Crash Course: Hedge Fund Investing Basics

The public and investing world love to use hedge funds as a punching bag. Simultaneously romanticized as the purview of the uber-wealthy and demonized for associations with greed and fraud, our general understanding of hedge fund investing falls short. In theory, this makes the fact that only accredited investors can access these complex investments seem reasonable.

But the unrelenting pace of financial innovation has changed the game. Retail investors may now gain exposure to hedge funds through products like ETFs and mutual funds. As many look for alternatives in a market where the 60/40 paradigm is struggling, such products hold understandable appeal.

Warren Buffett is known for encouraging investors to invest in what they know, and we wholeheartedly agree. To this end, let’s break down some of the basics of hedge fund investing.

What Is a Hedge Fund?

A hedge fund is an alternative investment that pools the money of wealthy, sophisticated investors to execute complex investment and trading strategies. These funds promise to deliver alpha to their investors or returns in excess of an established benchmark.

To fulfill this promise, hedge funds may use a variety of financial instruments, including securities, bonds, derivatives, and more. They often employ leverage to amplify their returns.

Hedge funds often get described as a ‘hedge’ against volatile markets. Under certain circumstances, this has been true. However, the use of complicated instruments and strategies can also be risky.

How Do Hedge Funds Invest?

Generally, hedge funds may be considered discretionary, systematic, or a hybrid of the two. In a discretionary program, managers make decisions based on – you guessed it – their discretion. With a systematic program, rules determine when to enter or exit an investment or trade based on available market data. When looking at a hybrid system, managers have a set of rules they follow but may override those rules should the situation call for it.

Hedge funds market their strategies as unique to differentiate themselves from competitors. Though the technical details of their approach are often shrouded in secrecy, they usually fall into one of a number of ‘categories.’ Though much debate exists regarding which categories are most useful, they often include:

• Global Macro – Trading based on global macroeconomic trends related to things like interest rates, currencies, and economic cycles.
• Directional – Sometimes referred to as trend following, directional funds seek to latch onto and ride trends up or down in different markets.
• Event-driven – Seeks to capitalize on significant developments in a given market, such as acquisitions or bankruptcies.
• Relative Value Arbitrage – Tries to take advantage of price discrepancies between securities. These trades get placed with the expectation that the prices will either move toward or away from each other over time.
• Long/Short – Assuming similarities between two securities, managers ‘bet’ one will go up while the other goes down in what is known as a ‘pair trade.’ This might include betting that McDonald’s will go up (going long or buying stock) while betting that Burger King will go down (going short or selling stock).
• Capital Structure – Takes advantage of pricing inefficiencies within a single entity. For example, a fund might go long on a company’s higher-interest subordinate bonds while shorting senior bonds, assuming that the prices will correct over time.

Are these categories all-inclusive? No. Some hedge funds don’t fit neatly into these buckets. Some use a combination of strategies and get classified as ‘Multi-Strategy.’ Even within each category, sub-categories abound.

Why Do People Invest in Hedge Funds?

The reasoning behind allocating to a hedge fund varies from investor to investor. An individual accredited investor might, for instance, choose to invest with a friend or family member who is running a fund. An institutional investor, on the other hand, may conduct extensive, time-consuming due diligence before pulling the trigger. But broadly speaking, there are many primary reasons investors gravitate toward hedge funds.

The Race for Returns

Hedge funds promise high returns to potential investors. Sometimes, they deliver. Sometimes they don’t. But when they do, the numbers can be staggering. With great reward comes great risk (more on that in a minute).

The Manager’s Edge

Hedge funds may try to impress investors with descriptions of complicated strategies and performance track records. But the manager behind the numbers matters, too. Investors like to hand over their money to people they believe in. Hedge fund managers benefit from their perceived edge over other market players due to intellect and experience.

The Hedging Part of Hedge Funds

Allocations to hedge funds are often part of an investor’s attempts to diversify their overall investment portfolio. The idea is that a manager’s attempts to navigate volatility in the marketplace will deliver returns that do not necessarily correlate with more traditional investments.

Asset Class Access

High minimums, long time horizons, and complex transaction mechanisms make accessing alternative investments challenging for individuals. Because hedge funds pool the assets of multiple investors, they can offer exposure to alternatives that would otherwise be out of reach.

