How To Invest In A Hedge Fund – The Basics You Should Know
If you’ve taken to watching Showtime’s hit TV series “Billions” and would like to get into the world of hedge funds, then take a seat! Hedge funds aren’t exactly an investment option you’ll find in your 401(k) plan or at the local Edward Jones office. These are complex and often very exclusive investment vehicles that require a much higher level of commitment than a standard stock or ETF investment.
If you think you’ve got what it takes, then here’s everything you need to know about how to invest in a hedge fund.
What Is A Hedge Fund?
According to Investor.gov: Hedge funds pool money from investors and invest in securities or other types of investments to get positive returns.
Their basic concept of combining money from multiple investors is similar to that of a mutual fund. However, hedge funds are not as heavily regulated which gives the managers more leeway to pursue complex investment strategies and take on increased risk.
Hedge funds have a reputation for being able to produce superior returns over normal “conventional” investments. Because of strict requirements for who is eligible to invest, they are generally perceived as being reserved for only the rich and wealthy.
What Do Hedge Funds Invest In?
What is it about the investment strategies of hedge funds that make them so special and gives them a supposed edge over other types of securities like mutual funds and ETFs?
Unlike conventional funds which generally just invest in publicly traded companies and other common assets, hedge funds often employ some very complex and complicated methods for making their billions.
Forbes broke down some of the top ways that hedge funds typically make their money. Here are just a handful of their strategies:
- Long/short. The idea that you can balance a portfolio of long-term stocks with select short sales (bets that a stock will fall) so that you decrease volatility and lose less money.
- Event Driven. Rather than buy a stock when it’s about to increase or short a stock when it’s about to decrease, why not do both? This strategy looks for deals where one company is about to buy the other and then seeks to make as money as possible on the spread.
- Discretionary Macro. This is a speculative approach where the manager bets on the direction of currencies, commodities, interest rates, and market indices. It’s generally driven by current world events and predictions of how that will impact the financial markets in the short-term.
- Systematic CTA (Commodity Trading Advisors). The use of computer algorithms to follow the market trends of various assets and then make predictions about whether they should buy or short them.
- Credit. Lending to corporations in need of capital and trading derivatives (complex financial contracts).
How To Invest In A Hedge Fund
In order to invest in a hedge fund, you have to first be what is referred to as an “accredited investor”.
Individual investors with a net worth greater than $1 million (excluding the value of their primary residence) are considered to be accredited investors. Alternatively, if you earn a minimum of $200,000 per year (or $300,000 if you file jointly with a spouse), then you might also be considered an accredited investor.
These requirements come from a government publication called “Regulation D”. In addition to defining who is an “accredited investor”, it also puts limits on the number of people who can participate in the fund, how hedge funds advertise, and so on. You can find out more about Regulation D here.
Why Are Hedge Funds So Mysterious?
If hedge funds seem vague and mysterious, then you’re not alone. Much of what we (the general public) know about hedge funds are limited to what we’ve seen in fictional movie settings or the media; usually when someone associated with hedge fund investing has done something wrong such as Jeffrey Epstein.
Because hedge funds are often limited to such a small niche group of investors and are generally not allowed to advertise to the masses, they’re just simply not something you’ll come across or even have to ever think about as a typical middle-class citizen.
The World’s Top 10 Hedge Fund Firms
Suppose you do meet the requirements to be considered an “accredited investor” and can participate in a hedge fund. Who would you even call?
Instead of going to a traditional full-service broker like Vanguard or Fidelity, to invest in a hedge fund you’d have to seek out a financial firm that specializes in these types of investment strategies.
Here are the top 10 hedge fund firms from around the world:
- Bridgewater Associates
- Renaissance Technologies
- Man Group
- AQR Capital Management
- Two Sigma Investments
- Millennium Management
- Elliott Management
- Davidson Kempner Capital
Do Hedge Funds Really Deliver Higher Returns?
Although hedge funds are often characterized as being these superior alternative investments that are certain to outperform the broader market, is this really the case?
Unfortunately, some data suggests the answer might be “no”. In a study by Yale and NYU Stern economists, they examined a six-year period and found that the average annual return for offshore hedge funds was 13.6% whereas the average annual gain for the S&P 500 was 16.5%.
Here’s another example. Back in 2008, Warren Buffett made a $1 million wager (for charity) that you could make more money investing in a simple index fund than entrusted it to hedge fund managers. In 2018, Buffett won that bet. His pick, the S&P 500 (OEX), gained 125.8% over the ten-year span. The five hedge funds picked by a firm called Protégé Partners only made a 36% return.
A Better Strategy For The Common Investor
If you don’t happen to have $1 million or so to invest in a hedge fund, then don’t worry. As the examples above illustrate, you may not be missing out on as much as you think.
Today, most investors could benefit from just investing in a simple index fund (usually a mutual fund or ETF) that contains all of the same holdings as a major market benchmark, such as the S&P 500 stock index. Currently, the long-term average return of the S&P 500 index is 10 percent. That’s not too shabby, especially when you consider how easy it is to invest in one.