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- Hedge funds are pooled investment vehicles that seek to maximize returns and protect markets from losses. They invest in a greater variety of assets.
- Hedge funds can be riskier because they charge higher fees and are subject to fewer regulations.
- Hedge funds can be accessed by individuals, large corporations, and pension funds, provided they meet certain asset requirements.
A hedge fund is an investment type that’s available to the public. Accredited investors. The objective is to have participants come out ahead regardless of the performance of the overall market. This could help you protect and grow your portfolio over time. However, hedge funds can be risky. Before you dive in, it’s important to understand the risks.
What is a hedge-fund?
A hedge fund, a private investment, pools money from many high-net-worth individuals and large corporations with the goal to maximize returns and reduce risk. The fund may make two investments to protect against market volatility. If one investment does well, then the other loses money — theoretically reducing the overall risk to investors. This is where the term “hedge” actually comes from. Using different market strategies can help offset risk or “hedge” the fund against large market downturns.
Understanding how hedge funds operate
Hedge funds have lots of flexibility when it comes to how they make their money. Hedge funds can invest domestically or internationally and can use any type of investment strategy to generate active returns. For instance, the fund may borrow money to grow returns — known as Leveraging — make highly concentrated bets, or take aggressive short positions.
These investment vehicles can be risky even though they are called “hedge” funds. “Hedge funds are opaque and managers have the ability to do whatever they like inside the fund,” Meghan Railey, certified financial planner, co-founder/chief finance officer at Optas Capital, says. They can place huge bets on the direction of the market, which could prove to be disastrous.
The elevated risk is why only accredited investors — those deemed sophisticated enough to handle potential risks — can invest in this type of fund. You must have earned at least $200,000 each year ($300,000.00 for married couples) and have a net worth greater than $1 million to be an accredited investor.
Hedge funds vs. the S&P 500
Hedge funds are difficult to compare to the S&P 500Chris Berkel, founder of AXIS Financial and investment advisor, said that there are many types of hedge funds and that the markets they invest might be global-oriented. “However, we can say that a broad index of hedge funds underperformed the S&P 500 over the last 10 to 15 years,” Berkel says.
Berkel points out data The American Enterprise Institute compiled this information (AEI) from both the S&P 500 and the average hedge fund from 2011 to 2020. The data shows that S&P 500 index outperformed a sample of hedge funds in each of the 10 years from 2011 to 2020:
“The S&P 500 is a systematic risk, which cannot be diversified away,” Berkel says. A hedge fund may provide some safeguards to your portfolio, which you won’t get with the S&P 500.
Hedge funds pay structure
While hedge funds can bring in more money than mutual funds, investors pay higher fees. Berkel states that the management fee is charged each year regardless of performance. An incentive fee is also charged if the manager performs above a certain threshold, usually its high-water mark.
The usual fee structure is “2% and 20%.” In this example, the annual fee is 2% of participants’ investment and 20% of any gains. Evan Katz, Crawford Ventures Inc.’s managing director, said that recently many hedge funds have lowered their fees to “1.5% or 15%”.
You will need to follow the rules regarding when your money can be withdrawn once you have invested in the fund. Berkel states that hedge funds have the right to “gate” or prevent investors from redeeming shares during market turmoil. “It protects other investors, and it helps the fund manager keep the integrity of their strategies,” Berkel said.
You can withdraw money at specific intervals, such as quarterly and annually, if you don’t have lockup periods.
Are hedge funds regulated or not?
Hedge funds may be regulated but in a less strict manner than other investments like stocks. Mutual funds. Hedge funds don’t have to register with the Securities and Exchange Commission. This means that they are not subject to the disclosure and rules designed to protect investors. It can be difficult to verify and research a hedge fund before you invest in this type product. Hedge fund investors have protection against fraud. Fund managers also have a fiduciary responsibility to the funds they manage.
The bottom line
Hedge funds can help you grow your portfolio, but it’s not a good idea to put all your money here. Hedge funds are risky as they require more capital, have higher minimum investment requirements, are restricted to accredited investors and are subject to fewer regulations than other types investments.
Railey advises that you consult a financial professional not being paid to sell you a hedge-fund fund. Ask questions about the past performance and find out their future strategy. She suggests that you allocate between 5% and 10% of your total investable assets to a hedge fund.
There are options for you if your retirement account doesn’t allow you to invest as an accredited investor. An online brokerage account might be an option. Keeping your money in the market over time — instead of trying to buy and sell based on market conditions — can be a good strategy, Railey says. Keep it simple. Then, as you get more experience, add complexity.
