Broker Check

What are Hedge Funds?

August 28, 2017
Share |

What is a hedge fund? 

For an investment newbie, hedge fund may seem like a bit of a misnomer. Hedge funds are not a single fund or type of investment; rather, they are privately-held financial companies that pool investors’ money and invest this sum into an asset or venture they suspect will yield high returns – regardless of market performance. Typically, these pooled investment structures take the form of a limited partnership or limited liability company.

Unlike mutual funds, hedge funds are a more aggressive form of investment as money managers or registered investment advisors are able to use speculative strategies and short-sell stock, both of which carry higher risks as the initial outlay often requires leverage, or borrowed capital – in other words, debt. However, there are investors who take the stance of “higher risks yield higher rewards”.

What kinds of investments do hedge funds make?

Hedge fund managers can invest in any commodity or venture using any number of strategies they see fit. For example, there are hedge funds that buy shares of a privately-held business, either all or a majority, to wield enough influence to make profitable improvements and later sponsor an initial public offering (IPO). Other hedge funds might invest in startups, fine art, precious metals, patents, real estate, or junk bonds.     

Hedge fund managers may also buy and sell stock in a way that enables them to profit even when stock prices fall. This strategy is called short-selling. To demonstrate, say a company’s stock – we’ll call it stock x – is valued at $50 per share, but the manager speculates the stock’s price will soon fall. They might borrow 100 shares of stock x from one of their investor’s portfolios and sell it for the current value, netting $5,000. They’ll set this money aside and wait for stock x prices to fall. When stock x falls to $40 per share, the fund manager will buy back 100 shares, costing them $4,000 but netting them $1,000. So, basically, the fund manager themselves started with zero dollars, invested with borrowed stock, and profited by $1,000.  

How are hedge fund managers compensated?

The industry-wide tradition is called the “two and 20” standard. Most hedge fund managers receive 2 percent of net assets per year and 20 percent of profits after a certain threshold. However, there are some arrangements allowing managers to receive substantially more.

Who can invest in a hedge fund?

Because of certain federal regulations, only qualified or accredited investors are allowed to finance hedge funds. To qualify, investors must meet at least the following standards:

  • Earn at least $200,000 per year for at least two consecutive years – and are deemed likely to remain at or above this income level in the future.
  • Have a net worth of at least $1 million, excluding personal property.

Are hedge funds risky?

Hedge funds offer three qualities that make them desirable to some investors, including fewer financial regulations, contingency fee models, and a wider variety of investment options. However, these same qualities that make hedge funds desirable for some, make it highly risky for others.

Though the 2010 Dodd-Frank Wall Street Reform Act regulates certain aspects such as the size and transparency of hedge funds, they are still allowed to use riskier investment strategies than, for example, mutual funds or exchange-traded funds (ETF).    

Should you invest in a hedge fund?

The decision to invest in a hedge fund depends entirely on your financial circumstances and your tolerance to risk. Before investing, though, it is important to do your research, such as looking up background information on potential hedge fund managers or understanding their primary investment strategies.

Investing is both art and science, and as such requires a practiced eye. If you’d like to learn more about how to invest your income while minimizing risk, contact Retirement Income Specialists. We’ll help you create an investment portfolio with the potential to substantially increase your retirement income.