What are hedge funds? Do I need a lot of money to invest in them?

Many years ago, I was teaching an investing 101 class and after the session, a young man approached me to ask about investing in hedge funds.

He shared that he had read about them and thought they sounded “cool” and a great investment opportunity.

I shared with him that hedge funds often cater to very wealthy individuals but there are ways to invest in them if you are not part of the one percent.

Today, we’re beginning our three-part series on investing in a hedge fund.

Usually, hedge funds are reserved for those with a lot of money but I show you how you can invest in a hedge fund even if you don’t have a lot of money.

What are hedge funds?

Hedge funds are private investment vehicles that manage money for institutions and wealthy individuals.

They generally are organized as limited partnerships, with the fund managers as general partners and the investors as limited partners. The general partner may receive a percentage of the assets, additional fees based on performance, or both.

Hedge funds originally derived their name from their ability to hedge against a market downturn by selling short.

Though they may invest in stocks and bonds, hedge funds are typically considered an alternative asset class because of their ability to implement complex investing strategies (see below) that involve many other asset classes and investments.

How do hedge funds differ from mutual funds?

Hedge funds are not available to the public

Unlike mutual funds, hedge funds traditionally have not been offered for sale to the public at large; they are available only to a limited number of investors. In the past, the demand to participate in the most successful hedge funds has sometimes been so high that those funds have been able to pick and choose who is permitted to invest.

Hedge have minimum investments

Investors normally must have a significant amount of money available to invest or have a high level of financial sophistication.

For example, to invest in a hedge fund, an individual must have at least $1 million (not including the value of a primary residence) or an ongoing income of at least $200,000 in each of the two previous years ($300,000 if a spouse’s income is included).

Depending on how the hedge fund is structured and the demand to participate, the minimum requirement can be much higher.

Also, hedge funds usually require an investor to invest in the fund for a period of one year or longer and may limit transferability, making them a less liquid investment than mutual funds.

By contrast, mutual fund minimums are typically $1,000 or less, and investors may typically sell at any time (though some funds impose a fee for short holding periods).

In recent years, the financial services industry has developed ways to make investing in hedge funds more accessible (see below).

Techniques used by hedge funds

Hedge funds use a variety of investment types and strategies to try to minimize risk and maximize return. They include:

  • Hedging: buying an investment that has the potential to offset losses in other investments

  • Selling short: borrowing shares and selling them immediately, hoping that the price will drop and the shares can be replaced at a lower cost, thereby generating a profit.

  • Arbitrage: simultaneously buying and selling the same security to take advantage of different prices

  • Leverage: investing with borrowed money to try to maximize profitability

  • Concentrating positions: making big investments in relatively few securities that are expected to be highly profitable

  • Investing in distressed or bankrupt companies

  • Investing in derivatives, such as options or futures contracts

  • Investing in privately issued securities

How a given fund employs any or all of these techniques constitutes its unique investing strategy. Many of these techniques involve unique risks and pitfalls, and there have been some spectacular crises with hedge funds that used them.

Hedge fund returns may be very different from returns for the overall market

Their unique strategies mean that hedge fund returns may not be highly correlated with the public markets. As with any alternative asset, they may offer an opportunity for greater diversification of a portfolio.

Next week, we will move on to part two and learn 4 things you should know before you invest in a hedge fund. We’ll also learn how to choose a hedge fund.

Now it’s your turn. Have you ever considered investing in a hedge fund?