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Your Golden Ticket: How to Invest in a Hedge Fund

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Jacob Wolinsky
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Hedge funds are investment vehicles that are commonly related to individuals, and institutional investors with very high net worth. They can bring significant returns but often come with high risk. But, investing in hedge funds is not simple, and you need to know how to invest in a hedge fund.

The first and most important condition to invest in the hedge fund is to be accredited as an investor. To do so an individual must have a net worth of at least $1 million. The other option is to have a minimum annual income of $200,000. This bar rises to $300,000 if the individual is married. Most hedge funds also have a minimum investment requirement. It varies from fund to fund.

Also, there are exclusive hedge funds that work on an invite-only principle. People often ask themselves why is it so difficult to invest in a hedge fund. If you want to learn more about conditions and ways to invest in a hedge fund, stay with us. If you cannot invest in hedge funds, we discussed some alternatives that offer some features of hedge funds.

Significance of Hedge Funds in The Investment Landscape

Today several investing vehicles offer different options and potentials for investment. They are lowering the bar for investments, and are offering new financial products to the market. That brought an edge to the finance market and hedge funds are in the process of adapting.

What sets hedge funds apart from others is the possibilities that they are offering to the investor. To fully understand this topic, we need to dive deeper into the hedge fund essence. It is easier to understand their importance once we have all the facts.

Understanding Hedge Funds

Hedge funds are investment vehicles that pool capital from accredited high-net-worth investors and institutions. They can use one or more investment strategies to pursue high annual returns. They are flexible and have very active management. That way they can generate a high rate of returns in different market conditions.

These are the primary characteristics of hedge funds:

  • Diverse investment strategies. Primary hedge fund strategies are long-short equity, global macro, event-driven, market-neutral, and investing in distressed debt. All these strategies aim to exploit price fluctuations and discrepancies, along with market inefficiencies. A hedge fund can focus on using just one strategy, but they usually try to use several
  • Aim to generate positive returns regardless of market conditions. Mutual funds tend to outperform benchmark indexes. Hedge funds focus on producing strong and consistent returns no matter the overall condition of the market
  • Fee structure. A hedge fund’s fee structure is different from other types of funds. There are management fees and performance fees. A management fee is based on the percentage of the assets under management (AUM). The standard management fee is 2%. Performance fees are based on the percentage of the fund’s profits
  • Limited liquidity. Mutual and exchange-traded funds have a higher, usually interday liquidity. That means that the investor can buy and sell stocks without impact on the fund. On the other hand, hedge funds have very limited liquidity. Most hedge funds have a lock-up period for investors that can last for years. They also limit the chance for the investors to redeem their investments. Depending on the fund investors can redeem monthly, quarterly, or annually. This way the hedge funds are protecting their investments
  • Portfolio diversification. For investors who are looking to diversify their investment portfolio, the hedge fund is arguably the best way to go. Hedge funds employ different investing strategies. They offer exposure to different types of securities like bonds, currencies, stocks, credits, commodities, etc.
  • High level of minimum investment. The first threshold hedge fund investors must pass is to become accredited. But, for some hedge funds that is not enough. Certain hedge funds have their policy regarding minimum investments. This way they want to have fewer major investors which makes fund management easier. In comparison, ETFs and mutual funds have a lower threshold for investment
  • Risk management. Investing in a hedge fund comes with risk. Some investing strategies are riskier than others. Those include short-term trading, investing in distressed debt, and emerging markets. To counter those risks hedge funds use different strategies like stop-loss orders and hedging. They also utilize risk management models like Value at Risk and stress testing. That way the fund managers determine the levels of risk, and choose the best investment options
  • Active management. Larger hedge funds have financial advisors teams composed of analysts and fund managers. To work in the hedge fund you must be the best among the best. Hedge funds are actively managed in comparison to ETFs and mutual funds. Mutual funds employ portfolio managers. They usually base their investment on buy-and-hold strategies. ETFs are passively managed and often aim to mirror the performance of a market index.

