What exactly is a hedge fund? My favorite definition was provided by Cliff Asness, one of the founding partners of the hedge fund AQR:
Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred-year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.1
This definition is humorous precisely because it is true, or at least more true than most hedge fund managers would care to admit.
There is no absolutely precise definition of a hedge fund because they are so heterogeneous. Most definitions focus on hedge fund structure and fee arrangement rather than the composition of the investments. Perhaps the best way to get a basic understanding of hedge funds is to compare their primary characteristics with the plain-vanilla investment structure of long-only mutual funds.
The following are the essential differences between mutual funds and hedge funds: