Hedge funds are one of the single most crucial alternative investment opportunities available today. In this type of investment, investors come together to pool resources that are later reinvested for returns by investing in securities or other alternative investments at the discretion of the hedge fund managers. Access to such investments is restricted to the accredited investor because they have a freer reign due to minimal securities and exchange commission (SEC) regulation, which increases the risk exposure. The freer reign enables hedge funds to pursue investment aggressively compared to safe investments such as mutual funds that are highly regulated to minimize risk to investors. A general characteristic of hedge fund investors is that they are usually wealthier hence can afford to absorb the high-risk characteristic of their investments and the high fees charged. Investors must also be accredited as stipulated in the federal securities law.
What makes hedge funds unique investments?
- Hedge funds offer investors a wider investment latitude as they can invest in anything as long as the fund has the mandate to do so. Some investments where they invest money pooled from investors include derivatives, stocks, currencies, real estate, and land, among others.
- The fee structure of hedge funds is unique because it charges performance fees and expense ratios. Generally, the fees are at 2% of the assets and a performance fee charged at 20% of the fund’s profit. Other traditional investments charge only the expense ratio.
- Potential investors must be accredited, meaning they must satisfy the minimum income and asset levels required to invest in the fund. The minimum income requirement, usually of $200,000 a year, is imposed to ensure investors have the capacity to absorb potential risks.
- Hedge funds often borrowed money or leverage to grow their portfolios, exposing them to increased risk. By using leverage and debt obligations that are collateralized to invest, turbulence in the economy exposes them to greater risks.
So what must potential investors look at if they intend on investing in a hedge fund?
- Read and understand the hedge fund’s prospectus and other material relating to the fund. Doing this ensures you understand the fund’s investment strategies and the risk involved to ensure they are compatible with your risk tolerance and investment goals.
- The size of the fund or the firm. The preference of the investor informs the size of the fund they are most comfortable investing in. Institutional hedge fund investors opt for firms that are large because their size allows them to accommodate the huge capital investments.
- What is the minimum investment, and what does this indicate? The minimum hedge fund investment can indicate a number of things. Some minimums might be too low for the fund manager to diversify the portfolio, effectively exposing investors to risk, so you want a fund that has the capacity to diversify its investments. In most cases, when minimums are low, there are more individual investors as opposed to institutional ones. On the other hand, large minimums are typically indicative of institutional investors.
- Check the track record of the fund. The track record indicates the performance of the fund manager and indicates how successful or otherwise they have been while managing the fund. You want to invest in a fund that has a proven record of delivering value to investors.
- Understand your redemption rights. Most hedge funds will limit investor’s opportunities to cash in or redeem their shares because doing this has liquidity implications that might affect the fund adversely. A fund manager might impose redemption limits when the portfolio is illiquid but allows investors to redeem when there is adequate liquidity of the portfolio.