Typically limited to accredited investors, these pooled investment vehicles offer the opportunity for sizable returns. But the trading strategies they use are riskier than most and require leverage, exposing investors to potentially devastating losses.
What is a hedge fund?
A hedge fund is a financial partnership between a group of investors and a professional fund manager. Investors pool their funds and the fund manager is responsible for monitoring the investments and generating returns.
Hedge funds earn their name from the hedging strategies fund managers use to pursue returns for their investors. These strategies — like going long or shorting stocks — can be effective but require leverage, contributing to higher risks for investors.
Hedge funds are typically limited to accredited investors and can be organized as a limited partnership or limited liability company.
How does it work?
Investors pool their money and the fund manager decides how to allocate the funds. If the fund is profitable — and there’s no guarantee it will be — investors receive a return after the fund manager takes their cut.
Outside the primary goal of maximizing returns, different types of hedge funds may pursue different types of goals. Some funds exclusively invest in real estate. Others are limited to private equity. It’s the hedge fund manager’s responsibility to communicate their preferred investment strategy to help potential investors decide whether they’d like to participate in the fund.
Hedge fund vs. mutual fund
Hedge funds and mutual funds have a few things in common. They both rely on pooled funds from a group of investors and are managed by a professional financial advisor. But that’s where the similarities end.
Hedge funds differ from mutual funds in that they typically rely on more assertive investment strategies. And while mutual funds tend to stick with stocks and bonds, hedge funds may dabble in stocks, derivatives, real estate, currencies and other alternative assets.
Hedge funds are also limited to accredited investors and are considered a private investment. Mutual funds, on the other hand, are available to the general public and can be accessed from a self-directed brokerage account.
In Canada, each province can technically establish its own policies for investor accreditation. However, people or organizations who meet any of the following criteria are typically considered accredited.
Individual accredited investors
Any individual who, either alone or with a spouse, has net assets of $5 million or more
Any individual whose net income before taxes over the last two years is over $200,000 (or over $300,000 with a spouse’s income). This individual must also reasonably expect to make over the income threshold in the current year.
Anyone who works professionally as an investment advisor
Anyone who regularly trades securities for others’ accounts (a “dealer” according to securities regulations)
Anyone who regularly trades securities for their own account, as long as those securities count as inventory for their regular business
Anyone who is registered as an agent of a professional investment advisor or stock trader
In Ontario, accredited investors also include any company, limited liability company, limited partnership, limited liability partnership, trust or estate with net assets of $5 million or more based on its most recently prepared financial statements. A mutual fund or non-redeemable investment fund can only have “accredited investor” status if it distributes securities to other accredited investors (either individuals or companies).
Organizations and entities as accredited investors
Investment funds advised by a registered advisor or someone who is exempt from registering as an advisor
Registered charities that have gotten investment advice from registered advisors
Trusts established by accredited investors for the benefit of their families (other conditions must also be met)
National, federal, provincial, territorial, state and municipal governments as well as their agencies
What’s an accredited investor in the United States?
To be considered an accredited investor in the US, you must meet one of the following criteria set by the US Securities and Exchange Commission (SEC):
You earned over USD $200,000 in each of the last two years and expect the same for this year.
You and your spouse earned over USD $300,000 in each of the last two years and expect the same for this year.
You have a net worth of at least USD $1 million, alone or together with your spouse, excluding the value of your primary residence.
Most hedge funds rely on the 20-2 fee structure: fund managers receive 2% of net assets annually alongside 20% of any profits the fund generates. The 20-2 fee structure is the industry standard, but has become increasingly criticized. With this fee structure, fund managers pocket 2% as an asset management fee, regardless of whether the fund is actually profitable.
The 20-2 fee structure is common, but there are others out there, too. The 20-1 setup is becoming more popular, reducing the fund manager’s asset management fee to 1% instead of 2%. Another approach is to eliminate the asset management fee entirely, but increase the fund manager’s profit cut to 25% — an incentive for the fund manager to pursue strong returns for all involved.
Leverage. Many hedge fund investment strategies require leverage — the use of borrowed money — to increase potential returns. But leverage can amplify losses, too. If things go south, an otherwise conservative investment could result in dramatic losses for all involved.
