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What are the Risks and Rewards of Investing in a Hedge Fund?

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As we grow older, finding financially smart ways to handle our money becomes more important than ever. Investments like hedge funds are key in helping your wealth grow and be even more successful than you had imagined. But, is a hedge fund worth it?

Like all investments, hedge funds do have both risks and rewards that are crucial to look into before you make your final decision. For everything, you’d need to know about hedge funds and their risks and rewards, keep on reading.

What is a Hedge Fund?

Let’s start with the basics. What even is a hedge fund? When we talk about hedge funds, we’re referring to a type of investment partnership that utilizes pooled funds to allow for more flexible, aggressive investing.

While mutual funds are investments offered to the public for daily trading opportunities, hedge funds are special investments that are only available to the most accredited investors. That lets you know that hedge funds really mean business.

In general, hedge funds are known for having a bit more risk associated with them than other investment strategies, but with high risk can come high reward, as well. Below, we’re talking about both the risks and rewards of this private investment partners to help you easily see the pros and cons.

Hedge Fund Risks

To get you prepared for what you might face if you invest in hedge funds, we’ve listed out the primary risks involved with these types of investments. Whether these are worth it or not are up to you; we’re just trying to show you both sides of this unique investment opportunity.

Fees

If you’re investing in hedge funds, be prepared to pay a lot of fees. Both expense ratios and performance fees tend to be much higher than the average of 2% and 20%. With hedge funds being so exclusive, they’re assuming that you already have the wealth needed to pay these extra fees and such.

Again, because these are private investments, hedge fund managers essentially have free reign to charge what they want to charge, making them the most money possible.

While it is normal for a hedge fund manager to receive 2% of the asset as well as 20% of total profit, these managers can easily choose to wave asset fees and charge much higher performance cuts. Essentially, they have the ability to control how much money they’ll take from your overall profit.

If you’re willing to accept these higher fees when you make money, then that’s perfect. But, if you’re someone who isn’t sure they can accept this kind of risk and high-payments, hedge funds might not be for you.

High-Risk

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In general, hedge funds are considered to be high-risk investments because of the huge potential for money loss. Again, these funds are primarily controlled by hedge funds managers, and with pools of money going into investments, there is likely going to be some loss. Some experience huge money losses through hedge funds because of the concentrated strategy, while others experience huge gains.

Compared to other investments, particularly due to the privatization of it all, hedge funds are definitely going to put your money at higher risks. If this is a risk you’re willing to take, then you’re perfect for a hedge fund. But, if you can’t risk having the future of your money so up in the air like that, there are other investments for you.

Locks Up Funds

With hedge funds, you’ll likely experience a longer lock-up period in between investing and actually making money. Lock-up periods are typically utilized so the hedge fund manager can quickly rid any investments that aren’t making the profit they’re hoping for. Unfortunately, this time period can actually take months to go through, leaving you without your money for between one and three months.

Hedge fund managers also may require that the money stay locked up for even longer. Some have reported their money in lock-up periods for years. For those who want to see their profit and their hard work pay off quickly, hedge funds may not be the best choice. You have to be quite patient.

Less Liquidity

When buying stocks or investing money, you want to ensure that you’re investing in companies that have adequate liquidity. Otherwise, you’re never going to make money. Unfortunately, hedge funds are known to have less liquidity than other investment strategies. Without the guarantee that these stocks can turn around and make money without influencing stock price too much, you’re sitting at high-risk.

Investments that have good liquidity have a good relationship with their buyers, having an equal bid-ask ratio. This is referring to the amount that customers want to pay for their stock (the bid) versus how much the company is actually willing to offer (ask). Hedge funds tend to have less liquidity as this relationship is not nearly as balanced as other investments might be.

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Hedge Fund Rewards

Of course, with high risk comes high reward. There’s a reason why people are still turning to hedge funds after all these years, and that reason is money. Hedge funds do offer some serious rewards that keep people coming back and using these tricky investments. Below are all of the greatest rewards you’ll find through hedge funds.

Provides Diversification

Hedge funds are great investments because they provide serious diversification within what you’re investing in. Most investments are stagnant and don’t offer an array of different investment markets– instead, you’re stuck with what you got. But, with hedge funds, this isn’t the case at all. Hedge funds provide a huge selection of different investment opportunities, like long/short, tactical trading, and even event-driven.

If you can properly utilize these diverse markets, you can actually lower your overall risk levels, too. With hedge funds, you’re able to diversify your portfolio almost immediately. There are so many different types of investments involved that it’s nearly impossible not to find diversification in your investment portfolio.

Flexible

The flexibility of hedge funds is primarily why so many people turn to them in the first place. As we mentioned, mutual funds are investments offered to the public, so they’re often subjected to much more scrutiny and regulation than other types of investments.

Hedge funds, on the other hand, are privatized investments so this regulation just simply doesn’t exist. The Securities and Exchange Commissions (SEC) hardly pay any attention to hedge funds in general.

Also as we mentioned above, hedge funds offer diversification. With this wide array of different types of investment opportunities offered within hedge funds, you also have much more flexible options as to which strategies you want to embrace. This makes investing a lot more interesting than through other, more public routes.

Transparent

A man looking on his cellphone screen that displays hedge fund graph.

With hedge funds, you experience a lot more transparency than you would with other public investors. Again, this is because you’re not trading through the public sector and, therefore, all of your information is disclosed and safe.

Hedge fund managers will be much more transparent about their companies, and you can easily take a look through their portfolio to see if this is an investor you want to partner with or not.

Any hedge fund managers that aren’t willing to disclose this kind of important information will actually be subjected to fees and penalties. To ensure that this doesn’t happen, on top of being fined, hedge fund experts have crafted basic transparency guidelines they expect their investors to follow.

Expert Advice

Finally, hedge funds are ideal because you’re dealing with the experts themselves. In public trading sectors, people are just kind of throwing their money places left and right without much regard for where it is actually going.

Hedge funds, however, are private and only allowed to be invested in by those with the most experience. This means that you’re working with only the best of the best to make money.

With hedge funds managers being so in-tune to the investment market, you can often turn to them for advice or tips on managing money. They’re some of the best people to go to, and they can give you accurate, helpful information about the private stock world you’re getting into.

You Decide

At the end of the day, it is up to you to decide where or not you want to invest in hedge funds. While all investments are risky, hedge funds are some of the riskiest. But, with this risk comes a huge chance for reward, diversification, and education. You just have to decide where or not those rewards outweigh the risks.

Do some more research, ask those who have invested, and start asking yourself whether or not you think it’s worth it. If it is, it’s time to start investing that money. In case you’re still a little unsure about all of this investment talk and what it means about your future, check out the rest of our blog to get even more helpful information.

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