With government restrictions and expensive buy-ins, hedge funds are virtually inaccessible to most purely investing mortals. But that can’t be that bad. Hedge funds are much riskier than most other investments. And if you want to maximize your returns, they may not even be a better option than low-cost index funds. Here is everything you need to know about investing in hedge funds.

What is a hedge fund?

A hedge fund pools money from investors to buy stocks or other types of investments. If that sounds a lot like a Investment funds or exchange traded fund (ETF) You are not wrong for you. But hedge funds aren’t as constrained as mutual funds. They are more likely to use aggressive investment strategies, such as Leveraged, debt-based investing and short sales, and they can buy types of assets that other funds cannot invest in, such as real estate, art, and currency.

These strategies used by hedge funds come with significant risks, says Sarah Catherine Gutierrez, a certified financial planner (CFP) and CEO of Aptus Financial.

“Hedge funds are riskier investments because they often invest in investments for oversized, shorter-term gains,” she says. “It can even be with borrowed dollars. But these bets can lose. “

Hedge funds pursue these riskier strategies in order to generate returns regardless of market conditions. This tactic appeals to investors who are also in Bear markets. And there can be a certain glamor associated with qualifying to invest in hedge funds.

“Hedge funds are seen by some as an exclusive club to qualify for,” said Katie Brewer, CFP and president of Your Richest Life. “Hedge funds can have their advantages – an opportunity for higher returns – and disadvantages, including illiquidity, volatility and risk.”

What is a hedge fund manager?

A hedge fund manager is an investment manager who makes daily investment decisions for a hedge fund. You decide how the money invested is distributed and how the fund’s risk is managed.

Hedge fund managers are motivated to be successful; they receive a performance fee – which can be up to 20% of the fund’s profit – if the fund is profitable.

Because of the huge role they play in managing your money, you want to make sure that every hedge fund manager is qualified to handle your money. You can review a hedge fund manager’s disciplinary history, fees, and investment strategy by looking at the ADV form. You can find this form on their website or through the SECs Public disclosure database for investment advisors.

Hedge Fund Fees and Minimums

The minimum investment amounts for hedge funds range from $ 100,000 to $ 2 million. Hedge funds are not like that fluid how shares or bind either and may only allow you to withdraw your money after it has been invested for a certain period or at certain times of the year.

Hedge funds also come with high fees. Typically, hedge funds will charge an asset management fee of 1% to 2% of the amount you invest plus a performance fee of 20% of the profits of the hedge fund. All of these fees can affect your overall return. This may not be a huge problem if hedge funds are drastically outperforming the rest of the stock market, but they generally don’t. This can make index-based ETFs and mutual funds with an average expense ratio of 0.13% even more attractive.

Historical hedge fund performance

Historically, hedge funds have lagged the stock market indices. From January 2009 to January 2019, hedge funds outperformed the S&P 500 in just one year: 2018. It’s worth noting that this is partly because December 2018 saw a general market slump that brought a decade-long bull market into almost bear market territory, and hedge funds aim to weather market downturns better than the market as a whole. Even so, hedge funds still lost 4.07% in 2018. That was a little less than that S&P 5004.38%.

By 2019, hedge funds had recovered, averaging 6.96%. But over the same period, the S&P 500 was up 28.9%, while the Dow Jones Industrial Average was up 22.3% and the NASDAQ was up 35.2%. This is an exaggerated difference, perhaps, but in line with historical data: From 1980 to 2008, according to the Journal of Financial Economics, hedge funds achieved average returns of 6.1 percent after fees. Over the same period, the S&P 500 rose an average of 12.5% ​​each year.

In the hedge fund vs. mutual fund or ETF debate, does that mean that hedge funds always lose? Not necessarily. The goal of hedge funds is not necessarily to outperform the indices; Instead, they are designed to enable growth despite market conditions.

“Hedge funds have always been designed to complement a well-rounded asset allocation with US and international stocks and US and international cash or cash equivalents,” says Brewer.

Who can invest in hedge funds?

Because of the higher risk associated with hedge funds, the US Securities and Exchange Commission has regulations about who can invest in them.

To invest in hedge funds as an individual you must be an institutional investor such as Pension fund, or an accredited investor. Accredited investors have a net worth of at least $ 1 million (excluding the value of their primary residence) or an annual individual income of over $ 200,000 ($ 300,000 if married).

Overall, that’s a small fraction of the US population. According to the United States Census Bureau, only about 4% of households earned more than the $ 300,000 it takes a family to achieve accredited investor status in 2019.

However, more people are now qualifying than originally intended.

“Interestingly, the thresholds for an accredited investor have not been updated since the 1980s and now include many more people than originally thought,” says Gutierrez. If those numbers were adjusted for inflation, they would be closer to a net worth of $ 2.5 million or salaries of $ 500,000 ($ 750,000 if you’re married), she says. “Hedge funds are not intended for the average investor.”

SEC guidelines support this claim: In August 2020, the SEC has introduced regulations to enable those who demonstrate advanced investment knowledge through qualifying work experience or certain financial licensesto become accredited investors, even if they lack the financial prerequisites.

How to invest in hedge funds

In order to invest in hedge funds, the first research funds are currently accepting new investors. Although there are some research tools online, you will likely find the guidance from a Financial advisor find potential hedge funds. After using the Form ADV to review the fund managers and investment objectives of these funds, you will need to contact a hedge fund and request information about the minimum investment requirements.

You will also need to confirm that you are an accredited investor. There is neither a standardized procedure nor a central accreditation body. Each fund determines your status based on its own practices. You may need to disclose your income, assets, debts and experience and have this verified by licensed third parties, such as: B. a financial institution you have accounts with, an investment advisor, or an attorney.

Invest like a hedge fund

If you don’t meet the requirements of the hedge fund companies or don’t have accredited investor status, there are a few ways you can mimic hedge funds.

There are ETFs, mutual funds, and funds of funds that use strategies similar to hedge funds, such as short selling or leveraged investing, Brewer says. One ETF, the Global X Guru (GURU) and a startup, Titan, even claim to be following the same strategies as selected hedge funds.

Just remember, you don’t have to invest in hedge funds to grow your wealth. Historically, broad market indices have outperformed hedge funds, so you may be better off investing in Index funds instead of this. And remember, when trying to build wealth, invest long-term. By continuing to invest in index funds during years when the market is declining (and hedge funds are supposed to shine), you can buy cheap and get higher returns when the market rebounds.

Should You Invest in a Hedge Fund?

If you qualify as an accredited investor and are willing to invest hundreds of thousands of dollars – or even millions – at once, investing in hedge funds can be a smart way to diversify your profile and hedge against market volatility. But for the average person looking for high returns, investing in index funds that track major indices like the S&P 500 is likely a better option.

“Most people are better off with passively managed portfolios that simply invest in the entire market,” Gutierrez says. “Our goal in investing should be to own the entire market and grow our investments over time as the companies we own grow. In other words: being average is a win. “

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