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This guide seeks to help accredited investors understand hedge funds and start the conversation about whether they might have a place in an investor’s portfolio. This article covers:
What is a hedge fund?
A hedge fund is a type of investment in which a professional fund manager invests a pool of money for accredited investors, with the goal of maximizing returns and minimizing risk. To achieve this, hedge fund managers attempt to make money in both rising and falling stock market conditions, sometimes by using aggressive trading strategies and making speculative investing bets.
This type of active management comes with a considerable level of risk, so investors should consider whether they're comfortable with this approach before investing. Hedge funds also tend to have higher minimums and costlier management fees than other types of investments.
How hedge funds differ from mutual funds
Mutual funds also invest pools of investor money. But mutual funds are quite different from hedge funds.
Like mutual funds, many hedge funds hold stocks and bonds. But they’re also allowed to invest in more speculative fare, such as private equity, 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.
To understand how hedge funds work, we’ll compare them with their more approachable cousin, mutual funds:
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 accept only 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,” in which 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.
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Hedge fund strategies
To hedge, an investor or fund manager makes two investments that react in opposite ways — if one investment goes down, the other goes up, which reduces overall risk.
One example of this that often makes headlines is the “short.” Hedge funds may short a stock if they think the price is going to fall in the near future, and continue to hold stocks they think will keep performing well. This is known as an equity long/short strategy.
To profit from a drop in the stock price, the hedge fund may borrow shares from a financial institution, then immediately sell them. If the stock price falls, the fund uses the proceeds from the sale to buy the stock back at the lower price, return the borrowed shares and keep the difference in price as profit. (Learn more about how shorting a stock works.)
Hedge funds may also use a “global macro” strategy, through which they base their investments on an analysis of macroeconomic events on a huge scale. For example, fund managers may analyze interest rates and monetary policy of a particular country, and use that information to make bets through currency and currency derivative products.
Other strategies include:
Buying distressed securities. This may mean buying stock in bankrupt or financially struggling companies.
Merger arbitrage. This approach takes advantage of price differences before and after a merger.
Fixed-income arbitrage. This strategy capitalizes on price changes in fixed-income securities, such as bonds.
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How to invest in hedge funds
Once you understand and accept that hedge funds come with higher minimums, fees and risk than traditional mutual funds, and offer less liquidity and transparency, you may be in a place to start researching hedge fund managers.
If you have a fund manager in mind, first check their disciplinary record with the SEC. This can be found on the firm’s Form ADV, which investment advisors are required to submit. This form features information about the advisor’s business, its clients, business practices and any past disciplinary events. This form is also required to clearly explain fee structures, any potential conflicts of interest, services the advisor offers and any additional costs for those services.
In short, this is the place to go to weed out any hedge fund managers whom you don’t feel comfortable working with. You can find an advisor’s Form ADV on the SEC’s Investment Advisor Public Disclosure search function.
Choosing a hedge fund manager to handle huge sums of your money can be daunting. If you don’t have a manager in mind, or need a place to start, consider Pensions & Investments' annual list of the largest hedge funds by assets under management. The most recent list’s top 5 largest hedge funds by assets under management are:
However, the level of assets a fund holds may not translate to the best fund for you. What’s more, hedge funds are not a uniform asset class; varying strategies result in a wide range of risk/return profiles. Even fund managers deploying the same strategies over the same period have seen widely varying returns, demonstrating the elevated risk of hedge funds. Choosing a winning hedge fund can be extremely difficult.
Hedge fund analysis tools and databases do exist, but if you’re serious about finding the best hedge fund for you, it may be best to work with a wealth advisor. With a holistic look at your particular financial situation, these experienced professionals can help you decide whose fees, minimums and strategies match your investor profile, and find funds that are currently accepting new investors.
» Ready to get started? Learn how to choose a financial advisor
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Are hedge funds right for all accredited investors?
Because accredited investors have substantial financial resources, the thinking goes, they can participate in riskier investments, such as hedge funds, and escape potential losses mostly unscathed.
However, hedge funds may not be the answer even if you’re accredited, according to Alex Crouch, a certified financial planner and associate at Abound Wealth in Franklin, Tennessee.
“It is important to understand that just because you have access to invest in hedge funds, doesn't mean that you should,” Crouch said in an email interview. “People often assume that once they hit a certain level of wealth they should be using more sophisticated strategies. But the truth is that most hedge fund investors over the past 20 years would have been better off investing in an index fund, especially after factoring in the higher fees that hedge funds demand.”
If you’re looking for a higher risk/reward profile than tracking broad indexes but aren’t ready (or aren’t qualified) to dive into hedge funds, investing in index funds that track specific sectors, geographic regions or company sizes may suit you.