A Beginner's Guide To Hedge Fund Investing

Hedge funds are alternative investment funds that pool money from investors and invest it with the goal of making a profit. They are typically managed by institutional investors who use a wide range of non-traditional investment strategies, with the primary goal of mitigating risk and generating returns regardless of market conditions. While hedge funds can provide higher returns, they are also associated with higher risk and are less regulated compared to traditional investment options. Due to these factors, hedge funds are generally only accessible to accredited investors or high-net-worth individuals who meet certain income or wealth requirements.

Hedge funds vs mutual funds

Hedge funds and mutual funds are both managed portfolios that pool funds from multiple investors to invest in securities. However, there are several differences between the two.

Mutual funds are open to all investors, whereas hedge funds are exclusive to high-net-worth individuals. Mutual funds are also regulated and trade daily, whereas hedge funds have limited access and less oversight.

Mutual funds tend to stick to lower-risk investments and are therefore considered safer. Hedge funds, on the other hand, take on more complex and volatile trading strategies to achieve higher returns. They are known for their riskier investments, attracting wealthier investors who are willing to take larger bets.

Mutual funds charge flat fees, typically ranging from 1% to 2% of assets under management. Hedge funds, however, charge both management and performance fees. The typical fee structure for hedge funds is the "two-and-twenty" model, where investors pay a 2% management fee and a 20% performance fee.

Mutual funds are limited to investing in publicly traded securities, such as stocks and bonds. Hedge funds, on the other hand, have more freedom and can invest in alternative assets such as real estate, private companies, cryptocurrencies, and more.

Hedge funds also tend to be less liquid than mutual funds, with lock-up periods that restrict investors from accessing their funds for a certain period.

In summary, mutual funds are more suitable for everyday investors who want a regulated and relatively safer investment option. Hedge funds, on the other hand, cater to high-net-worth individuals who are willing to take on more risk in pursuit of higher returns.

Who can invest in hedge funds?

Hedge funds are financial institutions that tend to be privately owned and managed. They are funded by private capital pooled from investors, companies, or other clients. In particular, hedge funds do business with accredited investors—individuals with a high net worth.

Due to 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 are individuals with 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).

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, 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 lack the financial qualifications.

Hedge funds are not intended for the average investor. They are much riskier than most other investments and employ aggressive investment strategies, such as leveraged, debt-based investing, and short-selling. They also invest in assets that other funds can't, like real estate, art, and currency.

Minimum initial investment amounts for hedge funds range from $100,000 to upwards of $2 million, and they are not as liquid as stocks or bonds. Hedge funds also carry hefty fees, including an asset management fee of 1-2% and a performance fee of 20% of the fund's profit.

If you don't meet the requirements to invest in hedge funds directly, there are still some options to emulate hedge fund strategies. You can find ETFs, mutual funds, and funds of funds that use similar strategies, like short-selling or leveraged investing. Additionally, investing in the stock of a financial company that operates hedge funds could be a way to gain indirect access.

Hedge fund fees and minimums

Hedge funds charge fees for asset management and performance. The typical fee structure for hedge funds is the "2-and-20" rule, where managers charge a 2% management fee and a 20% performance fee. The management fee is calculated as a percentage of the total assets under management (AUM) and covers the fund's operating expenses and profits. The performance fee is calculated as a percentage of the profits from investing and is intended to incentivize greater returns for employees.

Over time, the average management and performance fees have decreased. In Q1 2023, the average management fee was 1.36%, and the average performance fee was 16.17%. Larger funds above $1 billion in AUM tend to have management fees ranging from 1% to 1.5% and performance fees ranging from 15% to 20%. Smaller emerging funds charge higher fees, with management fees ranging from 1.5% to 2.5% and performance fees ranging from 15% to 25%.

The minimum initial investment amount for hedge funds varies but typically ranges from $100,000 to upwards of $2 million. These high minimums, along with the illiquid nature of hedge funds, make them inaccessible to most retail investors.

Hedge fund fees can significantly impact investors' returns. High management and performance fees reduce the fund's profits, resulting in lower overall returns for investors. Therefore, it is crucial for investors to carefully review and understand a fund's fee structure before committing capital.