Conflict of interest. Because of how most hedge fund fee structures work, fund managers make money from investors even when the fund isn’t profitable. Fund managers have also been caught investing funds into companies they’re privately affiliated with. Thoroughly investigate your fund manager’s industry reputation and the fund’s history for any potential conflicts of interest.
Lock-up periods. Many hedge funds impose a lock-up period for new investors: a period of time in which you can’t cash in your shares in order to enforce commitment to the fund. Lock-up periods typically last one year or more.
Limited liquidity. In addition to lock-up periods, some hedge funds only allow investors to redeem shares monthly, quarterly or annually.
Redemption fees. You may be required to pay a redemption fee in order to access your funds. Most redemption fees range from 2% to 5% of withdrawn funds.
Suspended redemptions. In times of economic hardship, fund managers may reserve the right to suspend investor redemptions. This means you’ll be unable to access your money until the suspension is lifted.
Unqualified fund managers. It’s not unheard of for unqualified hedge fund managers to practice without registering with the SEC or state securities regulators. Carefully vet your fund manager’s credentials and reputation before signing up for a fund.
How to invest in a hedge fund
Interested in participating in a hedge fund? To get started:
Find a hedge fund. Hedge funds are private investment opportunities that are inaccessible by brokerage account or stock exchange. For many years, the SEC’s Regulation D prohibited US hedge funds from advertising themselves. While US hedge fund managers can now advertise themselves, many don’t. Spend some time researching available funds in your area.
Review the fund’s strategy. What types of assets does the fund invest in? Does the fund’s investment strategy correlate with your risk tolerance? Explore the fund’s holdings and investment vehicles and compare these to your short- and long-term investment goals.
Vet the fund manager. Make sure the fund manager holds the proper credentials. Check whether Canadian investment professionals are licensed on the Canadian Securities Administrators website. For Ontario investment advisors, check the Ontario Securities Commission website. For US hedge funds managers, request their Form ADV — a statement that confirms the fund manager has registered with state and federal regulatory authorities. You can also find this form on the SEC’s Investment Advisor Public Disclosure website. FINRA’s BrokerCheck can also be a useful tool for uncovering additional information about your fund manager.
Assess fees. Hedge fund managers charge asset management fees and take a cut of investor returns. Make sure you know where your money is going by asking how the fund’s fee structure works.
Ask about redemption timetables. You may need to commit your money to the fund for a year or longer in a preliminary lock-up period, or may only be allowed to redeem your shares on a strict timetable. Ask about potential lock-up periods and redemption timelines so you’re not blindsided by limited liquidity.
Confirm the fund’s eligibility criteria. Most hedge funds are only open to accredited investors, so find out what expectations your fund has of its investors and how you’ll be asked to document your accreditation status.
Setup your portfolio. Contact the fund to communicate your interest and fill out any application documentation required.
Transfer funds. Complete the process by transferring funds from an external account.
Alternatives to hedge funds
There are plenty of ways to passively grow your money outside of investing in a hedge fund. Here are some popular hedge fund alternatives:
Robo-advisors. Open an account with a robo-advisor for hands-off, algorithm-driven investment guidance.
Fiduciaries. Hire a fiduciary to help you select the ideal assets for your portfolio.
Managed portfolios. Sign up for a portfolio management service and leave your investments in the hands of a financial advisor.
Hedge funds present a potentially lucrative investment opportunity, but are typically limited to accredited investors and can be quite risky. Before you invest, explore your account options across different trading platforms to find the investment vehicle that best fits your financial goals.
Frequently asked questions
According to Hedge Fund Research, global hedge fund capital grew to $3.32 trillion in 2020.
In Canada, there are no formal educational requirements or certification standards to start a hedge fund. However, you must meet provincial/territorial registration requirements to handle securities and perform the types of investment services you’ll be performing as a hedge fund manager. This could mean becoming a licensed broker or investment advisor. Check with the securities commission in your province or territory to find out exactly what requirements apply to you.
In the US, the SEC allows hedge funds to accept up to 35 nonaccredited investors over the lifetime of the fund. But the decision to accept a nonaccredited investor is entirely at the fund manager’s discretion.
Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading CFDs and forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades.
Shannon Terrell is a senior writer for Finder who has written over 400 personal finance guides. With a focus on investments and personal finance, she breaks down jargon-laden topics to help others make informed financial decisions. She studied communications and English literature at the University of Toronto.
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