Hedge funds have entered the public consciousness as one of the best ways to grow your wealth over time. Compared to investments like mutual funds and ETFs, hedge funds are able to make bigger bets and diversify portfolios by investing in assets like real estate and commodities.
But investing in hedge funds isn’t as simple for everyday investors as putting your money in other types of funds. In this guide, we’ll explain how hedge funds work, why they’re out of reach for the average investor, and what alternatives are available to you.
What are Hedge Funds?
Hedge funds are pools of money contributed by individual investors for collective investment. Like mutual funds, hedge funds are controlled by a fund manager who directs what investors’ money is used to purchase.
The difference between hedge funds and other types of funds is that hedge funds invest in much more than just stocks and bonds. Hedge funds may invest in alternative assets like real estate, currencies, commodities, or even more exotic assets such as fine art. In addition, hedge funds have the freedom to establish short positions or to invest in derivatives to manage risk.
Another important difference that investors should be aware of before considering a hedge fund is that they often have large minimum deposits and lock-up periods. You can’t simply invest a few hundred dollars in a hedge fund and sell your position whenever you want. Rather, you may be required to commit tens or even hundreds of thousands of dollars at a time, and that money may be inaccessible for several years. After that, you may only be able to withdraw money once per quarter or once per year.
These restrictions are part of what allows hedge funds to invest in riskier assets. For example, if a hedge fund invests in a real estate development project, the fund’s money may be tied up for several years – so investors must be locked into the fund during that time.
Why Invest in a Hedge Fund?
There are several advantages that investors get in exchange for taking on the risk and lock-up periods associated with hedge funds.
First, investors get access to investments that they normally would not otherwise be able to include in their portfolios. Individual investors rarely have access to the commercial real estate market, for example, but hedge funds have a free hand to buy and sell buildings or development projects. One of the primary purposes of a hedge fund is to diversify investors’ portfolios so that they are protected from – hedged against – a downturn in the stock market.
The other major advantage to hedge funds is that many have excellent track records. Hedge fund managers can charge high fees, so the field tends to attract some of the most savvy investors in the world. Since these managers have a relatively free hand to operate, they can also place bets with a lot of risk and a lot of potential reward. While not every hedge fund pays off, some of them can generate significant windfalls for investors.
How Do You Invest in a Hedge Fund?
There’s no simple way for most investors to jump into a hedge fund. Most of the time, you need to know the fund manager or someone who is already invested in the fund. Even if you do have an “in” at a hedge fund, many funds require a minimum investment of $100,000 or even $1 million to participate.
Why are Hedge Funds So Hard to Invest In?
Much of the difficulty investors face in accessing hedge funds comes from an SEC regulation known as Regulation D. This regulation requires that hedge funds only accept accredited investors, a classification that is essentially limited to investors with a net worth greater than $1 million and financial professionals. Hedge funds may accept up to 35 non-accredited investors over the life of a fund, but those spots are usually reserved for family members of prominent investors.
These rules were devised to protect ordinary investors. Hedge fund managers aren’t required to alert investors to changes in the fund’s portfolio and shorting the market can be extremely risky. By only allowing accredited investors, the SEC’s goal is to make sure that anyone who invests in a hedge fund fully understands the risks.
On top of that, there is no requirement for a fund manager to let anyone invest in their fund – the decision to admit an investor is entirely at the manager’s discretion. So, even if you quality for a hedge fund, you still might not be able to invest without a personal relationship with someone inside the fund.
What are Alternative Options for Investing in a Hedge Fund?
While you might not be able to invest in a true hedge fund, there are some alternatives available to the everyday investor. Funds are occasionally structured as mutual funds, making them widely accessible, and themselves invest in hedge funds. While this is one step removed from investing in a hedge fund, it still provides some exposure to the assets that these funds invest in.
You can also invest in some asset classes that hedge funds invest in on your own. For example, real estate investment trusts (REITs) can give you access to the real estate market, while there is nothing to stop you from investing in currencies and commodities on your own through a brokerage. That said, you lose out on the knowledge and expertise of a dedicated fund manager when investing on your own.
Should You Invest in a Hedge Fund?
Before you go looking for hedge fund alternatives or consider investing in a hedge fund if you’re eligible, it is worth considering whether that’s a worthwhile investment.
Hedge funds promise excellent returns, but they also come with very high management fees. Most funds charge based on a rule of thumb known as “2 and 20” – you are charged 2% of your total investment each year, plus 20% of your profits from the fund.
In addition, the added risk that hedge funds bring simply doesn’t outweigh the allure of diversification for many investors. Risk-averse investors may be better off with low-cost passive mutual funds or ETFs that attempt to match the market rather than beat it.
Finally, the lock-up periods that many hedge funds come with can be counterproductive for some investors. If you may need access to your money during an economic downturn or to take advantage of another opportunity, it is worth thinking twice before you invest in a hedge fund.
Hedge funds are attractive to investors because they offer exposure to alternative assets and potentially significant returns. But, hedge funds are off-limits for the vast majority of investors because of SEC rules around who they can accept. If you’re not eligible to invest in a hedge fund but would like to, you have several alternatives including investing in a fund or funds or buying your own diversified assets.