How to Invest in Hedge Funds

Hedge fund strategies can be expensive, and identifying the right managers is challenging, particularly for retail investors. New options, including liquid alternatives and quantitative portfolios like strategies on Composer, may give investors many of the benefits of hedge funds with fewer drawbacks.

What is a Hedge Fund?

Hedge funds are investment strategies where managers pool investor money and invest in securities to achieve a positive return. Sounds simple enough. Let’s dig deeper.

The best way to think about hedge funds is that the investment manager has a blank slate to achieve the highest returns possible. Two defining characteristics of these vehicles are aggressive investment styles and lack of regulation.

With the lack of regulation and associated flexibility, hedge funds come in many different styles. Some simply invest in the stock market, while others invest in real estate, commodities, derivatives, and currencies. Hedge Fund Research, Inc. (HFR) categorizes funds into six groups:

1. Equity hedge

2. Event-driven

3. Fund-of-funds

4. Macro

5. Relative value

6. Risk parity

Hedge funds use strategies usually not found within standard mutual funds and Exchange-Traded Funds (ETFs), including leverage, derivatives (e.g., options and futures), illiquid securities, and short-selling.

Considerations for Investing in Hedge Funds

There are several considerations for investors considering investing in hedge funds, which is why we lay out alternatives to this asset class in this guide.

Hedge Fund Eligibility

First and foremost, you must be ALLOWED to invest in hedge funds. It’s an exclusive club. The most common investors in hedge funds are endowments, foundations, pension plans, insurance companies, and wealthy individuals. Because hedge funds are not sold publicly like mutual funds or ETFs, the Securities and Exchange Commission (SEC) sets strict guidelines on what constitutes a wealthy individual, calling these people accredited investors. The SEC mandates that accredited investors must have a minimum net worth of $1,000,000, an annual income of $200,000, or a joint income of $300,000. Even then, marquee hedge funds frequently have investment caps and tend to accept investments only for a limited time.

Regulatory Landscape

Second, investors should also consider the regulatory landscape for these investment vehicles. Hedge fund managers are not subject to most investor protections and may not be required to register with the SEC. In addition, they are often exempt from FINRA regulations. [1] For example, hedge funds do not need to issue a prospectus, making it difficult for financial advisors to give sound advice on a fund’s investment philosophy and process. [2] While hedge fund managers have a fiduciary duty to their clients and are not allowed to commit fraud, that has not stopped criminals like Bernard Madoff from using hedge funds as a cover for illegal activities.

Fees and Costs

Third, investors should consider the high costs of investing in hedge funds. There are two types of costs associated with a hedge fund: i) management fee and ii) performance fee. This is famously known as the “2-and-20” structure, although fees can sometimes be much higher. The management fee is a pre-defined fee paid by investors, which tends to be around 2% of AUM, regardless of performance. This is multiple times higher than the few basis points paid by ETF investors. The performance fee, typically 20% of gains, is a share of profits taken away by hedge fund managers, even before profits are returned to individual shareholders. Most hedge funds operate on a “2-and-20” structure, while some, such as Millenium and Citadel, have been known to charge even higher fees. Hedge fund investors entirely bear these costs, making hedge funds one of the most expensive investment vehicles for retail and institutional investors globally. On the contrary, ETFs or index fundissuers tend to be some of the lowest-cost investment avenues.

Investment Risk

Fourth, investors should consider the risks associated with hedge fund investing. Hedge funds often make concentrated leveraged bets that can result in significant performance swings. This creates a double-edged sword because if a concentrated bet with leverage goes wrong, a large part of savings can be wiped out entirely. To illustrate, a hedge fund might take the view that oil prices would rise because of the OPEC coalition strengthening their alliance - and they could take on additional leverage to buy oil futures. However, if oil fell due to fears about the recession, the fall in oil prices could hurt the investor multiple times due to leverage on the investment. And guess what? Since there is no warranty, the hedge fund manager would continue to earn the 2% of assets (or more) through management fees, regardless of fund performance!

Due Diligence and Conflicts of Interest

Fifth, investors should understand the strategies they are investing in. Investors should ideally do a lot of due diligence on hedge fund strategies and managers. Some strategies can be macro-driven, such as currencies or interest rates which would depend on many global factors, and some could be more micro-driven, including a large spectrum of fixed-income or long/short strategies. New investors typically do not get access to granular data on strategies, and even the largest pension funds are often only given high-level data. As far as managers go, investors should consider potential conflicts of interest. Firstly, your advisor and hedge fund manager may earn more than you based on investing your money! Secondly, several large hedge funds have smaller investing teams - and these teams often take opposing positions, which overall only benefits the managers and brokerage firms.

In the Bernard Madoff investment scandal, prosecutors estimated the size of Bernard Madoff’s hedge fund to be $64.8bn, mainly due to fictitious profit reporting. He admitted to one of the largest Ponzi schemes the USA has witnessed. To make matters worse, Madoff employed his daughter and brother to run compliance for the firm. Such conflicts of interest in investment decisions taken by hedge funds are essential to diligence and pose a clear threat to the interests of retail investors. Hedge fund investment advisers often will not fully disclose such risks.

Offering Memorandums

Lastly, some more diligence needs to be done by investors (i.e., the limited partners) to understand the complex offering memorandum documentation offered by the hedge funds. A few technicalities to be aware of include liquidity clauses, lock-up periods, arbitrage strategies, and the fund's valuation approach (growth vs value). Many retail investors are lured by past performance, which is often shown before high fees are deducted. Notably, past performance does not have significant predictive power for future returns. Other issues with hedge funds include a lack of full underlying investment transparency, higher costs associated with establishing and maintaining the fund investment structures, and generally longer–lived investment commitment periods with limited redemption availability.

Warren Buffett has also called out this problem of fee structure, saying that “hedge funds get unbelievable fees for bad results”! [3]

Goals of Hedge Funds

Hedge funds technically have a blank slate to pursue any investment strategy, but before you invest through hedge funds or other risky alternatives, take a moment to consider your investment objectives. We believe that the most essential goals for an individual’s portfolio include downside protection, diversification, and performance. Through downside protection, one should seek first to eliminate excessive risk and focus on steady compounding over the long term. Diversification is an important element in this process, through which one can thoughtfully spread the initial investment risk across different assets and asset classes. Finally, with the help of common sense investing and basic risk minimization, retail investors should aim to achieve returns that meet their goals.

Hedge funds solve some of these objectives some of the time, but it is hard to find hedge funds that consistently solve all of these objectives. One should also consider other issues, such as volatility and the risk of managing drawdowns. Because of their opacity, hedge funds effectively function like a private investment, and this is an alternative investment space that investors should understand carefully before investing.

Alternatives to Hedge Funds

Many investors do not qualify as accredited investors or are uncomfortable with the fees, lack of transparency, and aggressive strategies of hedge funds. Current U.S. Securities and Exchange Commission (SEC) rules restrict new investors from investing directly in hedge funds. So what alternatives exist for investors seeking diversification and downside protection? Publicly available alternatives may not have the same flexibility or ability to achieve huge returns, but they can help investors diversify and meet their goals.

• Liquid alternatives are an excellent way to get direct, fast, and reliable access to diversifying strategies. These typically do not mandate a minimum investment amount, and one is free to invest across sectors. ETFs that invest in managed futures, like DBMF, or mutual funds, like Vanguard’s Market Neutral Fund, are included in this category.