Hedge funds are more loosely regulated than traditional mutual funds and tend to invest in different types of securities. This can mean higher returns, but it can also mean higher fees and greater risk of loss, as we’ve seen over the past week with short squeezes on Gamestop, AMC and other volatile stocks. If you’re thinking of investing in a hedge fund, here’s what you need to know.
What Is a Hedge Fund?
Hedge funds are like mutual funds, except that they’re designed to increase potential returns and hedge against market losses by investing in a wider array of assets.
Hedge funds don’t experience the same regulatory scrutiny as mutual funds. This gives their managers more room to operate and take risk. That might mean shorting stocks, making leveraged investments and betting on foreign currencies and commodities.
This is one reason why hedge funds are restricted to accredited investors. These are investors who have the resources to withstand high fees and (potentially) heavy asset declines. To qualify as a hedge fund accredited investor, you must clear two primary hurdles established by the SEC:
- An individual must demonstrate earned annual income of $200,000 (or $300,000 for married spouses) in each of the past two calendar years. That income must be equal or greater in the year he or she applies to be an accredited investor.
- A person or married couple can qualify by showing they have a net worth of $1 million or more. Note that this does not include any assets linked to their primary residence.
Getting Ready to Invest in a Hedge Fund
If you meet these criteria, here’s what you should look for in potential funds.
Vet the fund. Start by thoroughly reviewing the hedge fund you’re considering. Focus first on the fund’s prospectus and its marketing and performance-related collateral. It’s always a good idea to get a financial advisor on board at this stage of the process, so you can get a realistic view of the fund’s risk potential and how it fits into your own unique investment needs, goals and timetable.
Don’t focus solely on any history of high returns, and always make a thorough risk evaluation before writing any checks.
Focus on fund assets, too. You’ll need to properly evaluate the value of a fund’s holdings. Hedge funds often hold investment vehicles that can be hard to sell and difficult to price. A financial professional with hedge fund evaluation experience can help you understand a fund’s holdings.
Understand your fee obligations. Hedge funds charge higher fees than regular mutual funds. Expect to pay between on 1%-to-2% of total assets, along with a 20% performance fee based on the hedge fund’s profit levels. Note going into your hedge fund investing experience that it’s common for hedge fund managers to take greater investment risks to earn that profit and collect that 20% fee.
Know your redeemable timelines. Hedge funds don’t let investors redeem shares any time they want. Instead, you can only redeem your shares four times (or fewer) annually. There are also lockdown periods when you can’t get your money. Know before you invest what your hedge fund’s share redemption timetable is, and if it meets your unique personal financial needs.
Know your hedge fund manager. One of the most important “homework” tasks as a potential hedge fund investor is to research your fund manager before you invest any money. Specifically, be sure to check the advisor/manager’s Form ADV, which spells out all information related to a fund, including its investment strategies and any conflicts of interest or past disciplinary actions. You can search for a Form ADV on the SEC’s Investment Advisor Public Disclosure (IAPD) website.
Final Hedge Fund Considerations
Above all, keep your checkbook closed until you get all of your questions about the fund answered to your satisfaction. You’ll want to know who is managing your money and how they intend to invest it. You should also know if there are any potential road blocks in getting your cash back. If any of those questions aren’t answered to your satisfaction, keep looking for another hedge fund. You may also need to entertain the possibility that hedge funds aren’t the right investment for you.
Still convinced that a particular hedge fund is right for you? Investing in a hedge fund is not a simple matter of creating an account on a website and transferring in some funds, as is the case on a typical brokerage account. You’ll likely have to contact that hedge fund or have your financial advisor do it for you. At that point, you might find that the fund is no longer accepting new investors, or that the minimum investment amount is out of your reach.
But if the fund is accepting new investors, and you meet the criteria, you can become a hedge fund investor – with all the risk and reward that this entails. Especially lately, there’s been significant risk when it comes to investing in hedge funds. Short squeezes coordinated by retail investors on platforms like Reddit’s WallStreetBets may make investing in hedge funds more risky. It’s important to always ask the right questions so that you’re prepared for whatever the market may do to your hedge fund investments.
Tips for Building an Investment Portfolio
- Even if you don’t qualify for a hedge fund, you can still invest in the market with an online brokerage account. Through these web-based portals you can research investment performance of different equities and funds, then buy the assets that make sense for your portfolio.
- Whether you need guidance in picking investments or wish to build a financial plan, a financial advisor can help. The SmartAsset financial advisor matching tool will set you up with as many as three local advisors who are equipped to meet your personal needs.
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