Hedge fund strategies

Hedge funds employ a variety of strategies to generate active returns for their investors. Here is an overview of some common hedge fund strategies:

Long/Short Equity

The first hedge fund launched by Alfred W. Jones in 1949 used a long/short equity strategy, and it remains one of the most common strategies today. The concept is to take long positions in expected winning investments and short positions in expected losing investments. This approach creates more opportunities for gains and reduces market risk by offsetting long market exposure with shorts. Long/short equity is essentially a form of pairs trading, where investors go long and short on two competing companies based on their relative valuations. It is considered a relatively low-risk bet on the manager's stock-picking skill.

Market Neutral

Market-neutral hedge funds aim for zero net market exposure, with short and long positions of equal market value. As a result, managers generate returns solely from stock selection, leading to lower risk but also lower expected returns compared to long-biased strategies.

Merger Arbitrage

Merger arbitrage is an event-driven strategy that involves investing in companies undergoing mergers or acquisitions. After a share-exchange transaction is announced, a hedge fund manager may buy shares in the target company and short-sell the buyer's shares according to the merger agreement. This strategy carries the risk of significant losses if the transaction falls apart.

Convertible Arbitrage

Convertible arbitrage hedge funds typically take long positions in convertible bonds and short positions in a proportion of the shares into which they convert. Managers aim to maintain a delta-neutral position, adjusting their hedge as the market fluctuates, which forces them to buy low and sell high. This strategy thrives on volatility and benefits from high or declining volatility but struggles when volatility spikes during market stress.

Event-Driven Strategies

Event-driven strategies focus on companies in financial distress or bankruptcy. Hedge funds buy the debt of these companies, often focusing on senior debt, which is most likely to be repaid. Managers may also sell short equity, anticipating a decline when the company files for bankruptcy or negotiates an equity-for-debt swap. Event-driven strategies work well during periods of economic strength when corporate activity is high.

Fixed-Income Arbitrage

Hedge funds employing fixed-income arbitrage strategies seek returns from risk-free government bonds, eliminating credit risk. They use arbitrage to buy and sell assets or securities across different markets, profiting from price discrepancies. Managers make leveraged bets on how the yield curve will change and typically use high leverage to boost modest returns, increasing the risk of loss if their bets are wrong.

Global Macro

Global macro funds analyze how macroeconomic trends will impact interest rates, currencies, commodities, or equities worldwide. They take long or short positions in the most sensitive asset classes, often favouring highly liquid instruments like futures and currency forwards. Macro funds make large directional bets, leading to volatile returns.

Relative Value

Relative value is a newer strategy that leverages market data to identify inconsistencies and errors in how the market prices individual securities. It focuses on market behaviour rather than individual companies. Substrategies within relative value include convertible arbitrage and volatility arbitrage.

Specialist Strategies

Specialist hedge fund strategies require highly specialized skill sets for trading in niche markets. Examples include volatility trading, which aims to capture relative timing and strike pricing opportunities arising from changes in the term structure of volatility, and reinsurance/life settlements, which involve purchasing pools of life insurance contracts.

Multi-Manager Strategies

Funds-of-funds and multi-strategy funds provide steady, low-volatility returns through strategy diversification. Multi-strategy funds have generally outperformed funds-of-funds but exhibit higher variance due to their use of relatively high leverage.

How to invest in hedge funds

Hedge funds are alternative investment funds that pool money from investors and invest it with the intent of making a profit. They are typically managed by institutional investors who use a wide range of non-traditional investment strategies, with the primary goal of mitigating risk.

Who Can Invest in Hedge Funds?

Hedge funds are not for the average investor. Due to 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 are considered 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, excluding the value of their primary residence, or an annual individual income of over $200,000 ($300,000 if married).

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 very liquid and may only allow investors to withdraw their money after a certain period or during specific times of the year.

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

To invest in hedge funds, first research funds that are currently accepting new investors. While there are some online research tools, you will likely need a financial advisor to locate potential hedge funds. Once you've looked into the fund managers and investment goals, you'll need to contact a hedge fund and ask about minimum investment requirements.

You'll also need to verify your status as an accredited investor. There is no standardised method for this, and each fund determines your status using its own practices. You may have to provide information on your income, assets, debts, and experience, which will need to be confirmed by licensed third parties, such as a financial institution or attorney.

Alternatives to Direct Hedge Fund Investment

If you don't meet the requirements for direct investment in a hedge fund, there are other ways to gain exposure to hedge fund-like investments. You can find ETFs, mutual funds, and funds of funds that use similar strategies to hedge funds, such as short-selling or leveraged investing.

Additionally, you can invest in the stock of a financial company that operates hedge funds, or in publicly traded investment advisors and asset management firms.

Frequently asked questions