Investment banking vs hedge funds: what is the difference?

A hedge fund is a private pool of money, open only to wealthy and institutional backers, that trades in securities and other assets for a management fee and a share of the gains. An investment bank is the firm on the other side of those trades, and the firm that advises companies on deals. The bank is an agent and a market-maker; the fund is a principal that lives or dies by its own positions.

What a hedge fund is

The defining characteristic of a hedge fund is that it can take both long and short positions, use leverage and use derivatives; it is usually organised as a limited partnership in which the backers are limited partners and the manager is the general partner with discretion over the strategy[1Source 1K. Thomas Liaw, The Business of Investment Banking: A Comprehensive Overview, 3rd ed. (Wiley, 2011), “Hedge Funds”, p. 291.]. The name comes from the fund usually credited as the first, in 1949, which hedged assets it expected to rise with short sales of assets it expected to fall, removing the market’s overall movement; most funds that carry the name today are not hedged in that sense[2Source 2David P. Stowell, Investment Banks, Hedge Funds, and Private Equity, 3rd ed. (Academic Press, 2017), ch. 11, “Overview of Hedge Funds”, p. 242.]. Because they raise money only from accredited backers rather than the public, they are exempt from much of the regulation that governs mutual funds[3Source 3David P. Stowell, Investment Banks, Hedge Funds, and Private Equity, 3rd ed. (Academic Press, 2017), ch. 11, “Overview of Hedge Funds”, pp. 242–243.], and can pursue almost any strategy: long and short equity, distressed securities, merger arbitrage, convertible and fixed-income arbitrage, global macro and more[4Source 4John C. Hull, Risk Management and Financial Institutions, 6th ed. (Wiley, 2023), ch. 4, summary, pp. 94–95.].

The fee is the famous “2 and 20”: a management fee of around two percent of net asset value and a performance fee of around twenty percent of the increase, a structure much higher than most money managers’ and matched only by private equity[2Source 2David P. Stowell, Investment Banks, Hedge Funds, and Private Equity, 3rd ed. (Academic Press, 2017), ch. 11, “Overview of Hedge Funds”, p. 242.]. The performance fee is calculated on the value of the assets, so it can be paid on gains that have not yet been realised; a private equity firm’s equivalent share arrives only when an investment is sold[5Source 5John Gilligan and Mike Wright, Private Equity Demystified: An Explanatory Guide, 4th ed. (Oxford University Press, 2020), “What are Hedge Funds and How Do They Differ from Private Equity Funds?”, pp. 66–67.].

What the trading floor does for it

Hedge funds are among the large institutional clients of a bank’s sales and tradingInvestment banking vs sales and trading: what is the difference?The investment banking division advises companies on deals; the sales and trading division buys and sells securities for big funds. Two floors, two jobs.One field against another · revised 28 September 2026 · 806 words · 7 sources · 4 min division, which serves them with ideas, execution, financing for their positions and liquidity through market-making, and earns fees, commissions, interest and spreads for it[6Source 6David P. Stowell, Investment Banks, Hedge Funds, and Private Equity, 3rd ed. (Academic Press, 2017), ch. 5, “Sales and Trading”, pp. 118–120.]. The bank’s prime brokerage business finances and services a fund’s trading[6Source 6David P. Stowell, Investment Banks, Hedge Funds, and Private Equity, 3rd ed. (Academic Press, 2017), ch. 5, “Sales and Trading”, pp. 118–120.]. Banks have also sponsored alternative funds of their own, hedge funds included (a 2008 guide says all of them did), though the Volcker rule has since limited bank sponsorship of, and investment in, hedge funds[7Source 7Michel Fleuriet, Investment Banking Explained: An Insider’s Guide to the Industry (McGraw-Hill, 2008), “Alternative Investments and the Strategy of Investment Banks”.][8Source 8K. Thomas Liaw, The Business of Investment Banking, 3rd ed. (Wiley, 2011), “Volcker Rule”, pp. 7–9.]. So the relationship is customer and supplier: the fund trades, the bank executes and lends. On the banking side the contact is less direct: the investment banking division advises companies rather than funds, though hedge funds do take part in mergers and acquisitions[1Source 1K. Thomas Liaw, The Business of Investment Banking: A Comprehensive Overview, 3rd ed. (Wiley, 2011), “Hedge Funds”, p. 291.].