Take a Look At How The Hedge Funds Trade:

Eligibility and Requirements for Investing in a Hedge Funds

Hedge funds have a strict investment policy that all potential investors must comply with. The set of criteria needed to become an accredited investor includes:

  • Individual income. An individual must have a $200,000 annual income in the last two years. Also, the investor should keep this level of income in the current year. If the investor is in a marriage, their combined annual income must be $300,000. Some hedge funds have set higher income standards for their investors
  • Net worth. The combined net worth of the individual and the spouse is $1 million. This excludes the value of their primary residence. Also, some hedge funds have a higher bar for this criteria
  • Institutional investors. Corporations, and different types of funds, like pension funds, and trusts can become accredited investors. The thresholds vary between entities and funds
  • Level of experience and knowledge. Securities and Exchange Commission (SEC) allows individuals who don’t fulfill the individual and net worth criteria to become accredited investors. This rule applies if the potential investor has knowledge and experience in financial and business matters.

Before acquiring an accredited investor status, individuals and institutional investors have to provide various documentation that includes the following:

  • W-2 Forms or income tax returns. To verify their income individuals have to provide W-2 forms or income tax returns
  • Bank statements. Financial records and bank statements are used as proof of net worth and annual assets
  • Entity documentation. This documentation is referred to institutional investors. They have to provide partnership agreements or other types of contracts that prove their accredited status
  • Proof of experience in investments. If the investor wants to gain accredited status based on investment experience he has to provide proof of it.

Hedge funds are not solely based on pooling investments from individual investors. Fund assets are also pooled from institutional investors. Their participation in hedge fund investment has grown over the years.

Like individual investors, institutional investors are often high-net-worth institutions with large pools of capital. Common examples of institutional investors are endowments, pension funds, and insurance companies. They aim to increase the returns of their investors. These institutions are less prone to regulatory oversight when compared to individual investors.

Like potential investors have to comply with a set of rules, so do the hedge funds. A regulatory framework that impacts the hedge funds and their investment is complex and includes:

  • Regulation D. This is a set of rules and exemptions set by the U.S. Securities and Exchange Commission (SEC). It allows hedge funds to raise capital by selling securities without registering them with the SEC. This allows hedge funds to offer private securities to investors while complying with securities laws
  • Know Your Customer (KYC) rules. These are sets of requirements demanded from hedge funds to verify and identify their customers. These rules are enforced so the possibility of money laundering, fraud, and financing terrorism is minimized
  • Anti-Money Laundering (AML) rules and regulations. Like KYC rules, AML rules are set in place to prevent fraud and money laundering. This involves identifying the identities of customers, investigating the source of funds, and screening politically exposed persons. AML programs also monitor investment transactions for any suspicious activities
  • Reports and disclosure of data and information. Hedge funds may need to report different data to the investors and authorities. The goal is to keep both the investors and the authorities informed about the conducted business. This was a major issue in the past, but today, hedge funds are much more transparent thanks to these regulations
  • Tax reporting. Hedge funds have an obligation to provide tax reports to the investors
  • Advertising and marketing regulations. One of the SEC rules refers to regulating the marketing and advertising of hedge funds. Hedge fund advertisements have to be accurate, and not mislead any potential or current investors
  • Hedge fund record keeping. All business institutions, including hedge funds, must keep and maintain certain records like transaction records, and communication with investors. This requirement is also set by the SEC, to provide additional security to investors. Depending on the type of records, a keeping period may vary, but in most cases is limited to 5 years
  • Insider trading regulations. They are set in place to prevent the unlawful trading of securities based on material nonpublic information. This information is defined as information that the investor finds important and relevant to an investment. These regulations also prevent tipping which refers to providing nonpublic information for the use of trading. Both investors and hedge fund employees are prohibited from tipping. The SEC is responsible for investigating and prosecuting insider trading violations.

