What Is a Hedge Fund?
Hedge funds give investors access to unique and alternative investment strategies. Learn more about how they work in this article.
In investing, diversification is crucial to mitigate volatile market conditions. However, there are many ways to accomplish this, such as with mutual funds and exchange-traded funds. Another method for wealthier investors is by pooling money in a hedge fund.
With a hedge fund, several investors combine their capital, which a manager uses to invest in a wide array of securities. The goal is typically to invest in such a way as to net significantly positive returns. In this article, we’ll explain how these funds work, including the strategies they use. You’ll also learn about the benefits and disadvantages of investing in them and who they’re ideal for.
Understanding Hedge Funds
A hedge fund is an investment vehicle in which a group of investors (usually wealthier individuals) pool their money to buy various securities to net positive returns. Unlike mutual funds, these often invest in non-traditional securities and prioritize more complex trading techniques. Additionally, they’re not subject to the same rules and regulations as mutual funds.
Because of the non-traditional strategies hedge funds employ, they’re typically considered an alternative investment. For example, they often invest in options, both long and short. They also typically leverage (or borrow money) to increase the chances of high returns. However, this also exposes them to more risk.
To invest in a hedge fund, you must be an “accredited investor,” which means meeting a minimum level of income and assets. Currently, this refers to anyone who has:
- $200,000 of income in each of the past two years (or $300,000 combined if married).
- A net worth of over $1,000,000.
- A valid Series 7, 65, or 82 license.
Beyond individuals, institutional investors may also invest in a hedge fund. This includes entities like insurers, pension funds, and banks.
Role of a Hedge Fund Manager
Managers are responsible for selecting the investments a hedge fund makes. Shareholders place a great deal of trust in these individuals to manage their money and gain returns. Typically, those who invest pay an asset management fee of 1 to 2% and a varying performance cost.
Because you’re entrusting a hedge fund manager with your money, they have a fiduciary duty to choose investments with the shareholders’ best interest in mind. However, before you invest, you should ensure a fund manager is qualified and trustworthy. To do this, you can check a firm or individual’s Form ADV via the SEC’s Investment Adviser Public Disclosure (IAPD) website. Alternatively, you may use FINRA’s BrokerCheck to find similar information.
Types of Hedge Funds
While hedge funds largely share the same characteristics, they may employ unique strategies. In general, there are five major strategy types, all of which aim to curb risk, achieve diversification, and gain positive returns. Here’s a breakdown of each type:
- Equity. This is the most common strategy these funds use. It focuses heavily on investing in long/short equities, as well as those from specific sectors.
- Event-driven. With this approach, a hedge fund will try to take advantage of a major event that raises a company’s stock price, such as a merger, acquisition, recapitalization, or bankruptcy.
- Macro. These types of funds invest based on global economic and political trends. In addition, they’re free to invest in a wide array of securities, provided they fit into the fund’s overarching strategy of taking advantage of geopolitical events.
- Risk-parity. This type of hedge fund makes investments based on its “risk budget,” which is the amount of risk to which a manager is willing to expose the fund. Essentially, an investment manager will allocate funds to certain securities based on how much risk they present, rather than dollar amounts.
- Arbitrage. In this case, a fund manager seeks to profit by simultaneously buying and selling investments with significant price differences.
While the above are many of the most common strategies, each also divides into several sub-approaches. Some hedge funds may also follow more than one of the above to generate returns for their shareholders. Before investing in one of these vehicles, it’s key to understand what strategy or philosophy it follows. If you’re unsure if a strategy aligns with your goals, we recommend speaking with a financial advisor to gain more clarity.
Pros and Cons
Hedge funds may be a way to net big returns, but they come with plenty of risk. They’re also not for the average individual, requiring you to be an accredited investor to be part of one. Like any other investment option, these funds come with pros and cons that you should consider before diving in. Below is a more specific outline of the benefits and disadvantages you can expect from these pools:
- Opportunity for diversification. They typically invest in a wide array of securities, allowing you a more diversified portfolio.
- Potential for high returns. While they can pose a significant risk, they can also net you big returns, especially given ideal market conditions.
- Unique investment strategies. They employ alternative and complex investment strategies that may not be available through other types of funds. Investing in one allows you to gain access to and potentially benefit from these techniques.
- Less regulation. They aren’t held to the same standard by the SEC as mutual funds. While this affords more flexibility, it also means you won’t always be informed of the fund’s activities, good or bad.
- High fees. The cost to invest in one can be steep, with some charging as high as 2% of your asset value.
- Risk. With the potential for huge returns comes high risk. Often, these funds leverage (borrow money), which can bankrupt it entirely if its investments don’t pan out.
- High barrier to entry. They require you to be an accredited investor to buy in. This means you must have significant assets or income, which doesn’t apply to the average investor.
Who Should Invest in Them
For most, investing in a hedge fund either doesn’t make sense or is unattainable. However, some stand to benefit from this type of investment. Wealthy individuals or institutional investors, such as corporate and state pensions or insurers, may choose to buy into one for diversification purposes, as well as to see returns despite market volatility.
As mentioned previously, to invest in one, you must be an accredited investor. Most people won’t fall into this category, however. For this reason, these investment vehicles are for individuals or firms with vast resources that are looking to mitigate risk while also gaining reliable returns over time.
What to Consider Before Investing in a Hedge Fund
Provided you’re an accredited investor and can invest in a hedge fund, there are some important factors to consider before doing so. Most importantly, you should have an acute awareness of how qualified the fund manager is, as well as what types of investments they make. This includes understanding, at least on a basic level, the fund’s investment strategy.
Additionally, it’s key to know how to value the fund and its method for measuring performance. Unlike mutual funds, hedge funds don’t need to report performance based on specific metrics like current and tax equivalent yield. Be sure you understand the metrics your fund manager uses to calculate progress and value.
If you need help determining whether a fund is right for you, we recommend you talk with a financial advisor, such as one with the Chartered Alternative Investment Analyst (CAIA) designation. They can work alongside you to research a fund or decide if it fits into your portfolio. In addition, an expert can assist with other tasks, such as financial planning, wealth management, and portfolio management. To find an advisor, we suggest you take advantage of this free matching tool, which will pair you with up to three vetted professionals in your area.
Frequently Asked Questions
How much money do you need to invest in a hedge fund?
You must be an accredited investor to invest in one of these pools. This means having an income of at least $200,000 in each of the past two years (or $300,000 between you and a spouse), as well as a net worth of $1,000,000. This mainly applies to high-net-worth individuals and institutional investors, such as pension plans and large organizations.
Why would anyone use a hedge fund?
Hedge funds can be an effective way for one to diversify their portfolio and net positive returns over time. However, they can come with a considerable amount of risk due to their lack of regulation and unique strategies. Before investing in one, you should use caution and do your due diligence by thoroughly researching it.
Are hedge funds bad?
Hedge funds aren’t inherently bad, but they do come with a high level of risk. The SEC doesn’t hold them to the same regulatory standard as it does mutual funds. For this reason, there may be a lack of transparency from fund managers in how they invest your money or report progress.
What is the biggest hedge fund?
The largest in the world is Bridgewater Associates, founded by Ray Dalio, which boasts $97,200 assets under management (AUM).
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