HEDGE FUNDS: ARE THEY FOR YOU?

What is a hedge fund?

A hedge fund is a private investment fund, often structured to minimize governmental oversight, regulation, and taxation. It’s usually limited to fewer than 100 investors: usually institutions or individuals of high net worth. Because of their unconventional investment strategies, hedge funds often can turn a profit no matter whether the key financial markets are rising, falling, or volatile.

How do hedge funds invest?

The general partner or manager makes the investment decisions. The earliest hedge funds relied mainly on “short selling”: borrowing shares, selling them, waiting for the stock to decline, then re-buying at a lower price and returning those shares to the original owner. Hedge funds still use this method, coupled with a “long” strategy of buying stocks that are expected to rise in value. Some funds focus on derivatives, options, or futures. Some don’t invest in stocks at all. Depending on the fund manager’s style, a hedge fund might trade dynamically, or hold investments for long-term growth.

Many hedge funds are “event-driven”: They make opportunistic investments in reaction to (or anticipation of) events such as mergers, takeovers, bankruptcies, or initial public offerings.

What are the upsides to investing in a hedge fund?

Because they’re lightly regulated, hedge funds offer their investors a much higher degree of privacy than other vehicles. Often they’re registered off-shore, to decrease the tax burden. Their investments are often highly leveraged, which enables them to take strong positions in profitable ventures. Their high-risk, high-return platforms appeal to the daring investor.

What are the downsides?

The fund manager commands a high fee: often 2% of the assets under management and 20%—in some cases more—of the fund’s profits. While many hedge funds perform very well, some experts contend that as a group, their investment strategies have become too highly correlated, leading to the possibility of overcrowding in certain areas. Moreover, since their investments tend to be speculative, fund managers occasionally guess wrong—which in a leveraged environment can be disastrous.

How can I invest in a hedge fund?

To qualify for entry of a hedge fund, you must be an “accredited investor” according to the Securities And Exchange Commission (SEC), which means you must have a net worth (individually or jointly with a spouse) of $1 million, or an annual income of $200,000 ($300,000 jointly with a spouse). Various types of businesses and other organizations can also qualify as accredited investors. Most hedge funds require a high minimum investment: often as much as $1 million.

If you don’t have that kind of money, you can sometimes invest in a “fund of hedge funds.” This is an investment fund that invests in other investment funds, rather than investing directly in liquid assets. A fund of hedge funds typically has a much lower minimum investment: as little as $25,000. The downside is that funds of funds charge extra fees—in addition to the fees charged by the funds they invest in—to compensate their managers.

How do I know which hedge fund is right for me?

Hedge funds are less overseen and regulated than most other types of funds, and while that’s an advantage in some ways, it puts the burden of due diligence squarely on your shoulders.

Go over the fund’s prospectus or offering memo very carefully—and get a second and a third opinion. Are you comfortable with the manager’s investment strategies? Do they relate well to your own investment goals and risk tolerance?

What are the manager’s qualifications? What’s his track record? Has he been in trouble with the law, or disciplined by the securities industry?

Examine the fee structure. Figure out how much of the fund’s profits will go into your pocket once the fees are deducted. A fund with a very high return might justify higher fees—or it might not.

Know the exits. How easily can you get your money back? To what extent will your investment be protected?

How will you know how the fund’s assets are valued? The valuation process can differ considerably from fund to fund, so compare your fund’s own valuation of its holdings to valuations by other sources.

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