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Government restrictions and expensive acquisitions make hedge funds inaccessible to most mere investors. But that might not be such a bad thing. Hedge funds are much riskier than most other investments. Here's everything you need to know about investing in hedge funds.
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What is a hedge fund?
Hedge funds pool money from investors to buy securities and other types of investments. If this sounds a lot like mutual funds or exchange-traded funds (ETFs), you wouldn't be wrong. However, hedge funds are not restricted in the same way as mutual funds. They often employ aggressive investment strategies such as leveraged debt-based investing and short selling, and can also purchase types of assets that other funds cannot invest in, such as real estate, art, and currencies. Masu.
The strategies used by hedge funds come with significant risks, says Sarah Katherine Gutierrez, a certified financial planner (CFP) and CEO of Aptus Financial.
“Hedge funds are riskier investments because they often bet on investments that seek outsized returns in the short term,” she says. “This is also possible with borrowed money. But that bet can be lost.”
Hedge funds employ these riskier strategies to generate profits regardless of market conditions. This tactic is attractive to investors who want to continue making profits during bear markets. Also, qualifying for hedge fund investing may have some appeal.
“Hedge funds are seen by some as an exclusive club that requires qualifications,” says Katie Brewer, CFP and president of Your Richest Life. “Hedge funds have the advantage of the opportunity to earn higher returns, but also the disadvantages of illiquidity, volatility, and risk.”
What is a hedge fund manager?
A hedge fund manager is an investment manager who makes day-to-day investment decisions for hedge funds. They choose how to allocate their investment funds and manage the fund's risk level.
Hedge fund managers have a drive to succeed. If the Fund is profitable, a success fee equal to up to 20% of the Fund's profits will be paid.
Hedge fund managers play a big role in managing your funds, so you want to make sure that any hedge fund manager is qualified to handle your funds. By looking at a hedge fund manager's Form ADV, you can determine the hedge fund manager's disciplinary history, fees, and investment strategy. This form can be found on the SEC's website or using the SEC's Investment Advisor Public Database.
Hedge fund fees and minimums
The minimum initial investment for hedge funds ranges from $100,000 to more than $2 million. Hedge funds are also less liquid than stocks and bonds, and you may only be able to withdraw your funds after investing for a certain period of time or at specified times of the year.
Hedge funds also charge high fees. Hedge funds typically charge an asset management fee of 1% to 2% of the investment amount, plus a performance fee equal to 20% of the hedge fund's profits. All of these fees can eat into your overall revenue. This might not be a big concern if hedge funds were significantly outperforming the rest of the stock market, but this is generally not the case. This could make index-based ETFs and mutual funds, which have an average expense ratio of 0.13%, even more attractive.
Hedge fund past performance
Hedge funds have historically underperformed stock market indexes. From January 2009 to January 2019, hedge funds outperformed the S&P 500 in only one year, 2018. Notably, this is also because the overall market crashed in December 2018, pushing a decade-long bull market into near-bear market territory. And hedge funds aim to weather market downturns better than the broader market. That said, hedge funds still fell 4.07% in 2018. This was slightly less than the S&P 500's 4.38%.
By 2019, hedge funds were on the rise again, with an average return of 6.96%. But over the same period, the S&P 500 rose his 28.9%, the Dow Jones Industrial Average rose his 22.3%, and the Nasdaq rose his 35.2%. This may be an exaggerated difference, but it is consistent with historical data. According to the Journal of Financial Economics, from 1980 to 2008 hedge funds' average return after fees was 6.1 percent. During the same period, the S&P 500 index rose an average of 12.5% annually.
Does this mean that in a debate between hedge funds and mutual funds or ETFs, hedge funds always lose? necessarily. A hedge fund's goal is not necessarily to outperform an index. Instead, it is designed to deliver growth regardless of market conditions.
“Hedge funds have always been viewed as complementary to a balanced asset allocation that includes U.S. and foreign stocks and U.S. and foreign cash or cash equivalents,” Brewer says.
Who can invest in hedge funds?
Because of the high level of risk associated with hedge funds, the U.S. Securities and Exchange Commission (SEC) has regulations on who can invest in hedge funds.
To invest in hedge funds as an individual, you must be an institutional investor, such as a pension fund, or an accredited investor. An accredited investor has a net worth of at least $1 million, excluding the value of their primary residence, or a personal income of more than $200,000 per year (or $300,000 if married).
All in all, this is a small portion of the U.S. population. According to the U.S. Census Bureau, in 2019, only about 4% of households earned more than the $300,000 needed to reach accredited investor status.
However, more people are now eligible than originally planned.
“Interestingly, the criteria for accredited investors has not been updated since the 1980s and now includes far more people than originally imagined,” Gutierrez says. If those numbers were adjusted for inflation, she says, she would have a net worth of $2.5 million, or a salary closer to $500,000 (or $750,000 if married). “Hedge funds are not aimed at the average investor.”
SEC guidelines support this claim. In August 2020, the SEC introduced a provision allowing those who demonstrate advanced investment knowledge gained through qualified work experience or certain financial licenses to become accredited investors even if they do not have financial qualifications. Did.
How to invest in hedge funds
To invest in hedge funds, start with research funds that are currently accepting new investors. There are some research tools online, but you'll probably need the guidance of a financial advisor to find potential hedge funds. Once you have researched the fund managers and investment objectives of these funds using Form ADV, you should contact the hedge fund and ask for information regarding minimum investment requirements.
You will also need to confirm that you are an accredited investor. There is no standardized method or central certification body. Each fund will determine your status based on its own practices. You may need to provide your income, assets, debt, and experience and have it verified by an authorized third party, such as a financial institution where you hold an account, an investment advisor, or an attorney.
How to invest like a hedge fund
If you don't meet the requirements of a hedge fund company or don't have accredited investor status, there are several options for imitating a hedge fund.
Brewer said there are also ETFs, mutual funds and funds of funds that employ strategies similar to hedge funds, such as short selling and leveraged investing. One of his ETFs, Global X Guru (GURU), and startup Titan even claim to employ the same strategy as some hedge funds.
However, keep in mind that you don't need to invest in hedge funds to grow your wealth. Historically, broad market indexes have outperformed hedge funds, so you may be better off investing in index funds instead. And remember this. When you're trying to build wealth, you're investing for the long term. By staying invested in index funds for years when the market is down (where hedge funds are supposed to shine), you can buy cheap and enjoy higher returns when the market recovers.
Should you invest in hedge funds?
If you qualify as an accredited investor and are willing to invest hundreds of thousands or even millions of dollars at a time, investing in hedge funds is a smart way to diversify your profile and avoid market volatility. It may be a method. But for the average person looking for high returns, investing in an index fund that tracks a major index such as the S&P 500 is likely a better option.
“Most people are better off with a passively managed portfolio that simply invests in the overall market,” Gutierrez says. “Our investment goal is to own the entire market and grow our investments over time as the companies we own grow. In other words, being average is winning.”
