What is a Hedge Fund?
Hedge funds are private investments that use various nontraditional investing strategies to try to offset investment risk, an approach known as “hedging”. Hedge funds are attractive to investors because they can provide consistent returns even in a bad market.
Hedge Funds vs. Mutual Funds
Unlike a mutual fund, hedge funds are managed more aggressively and can take speculative positions in derivative securities such as options, shorting selling stocks and other relatively obscure or sophisticated vehicles. As a result, hedge funds can make money when the market is falling. Mutual funds, on the other hand, cannot take highly leveraged positions and are typically safer and rely on the market going up to make money.
Additionally, the SEC (Securities and Exchange Commission) doesn’t have strict rules for hedge funds as with traditional mutual funds. Hedge fund managers can manage the fund and create portfolios any way they want and do not have to provide information about performance or holdings. Additionally, there are no rules about pricing, so investors may not be able to determine the value of their investment at any particular time. As a result, there is really no way to tell the risk level of a particular hedge fund.
Hedge Fund Requirements
Hedge funds typical require a minimum investment of $1 million; however, there are “lite” hedge funds that are more affordable. Not everyone qualifies to invest in hedge funds. According to SEC guidelines, hedge fund investors must be “accredited”, which means you must have a net worth of at least $1 million. Additionally, you must have an individual income of at least $200,000 for the past 2 years or you and spouse must have a joint income of at least $300,000 for the past 2 years.
Downside to Hedge Funds
Hedge fund fees are much higher than traditional mutual funds, typically charging 1% or 2% of assets plus 20% of profits, which kicks in after a certain threshold.
Because hedge fund managers typically buy and sell frequently so investors will incur higher short term capital gain taxes. Hedge funds are better suited for retirement accounts where tax consequences don’t matter.
Another limitation of hedge funds is the lack of liquidity. Your money may be locked up for up to 5 years, although it’s typically 1 year. After you must provide 45 days notice if you want to make any withdrawals and you maybe limited to the amount of times you can make withdrawals. Some hedge funds only allow you to make a withdrawal only once per month.
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