Financial markets are highly diversified and offer anyone an opportunity to invest their capital. From lower-risk investments like exchange traded funds and traditional mutual funds, different types of bonds, to complex and risky hedge funds, finding the right investment vehicle is a tricky process. Hedge funds typically draw wealthier investors, but there is some open space for small investors.
The barrier that keeps the majority of smaller investors from investing in hedge funds is the requirement to be accredited investors. This includes passing the requirements set by the Securities and Exchange Commission. Accredited investor has a net worth value of at least $1 million, or annual revenue of $200 thousand or more. Another option is to passively invest in hedge funds, through Fund of Funds. This is a vehicle that essentially invests in hedge funds providing wide diversity to their investors.
While not being the same, smaller investors may look elsewhere for strategies that resemble those that are used by hedge funds. Those include some mutual and exchange-traded funds that try to mimic the hedge fund approach. If you want to learn more about why would you want to invest in hedge funds stay with us.
Key Takeaways
- To invest in a hedge fund an individual must be an accredited investor. To become one, it must have an annual revenue of $200 thousand or a net worth value of $1 million.
- In August 2020 the SEC broadened the definition of an accredited investor. The capital threshold is no longer the only way to get through, but also, if an investor can prove their professional experience backed with certifications, it can gain accredited investor status.
- Besides directly investing in hedge funds, investors can opt for Fund of Funds, which seek to buy stakes at hedge funds. This offers the benefits of diversification of portfolios based on the funds the investor has stakes in.
- If you pass the accredited investor's terms, before investing in hedge funds, conduct a thorough due diligence process to find the right fund to invest in.
Defining Hedge Funds
Hedge funds are pooled investment vehicles that utilize a wide array of strategies attempting to beat the market at any cost. Unlike mutual funds and ETFs which usually satisfy their appetites by replicating the performance of indexes, hedge funds aim to outperform them.
To achieve that, they utilize varying strategies that are often risky. Hedge funds also frequently resort to using debt and leverage to boost their investments. This can go either way, generating very high returns, or bringing the whole investment down.
Hedge funds offer a variety of strategies, that also includes investing in both liquid and illiquid assets. Funds that invest in startups, debt, or special situations have long lock-up periods that keep investors from redeeming their capital.
One of the crucial upsides of hedge funds over other investments is a high degree of diversification. While not all funds diversify their portfolios, the majority do. They can accomplish this through investing in almost any type of asset class available on the market. That combined with unlimited geographical availability, can create unique portfolios that can sustain several types of investment risks.
To combat risk, hedge funds employ risk management as an integral part of their strategy. This process includes due diligence, and utilizing different strategies to minimize potential losses.
Due to often high-risk, and complex strategies, hedge funds accept only sophisticated investors followed by high minimum investment requirements. Pension funds, along with wealthy individuals and financial institutions, meet the requirements to invest, emphasizing the exclusivity and high barriers that hedge funds impose on investors. This is the main argument that is keeping an average investor from even having a chance to invest in hedge funds.
Accessibility For Accredited Investors To Invest in Hedge Funds
As we mentioned, accessibility to hedge funds is highly restricted to average investors. Throughout hedge fund history, they were always reserved for high net worth individuals. This created accredited investors' definition, keeping hedge funds from most of the investors.
This is justifiable from the angles of hedge funds and investors. When looking at an average investor, if he would opt to push all its hard-earned capital into a risky hedge fund, and lose it all, it would be a disaster for him. That is why these alternative investments are reserved for those that can sustain occasional losses.
From the hedge fund perspective if they would have to deal with masses of low-capital investors that would make their job much harder. Going with a smaller number of wealthy investors leaves them more space to manipulate the capital, and find the best way to utilize it.
However, in 2020 SEC made a decision to loosen up the requirements for investing in hedge funds. While before an accredited investor checks with the required financial prerequisites, now this status can also be earned by having relevant experience and qualifications.
Meaning, that a professional investor, with experience in the field, does not need to have an annual income of $200 thousand to invest. His knowledge and experience are his ticket into the hedge fund arena.
Even if the investor cannot by any means get the status of accredited investor, there are other options. The first is to invest with a Fund of Funds. These investment vehicles focus on investing in hedge funds. They buy stakes at funds thus owning a piece of their portfolio holdings. These vehicles are available to anyone, with a minimum investment being usually $1 thousand.
