What are hedge funds? How do hedge funds make money?

Where does the money that hedge funds make come from?

• We all know that hedge funds are trading against each other and against other banks. If there are so many hedge funds making money, or beating the market, there ought to be some one losing tons and tons money. Who are these people?

• Answer:

  There don't necessarily have to be any losers.  There is also nothing magical about hedge funds when it comes to making money.  Let's say that you buy 100 shares of AAPL at $500 and sell at $700.  You made $20,000 as an individual investor.  See to understand why that doesn't require anyone to lose money.  Now a hedge fund may do that same trade but at 1000X the scale and repeat similar trades several times a year.  Some markets, like currencies and futures, do have a zero-sum nature and so for every dollar gained there is a dollar lost within that market.  However, that doesn't mean that there is a company that is losing money year after year and still keeps at it.  These markets have some participants who are not profit maximizers.  For example, futures markets have participants (like a utility company) who are hedging other positions that they take in the underlying markets.  So if you have companies that participate in both the zero-sum and non-zero-sum markets, you can imagine a world where everyone is a net winner.  Also, central banks trade in the currency markets and are not trying to maximize profits.  Their mandate is to pursue a particular monetary policy for their country and they can do that while losing from their trading.  Finally, there are some strategies out there that are just bad and have negative expectation, but the point is that those are not required to explain why hedge funds can be profitable.