Hedge Funds Defined [Plus: Why They’re Probably Not for You]

New investors often want to maximize their returns to grow their money as quickly as possible. After all, they see people getting rich through their investments on TV shows and in the news. In fact, hedge funds are often the type of investments commonly mentioned.

This may cause you to wonder, “What is a hedge fund, anyway?” The answer is that it’s a specific type of investment that, mostly, only large institutional investors and the wealthy use.

You may or may not want to invest in a hedge fund even if you could once you understand how they work. Here’s what you need to know about this particular private investment vehicle.

What is a hedge fund?

A hedge fund is an alternative investment that does not fall into one of the traditional asset classes. Other examples of alternative assets include real estate, private equity funds, and cryptocurrency.

A hedge fund is a company set up to make money through investing and is commonly referred to as a style of investing for the wealthy. Hedge funds take part in active investing, or purposefully choosing specific investments to beat the expected market gains.

Unlike other investments, hedge funds are unique entities that rarely have to follow many of the U.S. Securities and Exchange Commission regulations and reporting requirements that more commonplace investments do, such as mutual funds.

Instead, they invest money based on the goals of the hedge fund and often have more leeway to invest in what they see as a good fit. Hedge funds may invest in stocks, but they may also invest in derivatives such as options and futures. They may use techniques such as leverage to try to increase returns. More specific strategies and how they work are listed below.

Because of these strategies and the associated risks that many everyday people aren’t familiar with, most hedge funds require you to be an accredited investor. This means institutions, such as pension funds, and wealthy individuals are usually the entities investing money in a hedge fund.

How a hedge fund works

Despite their name, a hedge fund investment company doesn’t necessarily focus on making investments using hedging techniques. A hedge is defined as a strategy used to limit market risk when making investments by purchasing assets that could counteract negative outcomes.

For example, an airline may hedge the risk that jet fuel prices could rise by purchasing a futures contract for jet fuel. This investment gives the option of locking in a set fuel price in the future in exchange for an upfront cost today. If the jet fuel costs more in the future, the futures contract could provide the airline with lower-priced jet fuel or the financial means to offset the higher prices.

Instead of hedging, a hedge fund investment manager looks to aggressively maximize returns using any methods they believe will help. These aggressive tactics can sometimes backfire and result in considerable losses. Even so, these strategies can result in large gains when they work according to plan.

Hedge funds often employ leverage — a fancy name for debt — to make more significant investments than their cash balance allows. This may amplify positive returns if their investments increase in value. The gains must exceed the interest rate expense on the debt to be profitable, though. Conversely, investments that use leverage and don’t work out can result in bigger losses.

Investing in a hedge fund is also more expensive than investing in a low-cost exchange-traded fund (ETF). An ETF typically has a low expense ratio, or the cost of the ETF, whereas a hedge funds usually charge two fees:

• First, you must pay an asset management fee to cover the costs and management of the hedge fund. This is generally about 2%.
• Additionally, hedge fund managers want to keep some returns for the firm. This is known as a performance ratio. Customarily, the performance incentive fee is 20% of profits.

The fee structure of charging both the management and performance fee is referred to as a 2-and-20 fee.

Finally, a hedge fund may not provide much in the way of liquidity. You may not be able to withdraw money from the fund daily as you could do if you owned and sold stock. You may only be able to withdraw money from the fund on a set basis, such as monthly, quarterly, or annually.

You may also have to leave the money with the fund for a lock-up period specified by the fund. This can be as long as a year or more. Lock-up periods help hedge funds guarantee they’ll have money available to execute their strategies without having investors withdraw money at the first sign of trouble.

Hedge fund strategies

Hedge funds may employ many strategies to help maximize returns. Here are a few methods you may see used in the hedge fund industry:

• Long/short equity: Purchasing a stock viewed as an out-performer while simultaneously shorting stocks expected to under-perform.
• Equity market neutral: Purchasing long positions and short positions in equal market value amounts so the total exposure to the stock market nets out to zero when you compare the two positions.
• Merger arbitrage: Takes advantage of pricing inefficiencies when two companies merge by purchasing both companies’ stocks.
• Global macro: Purchasing investments in different countries around the world based on political and economic outlooks.
• Volatility arbitrage: A strategy based on taking advantage of volatility, or changing prices, to earn profits using options.
• Convertible bond arbitrage: Purchasing convertible bonds and shorting the underlying stock to take advantage of perceived pricing discrepancies.
• Fund of funds: A fund that invests in several other funds, such as a hedge fund investing portions of investors’ money in several hedge funds.

Who can invest in a hedge fund?

Investing in a hedge fund isn’t something most people qualify for. To invest in a hedge fund, you generally must first qualify as an accredited investor. This means having an annual income of over $200,000, or $300,000 with a spouse, for each of the two previous years. You must also expect to earn at least that amount in the current year.

Alternatively, you can qualify as an accredited investor if you have a net worth of more than $1 million without including home equity. You can also be eligible if you hold Series 7, 65, or 82 licenses, which are licenses for investment professionals.

Even if you’re an accredited investor, most people still can’t afford to invest in hedge funds or may not want to. Hedge funds often require a minimum investment of $500,000, $1 million, or more.

Because hedge funds use advanced investment strategies with fewer regulations, the money invested in a hedge fund is normally at a higher risk. People with total assets worth $1 million may not feel it’s responsible to put such a large portion of their net worth into such an investment. Putting half of your net worth or more in a volatile investment may not fit within many investors’ risk tolerances.

Should you invest in a hedge fund?

A hedge fund won’t likely be a good fit for the average investor saving for retirement or any other purpose, as hedge fund investors tend to be high-net worth individuals and institutions. Rather than focus on hedge funds, everyday people learning how to invest money may be better served looking into choices that can help them invest for their future while not charging high fees.

The best brokerage accounts offer a wide variety of account types and investing options. Some brokerages and the specific investments within those brokerages may have minimums that may not be easily attainable for new investors, but that isn’t always the case. Some of these services offer zero minimum investment funds with zero expense ratios.

Investors that prefer the mobile experience should look into the best investment apps. These apps can help you invest in unique ways or make getting started easier. Many of these apps offer low or no minimum investment requirements. Several support fractional share investing, which lets you buy a part of a share of a stock rather than having to wait so you can save up to buy an entire $200 or $1,000 share.

When looking at these options, consider what type of investor you want to be:

• People who want to take charge of their investments and pick their own individual stocks may prefer an app, such as Robinhood, that supports active investing with no commissions. You can learn more by reading our Robinhood review.
• Investors who want to have technology and expertise guide their portfolios may like robo-advisors, such as Betterment, that help you build a portfolio and keep it optimized. For more info, check out our Betterment review.

FAQs

Bottom line

Hedge funds may sound alluring, but they don’t fit most investors’ goals. The rich may allocate a small part of their larger portfolio to hedge funds in an attempt to boost their returns. That said, the volatility and risks hedge funds present, especially in times of financial crisis, make it less than ideal to invest a large portion of wealth in them.

Instead of investigating hedge funds to invest in, most people might prefer investing through a brokerage firm or investing app. These could allow you to get started almost immediately with just a few dollars. This way, you can begin your investing habit today to hopefully build wealth for your future.