Hedge Funds: What are They and How to Invest in Hedge Funds?

Table of Contents

1. What are Hedge Funds?

1.1. Key Characteristics of Hedge Funds

2. How Do Hedge Funds Work?

3. How to Invest in Hedge Funds?

3.1. . Who Can Invest in Hedge Funds?

4. Pros and Cons of Investing in Hedge Funds

5. The Concluding Words

While looking at various investment options, you must have heard about Hedge Funds. What are they? How to invest in Hedge Funds? Are they safe to consider as an investment option? In this article, we will get to know about hedge funds and how do they work…

1. What are Hedge Funds?

A hedge fund is an investment pool created by accredited individuals or institutional investors for distributing their portfolio and maximizing returns. The main motive is to reduce the risk through alternative investments, regardless of market climb or decline. In simple words, it is a private investment partnership between the investors and a fund manager. Also, the investment is structured as a limited partnership or limited liability company.

Hedge funds make use of several strategies to earn active returns for their investors and may be managed in both domestic and international markets. However, you must know that these funds are generally only accessible to accredited investors because they need fewer SEC regulations as compared to other funds. Also, hedge funds face less regulation than funds like mutual funds and more.

The general types of hedge funds include…

a. Open-Ended Hedge Funds: Under these hedge funds, the share is issued to the investor on a continuously basis and allow periodic withdrawals of the net asset value for each share.

b. Closed-End Hedge Funds: Under this category, only a limited number of shares are issued via an initial offering and no more shares are issues even if the demand increases.

c. Shares of Listed Hedge Funds: This section includes hedge funds that are traded on stock exchanges and even the non-accredited investors may purchase the shares.

1.1. Key Characteristics of Hedge Funds

1) Hedge Funds Are Only Open to Accredited or Qualified Investors

Who are accredited investors for hedge funds? Well, the investors with an annual income that exceeds $200,000 for the past two years or having a net worth of more than $1 million can invest in hedge funds. One thing to be noted that: net worth doesn’t take into account their primary residence.

2) Hedge Funds Offer More Investment opportunities that Other Funds

Hedge funds offer a wide investment latitude as compared to other funds and this may include options like land, real estate, currencies, derivatives, and more. As far as mutual funds are concerned, they have to stick to stocks or bonds and are usually for long-term only.

3) Two and Twenty fee Structure

Hedge funds have a 2-and-20 fee structure which means they charge both an expense ratio and a performance fee instead of charging just an expense ratio. In simple words, the structure represents a 2% asset management fee and a 20% cut of any income generated.

4) Hedge Fund Fees and Minimums

If you are planning to invest in hedge funds, the minimum initial investment amounts range from $1000,000 to upwards of $2million. As these funds are not as liquid as stocks or bonds, you may only withdraw your money after you’ve been invested for a certain period.

5) Hedge Fund Strategies

The main hedge fund strategies are divided into four categories namely Global Macro strategies, Directional Hedge Fund strategies, Even-Driven Hedge Fund strategies, and relative Value Arbitrage Strategies. You will need to understand them carefully before opting for one.

2. How Do Hedge Funds Work?

The following points might help you understand how hedge funds work…

1) Hedge funds are more like alternative investments that may utilize non-traditional investment strategies as well as asset classes.

2) The basic structure is like a partnership pool where a fund manager invests in different options such as securities and equities.

3) A hedge fund manager discusses an investment strategy with investors and those who consider it profitable, stick to the said strategy.

4) A hedge fund manager can only accept 35 non-accredited investors to any given partnership as per government regulations.

5) Hedge funds have a wide structure with investments like stocks, bonds, mutual funds, real estate, currency, and more.

6) Hedge funds often leverage other funds such as borrowed money to increase the returns but this may also increase the risk.

7) Hedge funds have a 2-and-20 fee structure under which an expense ratio and a performance fee are charged from their investor.

3. How to Invest in Hedge Funds?

Taking hedge funds as an investment option, each fund is constructed to take advantage of certain identifiable market opportunities. This is the reason why hedge funds use different investment strategies and are also classified as per investment style. With every style comes different risk attributes and investments.

Hedge funds are quite riskier investments but produce higher returns and that’s why a lot of investors these days prefer them over another type of funds.

Here’s how to start with hedge funds…

1) Verify as an Accredited Investor: First, you will need to verify that you are an accredited investor and each fund will determine your status using its practices. You will have to provide details like your assets, income, and debts to know whether you qualify to invest or not.

2) Research Funds Accepting New Investors: Do some research to know what funds are currently welcoming new investors. You can use online tools or consider taking guidance from a financial advisor. Once found, you will need to contact a hedge fund and ask for information.

3) Reviews the Hedge Fund: You should thoroughly review the hedge fund you’re considering investing in. Start with the fund’s prospectus and its market performance over the years to get a realistic view and understand the risk potential.

4) Understand the Fee Obligations: Know your fee obligations before starting and expect to pay between 1% to 2% of total assets along with a 20% performance fee. The performance fee is based on the profit levels.

5) Know Your Redeemable Timelines: Do remember that hedge funds won’t let you redeem shares any time you want so it is important to know the timelines. Generally, you can redeem your shares four times annually and there are also lockdown periods.

6) Get to Know Your Hedge Fund Manager: Yes, this is an important thing to do - know your hedge fund manager before you invest any money. Hedge funds are a big investment and riskier too, so be sure to check the manager’s Form ADV and investment strategies.

7) Get All Your Queries Answered: Do not open your checkbook until and unless you are satisfied with every aspect of the hedge fund. You will want to know who is managing your money and what will be the potential risks along with the expected returns.

Doesn’t meet hedge fund firm’s requirements? Don’t worry, you still have many investment options…

a. You can invest in mutual funds, ETFs, and funds of funds that use similar strategies like hedge funds.

b. You can consider options like short-selling or leverage investing to enjoy some good returns and grow your wealth.

3.1. Who Can Invest in Hedge Funds?

Being a high-risk investment option, the U.S. Securities and Exchange Commission (SEC) places some regulations on who can invest in Hedge Funds. If you want to invest in hedge funds, take a look at the following to know whether you qualify or not…

You must be an institutional investor or an accredited investor with a net worth of at least $1 million (no primary residence will be included) or have an annual individual income over $200,000. You need to have incomes over $300,000 if you have a spouse.

This clearly states that hedge funds are not for the average investor as a small fraction of the population qualifies for investing in these funds.

4. Pros and Cons of Investing in Hedge Funds

Just like other investment options, hedge funds do come with some pros and cons that you may need to know before making your final decision. Here, we’ve discussed some advantages and disadvantages of investing in hedge funds…

The Pros

1) You can expect a good return despite the market conditions due to the use of various investment strategies.

2) A balanced portfolio decreases your overall risk and you can enjoy multiple returns on investment.

3) You can customize your investment strategies and access the services of experienced investment managers.

The Cons

1．Your investment is exposed to a higher level of risks if you choose the wrong strategy.

2．You will need to lock in the money for years and cannot redeem it in between.

3．The use of borrowed money increases the expected returns but comes with greater risk.

5. The Concluding Words

A hedge fund is an investment firm that uses complex strategies and that’s why you need to take some time to understand it as your investment option. The strategies involve the use of leverage, derivatives, short-selling, and alternative asset classes to generate returns. This makes these funds a bit complex than other funds such as stocks and bonds.

Also, hedge funds tend to cater to individuals with high net-worth which makes it quite difficult for everyone to gain access to a quality hedge fund. So, do your research and make sure you qualify before investing…