If you have questions about how hedge funds work, you’ve got company. Hedge funds aren’t for the average investor, which means the average investor typically doesn’t understand much about how hedge funds work. Hedge funds are an investment vehicle open to a select group of qualifying investors which can potentially unlock significant returns. Those who qualify can pool their resources investing in both long- and short-term stocks, limiting or “hedging” their risk. Thus, hedge funds received their name, and it’s held ever since.
What is a Hedge Fund?
Hedge funds are pooled investments. Forming a private company, such as an LLC or partnership (LLCs are more common), hedge funds protect investors from bankruptcy by limiting their liability for loss. The investment pool – the hedge fund – is managed by a hedge fund investment advisor or money manager. Hedge funds are open only to qualifying investors and have no limits as to where investments can be placed offering greater investment flexibility than, say, a mutual fund.
Who Qualifies to Invest in a Hedge Fund?
Hedge funds aren’t open to everyone. To qualify for investment in a hedge fund, investors must be classified as either accredited or sophisticated.
To become an accredited investor, investors must meet one of the following criteria:
- Net Worth. Investors worth $1,000,000 or more. This amount is the same for single investors and married couples and does not include the value of the investor’s primary residence.
- A personal income of at least $200,000, earned for at least two consecutive years with a good chance of continuing. For married couples, the amount increases to $300,000.
- Hedge fund managers, employees of the hedge funds, and any other people with professional ties to the hedge fund can qualify to invest.
- A large number of hedge funds are institutional accounts. These include pension plans, corporate assets, trust funds, and more. To qualify, account net worth must meet or exceed $5,000,000.
Sophisticated investors are investors credited with a deeper understanding of investing. Sophisticated investors are not self-appointed. To earn the title of a sophisticated investor, investors must qualify through a brokerage firm. This may include an evaluation of personal assets and net worth. Beyond dollar amount, investors must possess the knowledge and experience necessary for distinction as a sophisticated investor.
How do Hedge Funds Work?
As mentioned above, hedge funds are amassed under the umbrella of a privately-owned company or partnership. This means that before a hedge fund can begin depositing money in the account, there are going to be legal steps to navigate. Initial investment and startup costs are separate. Start-up costs vary but can easily stretch into the six-figure range. The simplest way to become involved in a hedge fund is to approach a hedge fund manager. Other ways of becoming involved in a hedge fund include through a pension or institutional investment account, via personal connections, or by forming their own.
Hedge funds have extreme flexibility for investment. Hedge fund managers are free to make investments in almost anything. Hedge funds can invest in stocks and bonds, much like a mutual fund, but can also invest in practically anything else, from real estate to collectibles.
How are Hedge Fund Managers Paid?
Hedge fund manager compensation varies. Typically, hedge fund managers will adopt a compensation structure involving both a flat and bonus rate, should the fund perform well. Driven to achieve a profit threshold to unlock their bonus rate, hedge fund managers are motivated to make wise investments.
“Two and Twenty”
Hedge fund managers are paid according to an agreement between the investors and manager, but many typically employ what’s referred to as a “two and twenty” compensation structure. Under this pay structure, a hedge fund manager would receive 2% of the account balance annually as compensation for management. Once the account reaches a predetermined level of success, achieving a profit threshold, the manager would then receive 20% of earnings over that amount, while the pool of investors would split the remaining 80%.
What is the Goal of a Hedge Fund?
Returns! Hedge funds are exclusive, but that’s because they are supposed to offer returns regardless of whether the market is up or down. Hedge funds are diverse, with both long and short-term investments, allowing managers to rise above market trends. During the 2008-2009 recession, many hedge funds actually performed well. Hedge fund managers time investments carefully to limit investor risk, and to maximize returns. Hedge funds can offer significantly-greater payouts than average investment options if managed properly. For more about hedge funds, or for answers to financial questions, visit the San Diego wealth professionals at OverlandShanahan.com.
The Financial Consultants at Overland & Shanahan Wealth Advisors, Inc. are Registered Representatives with and Securities, offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Overland & Shanahan, a registered investment advisor. Overland & Shanahan, and Overland & Shanahan Wealth Advisors, Inc., are separate entities from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. Investors should be aware that hedge funds often engage in leverage, short-selling, arbitrage, hedging, derivatives, and other speculative investment practices that may increase investment loss. Hedge funds can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, and often charge high fees that can erode performance. Additionally, they may involve complex tax structures and delays in distributing tax information. While hedge funds may appear similar to mutual funds, they are not necessarily subject to the same regulatory requirements as mutual funds.