A hedge fund is like an exclusive investment fund that aims to outperform the market. Here’s everything else you need to know about hedge funds.
What is a hedge fund?
If the term “hedge fund” evokes rich guys in suits yelling into their mobile phones while blowing their noses with $100 bills, we don’t blame you. After all, “hedge fund manager” tends to be code for “rich person” in most conversations. But what actually is a hedge fund, and are they really just the domain of Wall Street bros?
Well, yes and no. A hedge fund is an investment fund that’s primarily available to institutions or individuals with significant assets. It’s been around since about 1949 when a Fortune magazine editor named Alfred Winslow Jones invested $100,000 using a pretty complicated method that hasn’t really changed since it was first created. It proved a success: from 1958 to 1968, his company’s investments increased by 1,000 percent.
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Unlike mutual funds, hedge funds are not regulated by the U.S. Securities and Exchange Commission, and can therefore typically invest in a wider range of securities than mutual funds can. So in addition to investing in stocks, bonds, commodities, and real estate, a hedge fund can invest in more complicated ways: usually through a process called short-selling, which we’ll get to in a minute. As with every investing endeavor, the goal is to maximize investor returns while minimizing risks. But unlike a mutual fund, a hedge fund tends to use more aggressive investing methods. Hedge funds are less accessible for the average person because of high investment minimums (usually between $500,000 and $1,000,000) and a strict limit on the number of investors. They also carry higher risk.
So where does the name “hedge fund” come from? It refers to the process of “hedging,” or offsetting potential losses from one investment through another investment. Think of it as a type of insurance. Hedge fund managers can hedge their risks by buying stock that they anticipate will rise in value, or short-sell stocks if they anticipate a drop in the market. In essence, hedge fund managers are betting on both rising and falling stocks.
This is another important difference between a hedge fund and mutual funds: While index mutual funds and index ETFs usually aim to track the market, a hedge fund will try to beat the market by making bets on how the market will perform.
How does a hedge fund work
A hedge fund is a fund that’s open to “select” investors and uses complex strategies to stay ahead of the market. The fund is set up as a privately-owned limited partnership or limited liability corporation in order to protect all involved from creditors in case the fund goes bankrupt. The whole thing is orchestrated by hedge fund managers, who essentially “trade” the money put into the fund by investors. One way to try to stay ahead of the market is by short-selling or selling an asset that you think will drop in price and then buying it back at a lower price later on and gaining on the difference. This is coupled with “going long,” which means buying an asset (often with borrowed money) where you expect its price to rise (and therefore offset any potential losses from the asset that you short-sold). By having a combination of both “long” and “short” investments, your money is potentially always making a profit in the market, despite downswings. The key word is potentially.
Obviously, this isn’t without its risks. Short-selling, in particular, is quite risky, and can lead to speculation and pressure within companies to push up their stock prices in the short term. This was apparent in the [2008 financial crisis], when hedge funds indiscriminately bought mortgage-backed securities that defaulted when housing prices started to decline. When no buyer could be found for those assets, giants like Lehman Brothers went down, dragging the entire global financial market with them. Since then, hedge funds have been subject to more scrutiny.
Because managers are in charge of making the buying and selling decisions for a fund, they charge higher fees than mutual fund managers. The most common fee arrangement for managers is known as “Two and Twenty,” wherein a hedge fund manager annually takes 2 percent of all managed funds, regardless of their performance, and then also gives themselves 20 percent “performance fee” taken from investors’ annual gains. For top managers like George Soros, these fees can really pay off. Soros is currently worth an estimated $24 billion. Those percentage fees might sound small, but fees are absolutely something you should watch out for — they eat into the amount of money you actually make. Ask yourself what am I getting for the fees I’m paying? And will I get higher returns in exchange for the fees I’m going to pay for a hedge fund?
How to invest in a hedge fund
The hedge fund is the exclusive, members-only club of investing. That means that if you want to invest as an individual, you need to be a so-called “accredited investor", which means your net worth exceeds $1 million or have an annual income that exceeds $200,000. You’ll also have to be able to pay the hedge fund manager’s high annual fees. Some hedge funds also have minimum account requirements that aren’t too modest either. Just because you have the money isn’t reason enough to invest in hedge funds.
