What is a hedge fund?
Hedge funds aim to make money in both bullish and bearish market conditions, sometimes by using aggressive trading strategies and making speculative investment bets. Investors should determine if they are comfortable with this level of risk, along with high minimums and expensive management fees, before investing in a hedge fund.
Definition of hedge funds
A hedge fund is a type of investment arrangement whereby a professional fund manager invests a mass of money contributed by a group of pre-qualified investors. Hedging involves using investment strategies designed to maximize investor returns while minimizing exposure to risk. To hedge, an investor or fund manager would make two investments that react in opposite ways: if one investment goes down, the other goes up, reducing overall risk.
Mutual fund also invest investor money pools. But mutual funds – which are standard offerings in workplace pension plans and IRAs – are quite different from hedge funds. A comparison of the two illustrates how hedge funds work.
Hedge funds vs mutual funds
Like mutual funds, many hedge funds hold stocks and bonds. But they are also allowed to invest in more speculative tariffs, such as private companies, bankrupt companies, art, currencies and derivatives. While the goal of a regular mutual fund is to beat the returns of the overall stock market or part of it, hedge funds aim to generate absolute positive returns, i.e. gains that are not tied to any particular benchmark over time. Other differences include:
Stricter requirements for shareholders
Mutual funds are open to all investors who can meet the minimum investment requirement, most often between $ 100 and $ 2,500.
Hedge funds only accept a limited group of “accredited” investors, defined by federal law as someone who has earned at least $ 200,000 (or $ 300,000 combined with a spouse) during each of the years. past two years and plans to continue doing so, or has a net worth of $ 1 million or more, excluding the value of a primary residence.
This requirement and high minimum investments (usually $ 1 million and more) should allow access only to more sophisticated investors who can handle a significant financial loss.
Less regulation and transparency
Mutual funds are required to register with the Securities and Exchange Commission, which subjects them to regulations. Most hedge funds are not, as they do not advertise publicly and therefore are not subject to the same protections and disclosure requirements that apply to mutual funds.
This lack of transparency makes it more difficult for investors to check a hedge fund’s claims and see exactly how their money is being invested. However, hedge fund investors are protected in the event of fraud (such as Ponzi schemes). The SEC has sued hedge funds that have distorted investment returns, account statements and the backgrounds of fund managers.
Riskier trading strategies
Hedge fund managers have the flexibility to use more aggressive trading strategies than their mutual fund counterparts. They can make very concentrated bets by investing the capital of the fund in just a few assets, and they often use leverage, which involves borrowing money to make transactions. Leverage can magnify returns and losses.
High performance based fees
Mutual funds and hedge funds charge an annual asset-based management fee, also known as an expense ratio or advisory fee. For mutual funds, these fees are typically between 0.25% and 1.5% of your investment in the fund per year.
Hedge fund investors also pay an additional incentive fee based on performance. A well-known configuration is called “2 and 20”, where shareholders pay an annual fee of 2% of their investment in the fund and 20% of the profits for each year above a predefined percentage. In recent years, fees have come down and are now approaching 1.5% and 18%.
Mutual fund investors are allowed to withdraw their investment at any time.
Because hedge funds sometimes invest in illiquid assets, they often have lock-in periods of several months to years when redemptions are not allowed. Some hedge funds have relaxed their lock-in provisions, but they can still restrict access to your money by requiring investors to provide advance notice well in advance of any withdrawal.
There are better investments than a hedge fund
A good first stop is to invest in an index fund, a type of automated mutual fund that buys baskets of companies that represent certain major stock indexes. You can increase with higher risk (and higher potential return) mutual funds that focus on growth stocks or niche investments.
A brokerage account that offers a range of no-transaction-fee mutual funds, index funds, and commission-free exchange traded funds is easy to open. Many have a minimum account of $ 0 (like our pick for the best tools and fundraising, TD Ameritrade), providing instant access to fund research tools and expert advice on selecting mutual funds for your portfolio. (See our full list of best brokers for mutual fund investors.)