What Risks Do Hedge Fund Investments Present?

Though hedge funds attract a lot of capital from accredited and institutional investors, they are not without risk. Those risks are different and more complicated than those you’d encounter in a traditional asset class. This is why there are limits regarding who can invest in the first place.

Risk of Loss

Make sure you read the fine print on a hedge fund’s prospectus. Most tell you that you stand to lose the entirety of your investment. Do you have the appetite for that?

Your hedge fund manager probably won’t ride a stock pick all the way down to $0. In most situations, the risk of loss comes from the use of leverage.

Essentially, managers will borrow money to take on a bigger position than the money they have on hand might allow. If their bet pays off, they make more money than they might have without employing leverage. Should the bet go south, though, there is no limit to the downside. This makes a fund’s risk management protocols critical in any allocation decision.

Liquidity Risk

Hedge funds offer investors opportunities to withdraw their investments from their funds. These windows only come about periodically, and redemptions can take weeks to process. To this end, converting to cash may prove more challenging for hedge fund investors than it does for investors in traditional asset classes.

Manager Risk

When you invest in a hedge fund, you’re trusting that the fund’s manager will make smart choices that deliver a return. Sometimes, the manager breaks that trust with catastrophic results.

We’re not just talking about Bernie Madoff. From embezzlement to mishandling of customer funds, recent decades have witnessed financial scandal after financial scandal. Even some of the largest institutions have made missteps.

When investing in smaller hedge funds, due diligence becomes even more important. Each year, dozens of new hedge funds are launched with dozens more closing their doors for good. In the meantime, nothing prevents an unsuccessful manager from shutting down one fund to start another. Without effective due diligence, a shiny pro forma performance track record can blind investors to more qualitative risks.

Diversification Risk

Yes, we just explained that hedge funds attract investors by promising diversification. To a certain extent, they can. But not all diversification looks the same.

The idea of diversification hinges on allocating to different asset classes that generally perform differently under the same circumstances. We measure this type of diversification according to correlation. A negative or inverse correlation indicates that two asset classes move in different directions at the same time, while a positive correlation indicates that they move in tandem.

As the argument goes, hedge funds provide diversification because their performance does not correlate with traditional assets. But do they? An analysis of correlation levels since 2000 shows that hedge fund performance tracks traditional assets much more closely than one might assume. Especially since the financial crisis of 2008 and through recent periods of market volatility, hedge fund performance has increasingly tracked traditional asset classes, reducing their effectiveness as a diversification tool. For instance, in 2024, a standard 60/40 portfolio (comprising 60% stocks and 40% bonds) delivered returns of nearly 15%, surpassing the average hedge fund returns of 10-11%

These numbers make sense if you think about it. The majority of hedge funds will have some exposure to equities in their portfolio, so we would expect some correlation between stocks and hedge funds. The data does, however, cut against assumptions about manager prowess.

While many push back on classifying hedge funds as their own asset class, they can function as a tool for accessing different asset classes in a manner that balances your overall investment portfolio. The total diversification value of a hedge fund depends on the individual fund’s holdings and strategy. For instance, if you already have a portion of your portfolio dedicated to domestic stocks, investing in a long-only equities hedge fund might not do you any favors.

How Are Hedge Funds Regulated?

Hedge funds are mostly regulated by the SEC. Depending on their strategy, the Commodities Futures Trading Commission (CFTC) and National Futures Association (NFA) may monitor a fund’s activity, too.

The regulation of hedge funds differs substantially from the regulation of traditional asset classes. As these funds cannot be accessed by the average investor, certain provisions intended to protect them from high-risk investments do not apply. The current regulatory regime assumes that accredited investors are savvy enough to make such calculations on their own.

How Much Does it Cost To Invest in a Hedge Fund?

The minimum investment required by a hedge fund depends on the fund itself. In some (relatively rare) cases, you may be able to get in the door for as little as $100,000. Other large funds require a minimum investment in excess of $10 million.

The median minimum investment, however, is $500,000. This high minimum investment serves as a barrier to entry for average investors. It’s also part of the equation that limits hedge funds to accredited investors. If your net worth is too low, meeting the minimum investment for a hedge fund may place all of your investment capital into a single fund. The idea is to protect average investors from risk exposure they may not fully understand.

