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.
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.
What’s an accredited investor?
To be considered an accredited investor, you must meet one of the following criteria set by the Securities and Exchange Commission (SEC):
- You earned over $200,000 in each of the last two years and expect the same for this year.
- You and your spouse earned over $300,000 in each of the last two years and expect the same for this year.
- You have a net worth of at least $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.
The SEC warns that hedge funds are not subject to the same regulations as other investments and urges investors to familiarize themselves with the risks before getting 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.
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. And for many years, the SEC’s Regulation D prohibited hedge funds from advertising themselves. While the SEC now allows hedge funds to advertise, 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 by requesting 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.
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.
- Index funds. Purchase a mutual fund or ETF that offers exposure to an entire sector or index.
Numerous investment platforms offer portfolio management services. Compare your options below.
Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.
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 numerous trading platforms to find the investment vehicle that best fits your financial goals.