What Are Hedge Funds?

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Hedge funds are high-risk investment vehicles that pool money together from participating investors. The fund manager uses the pool of money (and possibly additional borrowed funds) for just about any type of investment, from stocks to real estate to business turnarounds.

Unlike mutual funds and other types of investment funds that you may be able to choose for your 401(k) or individual retirement account (IRA), hedge funds are characterized by high-risk investments and strategies. The endgame is to make higher-than-average returns on the fund's investments.

Hedge funds aren't designed for beginning investors: They cater to high-net-worth individuals who have a significant amount of money to invest and who aren't afraid of tying up their money long term in high-risk investments. Hedge funds tend to carry hefty fees, but the potential for profit may be enough to entice qualified investors. Let's dive into how hedge funds work and who can invest in them.

How Does a Hedge Fund Work?

Hedge funds are actively managed, which means that a fund manager makes investment decisions on behalf of the fund's participants. They essentially raise capital from investors, then select investments aimed at netting high returns.

Hedge funds can take many forms. Some concentrate on specific sectors, while others take a more diversified approach and spread their investments across different industries. For example, a hedge fund might specialize in buying privately held businesses and grooming them to go public; others might concentrate on real estate investments.

Similarly, investment strategies and management styles can vary widely from fund to fund. But hedge funds are alike in that their sights are set on higher-risk investments. Some combine borrowed money with the fund's own capital to make larger investments, a strategy known as leverage, which amplifies potential investment gains and losses.

Most hedge fund managers collect a management fee in the range of 1% to 2% of managed assets. In addition, a 15% to 20% performance fee is typically tacked onto investment gains. The fee structure is steep, but it can incentivize fund managers to take a more aggressive investment approach.

Domestic hedge funds are typically structured as limited partnerships and registered as limited liability companies (LLCs). The fund manager usually serves as the general partner, with investors acting as limited partners.

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Who Can Join a Hedge Fund?

Generally speaking, hedge funds aren't open to everyone. You typically must be an accredited investor to show that you have adequate income, assets or experience to participate in the fund. Institutional investors, such as pension funds and large trusts, fall under this umbrella, as do certain individuals.

The U.S. Securities and Exchange Commission (SEC) defines an individual accredited investor as someone who meets at least one of the following criteria:

  • Has consistent earned income exceeding $200,000 ($300,000 if married)
  • Has a net worth that's more than $1 million, with or without a spouse, that excludes the value of their primary residence
  • Holds a qualifying professional financial license

Just because an individual can invest in a hedge fund doesn't mean they should, however. Because hedge funds often invest heavily in illiquid securities—investments that aren't easily redeemed for cash—investors must be willing to give up access to their invested money for considerable lengths of time and potentially sustain losses due to the inherent riskiness of the funds. With most hedge funds, investors can only cash in their shares a few times a year. It also isn't uncommon for a hedge fund to impose "lock-up" periods of at least one year where investors are unable to redeem their shares.

Those considering investing in a hedge fund should read and have a thorough understanding of its offering documents and agreements, which should outline the fund's investment strategies and fees. The SEC recommends consulting a financial advisor before investing in a hedge fund. If you're new to investing, there are many other, less risky ways to start building wealth.

Why Are Hedge Funds Considered Risky?

Hedge funds are risky by design. For one, they generally focus on high-risk investments with the goal of securing higher-than-average returns. Another important detail regarding hedge funds is that they aren't regulated as heavily as investment vehicles such as mutual funds. Instead, they often have greater flexibility to explore more speculative, nontraditional strategies and investments that could ultimately lead to more severe losses.

Beyond that, these types of funds may also invest in illiquid securities that are tricky to value. It's an important detail since fund asset valuations often affect the fees investors are charged. The SEC suggests getting a clear understanding of a hedge fund's valuation process before joining.

The Bottom Line

Hedge funds are designed for high-net-worth investors who have a large amount to invest and a healthy appetite for risk, as returns are never guaranteed. From 2011 to 2020, the average annual return on the S&P 500 was 14.4%, according to an analysis from the American Enterprise Institute. Meanwhile, the average hedge fund return was just 5%. Of course, there are outliers who score big.

Eligible investors should consult a financial advisor before investing in a hedge fund. In the end, financial wellness is about more than just investing. Maintaining healthy credit is equally important. Stay on top of your credit by getting your free credit report and credit score with Experian.