What Kind of Fees get Charged by Hedge Fund Managers?

Hedge fund managers typically charge what’s known as a ‘2 and 20.’ This refers to a 2% annual management fee and a 20% performance incentive. The management fee is calculated based on net assets under management (AUM), while profits are calculated based on the fund’s profits accrued.

In theory, this fee structure aligns the manager’s interests with those of the investor. After all, they make more money if you do. Some, however, argue that the fees are too high overall. Such laments get louder during years when hedge fund returns contract.

In reality, hedge fund fees have been on the decline for years. While some larger institutions have pivoted toward lower management fees and higher performance incentives, most funds have dropped fees across the board. As of early 2023, the average hedge fund management fee is 1.36%, with a 16.05% performance fee.

How Do Hedge Funds Differ From Private Equity or Venture Capital Funds?

While some argue that private equity and venture capital funds are just different flavors in the hedge fund universe, they feature vital differences. Yes, they frequently come with similar fee structures. They both accept only accredited investors. Both require high minimum investments. In each case, the fund aims to deliver alpha in high-risk, high-reward scenarios.

Beyond this, philosophical, structural, and operational differences abound. Understanding them will help you make better allocation decisions.

Investment Methods

Generally speaking, private equity and venture capital funds invest in companies intending to turn a profit through expansion, going public, or selling the company and/or its assets. Hedge funds use a variety of investment strategies and invest in a wide range of asset classes.

Open-Ended vs. Close-Ended

The terms ‘open-ended’ and ‘close-ended’ often come up in conversations comparing mutual funds with hedge funds that trade as securities.

A mutual fund is traded daily according to its NAV, or net asset value. This means the share value of that mutual fund hinges on the performance of its underlying assets. They may issue as many shares as they like.

On the other hand, hedge funds that trade as companies issue a set number of shares. Share value is determined based on supply and demand.

However, the terms take on a slightly different flavor in discussions about hedge funds and private equity or venture capital firms. Whether a fund is open or closed-ended has much more to do with capital raise and redemption parameters.

Hedge funds are considered (mostly) open-ended because they may continuously raise and invest capital without term limits. We consider private equity and venture capital investments, on the other hand, as closed-ended. This means they have a specific term and a set number of shares or investors. These investors cannot withdraw until the fund is liquidated, and new investors cannot enter the fund now.

Sometimes, hedge funds toe the line between open and close-ended funds. This typically happens when a hedge fund hits critical mass in terms of assets under management. If bringing in new capital would compromise strategy performance by requiring, for instance, larger and less nimble positions, they may choose to ‘close’ to new investors.

Liquidity

Hedge funds usually deal with more liquid transactions. This includes publicly traded securities or bonds that can be traded quickly on the market and converted to cash. Private equity, however, invests in or acquires businesses. This allows hedge funds to offer staggered windows for investors to ‘redeem’ (withdraw) their capital. By their very nature, private equity investments ‘lock up’ your capital for as much as ten years.

Risk Exposure

Hedge funds tend to make riskier investments than private equity or venture capital funds. This is due in large part to issues related to liquidity and timeframe. Hedge funds can ‘hedge’ against market risk and volatility because their positions usually have a shorter time horizon. But this, combined with leverage, also means they are more susceptible to market volatility.

Private equity and venture capital face different kinds of risks. A single bad day or six-month stretch in the markets won’t make or break their ROI. Economic trends may, however, impact the factors that drive their companies’ performance and operational costs.

How Can I Start Investing in Hedge Funds?

As is the case with any investment, you must complete thorough due diligence before making a hedge fund allocation. You need to confirm regulatory registration and status, performance history, risk management protocols, asset class exposure, and more. This data provides a more complete picture of the opportunity in front of you.

As always, we recommend speaking with a financial advisor before making any decisions. Their resources and tools may bolster any due diligence you have completed yourself, and their understanding of your total portfolio will be deeper and more granular.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Digital Assets and Bankruptcy
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3. Tricks and Traps in Leveraged Finance

This article was originally published in 2020 and last updated on April 24, 2023.] 

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