News headlines regularly share stories of massive windfall profits and terrible losses at hedge funds. With so much money moving around, and so many millionaires and billionaires using the funds to grow their wealth, you may be interested in getting a piece of the action. New investors are able to buy into a hedge fund, but it is not as simple as investing in a stock or ETF. Here is a review of how hedge funds work, whether you may qualify and if you should invest.
- Hedge funds are often limited to wealthy investors and can invest in nearly any asset class, such as real estate, equities, or entire companies.
- Legally, new hedge fund investors must qualify as accredited investors under the Securities and Exchange Commission rules.
- Accredited investors must have an income of at least $200,000 ($300,000 with a spouse) for the past two years or a net worth of over $1 million.
- Hedge funds come with high risk and can lead to billions of dollars in losses, which may not be the best fit even if you can afford to invest.
What a Hedge Fund Is
A hedge fund works similarly to a mutual fund but does not have the same restrictions on how managers can invest fund assets. Unlike a mutual fund, investors cannot easily buy into or sell positions in a hedge fund. Hedge funds are generally open-ended and allow additional investments or withdrawals on a monthly or quarterly basis.
Hedge funds can invest in nearly any asset class, including risky short-sales, real estate, equities, buying and selling entire companies, or following a specific investment principle or guideline. Many members of the Billionaire Club made their money as hedge fund managers, including George Soros, David Einhorn, Bill Ackman, John Paulson, and a handful of others.
Unlike public mutual funds, hedge funds are generally limited to wealthy investors with an appetite for high risks and high fees. Typical hedge fund fees include a 2 percent management fee and a performance fee, typically around 20 percent, paid to the manager for investment gains over the prior year. With fees like that, it’s no wonder there are so many billionaires in the hedge fund industry!
Rules to Protect Inexperienced Investors
No specific rules are forbidding new investors from putting money into a hedge fund. The big hurdle new investors have to overcome is to qualify under the Securities and Exchange Commission (SEC) rules as an accredited investor.
To qualify as an accredited investor, you must have an income of at least $200,000—$300,000, including a spouse—in each of the two past years. You must expect the same for the current year or have a net worth over $1 million—alone or including a spouse—excluding the value of a primary residence. If you do not meet these rules, you do not qualify to invest in hedge funds regardless of your investment experience.
Accredited investor rules are not limited to hedge funds. They apply to most any private placement investments that are not open to the public on a major stock market or exchange. To buy regular stocks, bonds, and other investments, you need the cash to cover the investment. To invest in private placements, you must meet the accredited investor threshold.
Finally, note that many hedge funds require more than just meeting the accredited investor threshold, with minimum account requirements that put their funds out of reach for all but the richest investors. But the accredited investor threshold is the only legal requirement for investing in a hedge fund.
Just Because You Can, Doesn’t Mean You Should
If you are a new investor, you qualify as an accredited investor, and you find a hedge fund that will take your money. Congratulations, you have nothing holding you back from throwing your money at fund managers to do what they will. But as Dr. Ian Malcolm famously said in “Jurassic Park”: “Your scientists were so preoccupied with whether or not they could, they didn’t stop to think if they should.” The same holds for investors looking at hedge funds.
Unlike passive index fund investing, hedge funds come with plenty of risks. There is a good chance you could double your money or more, but you can just as easily lose every dollar. Unlike a business failure, which often leads to liquidating assets and paying back investors to some extent, hedge fund failures are often all-or-nothing. They can lead to billions of dollars in losses. New investors are far better off with a low-risk investment that will offer more predictable returns. Even if you can afford to invest in hedge funds, they may not be the right fit for your investment needs.
Determine If You Can Afford the Risk
In the world of investing, higher risk typically means higher returns. Nowhere is this more accurate than the world of hedge funds. With high-risk investment strategies, hedge funds can earn your money back multiple times over a short period.
But hedge funds can also suffer huge losses and failures, costing investors every dollar they have on the line. One reason that so many rich people invest in hedge funds is that they can afford to take on the risk, but that may not be true for you. If you are a new investor that meets accredited investor requirements, you absolutely can invest in hedge funds. However, you may not want to.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.