How to Invest in a Hedge Fund

What Is a Hedge Fund?

Hedge funds are actively managed investment vehicles. A fund manager gathers money from participants, then invests on their behalf. Mutual funds are managed this way, too, but hedge funds are different in that they specifically focus on high-risk investments and strategies and typically require a significant financial commitment from investors.

The goal of a hedge fund manager is to net better-than-average returns, and most hedge fund managers take a sizable piece of the action for doing so. Management fees typically cost 1% to 2% of managed funds. A performance fee is also generally added on top of investment gains and can range anywhere from 15% to 20%. Hedge fund fees might feel like a lot to swallow, but they can help motivate fund managers to adopt bolder investment strategies. This can be done in any number of ways. Here are some investment strategies typically used by hedge funds:

• Long/short equity: There are two sides to this coin—purchasing stocks that are anticipated to increase in value (long) and shorting stocks that are expected to lose value (short). Stock shorting involves borrowing and selling stocks that are expected to lose value to essentially bet against that stock. It's risky because the fund will lose money if stock prices unexpectedly go up. The goal is that taking both long and short positions will allow the fund to profit regardless of market conditions.
• Debt-based investing: It's possible for a financially distressed company to have a lot of debt and a strong business model. Some hedge funds will invest in this kind of debt, then reap high returns if the company is successfully restructured. Debt investing is inherently risky because there's no guarantee the company's financial outlook will improve.
• Merger arbitrage: This investment strategy requires fund managers to attempt to predict how an announced merger or acquisition will pan out. It involves buying and selling stock from both companies at the same time, based on anticipated future values. The endgame is to capture gains when the deal is finalized, but it's a speculative strategy that requires a lot of guesswork.

It's important to note that hedge funds are geared toward high-net-worth folks who are accredited investors. This reassures fund managers that they are financially capable of investing. According to the Securities and Exchange Commission (SEC), an accredited investor is someone who can tick off at least one of the following boxes:

• An income that consistently surpasses $200,000 ($300,000 for married couples)
• A net worth that exceeds $1 million (excluding the value of their primary residence), regardless of their marital status
• Is a qualified and licensed financial professional

Beyond that, most hedge funds also have steep minimum initial investments. These can range anywhere from $100,000 to tens of millions of dollars.

Pros and Cons of Hedge Funds

Pros

• Potential for high returns: An American Enterprise Institute analysis found that the average hedge fund return over the last decade was 5%. That may not sound like much, but it could translate to a large profit if you're investing a lot. It's worth noting, however, that this average return is still less than returns on stock market indexes and other lower-risk investment methods. Of course, there are hedge funds that score really big—TCI Fund Management, for example, raked in $9.5 billion for its clients in 2021, according to Reuters.
• Diversification: A diverse investment portfolio provides balance and spreads out risk across different asset classes, industries and geographic locations. Hedge funds can help here. While they may not always reap huge returns, they've historically done well to minimize losses during market downturns.

Cons

• Limited access to your money: Unlike mutual funds and exchange-traded funds (ETFs), hedge funds tend to invest in securities that aren't easy to cash out. What's more, investors may only be able to redeem their shares a few times a year. In this way, hedge funds are better suited for investors who are comfortable with giving up access to their invested funds for long stretches of time.
• Possibly severe losses: Just because investors could reap huge returns doesn't mean they will. Hedge funds make gambles and lean on high-risk investment strategies in an effort to maximize your earnings. These gambles don't always pay off, however, so putting too much of your money into hedge funds could jeopardize your nest egg.

How to Start Investing in Hedge Funds

The first step to investing in hedge funds is to become an accredited investor based on the requirements listed above. If you're confident you qualify, an experienced financial advisor can guide you in finding a hedge fund to invest in. Be prepared to provide financial documents to the firm proving that you're an accredited investor. This might include W-2s and 1099s, pay stubs, or a letter from your employer or accountant verifying your income. You'll also want to properly vet a hedge fund before investing. The SEC recommends reading the fund's prospectus and other materials to clarify the following:

• Its investment strategies
• Fees
• How the fund values its assets, which can shape its fees
• Your rights when it comes to redeeming shares
• Who the fund manager is and if you trust them to manage your money properly

The Bottom Line

Hedge funds are typically limited to high-net-worth individuals. They concentrate on high-risk investments with the intention of reaping higher-than-average returns, but investors are also vulnerable to severe losses. Hedge funds are also more loosely regulated when compared with other investment vehicles, such as mutual funds. This is all to say that they aren't for everyday investors.

You can still grow your wealth by exploring more accessible investment options like a 401(k), individual retirement account (IRA), mutual funds, ETFs and more. Your financial well-being is also directly linked to your credit health—one supports the other. Experian has you covered with free credit monitoring. It's one more resource to help keep your financial life moving in the right direction.