Whether you are an experienced investor trying to diversify your portfolio or a novice, just starting and trying to get your feet wet in the world of investments, you have likely heard of a hedge fund.
Named after the practice of “hedging” or holding on to both long and short stocks to ensure a profit in spite of market fluctuations, hedge funds have developed a number of different structures. These are based upon the goals of the fund’s investors, and the hedge fund manager’s strategies.
Are you wondering if investing in a hedge fund is a smart move for you? Read on to learn more about hedge funds, how to invest in them, the risks and possible rewards so you can take a step toward a more informed decision.
What Is A Hedge Fund?
Just because you’ve heard of a hedge fund, doesn’t mean you know exactly what it is. A hedge fund is an investment strategy in which a pool of investors places their money in the care of a hedge fund manager. The manager then invests the money in a way that is meant t maximize returns while minimizing risks.
The investment strategy should be made clear to the investor pool prior to handing over any money. The places the money is invested can vary wildly from stocks and bonds to art and real estate. Hedge funds will often try to increase returns by leveraging other funds.
There are fees associated with hedge funds, usually taking on the 2 and 20 structure, which in simple terms means the manager gets 2 percent of the assets in addition to 20% of the profit annually.
There are several different types of hedge funds, which are described by their investment strategy. We will go into more detail about those a little later.
Who Can Invest In a Hedge Fund?
Due to the high risk and decreased regulations, hedge funds are almost solely reserved for the wealthy. The minimum investments in the majority of hedge funds are between $100k to $1 million. To invest in a hedge fund you must be what is known as an “accredited” investor.
An accredited investor must meet one of the following criteria
- Have an annual income of $200k for singles or $300k if married
- Have a net worth of $1 million
- Be an executive involved in the hedge fund
- Have a trust fund worth $5 million
There are occasions when a non-accredited investor may be allowed to invest. Hedge-funds are allowed to accept up to 35 non-accredited investors, per government regulations. The majority of these positions are given to people who are personally connected to the hedge fund manager.
Unless you have a large amount in savings and are personally connected to a hedge fund manager, the majority of hedge funds are inaccessible to the average person. If you don’t qualify to invest in a hedge fund, don’t be discouraged. There are other investment opportunities out there that may be suitable for you, such as mutual funds.
How Do You Find Hedge Funds To Invest In?
The internet has made it easy to search out investment opportunities. However, you don’t want to be caught in a financially devastating investment scam. Well known investment firms that manage hedge funds include JP Morgan Asset Management, Bridgewater and Associates, and Renaissance technologies.
Before you can decide on a hedge fund to invest in, you need to be educated on the different types of hedge funds you may come across. The type of fund you invest in will have an impact on the risk you are taking on by investing in a hedge fund.
- Macro Hedge Fund- These funds invest in futures, stocks, and bonds. They rely on interest rates, global trade, and other macroeconomic variables to provide a return on investment. These tend to be the riskiest funds hedge funds to invest in despite being highly diversified.
- Equity (long/short) Hedge Funds- These protect against a sharp drop in equity by investing in stocks and immediately selling them if they prove to be overvalued. They may also split the investment by purchasing stocks that are undervalued and putting some money in long stocks while shorting others.
- Relative Value Arbitrage Hedge Funds- These hedge funds by securities that are predicted to appreciate, while shorting stocks from similar companies that will most likely depreciate.
- Distressed Hedge Funds- These take advantage of restructurings and loan payouts. They purchase securities that have a chance of appreciating and bonds that appear to be undervalued. This hedge fund poses a risk since these may not appreciate as predicted.
How To Invest In a Hedge Fund
Are you a qualified investor? Have you heard of a hedge fund that sparked your interest? Before you crack open your wallet, make sure you do your due diligence.
- Review the fund. Discuss the possible risks with your financial advisor, to help you determine if it meets your goals and your investment criteria.
- Find out the hedge funds holdings. The diverse spread of hedge fund investments, and can make it hard to determine the actual value of the holdings.
- Don’t neglect to ask about the fees. Hedge funds often expect you to pay between 1%-2% of total assets, in addition to a 20% fee based on the profits of the fund.
- Know when your funds are redeemable. There are limits to how many times you are able to redeem your funds per year, as well as lockdown periods where you are not able to redeem your money at all. If you need ready access to your money, you may want to consider a different investment strategy.
- Learn about the hedge fund manager. Find out if there has been any disciplinary action against them. Look into their investment strategy, and research any possible conflicts of interest.
- Find out the initial required investment. As mentioned this is usually anywhere from $100K to $1 million or more.
If you still feel this hedge fund is right for you, you will need to contact the hedge fund managers to find out if there is still room for you to invest. If you can invest, know that your initial investment will be locked up.
The initial lock-up period will vary by the hedge fund but is generally a year. For more advice on investing in hedge funds check out smartasset.
Hedge Fund Risks and Rewards
If you are in a position to invest in a hedge fund, the rewards can definitely be worthwhile. They can be extremely profitable, and hedge fund managers are experienced at finding the best ways to diversify the investment while taking advantage of the different directions the market might take.
The diversity of hedge funds can mitigate some of the risks associated with various investment strategies used by hedge fund managers.
There are definitely some caveats to investing in hedge funds. Very few hedge funds produce long term returns, averaging around 6.1% annually.
Since your funds are locked in for a set period of time, you will not have access to your capital which is problematic if you suddenly need access to funds. While the returns can be staggering, so can the losses.
Since the market can go unexpected directions based on unseen foreseen circumstances, you are in a position to quickly lose your capital should things not go as predicted.
You may also face unanticipated tax consequences. The tax structure for hedge funds can be complicated, and you may be forced to file extensions if you do not receive the tax information in time.
Perhaps the biggest risk is the lack of oversight involved in investing in hedge funds. Many of the protections offered by the SEC are absent when investing in hedge funds, making the chances of fraud higher than one would typically see if investing in more traditional ways (finra.org).
In spite of the risks, 80% of investors who have put their money into hedge funds have stated they plan to increase their investments into hedge funds, because of the long-term returns. This is according to a survey done in 2018 by Preqin.
For those who are able, investing in hedge funds can be worth all the risks. For the regular person, the barrier to entry may be too high, and the risks may not be worth the returns.
The amount of capital required upfront, combined with the income requirements means that hedge funds are, for the most part, an investment tool for the wealthy, the experienced investor, and corporations.
If you find you are interested in finding a way to invest in a hedge fund, talk to your financial planner, or asset manager. If you do not have one and you are interested in beginning to make investments, now is the time to find one. Not certain exactly how they can benefit you? Take a look at this article.
For those that are interested in investing, but know that investing in a hedge fund is not a realistic prospect, there are many other investment strategies available. These have much lower requirements to invest.
Mutual funds, which can be managed using a hands-on or hands-off approach, shares, and many other strategies are accessible to the average person or the beginning investor.