Methods of How To Invest in a Hedge Fund

Common methods of investing in a hedge fund are:

  • Pooled investments. This type of investment is usually organized as a limited partnership or a limited liability company (LLC). Several investors pool their investments which are managed by a fund manager
  • Direct investment with hedge fund managers. This type of investment is also known as separately managed accounts (SMAs). This investment is an arrangement between an individual investor or an institution and a specific hedge fund manager. This way the investors are directly investing with a financial professional, rather than pooling their investment with others
  • Utilizing investment platforms that offer hedge fund access. Since hedge fund investing experience is unavailable to the majority of individuals, that triggered the development of investment platforms. These platforms offer similar investing options to hedge funds, but requirements are lower. The major difference is in the minimum investment. This condition many potential investors cannot overcome. Investors can choose from several investment platforms, including hedge fund marketplaces
  • Robo-advisors. These are specific investment platforms that are completely automated. They offer algorithm-based financial planning and investment services. These platforms utilize risk assessment and can build a highly diversified portfolio. They are easy to use and their services are cheaper due to the level of automatisation. Investors can track their investments 24/7. Robo-advisors also offer different educational services so the investors can broaden their knowledge about finance and investing.

It is recommended that before investing the investor consult with the hedge fund manager. For both new and experienced investors, consulting with a financial advisor can shed new light and knowledge. They can offer valuable guidance and offer you the best investment plans based on your goals.

Special Considerations

Hedge funds require higher levels of minimum investment when compared to mutual fund companies and ETFs. The threshold for investing varies between funds. Exclusive funds often take investors on board only through an invite. Other famous and large funds demand millions of dollars to start investing. Smaller and younger funds lower this bar often below $100,000.

What investor also needs to consider is that their investment won’t bring returns any time soon. Once they place the money, the fund needs to invest it. Depending on the strategy, the fund may need to wait even years to have a significant return. An actual investment return also depends on the redemption periods, when investors can claim their positive returns.

Another investment consideration that can offer some features of the hedge fund is the Fund of Funds (FoF). The Funds of Funds is referred to as a multi-manager fund. This type of investment vehicle pools capital from the investors and invests it into a diversified portfolio of several underlying investment funds. These funds can be pension, mutual, ETFs, or other hedge funds.

Investing in FoF can bring several benefits, and offers some positives when compared to classic hedge funds:

  • Diversification across different managers and assets. Investing in FoF not only offers diversification regarding a wide array of securities but also across different managers
  • Constant liquidity. Investors can trade shares regularly. When compared to lockup and redemption periods of regular hedge funds, FoFs have accessible liquid assets
  • Access to hedge fund strategies. High investment requirements are often an impenetrable obstacle for many investors. Investing with FoFs offers investors access to different investment strategies and a wide portfolio of hedge funds. FoF investment offers a taste of hedge funds without investing in a particular hedge fund.

Publicly traded hedge fund companies are another alternative route to the hedge fund market. These companies are usually listed on stock exchanges and work as publicly traded companies. To invest in these companies investors buy shares. That way they indirectly invest in assets under the management of those firms.

Choosing to invest in a publicly traded hedge has its share of pros and cons. The upturns of this type of investment are:

  • Wider diversification. Investing in a publicly traded hedge fund can provide diversification across several hedge funds that are managed by the firm. This leads to lower risks and higher potential returns
  • Increased liquidity. Shares of these funds are more liquid when compared to investing directly in the hedge fund. investors can regularly trade these shares on the stock market during regular trading hours like with FoF
  • Higher transparency rating. Publicly traded companies are subjected to regulatory and reporting requirements. Investors have full access to financial statements and performance data of investments. These regulations are stricter than those in regular hedge funds
  • Constant income. These companies often generate income through management and performance fees. Investors, as shareholders of the company can benefit from dividend payments and capital appreciation.

The downsides of investing in publicly traded hedge fund companies are:

  • Investment performance. The performance of the hedge fund company’s stock may not reflect the performance of the underlying hedge funds. Financial conditions, corporate decisions, and market sentiment can have an impact on the value of stocks
  • External impact on the price of stocks. Stocks of these hedge fund companies can be influenced by major economic events or news that relates to the company. These external factors are often out of reach of the impact of the company
  • No control over individual hedge funds. Although this type of investment brings additional diversification, it also brings its share of problems. Investors do not have any impact on investment strategy or decisions made by individual hedge funds that the company manages.

