Investing in a Hedge Fund Can Be Difficult

Investing in Hedge Funds Can Be Virtually Impossible for New Investors

Investing in a Hedge Fund Regulation D
If you've ever wondered how to invest in a hedge fund, you might be disappointed because it can be very difficult if you are not an accredited investor, which means someone with $200,000+ in annual income or a $1,000,000+ net worth excluding home equity. PhotoLink, Photodisc, Getty Images

In an older article I wrote called What Is a Hedge Fund?, I explained to you what hedge funds are, how hedge funds work, and some reasons many wealthy investors consider hedge funds among the tools they want to employ as part of their quest to protect and grow their capital over the long-run.  For the right investor, with the right resources and experience, at the right fee schedule, and at the right time, hedge funds can be a great thing, especially if they are focused on an asset class that fits within the overall asset allocation targets of the individual in a way publicly traded securities such as stocks and bonds can't.

Now, I want to take some time to explain the reasons it can be nearly impossible for new investors to gain access to high quality hedge funds and some of the rules covering so-called private placement investments.  (A private placement means that you don't have the opportunity to participate in an investment as a member of the public, such as buying it over a stock exchange through a brokerage account as it is, instead, offered only to a select group of specific investors.  Technically, if your brother-in-law started a new corporation to roll out a chain of frozen yogurt stands and you were given the opportunity to buy shares while the general public was not, it would be considered a private placement investment.)  

To understand the reasons hedge funds are so inaccessible to the masses, you need to know that, even though hedge funds are privately held, and often structured as limited partnerships or limited liability companies, their limited partnership units or limited liability company membership units are considered securities under most conditions.

The rules are complex and frequently prohibitive for smaller money managers so the Securities and Exchange Commission, or 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 something known as “Regulation D”.

It is here, in Regulation D that you discover the reasons it is so difficult for new investors to buy into hedge funds.

To some degree, this may actually be a good thing for society as, taken collectively, ordinary investors tend to have less experience, less financial sophistication, and less capacity, as measured by both income and net worth, to absorb the significant risks that come with many hedge fund strategies.  Instead, their best bet is to avoid attempting to access hedge funds entirely and throw in the towel, investing in index funds or passive strategies, perhaps through individually managed accounts if they have at least several hundred thousand dollars, while keeping an eye towards tax efficiency and keeping things like the mutual fund expense ratio reasonable.

Nevertheless, let's dive into Regulation D and discover some of the requirements and restrictions.

Reason #1: Regulation D Makes It So That Non-Accredited Investors Have Only a Limited Number of Spots on the Roster

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 are the inability to raise money from more than 35 non-accredited investors or raising no more than $5 million in any 12-month period. (For more information, read What Is an Accredited Investor?).

Reason #2: For Many Years, Regulation D Made It So That It Was Against the Law to Advertise a Hedge Fund

For many years, Regulation D Rule 504, 505, and 506 generally banned advertising, making it nearly impossibly 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 is now outdated and, for all intents and purposes, got the SEC to change their stance.  For whatever reason, hedge funds have largely not been taking advantage of the ability to market themselves as some business journalists thought they would so the chilling effect remains.

 Whether that continues to be the case in the future as the new rules become part of the landscape, only time will tell.

Reason #3: Hedge Fund General Partners Can Admit Who They Want

The managers, general partners, and other executives of a hedge fund can accept or reject whomever they want into the fund without reason, discriminating at will.  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 visa versa.

A perfect example is the most famous investor in the world at the moment.  When Warren Buffett started his hedge funds, unless you were connected to him, his family, an existing investor, or his mentor, Benjamin Graham, you likely wouldn't have heard of him.  His original seven partners included family members and his college roommate's family.  

Reason #4: You May Not Meet the Minimum Investment Requirement for the Hedge Fund

The person or people running a hedge fund can set the minimum investment at whatever he or she wants 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!  It is simply a matter of efficiency.

I ran into this myself when my husband and I began planning the launch of our upcoming global asset management firm.  One of the first services we are intent on rolling out is known as a private account.  While not a hedge fund, and thus not subject to the securities regulations that we are discussing in this particular passage, this type of arrangement will allow affluent and high net worth individuals, families, and institutions to establish an account at a third-party custodian of their choice and then give our firm discretionary authority over it; authority that we use to build and maintain a bespoke portfolio for them using the same investing philosophy we employ when managing our own family's wealth.  In many ways, it's like having a private mutual fund created specifically for you; a way to attempt to combine the tax advantages of individual securities with the convenience advantages of outsourcing the entire job to a professional portfolio manager.  It also tends to involve fees that are a lot lower than a hedge fund, albeit with more restricted mandates.  For example, a hedge fund can take out bank debt and acquire entire companies, which you can't do with a private account as we are setting them up.

When we were working on the structure, I was originally tempted to set the minimum investment at between $1,000,000 and $5,000,000.  It was my husband who convinced me, after many, many afternoons and evenings of discussion, to lower it to $500,000.  Even still, when I announced it, I heard from a lot of people who were disappointed.  I've been trying to find a way to effectively get the minimum down to $250,000, at least in the beginning for people who are on the waiting list, which is still far beyond the reach of the typical American household.

I didn't do it out of a desire to exclude.  The reality is, it's simply too hard to service smaller accounts to the standards I want for my firm and I am not interested in charging the kind of fees so many regional banks and trust companies do.  That means having to shut the doors to a massive swath of society.  It's a pragmatic decision based on a trade-off analysis and the numbers.  Perhaps, one day, we'll launch mutual funds or exchange traded funds of our own to make our services accessible to smaller clients in the way other companies have - there are unquestionably less affluent investors out there who share our affinity for passive investing, a value-based approach, and tax efficiency - but it's definitely a challenge.

Finally, Don't Forget That a Hedge Fund Isn't a Type of Investment, It's a Generic Term That Covers the Waterfront and Is Impossible to Classify

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 can be good or bad. 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 that specialized in buying and selling hotels, one that bought stocks on a value investing basis, one that traded fine art, or one that bought and sold rare stuffed animals!  The hedge fund could be debt-free or highly leveraged.  It could focus its activities on assets within the United States or abroad.  The list of possibilities is endless.