Hedge Funds: Are They Worth The Investment Risk?

Hedge funds are a type of investment used by wealthy, accredited investors. They are actively managed investments that are only open to accredited investors and are typically less regulated and riskier than more traditional investments such as mutual funds. They often charge significantly higher fees than other investments and employ complex strategies to generate returns for their investors. While they can provide the potential for high returns and diversification benefits, they also come with higher fees and less regulatory oversight. Should you invest in hedge funds? That depends on several factors, including whether you qualify as an accredited investor and your ability to evaluate and accept the risks involved.

Hedge funds vs. mutual funds

Hedge funds and mutual funds are both managed portfolios that pool money from investors to buy securities or other types of investments. However, there are some key differences between the two.

Mutual funds are open to all investors, regulated, and trade daily. They are also limited in their ability to use riskier investment strategies and are restricted to investing in publicly traded securities such as stocks and bonds. Mutual funds charge a flat fee, typically between 1% and 2% of assets under management.

On the other hand, hedge funds are exclusive and have limited access. They target high-net-worth individuals and employ more complex and volatile trading strategies to achieve higher returns. Hedge funds are also able to invest in a wider range of assets, including cryptocurrency, private real estate, and even alternative assets like vintage single malt scotch. Due to their higher-risk strategies, hedge funds are only available to accredited investors, typically defined as individuals with a net worth of at least $1 million or an annual income of $200,000.

Hedge funds usually charge a management fee of around 2% and a performance fee of 10-30%, known as the "two-and-twenty" fee structure. This means that hedge funds can be more expensive than mutual funds, especially if they perform well.

In terms of performance, hedge funds have historically underperformed stock market indices like the S&P 500. However, they can provide diversification benefits and perform better in bear markets due to their ability to employ short-selling and other riskier strategies.

Overall, hedge funds are riskier and more exclusive than mutual funds. Mutual funds are more regulated and accessible to everyday investors, while hedge funds offer the potential for higher returns but come with greater risk and less liquidity.

The risks of hedge funds

Investing in hedge funds is much riskier than investing in most other assets. Here are some of the risks associated with hedge funds:

High Fees

Hedge funds often have high fees, including a management fee of 1-2% and a performance fee of 20% of the fund's profit. These fees can eat into your overall return.

Illiquidity

Hedge funds are not as liquid as stocks or bonds and may only allow investors to withdraw their money after a certain amount of time or during set periods of the year.

Underperformance

Historically, hedge funds have underperformed stock market indices. From January 2009 to January 2019, hedge funds only beat the S&P 500 in a single year.

Fraud and Misappropriation

Hedge funds are not subject to the same stringent reporting standards as mutual funds, and the risk of fraud is more prevalent. There have been numerous cases of hedge fund managers bilking investors out of large sums of money.

Operational Risk

Operational risk refers to the shortcomings of the policies, procedures, and activities of a hedge fund and its employees. Hedge funds often deal in the over-the-counter market, where positions can be tailor-made but are difficult to value due to a lack of public trading and liquidity.

Leverage

The use of leverage is common in hedge funds, as it can magnify gains. However, it is a double-edged sword, and even a small move in the wrong direction can put a major dent in a fund's returns.

Style Drift

Style drift occurs when a fund manager strays from the fund's stated goal or strategy to enter a hot sector or avoid a market downturn. This may not be in the best interests of the investors, as they invested based on the manager's expertise in a particular sector or strategy.

Overall Market Risk

Both equity and fixed-income funds are susceptible to overall directional moves by the equity markets, which can significantly impact the returns of a fund. In times of crisis, even the most diversified portfolio will not be safe from a market crash.

Concentration Risk

Concentrating assets in a single market means a greater risk of losses if that market underperforms.

Complex Structure Risk

The complex structure of hedge funds may make it difficult for investors to understand how their money is being invested and the risks they are taking on.

Counterparty Risk

Derivatives purchased "over the counter" by agreement with another party may lead to counterparty risk if the other party fails to honour the agreement.

