The Average Investor's Guide To Hedge Funds

Hedge funds, especially those run by prominent investors, get a lot of attention, and not just because investors want to invest in them. Those who don't have enough money to actually invest in hedge funds may see what stocks they buy to get ideas about where to invest. 

Difficulties investing in hedge funds

The biggest issue with investing in hedge funds for the average investor is the fact that they require a high minimum investment, usually of at least $500,000 or $1 million. Additionally, only accredited investors can invest in hedge funds, which means most average investors won't be able to buy into one. 

To be accredited in the U.S., investors must either have a minimum net worth of $1 million, excluding their primary residence, or income of at least $200,000 for the last two years. If married, accredited investors must have $300,000 in combined income for the last two years. They must also expect to make the same amount of money each year in future years. 

If you meet one of these requirements, you should check with your financial advisor to find out what else you need to do to become an accredited investor. This will enable you to invest in hedge funds if you desire to do so. 

Paying fees

It's also important to realize that investing in hedge funds comes with high fees. The typical fee structure is known as "2 and 20," which means a 2% management fee for handling assets and a 20% performance fee that's charged on any profits made on the investment.

The 2% management fee goes to support operations at the hedge fund. It pays salaries and general expenses to fund operations. The 20% performance fee pays bonuses to portfolio managers and key executives to reward any gains they make on your investment. The performance fee is generally only charged if the profits exceed a certain amount, with this amount varying from fund to fund. 

Not all hedge funds follow this same fee structure, however. There has been a growing competitive trend within the industry, so some funds have been undercutting the typical 2 and 20 structure. 

An alternative to hedge funds

If you aren't an accredited investor or can't yet afford the minimum buy-in charged by most hedge funds, there are other options that offer diversification and performance with lower fees. Passive funds like exchange-traded funds can be a good alternative for the average investor. They track a major index like the S&P 500, which means you don't have to pay high fees for someone to manage the fund. 

Studies show that investors who opt for ETFs instead of hedge funds are in good company. Greenwich Associates and IndexIQ released a study in November which showed that institutional investors were increasingly opting for ETFs rather than hedge funds. 

The study suggests institutional assets invested in liquid alternative ETFs are due to rise two and a half times, climbing to $114 billion from $47 billion. Public pension funds were most of the institutional investors that were included in the survey. Corporate pensions were the second-largest segment. Like hedge funds, many investors watch to see what pension funds invest in for clues about where they should put their money.

By Michelle Jones of Valuewalk

Michelle Jones was a television news producer for eight years. She produced the morning news programs for the NBC affiliates in Evansville, Indiana and Huntsville, Alabama and spent a short time at the CBS affiliate in Huntsville. She has experience as a writer and public relations expert for a wide variety of businesses. Michelle has been with ValueWalk since 2012 and is now our editor-in-chief. Email her at Mjones@valuewalk.com.