How exactly do most hedge funds make money?

Now one thing to note about hedge funds is that there is hedge funds and hedge funds. There really are companies that seem to deliver risk weighted superior returns beyond statistical fluke. But they probably don't even want you as their customer (Jim Simmons Renaissance Technologies is probably the most famous super fund). Running a hedge fund is not cheap as compliance requriements etc.etc. have started popping up, so some companies really have earned the 20% incentive fee anon user mentioned. But there is a huge bunch of funds that call themselves hedge funds but are in reality only in the business of what in laymans terms could be called "lottery ticket selling". They make highly leveraged "safe derivative bets", and seem to make spectacular returns until something surprising happens and they blow up. This is a kin of selling lottery tickets where there is a 10 000 tickets at 100 dollars each. The grand prize is  at 1 000 000 USD. If you sold five tickets a day, you would most likely look like a really fantastic businessman for years until someone gets the winning ticket and you have to pay up the million (we saw this just a couple of years ago with an umber of managers). Few standard risk measures really work for such tail risks, one has to know what one buys.

Let's assume you run a hedge fund. Let's assume you have one client. This client gives you some money on January 1 every year, and then they ask for their money back on December 31 every year. During the year, you use the client's money to bet on stocks going up and down. 1) In a year where your bets are right, you take 20% of the profit, and the client gets 80% of the profit. 1a) Correctly bet that stock A is going to go up. Buy low. Wait. Sell high. Profit. 1b) Correctly bet that stock B is going to go down. Borrow stock. Sell high the same day. Wait. Buy low. Return borrowed stock the same day. Profit. 2) In a year where your bets are wrong, you give 0% of the loss, and the client gives 100% of the loss. Heads, you win 20%, tails you lose 0%. (Of course, this is a simplified first approximation, and is only meant to give a general idea of how hedge funds make money to someone who has no idea how hedge funds make money. This simplification is not correct in several respects. Real hedge funds differ from this first approximation, and differ from each other.)

Hedge funds are just investment vehicles for the savvy and sophisticated investors. Thus they are unregulated. They have huge membership fee and commission structured and take a hefty cut from the returns they provide their investors. If you're asking how do they generate those returns, that's another story altogether.

Typically hedge funds make money from two things. Management fee and performance fee. The management fee is a fixed yearly fee for managing client assets, stated as a percentage of those assets. Although fees are coming down, the typical fee used to be a yearly 2% of assets under management. The performance fee is where the bulk of the money is made. That's a percentage charge from all profits. Some funds have a hurdle, for instance that they only charge of excess return over risk free or over a certain yearly percentage. Normally a high water mark is employed, so that you only charge a performance fee on new highs, not for recovering old losses. The industry standard for many years has been to charge a performance fee of 20% of profits. If you're asking how the returns to investors are created, that's a whole different story and a much more complicated one. But to answer the question of how we make money; we charge a management fee and a performance fee.

They buy low, and sell high, "low" and "high" being "relative to each other". It doesn't matter what - baseball cards, equities, guitars, real estate - just that they are profitable in doing it, and can repeat the process both on a longer-term basis and with a scalable strategy that can be replicated as easily with $10 million as with $10 billion.

I'm surprised no one has talked about the elephant in the room -- insider trading. If one looks at many of the most successful pure fundamental hedge fund investors, what they'll find is a ton of insider trading.  The ability to go long short doesn't really help from a return perspective and if anything is more likely to lead to underperforming the market. The unregulated nature of hedge funds allows them to obsfucate risks, catching the upside and leaving investors with the bag on the downside. Go read Cliff Asness's paper on how hedge funds manipulate their financial reporting data to make their sharpe ratios look much better than they actually are. http://faculty.chicagobooth.edu/john.cochrane/teaching/35150_advanced_investments/asness_crail_liew_hedge_funds_hedge_JPM.pdf The fee structure, 2% management fee + 20% return fee is ginormous. No one is providing an above market return after those fees consistently every year following the rules. It's simply too big of a hurdle to surpass without cheating. I'm only speaking to the fundamental hedge funds. The quantitative hedge funds are a different space.