Hedge Fund Investing
Do you have at least $100,000 to invest, or maybe 10 to 20 times that amount? Perhaps you are ready to enter the world of hedge fund investing. Such investing requires substantial capital. The potential returns of a hedge fund are very high. This is why so many rich people invest in them. Keep in mind that those possible huge rewards come with equally high risks.
What is a Hedge Fund?
A hedge fund pools money from investors. It then invests in securities or other types of investments with the goal of getting positive returns. That description sounds somewhat like mutual funds. But hedge funds may have more leeway to pursue riskier investment strategies. Additionally, they are privately owned, not publicly traded vehicles.
The Federal Reserve notes that hedge fund investing holds a wide variety of asset types, which may include:
- Real estate
Many hedge fund assets are illiquid, difficult to value or both.
If interested in hedge fund investing, it is also crucial to understand what a hedge fund is not. The IRS points out that a hedge fund is not a private equity fund, ETF, REIT, mutual fund, bond fund or Regulated Investment Company. These are the sorts of entities with which most investors are familiar.
The world’s largest asset manager, BlackRock, specializes in hedge funds. Its website explains that “optimal hedge fund portfolios seek to emphasize idiosyncratic (e.g., security-specific) sources of return while minimizing broad market risks.” In plain speak, that means an investment risk specific to a particular asset, such as an individual company. It may also refer to a specific asset class affected by an unexpected event. For example, the pandemic devastated the travel and airlines industries in unforeseen ways.
Who Can Invest?
Hedge fund investing is not available to everyone. Eligibility is limiting to those meeting specific financial criteria. Only accredited investors may invest in hedge funds. Such investors are supposedly more financially sophisticated. So they can understand the risks associated with hedge fund investing.
Accredited investors must have a net worth exceeding $1 million. This net worth does not include the value of their primary residence. For the prior two years, their income must have exceeded $200,000. If married, their income must have exceeded $300,000. Additionally, they must expect a similar income level for the current year.
Institutional investors are also accredited. These investment professionals must hold a Series 7 general securities representative license in good standing. They can also hold a Series 65 investment adviser representative license or a Series 82 private securities offerings representative license. Pension funds and insurance companies are examples of institutional investors.
Keep reading for more info on hedge fund investing.
Hedge Fund Organizational Structure
In essence, a hedge fund is an investment partnership run by a fund manager, and the investors. The latter is often referred to as limited partners. The manager makes the fund’s daily investment decisions and manages portfolio risk.
A hedge fund generally uses one of the following organizational structures:
- Single-entity fund: This structure involves a management entity and fund entity. It is the most common type of hedge fund structure in the U.S.
- Master feeder fund: This structure allows investment managers to manage a larger pooled portfolio. This master fund provides investors with dividends, interest and other benefits. The usual structure consists of one onshore feeder fund, an offshore feeder fund, and one master fund. The feeder funds are companies where investors’ funds originally go. In addition, the feeder funds then invest all or part of this money in the master fund.
- Parallel fund: Makes the same investments and divestitures at the same time as a main fund. The primary difference between the parallel and the main fund regards the tax framework. Parallel funds are generally for investors whose investments are in offshore structures.
- Fund of funds: This fund invests in a portfolio of different hedge funds.
Hedge fund investing strategies run the gamut. But what they have in common is a level of aggression, which is not something you can find in mutual funds. They want to bet big for large, short-term gains. Such strategies may include:
- Event-driven: maintaining positions in companies involved in mergers.
- Leveraged investing
- Market neutral: longs and shorts have equal market value.
- Quantitative analysis
Hedge Fund Fees
Hedge fund fees are steep. Typically, hedge funds charge an asset management fee of one to two percent of assets. There’s also a 20 percent performance fee of the hedge fund’s profit. That high performance fee percentage means hedge fund managers may take significant risk to generate substantial returns.
How to Invest in a Hedge Fund
If you meet the criteria for hedge fund investing, you can start in hedge fund investing by performing due diligence. It’s crucial to read the hedge fund’s prospectus and make sure you understand it. The investment strategies of hedge funds usually contain a high level of risk. Make sure you are comfortable with that risk level before committing your money.
It’s wise to consult with a financial adviser to find an appropriate hedge fund and help steer you through this process. You must meet the minimum investment requirements, which in some cases are $2 million or more.
Hedge Fund Investing Considerations
Before taking the plunge into hedge fund investing, keep in mind that hedge funds are not regulated as heavily as mutual funds. There’s usually a one-year lockup, in which you can’t sell your shares. After that, you are generally limited to cashing in shares four or fewer times annually. You could also get hit with a redemption fee. There’s also the fact that hedge funds usually don’t outperform the overall stock market. The main exception is better performance during bear markets.