With government restrictions and pricey buy-ins, hedge funds are all but inaccessible to most mere investing mortals. That may not be such a bad thing, though. Hedge funds are much riskier than most other investments. Here’s everything you need to know about investing in hedge funds.
What Is a Hedge Fund?
A hedge fund pools money from investors to buy securities or other types of investments. If this sounds a lot like a mutual fund or exchange-traded fund (ETF) to you, you’re not wrong. But hedge funds aren’t limited the same ways mutual funds are. They often employ aggressive investment strategies, like leveraged, debt-based investing, and short-selling. They can purchase types of assets other funds can’t invest in, like real estate, art, and currency.
Those strategies hedge funds use come with significant risk, says Sarah Catherine Gutierrez, a certified financial planner (CFP) and CEO of Aptus Financial.
“Hedge funds are riskier investments because they are often placing bets on investments seeking outsized, shorter-term gains,” she says. “This can even be with borrowed dollars. But those bets can lose.”
Hedge funds take on these riskier strategies to produce returns regardless of market conditions. This tactic appeals to investors looking to continue to earn returns even in bear markets. And, some glamour may be associated with qualifying to invest in hedge funds.
“Some see hedge funds as an exclusive club you have to qualify for,” says Katie Brewer, CFP and president of Your Richest Life. “Hedge funds can have advantages—a chance at 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. They choose how to distribute invested money and manage the fund’s level of risk.
Hedge fund managers are motivated to succeed; they get paid a performance fee—up to 20% of the fund’s profits—if it is profitable.
Due to their significant role in managing your money, you want to ensure any 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 their Form ADV. You can find this form on their website or the SEC’s Investment Adviser Public Disclosure database.
Hedge Fund Fees and Minimums
Minimum initial investment amounts for hedge funds range from $100,000 to upwards of $2 million. Hedge funds are not as liquid as stocks or bonds and may only allow you to withdraw your money after you’ve been invested for a certain amount of time or during set times of the year.
Hedge funds also carry hefty fees. Typically, hedge funds charge an asset management fee of 1% to 2% of your invested amount, plus a performance fee of 20% of the hedge fund’s profit. All of these fees can eat into your overall return. This might not be a massive concern if hedge funds drastically outperformed the rest of the stock market, but this isn’t generally the case. This can make index-based ETFs and mutual funds, which have average expense ratios of 0.13%, even more appealing.
Historical Hedge Fund Performance
Hedge funds have historically underperformed stock market indices. From January 2009 to January 2019, hedge funds only beat the S&P 500 in a single year: 2018. It’s worth noting that this is partly because December 2018 saw an overall market plunge that almost brought a decade-long bull market into the bear market territory. Hedge funds aim to weather market downturns better than the overall market. That said, hedge funds still lost 4.07% in 2018. This was just less than the S&P 500’s 4.38%.
By 2019, hedge funds were up again, returning 6.96% on average. But during that same time, the S&P 500 increased by 28.9%, the Dow Jones Industrial Average rose by 22.3%, and the NASDAQ grew by 35.2%. This is a perhaps-exaggerated difference but in line with historical data: From 1980 through 2008, hedge funds averaged returns of 6.1 percent after fees, according to the Journal of Financial Economics. During that same period, the S&P 500 rose 12.5% each year.
Does that mean in the debate between hedge funds vs. mutual funds or ETFs that hedge funds always lose? Not necessarily. The goal of hedge funds isn’t to outperform the indices; instead, they’re designed to provide growth despite market conditions.
“Hedge funds were always meant to supplement a well-rounded asset allocation containing U.S. and international stocks and the U.S. and international cash or cash equivalents,“ says Brewer.
Who Can Invest in Hedge Funds?
Because of the higher levels of risk associated with hedge funds, the U.S. Securities and Exchange Commission (SEC) places regulations on who can invest in them.
To invest in hedge funds as an individual, you must be an institutional investor, like a pension fund, or an accredited investor. Accredited investors have a net worth of at least $1 million, not including the value of their primary residence or annual individual incomes over $200,000 ($300,000 if you’re married).
Overall, that’s a small fraction of the U.S. population. According to the United States Census Bureau, only about 4% of households earned more than the $300,000 necessary for a family to reach accredited investor status in 2019.
However, more people qualify now than was initially intended.
“Interestingly, the thresholds for an accredited investor haven’t been updated since the 1980s and now include many more people than originally imagined,” says Gutierrez. If those numbers were adjusted for inflation, they’d be closer to net worths 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 introduced provisions to allow those are demonstrating advanced investing knowledge gained through qualifying work experience or specific financial licenses to become accredited investors, even if they lack the financial qualifications.
How to Invest in Hedge Funds
First, research funds are accepting new investors to invest in hedge funds. While there are some research tools online, you’ll probably want the guidance of a financial advisor to locate potential hedge funds. Once you’ve looked into those funds’ fund managers and investment goals using Form ADV, you’ll need to contact a hedge fund and ask for information on minimum investment requirements.
You’ll also need to verify you’re an accredited investor. There is no standardized method or central accreditation authority. Each fund determines its status using its practices. You may have to provide your income, assets, debts, and experience and have this confirmed by licensed third parties, like a financial institution you have accounts with, an investment advisor, or an attorney.
How to Invest Like a Hedge Fund
If you don’t meet hedge fund firms’ requirements or lack accredited investor status, you have a few options to emulate hedge funds.
You can find ETFs, mutual funds, and funds of funds that use similar strategies to hedge funds, like short-selling or leveraged investing, says Brewer. One ETF, the Global X Guru (GURU), and a startup, Titan, even claim to follow the same strategies as select hedge funds.
However, keep in mind that it isn’t necessary to invest in hedge funds to grow your wealth. Historically, broad market indices outperformed hedge funds, so you may be better off investing in index funds. And remember this: When you’re trying to build wealth, you’re investing for the long term. Continuing to invest in index funds through years when the market is down (and hedge funds are supposed to shine) allows you to buy low and enjoy higher returns when the market recovers.
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 may be an intelligent way to diversify your profile and hedge against market volatility. But for the average person seeking 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 in passively managed portfolios that simply invest in the whole market,” says Gutierrez. “Our goal with investing should be to own the whole market and to grow our investments over time as those companies we own grow. In other words, being average is winning.”