I always see hedge funds getting trashed on news programs, etc. and they get ridiculed on reddit
I love this question because I see this all the time and so many people have no clue what they're talking about. I'm an Alternative Investment (Hedge Fund) Auditor for a Big 4 accounting firm, and almost all of my clients are hedge funds located in New York. My job is to literally get up in their shit, scrutinize the shit out of their financial reports, and make sure that they are running a legit operation (and that their financial statements are free from error or material misstatement, blah blah). Needless to say, I know A LOT about hedge funds. Let me try and answer your question.
I want to know what exactly a hedge fund does/how they work, and how they make so much money
I'm going to assume that you know what a fund is, and there are other comments in this thread that describe them well in ELI5 language. A hedge fund is fundamentally just a type of fund, and operates the same way as other types of funds (such as mutual funds or private equity funds, they all work the same). You invest money in, a fund manager makes investments with your money which has been pooled with all the other investor's cash, and your investment's value goes up or down depending on the funds performance. So, there are a few different characteristics which distinguish hedge funds, many of which provide the foundation for answering why a lot of people have a negative perception of them. Here are some of the big ones (I'll try to keep it as ELI5 as possible):
You have to be what's known as an 'sophisticated investor' to even be allowed to invest in a hedge fund. What that means is you have to either be a. extremely loaded or b have enough money to spare to make the minimum investment and have sufficient experience and knowledge to be able to know what your getting into. Hedge Funds usually have a minimum investment of $1-2 million. Smaller ones don't take anything less than $500,000. Every now and then I see smaller investments, which are probably from people close to fund's employees such as friends and family. But for the most part, you have to have a lot of money laying around to even be allowed to invest in a hedge fund. In case you were wondering what 'extremely loaded' actually is, you have to either have $1 mil in the bank, or you need to have made $200,000 a year for the last 2 years and expect to make the same this year. And they are trying to raise it.
There is a reason you have to be rich or knowledgable in order to invest in a hedge fund. When it comes to what they can do with invested cash, their activity is largely unregulated. Owners must still do the proper 'paperwork' and everything required for running an investment company and investment funds. But there is little regulation on what a hedge fund can buy with investor money; they can buy pretty much anything they want.
The term hedge in hedge fund is dates back pretty far, and is not completely accurate in describing what they actually do. 'Hedging' means to lessen the risk of losing money, but a big allure of hedge funds today is their high risk-high return strategies. While many still use traditional hedging techniques in part of their portfolio, they still take advantage of the lack of regulation that exists. They could do anything, even invest in a restaurant if they wanted to. But what you mostly see these days is the use of derivatives.