What is a Hedge Fund and Should You Invest in One?
If you’re looking for a new investment account, or you’re brand new to turning your money into more money, a hedge fund is no doubt an option you’ve come across.
But what is a hedge fund, you ask? Can anyone invest in one or is it just for the bigshots on Wall Street?
We’ll clear up all your questions below and look at the difference between hedge funds and other types of investments.
What is a hedge fund?
A hedge fund is a type of pooled fund that uses a range of strategies to generate active returns for investors. They’re usually way more expensive when compared to other types of investment funds. And they’re usually only open to high net-worth investors.
That’s why when you hear the words ‘hedge fund,’ you get a very clear picture in your mind of a guy in an expensive suit with a briefcase.
How do hedge funds work?
The way hedge funds are designed is to take advantage of identifiable market opportunities.
But what does that actually mean?
It can mean many things. Hedge funds work by using a whole host of different investment strategies. Hedge fund managers closely watch market data, so they can jump on investment opportunities when they arise.
Those managers pick the best places to put your money, typically swaying towards riskier (but higher return) options.
Who can invest in hedge funds?
Hedge funds are a special type of investment method that has certain criteria before you can invest in one.
Hedge funds will look at a range of criteria from current wealth, assets, ability to absorb any significant losses, tax status, and much more.
Why so exclusive?
It’s not just a secret club. Hedge funds have a much higher level of risk associated with them. As a result, the U.S. Securities and Exchange Commission (SEC) places some strict regulations on who can invest in them.
Criteria for investors
To invest in a hedge fund as an individual investor, you will need to be accredited. This typically means you will need to have a net worth of at least $1 million — that’s not including the value of your primary residence. Or you must have an annual income over $200,000, or $300,000 if you’re married.
The other type of investor in hedge funds is called an Institutional Investor. These are professionals bodies that invest on behalf of pension funds, government workers, and unions. They typically invest large amounts of cash at once, and may be subject to slightly less scrutiny because they’re seen as less risky, professional investors.
Pros and cons of hedge funds
Advantages of hedge funds
Higher returns (potentially)
One of the main aspects that sets a hedge fund apart from other investment types is the aggressive investment strategy. Hedge funds don’t mess around, they go hard for the highest returns possible.
Another advantage of a hedge fund is that it offers a bit more flexibility than mutual funds. As investments in hedge funds are not traded publicly and have no real body regulating their performance, a hedge fund manager can use a range of strategies including derivatives, leverage, and short selling.
A hedge fund can invest in pretty much anything, whether it’s real estate, land, stocks, currencies, or derivatives.
When compared to other types of investment like mutual funds, you’re usually limited to just stocks or bonds. So, if you are looking for a bit more diversity in your portfolio, a hedge fund might be for you.
Disadvantages of Hedge Funds
A major disadvantage for hedge funds is that they usually have high fees attached. Most will use a fee structure called 2 and 20, which we’ll explain.
Hedge funds use a more aggressive investment strategy. This means high risk and (hopefully) high return. But the number one thing to know about any type of investment is that nothing is guaranteed.
Those high returns can just as easily become high losses. The kind that makes your eyes water.
Money is often locked away
Many hedge funds require investors to essentially lock away their money for years to get the maximum return on investment.
This may not be an issue for those who are used to keeping their money in the market long-term, but it does mean a bit less flexibility to sell whenever you want. They’re not for the short-term investor.
How much are hedge fund fees?
The standard type of hedge fund fee is called the 2-and-20 fee. The 2-and-20 fee structure works by charging both an expense ratio and a performance fee (instead of only an expense ratio).
It gets its name from charging a 2% asset management fee, and then a 20% cut of any gains on top of that.
Hedge funds vs mutual funds
Hedge funds are investment pools, so are mutual funds, but what’s the difference?
The main difference is availability to the average investor.
Mutual funds are regulated investment products that are offered to the public and are available for daily trading. This makes them the more popular and accessible option.
Hedge funds, on the other hand, are private investments that only accredited investors can use. They’re far more exclusive.
Another thing that sets them apart is that hedge funds are well known for using high-risk investment strategies to achieve the highest returns possible for investors. Mutual funds are a bit tamer in comparison.
Should I invest in hedge funds?
If you have an appetite for high risk, $1 million in the bank, and a financial safety blanket to cushion you from a significant loss, then by all means go for it.
However, with the eligibility criteria being so far out of reach for the vast majority of people, it’s probably not a viable option.
Even if you are eligible, we wouldn’t recommend diving into hedge funds if you are a beginner investor. It’s best to start smaller with something like a mutual fund or an index fund (we’d pick the latter).
Why choose an index fund?
Index funds are very tame in comparison to the glamorous world of hedge funds. But they’re also a great, steady way to get into investment.
Not everything has to be blackjack-style betting on the top companies in the world. Index funds instead invest in a pool of different companies and stocks such as the S&P 500 or the Dow Jones index.
Index funds are Ramit’s personal favorite, and what he recommends to most people new to investing. You might be surprised to learn that his net worth isn’t tied up in super-secret hedge funds, it’s mostly index funds instead.
Index funds are far less volatile. Maybe you won’t get those jaw-dropping returns but you probably won’t get those cry-in-despair losses either. (Although, we can’t promise anything when it comes to investing.)
Another great thing about them is that they don’t have loading fees when you buy or sell a fund, so they’re also a more cost-effective way to invest.
Hedge funds are a big scary concept for many investors and judging by the level of risk, that fear is not entirely misplaced. They may be the top choice for high net-worth or highly experienced investors, but for the vast majority of people – index funds are the way to go.