The benefits of hedge funds

Hedge funds are a pool of investors' capital that is managed by a fund manager according to the particular fund's strategy. They are generally more exclusive, aggressive, and riskier than mutual funds. Here are some benefits of investing in hedge funds:

Aggressive Investment Strategies

Hedge funds employ aggressive investment strategies to achieve high returns. These strategies can include leverage, derivatives, and long and short positions. For example, in a leverage strategy, investors borrow and trade money on top of their capital, increasing potential returns. While this approach can lead to significant losses, fund managers employ complex risk management tools to mitigate these risks.

Expertise and High Returns

Hedge fund managers are highly experienced and knowledgeable in financial investments. They provide expert advice on which funds to invest in, when to invest, and where to invest (domestic vs. international). This expertise can significantly increase your chances of receiving large returns on your investments.

Flexibility and Control

Hedge funds offer their managers a high degree of flexibility and control in generating positive returns. They can employ a wide range of investment strategies, such as taking long or short positions, using equity, debt, and derivatives, and leveraging global macro strategies. This flexibility allows fund managers to adapt to changing market conditions and pursue financial gains in both rising and falling markets.

Capital Growth Opportunities

Hedge funds provide opportunities for capital growth through a diverse range of investment strategies and vehicles. They can invest in various assets, including commodities, stocks, and bonds, and employ tactics like company mergers and acquisitions. This diversity allows hedge funds to pursue profitable opportunities and manage investment risk effectively.

Low Correlation to Traditional Investment Products

Hedge funds have a low correlation to traditional investment products, providing a way to diversify investment portfolios. They offer access to a wide range of assets and unusual trading strategies that are not typically available to individual investors. This diversification can help protect your portfolio from market downturns and enhance overall returns.

Who can invest in hedge funds?

Hedge funds are only open to accredited investors. These are high-net-worth individuals or organisations with a sophisticated understanding of personal finance, investing, and trading.

In the US, an individual must have a net worth of at least $1 million (excluding the value of their primary residence) or an annual income of over $200,000 ($300,000 if married) to be considered an accredited investor.

These requirements are in place to ensure that investors are able to accept the higher potential risk that comes with a lack of regulation. Hedge funds are loosely regulated and are therefore limited to accredited investors.

The vast majority of the investing public is excluded by these requirements. However, funds can and do make exceptions, usually for friends and family. The US Securities and Exchange Commission (SEC) allows hedge funds to accept up to 35 non-accredited investors over the life of the fund.

For ordinary individuals, investing in the stock of a financial company that operates hedge funds could be a way to gain indirect access.

How to invest in hedge funds

Hedge funds are loosely regulated investment vehicles that are limited to "accredited investors". In the US, these are individuals with a net worth of at least $1 million (excluding their primary residence) or an annual income of over $200,000 ($300,000 for married couples).

If you meet the criteria for accreditation, there are several steps you can take to invest in hedge funds:

Research Funds

First, research funds that are currently accepting new investors. While there are some online research tools, you will probably need the guidance of a financial advisor to locate suitable hedge funds.

Research Fund Managers

Once you have identified potential funds, research the fund managers and their investment goals using Form ADV. Form ADV is a form that investment advisors are required to submit, detailing their business practices, disciplinary history, fees, and investment strategy. You can find this form on the fund's website or via the SEC's Investment Adviser Public Disclosure database.

Contact Hedge Funds

After identifying suitable funds and fund managers, contact a hedge fund and ask for information on minimum investment requirements.

Verify Your Status as an Accredited Investor

There is no standardised method or central accreditation authority for verifying your status as an accredited investor. Each fund determines your status using its own practices, which may include providing information on your income, assets, debts, and experience. This information may need to be confirmed by licensed third parties, such as financial institutions, investment advisors, or attorneys.

Understand the Risks and Costs

Hedge funds employ complex and aggressive investment strategies, such as leveraging and short-selling, which carry significant risks. Additionally, hedge funds often have high fees, including management fees (typically 1-2% of the amount invested) and performance fees (around 20% of the fund's profit). These fees can eat into your overall returns, so it is important to carefully consider the cost-benefit calculation before investing.

Consider Alternative Options

If you do not meet the requirements for accreditation or are uncomfortable with the risks and costs associated with hedge funds, there are alternative options available. You can find ETFs, mutual funds, or funds of funds that employ similar strategies to hedge funds, such as short-selling or leveraged investing. Additionally, investing in index funds that track major indices like the S&P 500 may be a better option for the average investor seeking high returns.

Frequently asked questions