Preparing to Invest

Before you choose the fund to invest you should consider going through several steps:

  • Choosing the right type of manager. Fund managers often have preferred investment strategies. Also, their experience and knowledge vary. If you have a certain investing strategy and financial goals in mind, try to make a choice based on those
  • Check the qualifications and credentials. Analysts and fund managers can also obtain formal recognition of expertise. The most regarded are chartered financial analysts (CFA) and Certified Financial Planners (CFPs). To obtain these qualifications financial advisers must have a higher degree in business, several years in the industry, and pass a series of tests
  • Discuss fees and compensation levels. Most hedge fund managers work on 2/20 compensation, but this can vary
  • Check the liquidity and lock-up periods. This will impact the possibilities of redeeming the investment. For some investors, this is a key question, while others focus their investments on long-term
  • Reporting and transparency in work. Hedge funds have a reputation for providing limited information to investors. Disclose with the manager how will he monitor your investment, and when and in what form you will receive information. This is an essential question, and the goal is to have current and correct information about the investments. Also, maintain regular communication with the manager. That way you can get fresh information firsthand.

FAQs

What Are the Common Reasons for Investing in Hedge Funds?

Hedge funds are a favorite type of investment vehicle for many investors and institutions. These are the factors that set hedge funds apart from other types of investments:

  • High diversification. The use of different strategies, and investing in a variety of securities guarantee the diversification of portfolios. This is an important feature of hedge funds. It minimizes the investment risk and offers unique benefits
  • Active professional management. Hedge funds employ the best managers and analysts. They are often key factors for choosing a specific hedge fund to invest
  • Customized investment strategies. Some hedge funds offer investors to tailor their portfolios and strategies based on their goals and risk tolerance
  • They are tax-efficient. Hedge funds frequently employ tax-efficient strategies like tax-loss harvesting. Tax-loss harvesting allows investors to sell investments that are down, and replace them with reasonably similar investments. The funds offset realized investment gains with those losses. That way the hedge funds help minimize capital gain taxes for the investors.

What Are the Average Hedge Fund Fees?

Hedge funds fees vary between funds. This is often a result of differences in investment strategies and the terms that the fund manager offers. But, all hedge funds base their fees on two components:

  1. Management fees. These fees are usually set on 2% of the annual fund’s assets under management. Lately, some hedge funds lowered these fees as low as 1%. These fees are charged regardless of the rate of returns of the investments. These fees are used to cover the basic cost of business, including salaries, office space, etc.
  2. Performance fees. These fees are generated from the percentage of the fund’s profits. Standard performance fees are 20%, but some funds lowered their fees to 15%. This fee is calculated on the returns generated by the fund’s investments above a predetermined benchmark. In case the investments do not outperform the benchmark, this fee is not charged.

How Much Money Do You Need to Invest in A Hedge Fund?

To be able to start investing you need to have at least 1$ million net-worth, or $200,000 annual income. But, what is a minimum investment depends on the fund. Most hedge funds have a threshold for the investment of 1$ million.

There are larger and more exclusive funds that require several millions, or even tens of millions of dollars to start investing. Smaller and younger hedge funds often have a low bar for starting investments that go around $25,000.

Hedge fund alternatives like Robo-advisors usually have a much lower investment minimum, going to low as $1,000.

Conclusion

The rise of investing is not even a new trend, it is happening for some time. A lot of people are trying to find ways to invest, and hedge funds are on almost everyone’s top lists. Everyone is drawn by promises of high returns.

But, investing in hedge funds is limited to the extremely wealthy for a reason. This type of investment comes with high risks. These risks can nullify the whole investment. That is why hedge funds focus on wealthy individuals and institutions.

Due to stiff competition from online trading platforms, you do not need to be extremely wealthy to invest in hedge funds. Some funds lowered minimal investments. There are also options for investing in smaller and younger funds. Starting your investment career in a small hedge fund can be a great option. You can learn a lot about investment strategies, and a small hedge fund can be a great entry into a hedge fund arena.

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Jacob Wolinsky is the founder of HedgeFundAlpha (formerly ValueWalk Premium), a popular value investing and hedge fund focused intelligence service. Prior to founding the company, Jacob worked as an equity analyst focused on small caps. Jacob lives with his wife and five kids in Passaic NJ. - Email: jacob(at)hedgefundalpha.com FD: I do not purchase any equities to avoid conflict of interest and any insider information. I only purchase broad-based ETFs and mutual funds.