A hedge fund is a private fund, often not registered with the SEC, which invests in publicly traded securities and other assets with the aim of delivering higher-than-average returns.
Hedge funds are pooled investment funds, similar to mutual funds, but they are typically accessible only to high-net-worth, accredited, or institutional investors. They are not available to retail investors. Hedge funds have high investment minimums, often in the millions, and they rely on high-risk strategies with significant fees.
Unlike registered investment companies and open-end funds, hedge funds don’t have to follow regulations that govern most mutual funds and ETFs, including restrictions on the use of leverage, disclosure requirements around asset value and share pricing, and more.
In short, while hedge fund returns can be high, losses can be just as steep, and investors who qualify to invest in these vehicles need to understand the risks involved.
Key Points
• Hedge funds are similar to mutual funds and ETFs in that they are a type of pooled investment fund, but they are private funds not open to retail investors.
• Unlike most mutual funds and ETFs, hedge funds employ high-risk strategies to achieve higher-than-average returns.
• Owing to their potential to deliver big profits, hedge funds charge significant fees and require high investment minimums.
• While some hedge fund managers must register with the SEC, many hedge funds are unregistered, and are not subject to certain regulations — one of the reasons retail investors typically don’t have access to these funds.
• While hedge fund returns may be high, so is the potential for steep losses.
What Is a Hedge Fund?
Hedge funds are set up by a registered investment advisor or money manager, often as a limited liability company (LLC) or a limited partnership (LP). They differ from mutual funds in that they have more investment freedom — meaning, they’re not subject to standard SEC regulations — so they’re able to make riskier investments.
How Hedge Funds Work
By using aggressive investing tactics, such as short-selling, leverage, and alternative investment strategies, hedge funds can potentially deliver higher-than-market returns. But they also come with higher risks than other types of investments.
In addition to traditional asset classes, hedge funds can include a diverse array of alternative assets, including art, real estate, and currencies.
Hedge funds tend to seek out short-term investments rather than long-term investments. Of course assets that have significant short-term growth potential can also have greater short-term losses.
Historically, hedge funds have not performed as well as somewhat safer investments, such as index funds. However, investors also use hedge funds to provide growth during all phases of market growth and decline, providing diversification to a portfolio that also contains stocks, cash, and other investments.
Generally speaking, only qualified investors and institutional investors are able to invest in hedge funds, due to their risks and the high fees that get paid to fund managers — typically 20% of profits. In addition, the redemption rules around hedge funds — including a typical one-year lock-up period — can be complex as well as costly.
Types of Hedge Funds
Each hedge fund has a different investing philosophy and invests in different types of assets. Some different hedge fund strategies include:
• Real estate investing
• Junk bond investing
• Specialized asset class investing such as art, music, or patents
• Long-only equity investing (no short selling)
• Private equity investing, in which the fund only invests in privately-held businesses. In some cases the hedge fund gets involved in the business operations and helps to take the company public.
What Is a Hedge Fund Manager?
Hedge funds are run by investment managers who manage the fund’s investment strategy. If a hedge fund is profitable, the hedge fund manager can make a significant amount of money, often up to 20% of the profits.
Before selecting and investing in a hedge fund, it’s important to look into the fund manager’s history as well as their investing strategy and fees. This information can be found on the manager’s Form ADV, which you can find on the fund’s website as well as through the Security and Exchange Commission’s (SEC) website.
Who Can Invest in a Hedge Fund?
Hedge funds are not open to retail investors, who can buy stocks online, and there are several requirements to be able to invest in hedge funds.
In order for an individual to invest, they must be an accredited investor. This means that they either:
• Have an individual annual income of $200,000 or more. If married, investors must have a combined income of $300,000 per year or more. They must have had this level of income for at least two consecutive years and expect to continue to earn this level of income.
• Or, the investor must have an individual or combined net worth of $1 million or more, excluding their primary residence.
If the investor is an entity rather than an individual, they must:
• Be a trust with a net worth of at least $5 million. The trust can’t have been formed solely for the purpose of investing, and must be run by a “sophisticated” investor, defined by the SEC as someone with sufficient knowledge and experience with investing and the potential risks involved.
• Or, the entity can be a group of accredited investors.
How to Invest in a Hedge Fund
Investing in hedge funds is risky and involves a deep understanding of financial markets. Before investing, there are several things to consider:
The Fund’s Investing Strategy
Start by researching the hedge fund manager and their history in the industry. Look at the types of assets the fund invests in, read the fund’s prospectus and other materials to understand the opportunity cost and risk. Generally speaking, the higher the risk, the higher potential returns.
In addition, you need to understand how the fund evaluates potential investments. If the fund invests in alternative assets, these may be difficult to value and may also have lower liquidity.
Understand the Minimums
Investment requirements can range between $100,000 to $2 million or more. Hedge funds have less liquidity than stocks or bonds, and it’s also common for there to be lock-up periods for funds — and/or for there to only be certain times of year when funds can be withdrawn.
Confirm You Can Make the Investment
Make sure that the fund you’re interested in is an open fund, meaning that it accepts new investors. Financial professionals can help with this research process. Each hedge fund will evaluate an individual’s accreditation status using their own methods. They may require personal information about income, debt, and assets.
Understand the Fees
Usually hedge funds charge an asset management fee of 1-2% of invested assets, as well as a performance fee of 20% of the hedge fund’s profits.
The Takeaway
Hedge funds offer accredited and institutional investors the chance to invest in funds that are usually high-risk, but offer high potential returns. There are many rules surrounding hedge funds, and many investors may not even consider them as a part of an investing strategy.
For accredited investors, investing in a hedge fund may be one part of a diversified portfolio, although it depends on the investor’s risk tolerance, time horizon, and investing goals. If you’re not an accredited investor, or you’re worried about the risks associated with hedge funds, it may make more sense for you to consider other types of investments or to stick with ETFs, mutual funds, or funds of funds that emulate hedge fund strategies.
Ready to expand your portfolio's growth potential? Alternative investments, traditionally available to high-net-worth individuals, are accessible to everyday investors on SoFi's easy-to-use platform. Investments in commodities, real estate, venture capital, and more are now within reach. Alternative investments can be high risk, so it's important to consider your portfolio goals and risk tolerance to determine if they're right for you.
FAQ
What is a hedge fund in simple terms?
A hedge fund is a loosely regulated pooled investment fund that employs high-risk strategies in order to deliver returns.
How do you make money from a hedge fund?
Hedge funds typically invest in high-risk assets in order to deliver better-than-market returns. But there are no guarantees, and the combination of risk and high fees can lead to steeper-than-average losses.
How rich do you have to be to invest in a hedge fund?
Current SEC regulations require that most hedge funds accept only accredited investors, i.e., individuals with a net worth of $1 million or more, excluding their primary residence. In addition, minimum investment levels can start in the millions.
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