Hedge funds are alternative investments using pooled funds that employ different strategies to earn active returns, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).
It is important to note that hedge funds are generally only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles.1
Each hedge fund is constructed to take advantage of certain identifiable market opportunities. Hedge funds use different investment strategies and thus are often classified according to investment style. There is substantial diversity in risk attributes and investments among styles.
Legally, hedge funds are most often set up as private investment limited partnerships that are open to a limited number of accredited investors and require a large initial minimum investment. Investments in hedge funds are illiquid as they often require investors to keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.
Key Characteristics of Hedge Funds
They’re only open to “accredited” or qualified investors
Hedge funds are only allowed to take money from “qualified” investors—individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. As such, the Securities and Exchange Commission deems qualified investors suitable enough to handle the potential risks that come from a wider investment mandate.
They offer wider investment latitude than other funds
A hedge fund’s investment universe is limited only by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies. Mutual funds, by contrast, have to basically stick to stocks or bonds and are usually long-only.
They often employ leverage
Hedge funds will often use borrowed money to amplify their returns and also allow them to take aggressive short positions, depending on the fund’s strategy. As we saw during the financial crisis of 2008, leverage can also wipe out hedge funds.
2-and-20 fee structure
Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee. This fee structure is known as “Two and Twenty”—a 2% asset management fee and then a 20% cut of any gains generated.
How to Pick a Hedge Fund
With so many hedge funds in the investment universe, it is important that investors know what they are looking for in order to streamline the due diligence process and make timely and appropriate decisions.
When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each. These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the top five highest-performing funds in a particular category.