha winter,” the comeback is real.
And so because of those headlines, we thought this was a great opportunity to break down: what is a hedge fund anyway?
You hear the term all the time, and most people think they know; I myself used to think it was the highest risk thing you could invest in. But the reality is there are so many different types of hedge funds with different strategies, not to mention pod shops where you have tons of strategies under one roof and new hybrids with private capital arms. If you ask someone to “define a hedge fund”, most people wouldn’t be able to so accurately.
We’re going to break it all down: what hedge funds are, why they exist, who invests in them and WHY, and we’ll cover the truth about fees.
Hedge Funds Aren’t Built to Beat the Market
Let’s start here. The goal of most hedge funds is not to outperform the S&P 500. It’s why I (Kristen) got a bee in my bonnet when I heard the dialogue on Industry where someone says to a short-only hedge fund manager, “your job isn’t to track the market, it’s to outperform it.” That isn’t necessarily true.
Actively managed mutual funds are designed to outperform the market. They are benchmarked against indices like the S&P or NASDAQ, and their job is to deliver performance relative to said index: ideally to beat it by a few points while staying tightly correlated to it.
Hedge funds, on the other hand, aim for absolute returns. That means generating positive returns regardless of what the broader market is doing.
Why does this matter? Because it changes the benchmark for success.
Instead of tracking alpha (excess return over a benchmark), hedge funds are often evaluated based on their Sharpe ratio, a measure of return per unit of risk. It’s calculated as:
(Fund return – Risk-free rate) / Volatility
A Sharpe ratio over 1.0 is generally considered strong. For reference, the long-term Sharpe ratio of the S&P 500 is around 0.3. Hedge funds aim to deliver smoother, more consistent returns, especially valuable in volatile markets or periods of dislocation, like we’ve seen in macro, healthcare, and tech lately.
In a huge year for the equity markets, they may not perform as well, but the value proposition is that in a down year, they are less down to up. Let’s explain why that second part is so important.
Tail Risk, Compounding, and Why Downside Protection Matters
There’s a compounding concept that Einstein supposedly called the 8th wonder of the world. Here’s how it works in practice:
If you invest $100 and lose 50%, you’re down to $50. To get back to breakeven, you don’t need to make 50%. You need to make 100%. That’s the math.
Which brings us to the real value proposition of hedge funds: protection on the downside. When markets go south, hedge funds are supposed to lose less. And in doing so, they preserve capital that doesn’t need to dig its way out of a hole. That’s what institutions like Yale’s endowment (with $40 billion AUM) are paying for when they allocate 15–20% of their portfolios to hedge funds.
You can think about it like this: would you rather be down 20% and then up 25%? Or down 5% and up 10%? The first path takes you from $100 → $80 → $100. The second path gets you from $100 → $95 → $104.5.
This is especially important when you think about “tail risk”: rare, but extreme losses that don’t follow a neat bell curve. The S&P has negative skew (fatter left tail), meaning large drops happen more often and more violently than the math might suggest. That’s where hedge funds are supposed to play a role in mitigating exposure to fat tails, especially in portfolios where the goal is resilience rather than returns.
Why are we hearing about hedge funds all over the financial press again?
Simple answer: the current environment favors them.
For most of the 2010s, we had zero interest rates, low volatility, and stocks moving in one direction. There wasn’t much room for differentiated strategies. But now, dispersion is back. Rates are higher. Macro trends are volatile. And hedge funds that make bets on relative value, volatility, interest rate moves, or asymmetric risk are once again showing up in performance.
In 2025, a composite of nearly 1,300 hedge funds returned 11.9%. Some funds returned much more. RTW’s biotech fund was up 55%, Atreides Management’s tech strategy gained 40%, and Chris Hohn’s TCI Fund Management delivered nearly 28%.
But even more notable is where the money is going: 45% of institutional investors plan to increase hedge fund allocations in 2026, outpacing private equity, private credit, and venture capital. It’s the strongest showing in Goldman’s survey since 2017.
The Truth about Fees
People also glibly ask, “why pay 2 and 20 for an investment that underperforms the S&P?” Well, you now know performance relative to the S&P isn’t the metric by which hedge funds look to be judged.
So what exactly is the fee structure?
Traditional Fee Structure: “2 and 20”
“2 and 20”, for those unfamiliar with the term, refers to a 2% management fee based on total AUM, and a 20% performance fee charged on profits. While these numbers were historically typical, this isn’t some universal fee structure chiseled in stone.
These days, the vast majority of hedge funds have a lower fee structure, partially due to their decline in popularity in prior years. Sometimes, a manager first has to exceed some hurdle rate (say, 6-8%) before they get to charge performance fees. We even recently covered rare “first loss arrangements”, where investors trade downside protection for even higher performance fees. And then we have “pod shops,” who charge much higher, yet more opaque, fees.
Pod Shop Fees
Pod shops like Millennium, Citadel, etc. employ a “pass-through” expense model for the investment team, meaning headline-grabbing PM pay packages (e.g. $100mm+ for top performers) are charged back to investors. These funds also typically have an either/or model, where you pay either:
- 1%+ management fee floor in years where performance is poor OR
- Performance fee = 20% of gains, net of expenses to management teams.
In years where you pay that 20% of gains, the performance fee is netted against investment team expenses, so investors are paying very high embedded fees. If you’re a Millennium (for example), who has returned ~14%+ annually net of fees since their inception in 1989, you can get away with this structure.
And then there is the most extreme case: the legendary Renaissance Technologies (“RenTech”), which charges a 5% management fee and a 44% performance fee!!! BUT, they’ve also maintained ~66% annualized returns before fees (39% after), and no one except people who work there can even invest.
TL/DR
The point is, fee structure is both a function of a hedge fund’s ability to provide certain exposure that an investor’s portfolio otherwise does not have access to and a reflection of investor demand. No one wants to invest with you? You cut your fees. You’ve got a line of investors around the block? Charge what you want.
At the end of the day, hedge funds aren’t all created equal and they don’t always beat the market. But many are not trying to. What they do offer (when done correctly) is exposure to specialized strategies, less correlation to the market, and better downside protection.
In a world where uncertainty, volatility, and dispersion are here to stay, hedge funds are apparently cool again.