Most investors contemplating hedge funds have usually thought long and hard before taking the leap into this so-called alternative investment class. It’s nothing like simply setting up a brokerage account and buying an index fund. Hedge funds may have the lure of potentially big rewards, but they also carry the risk of total loss.
There’s also one important consideration to keep in mind: Although hedge funds loom large in the world of financial news and fiction, in reality these are investment vehicles that for the most part are not available to the average investor.
What is a hedge fund?
A hedge fund is a private investment pool, limited to wealthy individuals and financial institutions such as pension funds and college endowments. The pool is managed by a financial professional who invests the money in a variety of securities and financial contracts. Hedge funds set high barriers to entry, which screen out most investors.
Hedge funds tend to have specific characteristics and features.
- They require wealth to participate. Hedge funds typically require an investor to have a liquid net worth of at least $1 million, or annual income of more than $200,000.
- They often borrow money to use in an investment. This is known as leverage, and it can magnify a fund’s returns if the investment turns out right, or magnify losses if the investment is wrong.
- They can invest in a wide variety of securities and assets. For example, a hedge fund could invest in derivatives based on other securities, commodities, real estate—even art and antiques. It may also engage in short selling—profiting when an asset loses value—to hedge its long investment positions.
- They pay managers handsomely. The typical compensation for a hedge fund manager is known as the 2/20 package: The manager is paid a fee equal to 2% of the fund’s assets, plus a performance fee of 20% of any profits above an agreed minimum return.
Why do people invest in hedge funds?
Some investors look to hedge funds for big returns if they think the fund has a better strategy for beating market averages. They are looking for the next mathematically driven phenomenon like Renaissance Technologies or activist stock pickers like Pershing Square Capital—both of which have posted returns that top the market—to increase their wealth.
But most hedge-fund investors are focused more on preserving their wealth. They have already made lots of money; now they want to protect it from big market declines. Managers seek to create a mix of assets whose returns aren’t correlated with market averages, so that if markets tumble, the fund avoids or minimizes losses.
Hedge funds can use an array of financial instruments to control the risks while seeking opportunities for gains.
“Many hedge funds deal very heavily in derivatives and futures markets,” says Titan analyst Vincent Ning. “And they're able to also arrange counterparty contracts with banks to get the specific exposures that they want. They can trade in credit default swaps. That stuff is just not typically open to mutual funds.”
How do hedge funds compare with other investments?
Renowned investor Warren Buffett famously bet that a simple equity index fund would outperform hedge funds. In winning, he showed that hedge funds failed to match the benchmark Standard & Poor’s 500 Index. In the past decade, S&P 500 annual returns have averaged almost 14%, while hedge funds averaged 5%.
Yet hedge funds may compare more favorably in shorter time frames, such as the first quarter of 2020, when growing global concern about Covid-19 or changes in interest rates caused US stocks to tumble 20%. Hedge funds fell 6.4% in that period.
Who can invest in hedge funds?
Hedge funds typically accept only these investors:
- Accredited investors. As defined by the Securities and Exchange Commission for minimum wealth and income, accredited investors have an understanding of the risks of hedge funds.
- Institutions. These include pension funds, trusts, and college endowments.
That said, small investors do have a few options if they want to get a taste of hedge funds:
- Fund of funds. This is simply a fund that buys stakes in other hedge funds. It diversifies by holding funds with varying strategies—for example, a stake in a long/short fund focused on stocks, a stake in a macro fund focused on shifts in central-bank interest rates, and a stake in an arbitrage fund that profits from price discrepancies in markets.
Many funds of funds are offered by mutual fund companies, and usually require a smaller minimum investment, which would make them accessible to more investors. They have higher expenses, however, because the fund-of-funds manager’s fee is on top of the underlying hedge funds’ fees.
- Publicly traded hedge-fund companies or investment companies that have hedge funds as part of their business. Investors can indirectly get a taste of hedge funds without having to clear the hurdles for direct hedge-fund access. Apollo Global Management (APO) and KKR & Co. (formerly Kohlberg Kravis & Roberts, symbol KKR) are examples of companies whose business is focused on hedge-fund management. BlackRock Inc. (BK) and State Street Corp. (STT) are two large mutual-fund companies that also manage hedge funds.
What is Regulation D?
The Securities and Exchange Commission’s Regulation D is used to determine who qualifies as an accredited investor. It also allows a hedge fund to sell private shares to participating investors as a way to raise capital for the fund. Regulation D exempts hedge funds and other businesses from registering shares sold through private offerings, also known as placements.
Getting ready to invest
Investors who want to participate in private hedge funds should be aware that these investments can be an all-or-nothing outcome. There may be little chance to recover much of the investment if a manager closes a losing hedge fund.
Below are some of the things an investor can do to understand a particular fund:
- Research the fund. Get a copy of the private prospectus and marketing material, to understand the risks as well as potential returns.
- Learn about the fund’s managing partner. A good deal of information can be found in the manager’s Form ADV. This disclosure form is filed by investment advisers with the SEC and state securities regulators, describing the firm’s business, ownership, clients, possible conflicts of interest, and any history of disciplinary or regulatory violations by the firm or its managers.
- Examine the fund’s holdings. A hedge fund’s portfolio can often include things beyond stocks and bonds that are harder to understand and evaluate.
- Get a list of fees and charges the manager will take. The cost of being in a hedge fund often amounts to several percentage points. These are almost always much higher than fees for mutual funds and exchange-traded funds.
- Understand the lockup period. This is the amount of time investors must keep their money in the fund, before they can redeem. After this time, redemptions are typically limited to a few times a year, such as quarterly.
Because private hedge funds have high barriers to entry and require a lot of the above investigation and research, investors might consider easy-to-buy funds of funds and publicly traded hedge-fund companies an easier way to get a taste of hedge funds.
FAQs about hedge funds
Why are hedge funds considered risky?
Hedge funds generally have limited diversification, and many use strategies that involve concentrated bets on a few things such as a stock market correction (usually defined as a decline of 10% to 20%) or a change in interest rates. Some of these investments are made with large amounts of borrowed money, which exposes a fund to big losses if the strategy proves wrong. “You could wind up losing more money than you put up,’” Titan’s Ning says.
What are the rules to protect inexperienced investors?
There are no specific rules per se. The wealth and income barrier to entry is the de facto protection—it keeps a small investor from getting in over their head with an investment they may not understand.
The bottom line
Hedge funds were not designed with the average investor in mind. For the vast majority of investors, participating directly in a hedge fund will be difficult because fund managers have sole discretion about who can join the fund. Many investors who do participate in a fund have an existing business relationship with the manager or are solicited by the fund’s investor-relations team. Some publicly traded companies that operate hedge funds are available to investors, but as with any individual security it can be hard for the average person to understand the risks without the help of a financial advisor.