Other options include specific actively managed mutual funds that tend to use similar approaches like hedge funds. Also, there are ETFs that use similar strategies to win over potential investors.
Benefits Of Investing In Hedge Funds
The first benefit of investing in a hedge fund is that investors' capital would be actively managed by the top of ladder professionals. A fund manager must have extensive experience to climb so high in the pecking order.
Most hedge funds tend to diversify their portfolio. This allows investors exposure to several markets at the same time. In reality, with your money, you can own a piece of land, some rare material, high-yield bonds, and stakes at publicly traded companies. This way the investor lowers its investment risk by betting on uncorrelated assets that are almost never under the same risk.
Hedge funds with their broad use of investment strategies like long/short equity, global macro, and event-driven approaches, can not only reduce risk but enhance returns. Many hedge funds combine several strategies in which they find themselves comfortable.
With that in mind, hedge funds often invest in low correlation with traditional assets like stocks and bonds. This makes their portfolios resistant to market downturns. Another benefit is the improved risk-return profile of the portfolio.
Hedge funds also offer a dose of exclusivity due to their availability to invest in assets that are not always available to other funds. Those include private equity, distressed securities, complex derivatives, and leverage and margin trading.
All this leads to the potential of earning high returns. While mutual funds and exchange-traded funds do not aim for the sky, hedge funds do just that. They do not want to fight with the index, but they want to beat it. This is a risky approach, but if done properly it can generate the highest returns amongst investment vehicles.
Risks Of Investing In Hedge Funds
Hedge fund investors are more resilient to investment risks than an average person, due to the nature of hedge fund managers allocate the capital. That is one of the reasons for the exclusivity of hedge fund investments. But, nonetheless knowing what are you getting into before making an initial investment is a godsend.
A high level of illiquidity is often characteristic of a fund's strategy. Illiquidity comes with benefits and downsides. Although these investments can generate higher gains, they are also riskier, and they lock investors' capital for a prolonged time.
Dealing with a lack of transparency in funds operations is a reality that a vast majority of many investors. It is a general problem with the industry, but it can be downplayed with a bit of due diligence. Before investing in a fund, individual investors should check their reporting policies, and what types of information they share with investors.
Loosened regulations in comparison to other investment options are one of the causes for often low levels of transparency. Once the investors place their capital, hedge fund managers do not need to share information on how will they use it.
However, the question of transparency in work differs between hedge funds. Some will keep their cards relatively open, while others will share only the necessary info.
While being called a risk is maybe not the best term, hedge funds typically have high fees. Their fee structure is composed of a performance fee and management fee. In the past, their rate was 2/20 with 2% relating to the percent of AUM going to managers, and 20% being an incentive fee for outperforming before set benchmarks.
With the development of new investment vehicles and higher competition in the hedge fund market, some hedge funds decided to trim their fees.
The risk that comes hand in hand with illiquidity is redemption. Most hedge fund investors would have to wait at least a year after an initial investment to get a chance to redeem a part of their investment. Depending on the investment strategy of the fund, that period can get even longer.
How To Choose A Hedge Fund To Invest Into
If you pass the necessary requirements to invest in a hedge fund, and you want to commit to it, you need to go over a couple of questions.
The first, and most obvious one, is what are your goals? Are you looking for a way to maximize your gains in a shorter period, or you would be satisfied with conservative returns over a long time? Risk management is something that factors in with these questions. How hedge fund approaches investing, must design its risk management strategy to minimize a change for losses.
After you define your goals, you need to conduct due diligence on funds and fund managers. Strategy is not enough to be the deal breaker, but the hedge fund manager that would handle your capital. So, before investing, check the company and its personnel. Check their track record and relationship with new investors.
Also, checking the fees is an important issue, because there are quite a few options on the market. Standard 2/20 fees can chew through your gains, so compare how much the fund is delivering and what it is charging its clients.
If you managed to pick a couple of funds by now, the next step is to investigate their reporting practices, transparency in work, and liquidity. In the end, you are placing your money in their care, and you should know what you are getting in return. Some investors do not care about transparency if they get results, but if you want to know how your money is handled, double-check these facts.
When you decide on the one fund that meets all your expectations, check additional sources for any feedback. It can be an acquaintance, a friend, or an online source with relevant data. Leave no stone unturned. You are making a long-term commitment, and act accordingly.