Hedge funds are known for their riskier investments, attracting wealthier investors who seek greater returns and are willing to take larger bets.
As a strategy, hedge funds are valuable to investors because they provide access to return drivers that are not present elsewhere in their portfolios, says Chris Walvoord, partner and global head of hedge fund portfolio management and research at Aon in Chicago.
"While the overall level of the stock market is the dominant driver of nearly all conventional equity funds, most hedge funds attempt to hedge or minimize their exposure to the broad stock market," he explains.
Well-known hedge fund firms manage hundreds of billions of dollars and include names like Bridgewater Associates, AQR Capital Management, J.P. Morgan Asset Management and Renaissance Technologies.
Hedge funds are also known for taking a more aggressive strategy by using leverage or investing in alternative asset classes such as private companies, real estate, distressed assets, currencies and commodities.
This fund structure lends itself to more efficient capture of alpha sources that come from behavioral, analytical, informational and technical mispricing.
Historically, including hedge funds in a portfolio generally has helped enhance overall returns and reduce overall risk – in other words, "winning by not losing," says James Sweetman, senior global alternative investment strategist at Wells Fargo & Co.
For those interested in this type of fund investing, here's what you need to know:
What are hedge funds?
Are hedge funds right for you?
Hedge funds typically have a lock-up period.
Hedge funds offer diversity in portfolio allocation.
What Are Hedge Funds?
Hedge funds are financial institutions that tend to be privately owned and managed. They're funded by private capital pooled from investors, companies or other clients. In particular, hedge funds do business with accredited investors, or individuals who have a high net worth. This is because under the Securities and Exchange Commission Regulation D, hedge funds can raise capital only through nonpublic means.
This rule also exempts hedge funds from certain SEC registration requirements, allowing some companies to offer and sell securities without having to register the offering with the SEC, according to the commission's website.
Walvoord says hedge funds can invest both long and short across a wide variety of markets and they generally actively hedge or reduce their exposure to risk factors that they deem undesirable.
"These characteristics allow hedge funds to offer return streams that are very different from traditional investments. These return streams can be very diversifying to traditional investments and thus quite valuable to the overall portfolio," he says.
Fees are an important consideration and part of the equation. Hedge funds are traditionally more expensive than other pooled investment vehicles.
Hedge funds charge a management and performance fee. Investors are usually required to pay a 2% management fee on an annual basis.
A common hedge fund fee is "two and 20," which means 2% per year of the assets that are being managed and another 20% of the profits.
The minimum investment can vary greatly from one hedge fund to another. Some hedge fund entities require a minimum investment amount ranging from $25,000 to $100,000, or in some cases as high as $1 million from accredited investors.
Those investing in hedge funds are typically wealthy individuals who can invest in the minimum without becoming too concentrated in one fund.
There are also third-party feeder fund vehicles that provide access to hedge funds at lower minimums.
Are Hedge Funds Right for You?
Hedge funds have varying strategies, returns and fees, and managers usually have the ability to alter the fund's strategy or assets without alerting shareholders. Some of the managers of these funds focus on improving your returns, while others offer diversification such as including exposure to cryptocurrencies .
"The first step in approaching hedge fund investments is to be very clear with your reasons for investing," says Kristi Hanson, partner and director of Taxable Research at NEPC in Portland. "Is it for risk reduction, return enhancement, access to unique markets? This foundational decision will guide the approach to investing."
When choosing a hedge fund to invest in, it is important to ascertain what role alternative investments will play in a client's portfolio, Sweetman says.
"Some clients are searching for income, others downside protection and others growth. Depending on the client's investment objective, certain hedge fund strategies may be more suitable than others, so consulting with your investment professional is of the utmost importance," he says.
Hedge Funds Have Lock-Up Periods
Unlike stocks or exchange-traded funds, hedge funds typically require investors to leave their money in the fund for a certain period before making any redemption. This is known as a lock-up period, notice period or a restriction on redemptions; these are detailed in the legal documents.
Hedge funds often invest in real estate or mineral exploration rights but offer less liquidity than assets such as ETFs or stocks.
Lock-up periods prevent the investor from accessing those funds for a certain time, which could typically last at least a year or more, experts say.
Given these characteristics, investing with a hedge fund may be out of reach for retail investors who may not be able to afford high investment minimums or long lock-up periods, or those who are unable to carry higher levels of investment risk.
Hedge Funds Offer Diversification
Hedge funds can be a worthwhile investment because the assets allow them to diversify and provide a lack of correlation to the stock market.
"Instead of investing in stocks, bonds and cash, hedge funds often provide exposure to alternative asset classes that tend to exhibit low correlation with the traditional markets," says Ulrik Lykke, executive director at Cyprus-based hedge fund ARK36.
Daniel Milan, managing partner at Cornerstone Financial Services, says low correlations to traditional asset classes help improve a model's overall diversification profile, potentially providing lower overall portfolio risk and an improved downside capture profile.
That said, choosing the right hedge fund manager is not an easy task.
Performing investor due diligence is mandatory when picking a hedge fund, experts suggest.
Transparency in relation to investment strategy and performance goals should also be an important consideration, Lykke says.
"While a hedge fund may not be able to openly advertise its performance due to regulatory constraints, investors should be able to obtain such information in a private offer in unambiguous terms," he explains.
Investors who qualify under the definition of "accredited investor" and are interested in investing with hedge funds should consider the level of investment risk, fees and how hedge funds can add value to your overall investment strategy.
While working with hedge funds can potentially boost returns, balancing your risk and reward should always be top of mind for every investor.
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