For the right investor, with the right resources and experience, at the right fee schedule, and at the right time, hedge fund investing can be a great thing, especially if the fund is focused on an asset class that meets your financial goals.
It can be nearly impossible for new investors to gain access to high-quality hedge funds, though. Even though hedge funds are privately held and often structured as limited partnerships or limited liability companies, their investment units are considered securities under most conditions.
The rules for securities are complex and frequently prohibitive for smaller money managers, so the Securities and Exchange Commission (SEC) allows a way around this by exempting several different types of pooled investment vehicles from registration requirements. Most, but not all, of these exemptions are found in Regulation D of the Securities Act. In Regulation D that you discover the reasons why it's so difficult for new investors to buy into hedge funds.
Let's dive into Regulation D and discover some of the requirements and restrictions that make hedge fund investing challenging for new investors.
Non-Accredited Investors Are Limited
Specifically, there are three very important parts of Regulation D: Rule 504, Rule 505, and Rule 506. These three rules each have different benefits and drawbacks but the common denominator is that they allow a company or hedge fund to raise money from investors without filing a lot of paperwork. Common restrictions include the inability to raise money from more than 35 non-accredited investors or raising no more than $5 million in any 12-month period.
An accredited investor is an investor who holds an investment license, like a Series 7, or an investor with either a net worth of over $1 million (excluding their primary residence) or $200,000 in earned income in each of the past two years ($300,000 with a spouse or spousal equivalent).
Advertising Is Limited
For many years, Regulation D Rules 504, 505, and 506 generally banned advertising, making it nearly impossible for you to learn about hedge fund opportunities unless you have an existing relationship with an affiliated broker-dealer. This provision was meant to protect investors, but some business publishers argued that it was outdated and got the SEC to change its stance.
Hedge funds have largely not been taking advantage of the ability to market themselves for several reasons, including the requirement to include disclosures and the fact that they're geared toward accredited investors, not the general public.
Not Everyone Is Accepted
The managers, general partners, and other executives of a hedge fund can accept or reject whoever they want into the fund without reason. It isn't the same as investing in mutual funds or investing in stock where anyone who can afford to buy shares is entitled to do so.
This can benefit the hedge fund in a lot of ways. For example, the portfolio manager can make sure only like-minded investors with the same capital allocation policy are admitted, minimizing future conflicts and distractions. Unfortunately, it also means that outsiders have a harder time gaining access if they aren't already within the orbit of someone invested in, or otherwise connected to, the fund. This is an area where private banks and wealth management companies can play a role, introducing investors to fund managers and vice versa.
High Minimum Investment Requirements
Those running a hedge fund can set the minimum investment at whatever they want in most situations. Since there is a limit to the total number of investors that can be admitted under a Regulation D Rule 504, 505, or 506 exemption, they are going to want to make that figure high. Some hedge funds require a minimum investment of $100,000, while others may require $25,000,000 or more.
The Bottom Line
When someone says they bought a hedge fund, it doesn’t really tell you anything. A hedge fund isn’t necessarily a good investment anymore than a stock or mutual fund. It is merely a descriptive term that tells you that you are dealing with some sort of pooled investment fund that is probably not registered with the SEC because it falls under one of the Regulation D exemptions.
You could have a hedge fund specializing in buying and selling hotels, one that buys stocks on a value investing basis, one that trades fine art, or one that buys and sells rare stuffed animals. The hedge fund could be debt-free or highly leveraged.
What's consistent is that hedge funds are difficult to access for new investors. If you have a specific investment need, talk to your investment advisor about your needs and whether there's a hedge fund that makes sense for your financial situation and goals.