Strategies For Investing In Us-Based Hedge Funds

Investing in hedge funds is a complex and risky endeavour, often reserved for high net-worth individuals or organisations. In the US, hedge funds are defined as private investment companies that operate under exemptions from registration requirements under the Securities Act of 1933 and the Investment Company Act of 1940. This means they are less regulated than traditional mutual funds and employ aggressive investment strategies, such as leveraged, debt-based investing and short-selling.

Due to the high level of risk associated with hedge funds, the US Securities and Exchange Commission (SEC) places restrictions on who can invest. To invest as an individual, one must be an institutional investor or an accredited investor, i.e. have a net worth of at least $1 million or an annual income over $200,000 ($300,000 for married couples).

Hedge funds also come with significant fees. Typically, they charge an asset management fee of 1-2% of the invested amount, plus a performance fee of 20% of the fund's profit.

Before investing in a hedge fund, it is crucial to conduct thorough research and understand the associated risks, fees, and investment strategies.

Who can invest?

Who can invest in hedge funds?

The U.S. Securities and Exchange Commission (SEC) places regulations on who can invest in hedge funds due to the higher levels of risk associated with 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 are high net worth individuals or organisations and are presumed to understand the unique risks associated with hedge funds. They 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).

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, this threshold has not been updated since the 1980s, and if it were adjusted for inflation, it would be closer to a net worth of $2.5 million or a salary of $500,000 ($750,000 for married couples).

In August 2020, the SEC introduced provisions to allow those demonstrating advanced investing knowledge, gained through qualifying work experience or certain financial licenses, to become accredited investors, even if they lacked the financial qualifications.

Hedge funds are not intended for the average investor and are only accessible to sophisticated investors. They tend to cater to high net-worth individuals and require large sums to invest. It is possible to invest in hedge funds, but there are some restrictions on the types of investors who can do so.

Hedge funds are not as regulated as mutual funds or traditional financial advisors, and they are only accessible to accredited investors. These investors are presumed to have a sophisticated understanding of personal finance, investing, and trading.

Funds can and do make exceptions to these criteria, usually for friends and family. The SEC allows them to accept up to 35 non-accredited investors over the life of the fund.

Indirect methods of investing in hedge funds

If you don't meet the criteria to invest in a hedge fund directly, there are some indirect methods of investing.

• Investing in the stock of a financial company that operates hedge funds: This can be a way for ordinary individuals to gain indirect access to hedge funds.
• Investing in publicly traded fund companies: If you can't invest in a hedge fund directly, you might be able to capture some of the benefits indirectly by investing in the companies that run hedge funds. For example, Blackrock has a large alternative investments segment that operates much like a hedge fund and handles billions of dollars for ultra-wealthy clients and organisations.
• Funds of funds (FOF): Mutual funds were established to mimic the investment strategy of famous hedge funds. These so-called "funds of funds" are inexact replicas, as hedge funds have access to a much wider range of investment options.
• Replication equity funds: These funds try to imitate the performance of hedge fund benchmarks, similar to how an exchange-traded fund (ETF) aims to produce the same returns as an underlying index.
• Exchange-traded funds (ETFs): ETFs are good alternatives for investors who are interested in hedge funds but cannot gain access to them.

What are the fees?

Hedge funds typically charge a management fee and a performance fee. The management fee is an annual fee and is usually 2% of the assets under management (AUM). This fee is charged regardless of the fund's performance. For example, a fund manager with $1 billion AUM will earn $20 million in management fees annually, even if the fund performs poorly. The performance fee is charged when the fund achieves a certain level of profit. This fee is usually 20% of the profits made by the fund above a predefined benchmark, known as the hurdle rate.

The hurdle rate could be a preset percentage or based on a benchmark such as the return on an equity or bond index. For instance, if a fund with an 8% threshold level generates a return of 15% for the year, the 20% performance fee will be charged on the incremental 7% profit above the 8% threshold.

The management fee is used to pay staff salaries, administrative and office expenses, and other operational expenses. The performance fee is used to reward the hedge fund's key executives and portfolio managers.

The fees for hedge funds are often higher than for other types of funds, and they can eat into overall returns. This is a particular concern given that hedge funds have historically underperformed stock market indices.

Some hedge funds offer lower fees, such as "1.5 and 10" instead of "2 and 20". Some funds also offer discounts for investors who are willing to lock up their investments for a specified time period.

What are the risks?

Investing in hedge funds is risky. Here are some of the risks you should consider:

Losing Your Investment

Hedge funds are not regulated, and fund managers have free rein over the investment decisions they make. This freedom can lead to excessive leverage and other risky strategies that may result in significant losses for investors. The lack of regulation also means that hedge funds are not subject to the same stringent reporting standards as other funds, increasing the risk of fraud or unethical behaviour.

Style Drift

Style drift occurs when a fund manager deviates from the fund's stated goal or strategy, which may not be in the best interests of the investors. For example, a manager may enter a hot sector or try to avoid a market downturn, even if that means abandoning their area of expertise.

