Investing in a Hedge Fund
What is a Hedge Fund
Hedge funds are investment firms that use complex strategies and other forms of hedge fund management to generate returns for their investors. They are different from traditional investment funds that invest in stocks and bonds, and they are less regulated and much more opaque. This opaqueness is by design because many Hedge Funds are based offshore for tax and secrecy purposes. Hedge Funds are entirely legal, although generally one will have to be a Sophisticated Investor or Accredited Investor to access them.
Who Invests in Hedge Funds?
Hedge funds tend to serve high-net-worth individuals and invest large sums without taking ordinary investors into account. Generally, it is extremely difficult for an individual investor to access a high-quality hedge fund. It is possible to invest in a hedge fund, but there are significant differences in the types of investors that make up its investment pool, as well as in the quality of its management.
Many simply give up and are forced to find indirect investment methods through retail funds, such as private equity, mutual funds, or other investment funds.
Hedge funds are only accessible to sophisticated investors because they are not as regulated as investment funds and traditional financial advisers. For ordinary individuals, investing in a hedge fund run by a financial firm could be a way to gain indirect access. These so-called accredited investors are wealthy individuals or organizations and are more likely to understand the unique risks associated with hedge funds.
Hedge Fund Investment Standards
Hedge fund managers and shareholders often set high minimum investment standards. The minimum amount an investor can deposit into a fund is set by the Hedge Fund Manager and can be as little as $100,000 USD although it is more typical for a Hedge Fund to have a minimum investment level of $1million+
The Securities and Exchange Commission (SEC) requires that the majority of hedge fund investors must be accredited, which means that they have at least two years of experience in the investment management industry. It is not uncommon for those investing in a hedge fund to be charged a fee to participate in their investment funds, which is around 2% for very aggressive and actively managed funds.
Hedge Funds & Mutual Funds
Many mutual funds are created to mimic the investment strategies of famous hedge funds, but these requirements exclude the vast majority of the investing public. These so-called funds are inaccurate copies, as a hedge fund has no direct connection to the actual investment strategy of a known investment fund.
Hedge Funds and EFTs
There are also replication funds that attempt to mimic the performance of a hedge fund benchmark with an Exchange Traded Fund (ETF) that aims to achieve the same return as the underlying index. Some hedge funds are actually listed on the stock exchanges and have shares that can be purchased individually or through a broker.
Investing in a Hedge Fund
For investors who are interested in hedge funds but do not have access to them, you may be able to capture some of the performance by investing in the funds publicly traded holding companies. For example, BlackRock has a portfolio of alternative investments that act much like a hedge fund, managing billions of dollars for ultra-rich clients and organizations. By investing in BlackRock as company, rather than their funds, you are exploiting their ability to invest in the companies that run the hedge funds.
Criteria for Investing in a Hedge Fund
You can invest in a hedge fund, but only if you meet the criteria for membership of the fund. There are a number of investment advisers, such as Goldman Sachs and Morgan Stanley, that can offer access to a variety of hedge funds and other investment opportunities, so you don’t have to invest directly in them directly. However, these ‘fund of funds’ tend to be more interesting to those investing less than $100,000 USD in any situation.
Sophisticated Investing in a Hedge Fund
Accredited investor requirements are in place to ensure investors have the acumen to understand the advanced and aggressive strategies typically employed by hedge fund money, as well as the risks that this money takes. The rules usually follow the SEC’s minimum income rules:
- You must have earned at least $1 million in annual income over the past five years and
- Have net assets of more than $1 million.
- Funds can usually make exceptions to these criteria for family and friends, but only if they have a good reputation.
What is Investing in a Hedge Fund?
A hedge fund is a pooled investment vehicle. Now, you’re probably wondering what on earth is a pooled investment vehicle? So let’s actually just break down the hedge fund. You’ve got the word ‘hedge’, which in financial terms simply means to protect yourself in times of uncertainty. And then you’ve got a ‘fund’, which is a pooled investment vehicle. This vehicle collates different sums of money from different individuals, and places them into something called a hedge fund, then using that to invest in the financial markets.
Asset classes are areas in the financial markets which you can invest in. So there’s fixed income, there’s equities, there’s multi-asset, there’s quant, and there’s alternatives. When we talk about hedge funds, they fall into the alternative investment category.
The reason why hedge funds have become known for taking risky bets in the financial markets is because hedge funds can take investment positions or bets in both directions so they can go long or they can go short. They can make money whether the markets go up or down. On the flip side, Mutual Funds or more safe or less risky investment funds because they can only invest long.
The mutual funds tend to be regulated, and so that means they are limited in the way that they can invest. Hedge Funds are regulated by the Financial Service regulators in their country of domicile so are allowed to take positive bets on companies or financial securities or instruments, and they can also take negative bets.
Investing in a Hedge Fund to go Short
If the hedge fund manager thinks a company is going to be performing very badly, they can negatively invest in that company so they can create bets that assume that a company is going to perform very poorly over the next few months or years.
If investors are facing a very rough market environment, they might use hedge funds as investment vehicles to protect themselves from going both long and short. It’s important to note that some hedge funds are specifically long only hedge funds, so they might only focus on long strategies or positive growth strategies in the equity markets. Some hedge funds might specialize in real estate investments. Some hedge funds might specialize in the debt market.
Investing in a Hedge Fund for Leverage
Another reason why hedge funds are often considered to be risky is because they take on a lot of leverage. Now, what that means is in order to maximize their returns, they invest with borrowed money.
So let’s say a hedge fund has only $100 million to invest. If it believes that the opportunity is going to give a two percent return or a five percent return it may make $102 million or $105 million.
However, if the Hedge Fund borrows a further $100 million then $200 million invested would yield $210 million at 5% return.
Having done this, it provides a bigger risk because if the market went the opposite way as the loss would have been bigger. So when you lever up, when you take leverage, when you try and maximize your returns by borrowing money, the upside is bigger. But the potential risk is that there is a bigger downside and hedge funds tend to do this a lot. And so that’s why they are considered risky.
Risk and Reward of Investing in a Hedge Fund
For clients willing to take the risks the upside can be huge. It is not unusual for a hedge fund to deliver explosive capital growth of around 15% per year.
Asset Backed Investments
For those looking for solid returns from a fund, while limiting their exposure to market volatility certain Asset Secured Investments can deliver 10% yearly growth through their active and aggressive hands on management of UK and US distressed property situations. These funds have received much interest over the pasty years, as investors shun traditional retail ‘safe’ investments because of extremely low, or non existent returns.
Are Hedge Funds Unregulated
Mainstream banking and media will have investors believe that Offshore Investing is somehow shady or unregulated and this is simply incorrect. Hedge Funds are regulated by Offshore Jurisdictions many of whom are UK Crown Dependent Territories.
Accredited investors or people who can invest in hedge funds usually have a net worth of over one million pounds, and each investment size is usually a minimum of $100,000 USD.
How do Hedge Funds Make Money?
You may be familiar with the term two and 20. This means that Hedge Funds receive a two percent management fee and a 20 percent performance fee.
If a small hedge fund has $100million invested or in case, the management fee is two percent per year. The 20 percent fee is the hedge fund performance fee which kick sin at certain agreed levels.
Contrary to populist belief the management of $100million is not without cost or logistic and the 2% yearly management fee is wholly realistic for an aggressive and actively managed fund, especially one that is relatively iliquid such as property.