Keep in mind that hedge funds don’t offer the choice of immediate liquidity. As an investor, you often have to commit to keeping your money locked up for a certain period of time, and managers always have the right to limit withdrawals.
Once you’ve made sure you’re able to take on the financial costs associated with a hedge fund, it’s time to do some research. A hedge fund lives or dies by its manager, so you’ll want to find someone who you trust, who has a good reputation, and who’s running a portfolio that hold investments you’re comfortable with. Some hedge funds can hold assets that are more difficult to sell than others. Know how a potential fund’s holdings are valued by independent sources before you make the leap. It’s also wise to get a portfolio review from a financial advisor, some advisors may charge a fee others will do so in the hope of winning your business.
You’ll then have to assess whether you’re willing to take on the risks of investing in a hedge fund. While they offer the tantalizing possibility of high returns, there’s also a chance that you could lose a lot of money. If you’re a billionaire with $2 million to gamble in a hedge fund, it might not be so bad. Losing your life savings wouldn’t be so easy to handle. So, just because you can, doesn’t necessarily mean you should. This is assuming that the hedge fund manager has decided to accept you as an investor in the first place.
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Alternatives to investing in a hedge fund
Hedge funds are declining in popularity lately as the S&P 500 Index has outperformed hedge funds in recent years. Nobody knows how they’ll perform in the future but the trend is putting people off. There are also people who can’t afford the high account minimum or assume the risk that comes with hedge funds. So what do you do if you’re not mega-wealthy, mega ballsy or are not willing to take on a high amount of risk? Lucky for you, there are plenty of other options. But before we get into them, it’s important to keep in mind that no investment is a sure thing. Generally speaking the more risk you take on the more you stand to make (or lose.)
If you want something that’s almost totally safe you might be best served with a savings account. Savings are protected in the US up to $250,000 in case of bank failure.
If things go belly up, you’ll have some protection. Another option is to open a high-interest savings product, they normally come with higher interest and are comprised of either multiple savings accounts or ETFs that are typically seen as low risk.
If you like the idea of investing in a diversified fund that’s managed by an expert, then mutual funds might be for you. You essentially hire a manager to pick stocks, bonds, and other assets for you and pay a much lower account minimum than with a hedge fund (although it’s still usually several thousand dollars). They also have lower annual fees than hedge funds, although you still have to pay a commission every time you buy or sell a stock. Index mutual funds don’t try to beat the market but instead, they aim to mirror it. The advantage of this is that it’s less expensive to maintain than other mutual funds or hedge funds. The index fund uses machines rather than humans and since less research is required by analysts there are fewer expenses. Some index mutual funds require high account minimums and charge high maintenance fees, though they’re normally not as high as those of an active mutual fund.
Exchange Traded Funds
If mutual funds still sound too expensive, then there are exchange-traded funds. Like mutual funds, ETFs allow you to invest in large parts of the market without having to pick and choose stocks yourself. ETFs comprise a broad category of assets — including S&P 500 companies, real estate, bonds, etc. ETFs spread your money out across various assets, so you don’t need to worry about losing everything because a single stock tanked overnight. ETFs are the budget-conscious investor’s best friend. If you decide to buy and sell ETFs yourself, you can probably expect to pay minimal fees.
If making trades yourself sounds like too much work, there are plenty of automated investment services that will do it for you. When you sign up with a robo-advisor you invest your money in a whole platter of stocks, bonds, and real estate. Many have no account minimum which makes them much more accessible than hedge funds. Typically, they have lower fees than that of a hedge fund because you’re not paying for an expensive fund manager to pick stocks. Most robo-advisors follow a passive approach to investing and aim to mirror the market rather than beat it. This allows them to have much lower fees than expensive hedge funds. Some robo-advisors provide additional benefits like financial advice and portfolio rebalancing to ensure your investments never go off course.
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