Hedge fund against private equity

Students often lump hedge funds with private equity as “the buy side”, and the textbooks draw the line carefully. Both are private pools that charge high fees and are lightly regulated. But hedge funds generally invest in relatively liquid assets and take minority positions, long and short, across many kinds of asset, while private equity funds typically buy entire companies and hold them for three to seven years[9Source 9David P. Stowell, Investment Banks, Hedge Funds, and Private Equity, 3rd ed. (Academic Press, 2017), ch. 11, “Comparison with Private Equity Funds and Mutual Funds”, pp. 260–261.]. A guide to private equity adds the structural differences: a private equity fund is a closed commitment for a fixed term that cannot suffer a run, while a hedge fund is open-ended, lets its backers withdraw subject to lock-ups, often borrows inside the fund, and can therefore fail[5Source 5John Gilligan and Mike Wright, Private Equity Demystified: An Explanatory Guide, 4th ed. (Oxford University Press, 2020), “What are Hedge Funds and How Do They Differ from Private Equity Funds?”, pp. 66–67.]. The two overlap most in distressed investing, where a private equity fund tends to take control of a troubled company and restructure it and a hedge fund tends to trade its securities for a quick resale[10Source 10Giuliano Iannotta, Investment Banking: A Guide to Underwriting and Advisory Services (Springer, 2010), §2.1, “Definitions”.].

Careers

Hedge funds hire from the banks’ analyst classes, among other places; one textbook lists them among the destinations of departing analysts[11Source 11K. Thomas Liaw, The Business of Investment Banking, 3rd ed. (Wiley, 2011), “Investment Banking Financial Analysts”, pp. 52–53.]. The work is investing rather than advising, and the pay is tied to the fund’s results rather than to fees earned on deals, which is why a risk-management textbook notes that a hedge fund manager’s incentive resembles a call option on the fund’s assets and can encourage taking large risks[4Source 4John C. Hull, Risk Management and Financial Institutions, 6th ed. (Wiley, 2023), ch. 4, summary, pp. 94–95.].

Frequently asked questions

Is a hedge fund a type of investment bank?

No. A hedge fund is a private investment partnership that trades for its backers; a bank is a regulated firm that advises companies, underwrites securities and makes markets, and hedge funds are among its trading clients[1Source 1K. Thomas Liaw, The Business of Investment Banking: A Comprehensive Overview, 3rd ed. (Wiley, 2011), “Hedge Funds”, p. 291.][6Source 6David P. Stowell, Investment Banks, Hedge Funds, and Private Equity, 3rd ed. (Academic Press, 2017), ch. 5, “Sales and Trading”, pp. 118–120.].

What does “2 and 20” mean?

A management fee of about two percent of the fund’s assets each year plus a performance fee of about twenty percent of the gains, the fee structure two textbooks give as typical of hedge funds and of private equity[2Source 2David P. Stowell, Investment Banks, Hedge Funds, and Private Equity, 3rd ed. (Academic Press, 2017), ch. 11, “Overview of Hedge Funds”, p. 242.][4Source 4John C. Hull, Risk Management and Financial Institutions, 6th ed. (Wiley, 2023), ch. 4, summary, pp. 94–95.].

How is a hedge fund different from private equity?

A hedge fund trades liquid securities, often long and short, in an open-ended fund that backers can leave; a private equity fund buys whole companies with a closed fund for a fixed term and holds them for years[9Source 9David P. Stowell, Investment Banks, Hedge Funds, and Private Equity, 3rd ed. (Academic Press, 2017), ch. 11, “Comparison with Private Equity Funds and Mutual Funds”, pp. 260–261.][5Source 5John Gilligan and Mike Wright, Private Equity Demystified: An Explanatory Guide, 4th ed. (Oxford University Press, 2020), “What are Hedge Funds and How Do They Differ from Private Equity Funds?”, pp. 66–67.].

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  author       = {{xlsx.dev}},
  title        = {{Investment banking vs hedge funds: what is the difference?}},
  howpublished = {xlsx.dev Wiki},
  year         = {2026},
  month        = sep,
  url          = {https://xlsx.dev/wiki/investment-banking-vs-hedge-funds}
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