What is a hedge fund, and how do they differ from a investment firm?

An investment bank (IB) acts as an intermediary between idle capital and businesses in need of capital. The IB takes a commission or a set fee for their analysis and placement services (which could include financial modeling, legal structuring, sourcing capital, etc.). These are transactional shops which are constantly sourcing capital and deals.

This is why it is called a "bank". Like the cash in your savings account, the bank takes your idle money and loans it out for mortgages, businesses, etc. The IB finds a home for idle money (on a larger and riskier scale).

A hedge fund, by contrast, is an ongoing investment fund which is managed. The management firm takes a fee and/or a percentage of the profits of the fund. Depending on the objective of the fund, a hedge fund might invest in certain business deals for which they may employ an investment bank.

Investment managers may manage hedge funds or mutual funds or any number of other investment vehicles. The hedge fund or mutual fund itself typically doesn't have employees. Instead, it pays a fee to the investment manager for managing the fund. When you hear someone say they work at a hedge fund, they really mean they work for an investment firm which manages hedge funds.

A hedge fund is different from a traditional fund in a number of ways, I will outline a few below.
First, they can "hedge" their investments, which is how they get their name. A traditional mutual fund can only "buy long" or own shares...a hedge fund has the ability to "go short" or sell shares that they do not own in a company that they believe will go down. As such, they are deemed a riskier class of investment that only "accredited investors" can purchase. An Accreddited Investor is an investor with either a high income, larger than average liquid net worth, or both.

Second, they are regulated differently than normal funds because they are only sold to accredited investors. They do not have the same scrutiny that a publicly traded mutual fund has, due to their intended audience.
Finally, their fee structure is very different than a traditional mutual fund. With a normal mutual fund, you might pay a manager 1% to have your money professionally managed, and that is all. If you you invest 100k, you will pay 1k a year to have your funds managed. If they go up in value to 105k, you will pay $1,050 the following year. Where a Hedge Fund is very different is that they usually charge "2 and 20." A 2% management fee, and 20% of the gain that is made in the fund. So if you give them 1 Million to manage, they charge 20k via a management fee. Further, if the fund makes 100 Million in gain that year, they hold back 20 Million for the fund managers and the fund itself. Again, very different concept than a traditional fund.

Hope that helps!

DS