How to invest in a hedge fund
Editorial staff, J.P. Morgan Wealth Management
- Hedge funds employ sophisticated “hedging” strategies with the goal of consistently outperforming the market and other funds.
- You can directly invest in a hedge only if you are an accredited investor.
- If you are not an accredited investor, you can invest indirectly in hedge funds through a fund-of-funds or through publicly traded investment managers.
- Before you invest in a hedge fund, do your research. This includes research on the fund managers, the fund’s fee structure and investor capital requirements.
When we hear the word “hedge,” we often think of a garden. But this trading strategy is far more complex than keeping a jar full of change to save for some shrubs.
A hedge fund’s strategy is different than the typical buy-and-hold strategy you often see for many individual investors. By nature, a hedge fund is an actively managed fund whose managers will use various strategies in an effort to outperform the market. To be profitable, a hedge fund often takes some pretty large risks.
Because of this, hedge funds aren’t necessarily a good way for retail investors to preserve and grow their savings. That said, successful hedge funds can potentially generate outsized returns for their clients.
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What are hedge funds?
The thing that makes a hedge fund a hedge fund is its “hedging” investment strategy. The mechanics of the strategy may differ based on the fund, but the common thread is taking “long” positions in some securities (buying and holding investments that are expected to grow) and taking short positions in other securities (for example, “short selling” stocks to profit when they lose value).
Hedge funds are not subject to the same Securities and Exchange Commission (SEC) registration and reporting requirements that apply to funds that are registered with the SEC (like mutual funds, for example). The upside is that hedge funds can take bigger risks to get potentially bigger returns. The downside is the potential for substantial losses.
Hedge funds can accept only “accredited investors” who are either institutions like pension funds or insurance companies, or “natural individuals” (that is, real people) who have earned income that exceeded $200,000 for individuals or $300,000 for couples for the past two years and expect to do so for the current year; have a net worth over $1 million excluding the value of their primary residence; or hold a FINRA Series 7, 65 or 82 license.
In addition to the requirement to take money only from accredited investors, hedge funds often also have high minimum investments from $100,000 to $1 million or more. These minimum investments have the effect of keeping out small investors. Why do hedge funds accept only wealthy individuals or institutional investors? Because the regulating authorities believe that wealthy individuals and institutions can absorb high fees and potential losses of principle, whereas investors with a smaller net worth could be wiped out and impoverished.
Limitations for hedge fund investors
Hedge funds originally bought and shorted stocks, but in the 21st century, hedge funds may also own more illiquid assets like art, distressed debt or real estate. The fund’s strategy may take some time to work, and many funds require “lock-up periods” of one year or more, during which time an investor is unable to withdraw their investment from the fund.
The funds may also allow only limited windows for redemptions, like yearly, quarterly or monthly. Simply put, the price of a potential return is a large initial investment and limited ability to pull your money out in case of an emergency.
How to invest in a hedge fund
Accredited investors may have an investment advisor with their brokerage that can steer them toward hedge fund investments.
If you are not an accredited investor, you can invest in some hedge funds indirectly, either through a fund-of-funds or through an investment like an exchange-traded fund (ETF) that is constructed to mimic the strategy of a well-known hedge fund. Also, some investment management corporations are publicly traded companies that invest in hedge funds. By buying shares of these companies, you are indirectly investing in hedge funds.
Considerations for investing in hedge funds
If you are an accredited investor, there are a few steps you should consider before investing in a hedge fund.
- Read a fund’s offering memorandum and related materials. Contemporary funds have many different, sometimes complex, investing strategies. Make sure you understand how they work before you put in your capital.
- Determine if the fund is using leverage or other speculative investment techniques. Does the strategy rely heavily on borrowing against the assets of the fund? If it does, your risk is much greater.
- Evaluate potential conflicts of interest. If your advisor also manages the fund, for example, they may have a fiduciary conflict.
- Understand how a fund’s assets are valued. Funds should hire outside accountants to value their assets. Know who that accountant is and what their assessment says about the fund’s health.
- Understand how a fund’s performance is determined. Headline returns may look appealing but it’s important to understand how the fund arrived at that number.
- Understand any limitations on your right to redeem your shares. Before you put in your money, know what the “lock-up” and redemption policy is.
- Ask about fees and expenses. Returns aren’t so great if the cost of investing in the fund is also great. You might get the same return at a lower rate with an index fund that has very low fees.
- Ask about how a fund’s assets are safeguarded. Are the fund’s assets held in a custodial account at a reputable bank or broker? Can an independent third party confirm the existence of the fund’s assets? Any reputable fund will answer these questions without pause.
Once you are satisfied that the fund you want to invest in is a good fit for you, consider talking to your investment advisor about taking the next steps. And remember, hedge fund investing can be risky so make sure it aligns with your long-term goals.
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Editorial staff, J.P. Morgan Wealth Management
