Hedge funds are an increasingly popular, if rarefied, investment opportunity. Available to only the most sophisticated investors, they have the potential for large returns — or large losses. The U.S. hedge fund industry accounted for 72% of the $3.6 trillion in global hedge fund assets as of May 31, 2018, according to a 2018 survey by Preqin. The largest hedge funds in the U.S. include Renaissance Technologies and D.E. Shaw and Co.
So, how well do hedge funds perform? In 2007, Warren Buffett bet $500,000 — to be donated to charity — that a Standard & Poor’s 500 index fund would outperform five hand-selected “funds of hedge funds” over a nine-year period. These are funds made up of other hedge funds. Sure enough, the S&P 500 index fund returned 85.4% from 2008 to 2016. The hedge funds had returns ranging from 2.9% to 62.8% over the same period.
There are strict requirements to invest in hedge funds, and the typical investor rarely will satisfy them, making hedge funds available only to those with high net worth who are willing and able to take the risk hedge funds represent.
This guide will explain what you need to know about hedge funds.
- What Is a Hedge Fund?
- How Does a Hedge Fund Work?
- Who Can Invest in Hedge Funds?
- Common Hedge Fund Strategies
- What Is a 2 and 20?
- How Are Hedge Fund Profits Taxed?
- What To Know If You’re Considering a Hedge Fund
In a hedge fund, investors pool their money and purchase certain investments. A hedge fund can invest in just about anything, including short positions, junk bonds, real estate and private equity.
The name came from the fact that investments were often chosen as a “hedge,” or protection, against declining markets. The first hedge funds held both long and short positions so that they would make money even if the market went down — a short position being an agreement to buy or sell stock in the future at an agreed-upon price. If an investor expects a stock to go down, they can “short” the stock, effectively borrowing the stock at today’s price and “repaying” it later at a lower price.
A hedge fund manager decides which investments will be purchased by the fund, basing their decisions on the fund’s objective.
Check Out: Top 10 Hedge Funds in the US
A hedge fund purchases investments with the money investors pool together to create the fund. These can be traditional investments, like stocks and bonds, or alternative investments, such as derivatives and options.
Like all investments, hedge funds have pros and cons. Here are some of them:
- Potentially high returns: Because hedge funds invest in riskier positions, the potential for larger returns is always there.
- Active management: A hedge fund manager is an expert who studies potential investments carefully. An experienced, successful manager can generate good returns for investors.
- Potentially large losses: Higher risk means the probability of big losses if the manager’s strategy turns out to be flawed.
- Little regulation: Hedge funds, unlike mutual funds and exchange-traded funds, do not need to be registered with the Securities and Exchange Commission. This means they are not subject to the same regulatory standards.
- High fees: Hedge fund managers typically collect a fee based on the percentage of assets under management as well as a percentage of the income the fund generates. These fees reduce the return that hedge fund investors earn on their investment.
Special rules restrict who can invest in hedge funds. In order to invest in a hedge fund, you must be an accredited investor. An accredited investor is one who can show earned income of over $200,000 per year — $300,000 combined with a spouse — for the last two years and expects to have the same in the current year, and who has a net worth of over $1,000,000, either alone or in combination with a spouse, not including their primary residence. A trust with assets over $5 million is also considered an accredited investor, as is an entity in which all of the equity owners are accredited investors.
Every hedge fund has its own strategy, but several popular strategies have emerged. Here are some of the most common hedge fund strategies:
Global Macro Strategy
A global macro strategy is one that focuses on worldwide forces that might impact the performance of all companies rather than looking at an individual company and then interpreting how these forces might impact that particular company. Once these forces, which might be economic, political, social or demographic, are identified, the fund seeks to determine which companies will be impacted most, and then invests in those. Based on this analysis, the fund might take a long or short position in the targeted companies.
Long/Short Equity Strategy
Equity funds select long or short positions in equities (stocks), depending on whether the manager thinks the price of the stock will rise or fall in the short term. A long strategy means simply buying the stock and holding it until the price rises, then selling it at a profit. A short strategy means borrowing the shares and immediately selling them. When the price drops, you can buy the shares again at a lower price, pay back your brokers for the borrowed shares and pocket the difference.
Relative Value Arbitrage Strategy
Relative value arbitrage involves buying and selling two similar securities that have a discrepancy in their prices. If the hedge fund manager believes the two securities are not priced appropriately, they will buy one and short the other. This strategy is used with securities that typically move in the same direction but might diverge for some reason, which presents an opportunity for relative value arbitrage.
Distressed Debt Strategy
Distressed debt refers to buying the debt, which usually includes bonds and bank debt, of companies that are heading toward bankruptcy. The owners of this debt are often willing to sell it at a reduced price for fear that it will be entirely worthless if the company goes under. Hedge funds buy the debt and then influence the way the company restructures. The hope, for the hedge fund, is that the company will avoid bankruptcy and the fund can then sell the bonds at a profit.
An event-driven strategy is one that seeks to profit from an upcoming event, often a merger or acquisition. The hedge fund manager will analyze the likelihood of the event actually going through, and then compare the current price of the security with its likely price should the event occur — or not occur, whichever is more likely.
Hedge Funds and 9 More: Good Investments for Risk-Takers
A 2 and 20 is a common hedge fund compensation structure for managers. Under this structure, the hedge fund manager collects a management fee equal to 2% of the fund’s assets under management — i.e., the money that’s invested in the fund. This compensation is paid regardless of the fund’s performance. As an incentive for good performance, the manager is also compensated with a performance fee equal to 20% of the profits the fund generates after a minimum is met.
Hedge funds are typically set up as limited liability partnerships or limited liability companies — LLPs or LLCs. These are considered pass-through entities, meaning that the entities do not pay taxes, only the owners do. The gains on hedge funds are taxed as short-term or long-term capital gains, depending on whether the assets have been held for one year or longer.
The first thing to know if you’re considering a hedge fund is whether you can afford to lose your investment. Hedge fund investments are inherently risky and low-liquidity. You need to be prepared to keep your money tied up for an indefinite amount of time, or to possibly lose most or all of your investment.
If you still think a hedge fund is for you, do your homework. Read the prospectus, understand the risks and be fully aware of the fees you’ll be charged. Research the managers of the funds you are considering and make sure you’re comfortable with the background and past performance of the one you select.
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Karen Doyle is a personal finance writer and former financial advisor.