How to Invest in Hedge Funds

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Professional hedge fund managers consolidate investors’ money and then reinvest it in an effort to make positive returns. Most hedge funds seek to profit in various markets through aggressive trading strategies.

New investors can make a hedge fund investment, but it isn’t as simple as investing in an ETF or stock. Hedge funds are private investments and getting into one can be difficult. Hedge funds aren’t heavily regulated, involve speculative investing and costly management fees. They’re considered high-risk investments.

How to Start Investing in Hedge Funds

Investing in hedge funds is limited to a select few investors. A few critical components make hedge funds different from other pooled investments like mutual funds. Here are 2 main requirements you need to meet to start investing in hedge funds:

  • You must have earned an annual income of $200,000 (or $300,000 for a married couple) in each of the last 2 calendar years. This income should be greater or equal to that amount the year you apply to become an accredited investor.
  • You can also qualify by proving that your net worth is $1 million or more — that figure excludes your primary residence.

Most hedge funds are structured like limited partnerships, where the investors become limited partners. Typical hedge fund investors include wealthy individuals and pensions.

If you meet the criteria to become an accredited investor:

  • Vet the fund. Begin with a thorough review of the hedge fund you want to invest with. Pay more attention to its prospectus (the booklet that describes a financial security for prospective buyers) and marketing-related collateral. Understand the risk involved as well as how it fits your unique investment goals, needs and timetable. Avoid focusing entirely on a history of high returns — make a comprehensive risk evaluation before you decide on a hedge fund.
  • Know the fund’s assets. It’s important to know how many assets the fund holds. Usually, hedge funds hold investments that could be difficult to price and sell. A hedge fund manager could help you better understand the fund’s holdings.
  • Understand all fee obligations. Compared to mutual funds, hedge funds usually charge higher fees. Expect to pay anything between 1% – 2% of the total assets, in addition to a 20% performance fee, depending on the fund’s profit levels.
  • Familiarize yourself with your redeemable timelines. Hedge funds won’t allow you to redeem your shares at any time. Rather, you’re only allowed to redeem 4 times (or fewer) in a year. Hedge funds impose lockdown periods when you can’t access your money. Understand your fund’s share redemption timetable and whether it aligns with your future financial needs.
  • Know the hedge fund manager. One of the most important tasks you should undertake is to research the fund manager before you invest your money. Check the manager’s form ADV, which outlines all information regarding a fund. Learn about investment strategies, past disciplinary actions or any conflicts of interest.

Hedge Funds vs. Mutual Funds

Hedge funds vs. mutual funds? Which makes sense for you? Once you understand the basics, you can decide whether mutual funds or hedge funds are ideal for your personal investment objectives.

The Similarities

There are a few similarities between mutual funds and hedge funds:

  • Pooled investments: Both hedge funds and mutual funds are types of pooled investments, which means the assets comprise money from various investors consolidated into a single portfolio.
  • Diversification: Diversification means a fund is invested in several securities. Hedge funds and mutual funds are generally diversified but some funds concentrate on a specific security type or economic sector.
  • Professional portfolio management. Investors who put their money in mutual funds or hedge funds don’t choose which securities to invest in but instead a fund manager does it.

The Differences

Although both funds pool money from different investors with the aim of multiplying it, they have their differences. Here are the main differences between the two:

  • Accessibility: Hedge funds aren’t as available to the average investor as mutual funds. For instance, some hedge funds require investors to have $1 million in net worth. This is quite high compared to mutual funds which have a $100 minimum initial investment.
  • Regulation: Mutual funds are highly regulated by the SEC, but that’s not essentially the case for hedge funds which are loosely regulated.
  • Transparency: Mutual funds must annually publish their balance sheets/annual reports as well as the quarterly performance of their assets. Hedge funds, on the other hand, don’t disclose this information to the public but only provide it to their investors.
  • Redemption: It is relatively easier to redeem mutual funds since they are relatively less. Hedge funds have a lock-in period (typically 3 years) which makes redemption of funds difficult. 

Arguably the greatest benefit of investing with hedge funds is the potential to get steady returns that surpass inflation while still minimizing the market risks. Unfortunately, the average investor won’t possess a high net worth or meet the hedge fund minimum investments’ obligations.

For a majority of investors, a broad portfolio of exchange-traded funds (ETF) and mutual funds is a better investment choice compared to hedge funds. Mutual funds are cheaper and more accessible than hedge funds and the long-term returns could be equal or greater than those of hedge funds.

Hedge Fund Fees

Check out the fee structure before you choose a hedge fund. Hedge funds adhere to a common fee structure of 2 and 20 which implies a 2% management fee and a 20% incentive fee. With the 2 and 20 compensation structure, the 2% management fee is applied to all the assets that are under management while the 20% incentive/performance fee is charged on profits generated by the hedge fund, usually above a specific minimum threshold.

It is worth noting that the 2% management fee is usually charged on all assets under management irrespective of the investments’ performance under the manager.

Hedge Fund Minimum Investments

The individual or persons running the fund could set the hedge fund minimum investment at their discretion. And since there’s a limit to the number of investors who can be admitted under into the fund, they’ll want to make the minimum investment figure high. It’s quite common for new hedge funds to open up with minimum investments of between $100,000 and $500,000. The more established funds will have greater minimums; $25,000,000 isn’t unheard of. 

General partners could also waive the investment minimum to accommodate investors who are looking to make an investment that’s equal to or higher than the stipulated minimum over time, without starting so high.

Are Hedge Funds Safe Investments?

Hedge funds are very risky investments. Surprisingly, it’s the same risk that attracts many investors who believe that there are higher returns associated with higher risks. The 3 characteristics that let hedge funds promise higher rewards also make them incredibly risky.

First, the hedge fund managers receive a percentage of the hedge funds’ returns. But what happens when the fund loses money? Do they pay the hedge fund a fraction of the loss? Absolutely not. As a result, hedge fund fees structure makes managers highly risk tolerant. As a result, hedge funds could be very risky for investors, who could lose all the money they had put in the fund.

Secondly, hedge funds often invest in derivatives, which are risky due to leverage. Options ought to be delivered within a specific time frame. Should an unexpected economic event occur during that window, even if the manager was right about the long-term trend, all the investment could be lost.

While mutual funds are owned by public corporations, hedge funds traditionally were not regulated by SEC (Securities and Exchange Commission). A lack of regulation means that the fund’s earnings are not reported to SEC. And while funds are prohibited from fraud, the lack of oversight only creates more risks.

Should You Invest with Hedge Funds?

While there’s a good chance to double your money, you could easily lose each dollar as well. Unlike a business failure that results in asset liquidation to pay back the investors, hedge fund failures have no asset liquidation and could result in losses worth billions of dollars. If you’re a new investor, you’re better off starting with a low-risk investment offering more predictable returns. If you must invest in hedge funds, ensure you can afford to take on all the risks. And even if you qualify as an accredited investor, hedge funds might not align with your investment needs.

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