How to Invest in Hedge Funds

If you follow investing news, you’ve probably heard the term hedge fund before.

Traditionally, hedge funds have been exclusive to wealthy investors who have a lot of money to throw around.

Can everyday investors also get involved in hedge funds and the potential return they offer?

What is a Hedge Fund?

A hedge fund is a special type of investment fund, much like a mutual fund. The funds pool investor money and use that money to execute an investment strategy. 

While mutual funds typically invest in securities like stocks and bonds, hedge funds tend to use far more advanced investment strategies, such as using derivatives and leverage.

These complex strategies can help hedge funds increase their gains or reduce their losses or let them profit even in down markets.

The difficulty of implementing these strategies usually means that hedge fund managers charge significant fees to investors in their funds.

Because they rely on complex securities, leverage, and complicated investment strategies, hedge funds are typically classed as alternative investments.

Who Can Invest in Hedge Funds?

Hedge funds are complicated and can be hard for inexperienced investors to understand.

Depending on the strategies they rely on, investing in a hedge fund can also be risky.

Notably:

That combination of complexity and risk has led the government to restrict investment in hedge funds to institutional and accredited investors.

To qualify as an accredited investor, an individual must have:

• a net worth of $1 million or more (excluding their primary home)
• or an annual income of $200,000 or more.

Married couples must have a net worth of $1 million or more (excluding their primary home) or an annual combined income of $300,000 or more.

If you meet those requirements, an individual hedge fund may impose additional income or net worth requirements. Many also have minimum investment requirements that you have to meet.

If you don’t meet those requirements, you may be able to get indirect exposure to hedge funds.

For example, some publicly traded companies operate hedge funds. If you invest in those businesses and their hedge funds perform well, there’s a good chance their stock price could rise.

Some mutual funds open to everyday investors also aim to mimic the performance of well-known hedge funds.

How to Choose a Hedge Fund to Invest In

If you’re considering investing in a hedge fund, you should follow these steps before committing to the investment.

Read the prospectus

Before investing in any investment fund, whether it’s a mutual fund or a hedge fund, you should take the time to read the fund’s prospectus.

A prospectus is a document that describes the fund, it’s current holdings, its fees, and the investment strategy its managers use.

Comparing funds by reading their prospectuses can help you find one that meshes with your investment goals and portfolio needs.

Understand the fees

Investing in a hedge fund isn’t free.

You will have to pay one or more fees when you invest, so understanding what those fees are, and how you pay them, is important.

With mutual funds, the fee structure is usually simple.

There is an annual cost, called the expense ratio, which is charged based on the assets you’ve invested in the fund. You may also pay transaction fees when buying or selling shares in the fund.

Hedge funds often have more complex fee structures.

You may have to pay a fee when buying shares, plus ongoing management fees.

A common fee structure is the fund manager to charge a fee based on the invested assets plus to take a portion of the fund’s earnings each year. This is intended to incentivize successful investment by the manager, but also reduces the investors’ gains.

A common fee structure is between 1% and 2% of invested assets each year, plus 20% of the fund’s gains.

Check redemption limitations

Some funds place restrictions on investors’ ability to sell or redeem their shares.

Before you invest, you should make sure you understand these restrictions and how they affect your ability to access your money.

Some typical restrictions include:

• a limit on the number of times you can sell shares in a specified period,
• a minimum amount of time that you must hold shares before redeeming,
• or only allowing redemption on a set schedule.

If you need to have easy access to the money you’re planning to invest, that will impact the hedge fund you choose.

You’ll have more freedom to choose a restrictive fund if you aren’t relying on the ability to make a quick withdrawal.

Research the fund managers

Before you invest in a fund, do some research on the fund’s managers.

You might find some useful or interesting information, such as the manager’s track record with previous funds.

You can also look into things like the manager's registrations with the SEC and see if they have any kind of disciplinary history.

A good place to start:

Look at the advisor’s form ADV.

This is a standardized form that investment advisors have to submit to the SEC and state authorities. You can also reach do a search using FINRA’s BrokerCheck database or contact your state’s securities regulator to gather additional information about the manager.

Ask questions

When you invest in a hedge fund, you’re placing trust in that fund’s manager, hoping that they’ll manage your money effectively.

Hedge funds have more leeway than mutual funds to use different investing strategies and rely on the manager’s intuition to try to earn positive returns.

You should make sure that you trust the people who will be managing your money before you invest.

Ask about anything that wasn’t made clear in the prospectus. Also ask questions to make sure you understand the fund’s fee structure, restrictions on redeeming your shares, and anything else you want to know.

You might also want to read FINRA’s investor alert, which is a website that FINRA uses to send information to investors and which describes some of the risks of investing in hedge funds.

Should You Invest in Hedge Funds?

Whether you should invest in hedge funds depends on your investing goals.

Hedge funds are actively-managed investments that charge high fees. Most of them aim to produce positive returns in both up and down markets or, at worst, to limit losses in a downward market.

If you believe that an effective manager can help you grow your portfolio, then a hedge fund might be a good choice for you.

However, many experts argue that it’s almost impossible for a manager to outperform the market over the long term, especially after accounting for fees, and that most investors would be better served by a low-cost, passive mutual fund.

Alternatives to Investing in Hedge Funds

If you don’t think hedge funds are the right choice for you, or are not eligible to invest in hedge funds, the closest alternative is a mutual fund.

Like hedge funds, mutual funds pool investors’ money and use it to build a portfolio of other securities, like stocks and bonds.

While hedge funds often use derivatives and leverage as part of their investing strategies, mutual funds tend to invest in simpler securities, like stocks and bonds.

There are both actively-managed and passively-managed mutual funds. Actively-managed funds will be closest to hedge funds because their managers actively trade securities to try to produce the best possible returns. These funds tend to charge higher fees than passively-managed funds.

Depending on your investing goals and personal preference, either a passive or active mutual fund could substitute for hedge funds in your portfolio.

Conclusion

Hedge funds are complex and potentially risky investments that are typically restricted to investors with high net worths or incomes.

If you qualify to invest in hedge funds, they may be a suitable choice for your portfolio but everyday investors may want to consider investing in mutual funds instead.