Many may have heard the term “hedge fund” but may be unfamiliar with what hedge funds actually are, what sets them apart from other financial instruments, or how they are used to generate income for those who invest using this method.

Here is a basic overview of what hedge funds are and their essential defining characteristics.

Hedge Funds as Investment Tools
Hedge funds are primarily used as mechanisms to generate revenue based on investments provided by the “limited partners” and managed by the “managing partner” who controls where the money is placed. The managing partner is usually an experienced financial consultant with knowledge of the economy’s areas of growth and how to direct the fund’s money to capitalize.

These groups function as partnerships, wherein the limited partners (usually with sizable personal wealth) hand over investment control to the managing partner. If all goes well, every partner makes money off of the venture.

The Origins of the Hedge Fund
Writer Alfred Winslow is largely credited as the father of the hedge fund. In 1949, he built the foundation of the hedge fund by combining long/short equities trading, leveraging, and a newly created role for the managing partner with a financial incentive for the investments’ good performance.

Hedge Funds vs. Mutual Funds
As opposed to more conservative mutual funds, hedge fund managers are often more aggressive in their investment-making — relying on derivatives, for example, for greater returns.

Long/Short Stock Trading
The term “hedge fund” derives from the managing partner’s fiduciary responsibility to maximize growth in the portfolio regardless of the current state of the market. That’s where long vs. short trading comes in. If the partner foresees a market rise on a given stock, he or she will “long” it, meaning to hold onto the stock until it gains in value. “Shorting,” on the other hand, refers to dumping a stock in anticipation of its decline in value.

Long vs. shorting is as much of an art as it is a science; there is no guarantee that it will generate revenue as a hedge fund strategy – hence the inherently higher risk in hedge funds than mutual funds.

With the right leadership, hedge funds can be enormously profitable vehicles for investors to increase their wealth.