Am I the only that thinks of Sonic the Hedgehog when I hear the term “hedge fund”?
Hedge funds are the mystery players in the investment universe. We hear a lot about them, but few of us ever have any regular interaction with them, and we certainly don’t invest money with them. We assume that the only people who do are the big money people, like Georg Soros and Warren Buffet.
But that’s really the “TV version” of hedge funds. In reality, the people who invest with them are a lot closer to us than we think. Sure, they’re generally more prosperous than the average investor, but there are more of them than we generally assume. And they find hedge funds to be an attractive way to invest their money.
What is a hedge fund?
We can think of a hedge fund as something like a mutual fund for the very wealthy. The reason why it is for the wealthy is because hedge funds invest very aggressively, and are not regulated the way mutual funds and exchange traded funds are. They typically invest in derivative investments – both foreign and domestic – and can do so using a considerable amount of leverage.
Hedge funds use strategies that are aimed at providing above average returns by taking advantage of market inefficiencies (relative value funds). Because of these strategies, hedge fund investing is limited to more sophisticated investors, and have a high initial investment. They also require that your investment remains with the fund for at least one year, so you can’t cash out if you don’t like the arrangement after a few months.
Why you would invest in a hedge fund
Hedge funds offer an alternative way to invest, including alternative ways to invest in mainstream investments, such as stocks and bonds. And because of the lack of heavy regulation, these investments can be played in ways that mutual funds, ETF’s and even individuals can’t. It is even possible for hedge funds to be profitable when the broader financial markets are in retreat.
Hedge funds also work to create risk adjusted returns. In this way, they may not necessarily outperform the broader markets at all times, but they may produce more consistent returns with less volatility than the underlying market.
Hedge funds also strive to attain asymmetric returns. This is a strategy that enables a hedge fund to participate in most of a market's gain on the upside while simultaneously protect investors positions in down markets.
Who can invest in hedge funds?
Generally speaking, in order to invest in a hedge fund you must be an accredited investor. This refers to people who are considered to be sophisticated investors, who also have the financial wherewithal to take on the risk that hedge fund investing involves.
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The Securities and Exchange Commission (SEC) has very specific rules as to who qualifies as an accredited investor.
Those rules include someone who:
- Earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR
- Has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).
Translation: Hedge funds are not for the average investor.
In fact, many hedge fund investors are institutional ones, like college endowment funds. They may seek the greater returns, or the better investment protection that hedge funds can provide, rather than simply putting their investment capital into mutual funds or exchange traded funds.
How to invest in a hedge fund
There are many different hedge funds available, but they’re not as standardized as mutual funds or ETF companies. They generally have fairly high initial investment requirements, typically $50,000 or higher. Each may specialize in a certain aspect of hedge fund investing, and have their own specific policies and benefits.
For example, earlier I mentioned that hedge funds typically require that you invest your money with them for at least one year. But a fund like Sliced Investing allows you to withdraw funds on a quarterly basis. This gives you all the benefits of investing with a hedge fund, but without the lengthy holding period that typifies the industry in general. Another plus with Sliced Investing is that their initial minimum investment is just $20,000, which is well below industry requirements.
Should You invest in a hedge fund?
If you qualify as an accredited investor, and you’re willing to take on greater risk in search of greater returns on your money, then hedge funds may be the place to invest at least some of your money.
That isn’t to say that all of your money should be invested in hedge funds. Diversification is important with investments of all stripes, and that includes hedge funds. You may want to have the bulk of your money invested in mutual funds or ETF’s, stocks, bonds and real estate, but have a portion invested in hedge funds as well. For example, you may consider allocating 10% to 20% of your portfolio to hedge funds, split between two or three funds. This is similar to what you’d do with any other asset allocation.
Just make sure you thoroughly investigate any hedge fund that you plan to invest in, as they are not like other kinds of investments that you may be more familiar with.
Disclosure: This blog post was written for Sliced Investing pursuant to a paid content arrangement I have with the company’s representatives as part of an effort to raise awareness about alternative investment options.