Overall Market Risk

Both equity and fixed-income funds are vulnerable to overall market movements. For example, during a market crisis, even the most diversified portfolio may suffer losses due to high correlations between different assets. Additionally, widening credit spreads can negatively impact the performance of fixed-income funds, as corporate bond yields increase while Treasury yields fall.

Leverage

The use of leverage is common in the hedge fund industry, as it can magnify gains. However, it is a double-edged sword, and even small moves in the wrong direction can significantly impact a fund's returns. Funds that speculate heavily in commodities and currencies are particularly vulnerable to the risks associated with leverage.

Operational Risk

Hedge funds often deal in the over-the-counter (OTC) market, where securities are tailor-made for the involved parties. One of the biggest issues with OTC securities is valuing them accurately, as they are not publicly traded and are highly illiquid. This lack of liquidity can also make it difficult for investors to withdraw their money from the fund.

How to set up a hedge fund

Setting up a hedge fund in the United States involves several regulatory and legal steps. Here is a detailed guide on how to set up a hedge fund:

Define your strategy

Firstly, you need to define a clear, replicable, and scalable investment strategy. This strategy should not rely on specific economic conditions or policies to succeed. Common hedge fund strategies include long/short equity positions, merger arbitrage, distressed company acquisitions, and algorithm-driven quantitative approaches.

Choose a business structure

Hedge funds are typically structured as limited partnerships, with the fund manager as the general partner and investors as limited partners. Alternatively, you can set up an LLC or another structure after consulting a professional.

Register with the state

After deciding on a business structure, register with the secretary of state in the state where you plan to incorporate. You will need to file your articles of incorporation and apply for an Employer Identification Number (EIN) with the IRS. Many hedge funds choose to incorporate in Delaware due to its business-friendly laws.

Write corporate bylaws

The hedge fund firm's bylaws should include essential documents such as a mission statement, a compliance manual, an ethical code of conduct, supervisory procedures, and an advisor portfolio management agreement.

Register as an Investment Adviser

To establish a legal partnership, the company must register as an Investment Adviser with the Investment Adviser Registration Depository (IARD). This process can be completed online for free.

Register representatives as Investment Advisers

Representatives of the hedge fund firm, including the fund manager, will likely need to register as Investment Advisers with the U.S. Securities and Exchange Commission (SEC). They can do so by taking the Financial Industry Regulatory Authority (FINRA) Series 65 regulatory exam, which tests knowledge of securities laws, practices, and ethics.

Register the hedge fund offering with the SEC

The hedge fund offering must be registered with the SEC using Form D in each state where it will be offered. This registration will include key partners, large investors, and the fund's primary investment strategy.

Comply with consumer protection provisions

Hedge fund managers are subject to registration and reporting requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. If the manager has less than $25 million in assets under management, they must look to their home state for registration and licensing requirements.

Market the hedge fund to potential investors

The Jumpstart Our Business Startups Act of 2012 (JOBS Act) has provided hedge fund managers with greater flexibility in marketing their funds. Hedge funds can be marketed to investors who meet certain sophistication standards and to the general public if all purchasers are accredited investors.

Remember, setting up a hedge fund requires careful planning, compliance with regulatory requirements, and a solid understanding of the investment landscape. It is always recommended to consult with legal and financial professionals throughout the process.

How to invest like a hedge fund

If you don't meet the requirements to invest in a hedge fund or lack accredited investor status, there are still options available to emulate hedge funds. Here are some strategies to invest like a hedge fund:

• ETFs and Mutual Funds: You can find ETFs (exchange-traded funds) and mutual funds that employ similar strategies to hedge funds, such as short-selling or leveraged investing. The Global X Guru (GURU) ETF, for instance, aims to replicate the strategies of select hedge funds. These funds offer a more accessible way to gain exposure to hedge fund-like investments.
• Funds of Funds (FOF): Mutual funds are often established to mimic the investment strategies of famous hedge funds. These "funds of funds" invest in other funds, including hedge funds, mutual funds, or private equity firms. However, they are not exact replicas since hedge funds have access to a broader range of investment options.
• Replication Equity Funds: These funds attempt to imitate the performance of hedge fund benchmarks, similar to how an ETF tracks an underlying index. Replication equity funds provide another option for investors interested in hedge fund strategies but unable to access them directly.
• Investing in Publicly Traded Fund Companies: If direct investment in a hedge fund is not possible, consider investing in the companies that run hedge funds. For example, Blackrock has a large alternative investments segment that operates similarly to a hedge fund, managing billions of dollars for ultra-wealthy clients. By investing in such companies, you can potentially capture some of the performance of their hedge fund operations.
• Investing in the Stock of a Financial Company: For ordinary individuals, investing in the stock of a financial company that operates hedge funds can be a way to gain indirect access to the industry. This option may provide exposure to the performance of the company's hedge fund operations without the stringent requirements of investing in a hedge fund directly.

It is important to note that investing in hedge funds or hedge fund-like strategies carries higher risks than traditional investments. Hedge funds employ aggressive investment strategies and often invest in alternative assets. Therefore, it is crucial to thoroughly understand the risks and ensure that any investment aligns with your financial goals, risk tolerance, and investment horizon.

Frequently asked questions