Before investing in hedge funds, an individual must be an accredited investor. An accredited investor can be any individual with an annual income of $200,000 ($300,000 if married) or with a personal net worth of over $1 million.
What Is a Hedge Fund?
Hedge funds are a form of alternative investment vehicles that invests and manages portfolios of different assets and derivatives. Positions and exposure in various assets and derivatives gives them diversification benefits.
The primary reason to invest in a hedge fund, is to get fully diversified and get exposure to securities that aren’t readily available to retail investors. Investing in a hedge fund has both advantages and disadvantages.
Diversification benefits, professional advice, and new opportunities, are some of the advantages of investing in a hedge fund. Whereas high management fees, illiquid position, and lack of transparency, are some of the disadvantages.
How Does a Hedge Fund Work?
Hedge funds are generally structured as a limited partnership or a limited liability company. They have two partners, limited partners and general partners.
Limited partners are the providers of capital, and general partners are the professionals who manage the capital. Hedge funds usually have a lockup period which imposes restrictions on the investors to redeem their shares.
A redemption usually involves a redemption fee which is in place to discourage early liquidation. The capital that the general partners provide, gets invested into traditional and alternative investments, as well as derivatives to maximize returns and diversify the risks.
6 Steps To Investing In a Hedge Fund
After an individual meets the criteria to be classified as an accredited investor, it’s always advisable to follow the following six steps before investing in a hedge fund.
Step 1: Research the Fund
There are different types of hedge funds. They are distinguishable based on the strategies they use.
Long-short equity, dedicated debt, distressed debt, merger arbitrage, fixed income arbitrage, emerging market, and global macros, are some of the common types of hedge funds. A hedge fund specializing in distressed debt usually takes long positions in a company’s debt, to benefit from a reorganization proposal in case of bankruptcy.
In contrast, a hedge fund specializing in emerging markets takes long and short positions on equities in developing countries. Different strategies bring unique risks to the fund.
This is why one should always conduct thorough research about the fund’s strategies before investing. After an investor feels comfortable with a specific type of hedge fund, the fund’s turnover rate, volatility, historical performance, alpha and beta, etc., all must also be taken into consideration.
Step 2: Understand the Fee Obligations
Hedge fund fees consists of two components, a management fee and an incentive fee. A typical hedge fund management fee structure is 2% plus 20%.
Where 2% is the annual management fee and 20% is the incentive fee on profits. Management fees erode net returns to the investors.
An investor must also be fully aware of how a fee is applied, whether the management fee is applicable on the beginning market value or the ending market value, whether the incentive fee is applicable independent of the management fee or net of the management fee; And also whether the incentive fee is in excess of the hard hurdle rate or soft hurdle rate.
Apart from fees, investors must also understand the high-water mark clause and clawback clause regarding the hedge fund (if any).
Step 3: Get to Know Your Fund Manager
Implementation of a fund’s strategy is the responsibility of the fund manager. There are many resources online which rate fund managers.
The ratings are based on the fund’s risk-adjusted returns in comparison to their peers or the benchmark rate and the degree of risks taken by managers. The investors should also gauge the performance of the fund manager from the historical returns of the hedge funds they have managed.
Relying solely on an agency’s rating might be misleading at times.
Step 4: Gather the Minimum Investment Amount
The minimum investment amount depends entirely on a specific hedge fund. It can be anywhere from $100,000 to $1 million. Since hedge funds have a lockup period of usually one year, an investor must be comfortable tying up their money in an illiquid position.
Step 5: Proceed With Your Investment
After a thorough analysis, if the investor is comfortable with the fund, they can proceed with the investment.
Step 6: Plan Around the Redemption Timeline
Usually, the lockup period is one year. However, sometimes a fund can have an ongoing redemption period with some windows during a certain interval (usually quarterly) for redemption.
Most of the time, the redemption of shares is possible only after the notice period. This is usually 30 to 90 days after an investor gives the notice to redeem their shares.
Unlike mutual funds, investors cannot redeem their shares on the day they want, and this must be taken into consideration. Especially if an investor immediately wants to redeem his/her share immediately due to unforeseen circumstances.
During a market downturn, the fund manager might face difficulty liquidating their position, and some hedge funds might have the right to suspend redemption requests. This means investors are denied cash when they need it the most.
Understanding the redemption timeline is equally important for non-redeeming investors as well. Since redemption requires liquidation of positions taken by the fund manager, the cost of liquidating can magnify losses for the existing investors.
Are Hedge Funds For Me?
Hedge fund’s policies like the lockup period and management fees are different from fund to fund. Hedge funds specializing in distressed debt usually has longer lockup periods; whereas hedge funds specializing in long-short equities may have shorter lockup periods.
Understanding the type of hedge fund and the economic and political factors that impact each type of hedge fund is unique to the specific fund. Similarly, timing redemption is crucial during times of economic distress because redemption requests are usually clustered around the end of the quarter.
Investors might get overwhelmed with things to be taken into consideration before investing in a hedge fund. In such circumstances, consulting a financial advisor is always advisable.
A financial advisor will sit individuals through all possible advantages and disadvantages of investing in a hedge fund. Most importantly, whether the investment suits their client’s financial goal.
For example, investing in a hedge fund specializing in emerging markets exposes the investor to a developing country’s political, social and economic risk. A financial advisor might weigh whether his/her client is tolerant to such risks depending upon their financial goal.