Hedge funds aim to make money in both rising and falling stock market conditions, sometimes by using aggressive trading strategies and making speculative investing bets. Investors should consider whether they're comfortable with this level of risk, as well as high minimums and costly management fees, before investing in a hedge fund.
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Hedge fund definition
A hedge fund is a type of investment arrangement whereby a professional fund manager invests a pool of money contributed by a group of pre-qualified investors. Hedging involves using investment strategies designed to maximize investor returns while minimizing exposure to risk. To hedge, an investor or fund manager would make two investments that react in opposite ways — if one investment goes down, the other goes up, which reduces overall risk.
Mutual funds also invest pools of investor money. But mutual funds — which are standard offerings in workplace retirement plans and IRAs — are quite different from hedge funds. Comparing the two illustrates how hedge funds work.
Hedge funds vs. mutual funds
Like mutual funds, many hedge funds hold stocks and bonds. But they’re also allowed to invest in more speculative fare, like privately held businesses, bankrupt companies, art, currency and derivatives. Whereas the goal of a regular mutual fund is to beat the returns of the overall stock market or some portion of it, hedge funds aim to deliver absolute positive returns — meaning gains that aren’t tied to any particular benchmark — over time. Other differences include:
Stricter shareholder requirements
Mutual funds are open to all investors who can meet the minimum investment requirement, most often in the $100 to $2,500 range.
Hedge funds only accept a limited cadre of “accredited” investors, defined by federal law as someone who earned at least $200,000 (or $300,000 combined with a spouse) in each of the last two years and expects to continue to do so, or who has a net worth of $1 million or more, excluding the value of a primary residence.
That requirement and high investment minimums (typically $1 million and up) are to allow access only to more sophisticated investors who can handle a large financial loss.
Less regulation and transparency
Mutual funds are required to register with the Securities and Exchange Commission, making them subject to regulations. Most hedge funds are not, since they don’t advertise publicly, and they therefore aren’t subject to the same protections and disclosure requirements that apply to mutual funds.
This lack of transparency makes it more difficult for investors to verify a hedge fund’s claims and see exactly how their money is being invested. However, hedge fund investors are protected in case of fraud (such as Ponzi schemes). The SEC has sued hedge funds that have misrepresented investment returns, account statements and fund managers' track records.
Riskier trading strategies
Hedge fund managers have latitude to use more aggressive trading strategies than their mutual fund counterparts. They can make highly concentrated bets by investing the fund’s capital in just a few assets, and they often use leverage, which involves borrowing money to make trades. Leverage can amplify returns and losses.
High performance-based fees
Both mutual funds and hedge funds charge an annual asset-based management fee — also known as an expense ratio or advisory fee. For mutual funds, that fee is usually between 0.25% and 1.5% of your investment in the fund per year.
Hedge fund investors also pay an additional performance-based incentive fee. A well-known setup is called “2 and 20,” where shareholders pay an annual fee of 2% of their investment in the fund and 20% of any year’s profit above a preset percentage. In recent years fees have come down and are now closer to 1.5% and 18%.
Mutual fund investors are allowed to cash out of their investment at any time.
Because hedge funds sometimes invest in illiquid assets, they often have lockup periods of several months to several years when redemptions are not permitted. Some hedge funds have loosened their lockup provisions, but they can still restrict access to your money by requiring investors to provide notice well in advance of any withdrawal.
There are better investments than a hedge fund
For the majority of people, investing in mutual funds is the way to go. Mutual funds provide the everyday investor access to a wide range of investment types and strategies for a much lower fees.
A good first stop is to invest in an index fund, a type of automated mutual fund that buys baskets of companies that represent certain broad stock market indexes. You can augment with higher-risk (and higher potential reward) mutual funds that concentrate on growth stocks or niche investments.
A brokerage account that offers a range of no-transaction-fee mutual funds, index funds and commission-free exchange-traded funds is easy to open. Many have a $0 account minimum (like our choice for best fund research and tools, TD Ameritrade), providing instant access to fund search tools and expert advice on picking mutual funds for your portfolio. (See our full list of the best brokers for mutual fund investors.)