Hedge Fund Investing

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Hedge funds are professionally managed investment funds that look for profitable relationships between risky assets. Hedge fund investing incorporates both long and short positions in many asset types, including stocks, bonds, commodities, and derivatives to generate measured returns for investors. 

Global assets under management by hedge funds totaled over $3.8 trillion in 2020. Owing to their highly leveraged investing strategy, hedge funds are able to take on riskier bets and enhance overall returns. The resources available to hedge funds enable high-growth investing strategies that have fueled their rapid ascendency—in the 2000s alone, capital committed to hedge funds grew 17% year over year.

Hedge fund investing is usually reserved for accredited investors and high net worth individuals. However, regular retirement investors can invest in a hedge fund via indirect means to get around the capital requirements. In this guide, we’ll discuss how to invest in hedge funds to develop your retirement investing strategy. 

Hedge Funds 101: What Is A Hedge Fund?

Hedge funds pool money from high net worth individuals and other financial institutions to transact complicated, risk-managed investment strategies. 

As their name implies, hedge funds are largely concerned with protecting money. After all, to “hedge” a bet is to take precautionary action to prevent future losses, and a fund is merely a collection of money. By putting two and two together, it’s clear that hedge funds exist at least in part to protect investors’ wealth from losses as a form of strategic wealth preservation.

While this may have been their sole purpose at their inception centuries ago, hedge funds have evolved with time to take on riskier strategies. They are no longer only concerned with hedging bets and picking safe, low-beta assets but are increasingly oriented toward maximizing investor returns. 

Examples of Hedge Funds

To provide a clearer hedge fund definition, let’s take a look at some of the most prominent active hedge funds. Below are the largest global hedge funds ranked from largest to smallest by assets under management (AUM):

• Renaissance Technologies LLC ($165B)
• Bridgewater Associates ($140B)
• Man Group plc ($127B)
• Millennium Management ($48B)
• Elliott Investment Management LP ($42B)

For many, Citadel LLC (also called “Citadel hedge fund”) is top of mind with respect to multinational hedge funds. As a market maker, Citadel trades over 25% of all U.S.-listed retail volume and about 99% of all trade volume across 3,000 American option names. As such, they are a massive liquidity provider for other hedge funds and financial institutions.

Why Invest in a Hedge Fund?

High net worth individuals—and, in particular, business owners—are particularly well-suited for hedge fund investing. This is because those with an ownership stake in a private enterprise are, in a sense, doubly invested in the performance of the market. 

The basic premise is that, in the event of an adverse economic event, someone who’s overexposed to one type of risk can benefit from another. A classic example is that of a horse and carriage salesman buying stock in Ford Motor Co. to hedge against the automobile industry eating into his market share. 

Hedge fund strategies often involve significant leverage by pooling investment capital from many investors and spreading it across various non-correlated or inversely correlated risks. The example above is a simplified version of this process. Modern hedge funds invest in a large number of asset classes, including futures and derivatives, and simultaneously take long and short positions to protect against losses by any one asset in isolation. 

The Benefits of Hedge Fund Investing

Let’s assume that you’re a sophisticated investor, which is defined as an individual who earns an income above $200,000 USD per year for the past two years or someone with a net worth above $2.5 million. As such, you’re entitled to deal in unregistered securities, including stakes in hedge funds. 

Sophisticated (or “accredited”) investors can benefit from a range of advantages that this asset class provides, which we’ve listed below. 

Leverage and “Trading on Margin”

The average investor is held back by the relatively limited resources available to them. However, hedge funds utilize leverage to reap larger gains. Leverage refers to borrowing money to buy additional assets. Also known as “trading on margin,” leveraged investing allows for outsized gains but also, in turn, potentially severe losses. 

Hedge funds utilize leverage by borrowing from investment banks, such as Credit Suisse or Goldman Sachs, while also pooling money from other deep-pocketed financial institutions. In fact, many of the world’s largest public pensions invest billions of dollars in hedge funds, including the following (ranked by allocation):

• Teacher Retirement System of Texas (14.9%)
• Ohio Public Employees’ Retirement System (13.2%)
• CPP Investment Board (11.8%)
• Ontario Teachers’ Pension Plan (11.4%)
• SBA Florida (10.4%)

Together, their combined capital allows for both more aggressive risk-taking and broader diversification across non-correlated assets that wouldn’t otherwise be available in worthwhile quantities to regular individuals.

With a large capital advantage, hedge fund managers can seek out highly asymmetric investments that pose more upside potential than downside risk. Nonetheless, there is still a significant degree of risk inherent to any hedge fund investing strategy—any opportunity for making a profit necessarily carries the risk of loss.

How Leverage Investing Works

A leveraged investing strategy uses borrowed money to generate higher profits via the difference between the returns on the borrowed capital and the associated interest. The corollary is that higher leverage is associated with higher risk. 

To illustrate the power of leverage investing, take the example of an investor who purchases $100K worth of securities using $50K of their own money and the rest on margin. The value of the securities then rises to $150K. Instead of having their investment increase by 50%, they’ve effectively tripled their original sum due to leverage (i.e., $50K→150K). 

Hedge funds often employ leverage strategies to amplify their upside potential for quick, impressive returns. However, investors should beware that leverage creates the same multiplier effect for losses as well.

Managing Risks for Small and Medium-Sized Enterprise (SME)

Small business owners are especially well-suited for hedge fund investing. Those who own SMEs are often exposed to particular types of risk. 

For example, a tech startup may be disproportionately affected by market risk in the consumer technology sector. If an economic downturn hits the tech industry, the knock-on effects could prove disastrous for an SME in the sector. 

Hedge fund managers can mitigate these risks by diversifying investment capital across commodities (e.g., crude oil futures, lumber, cryptocurrencies), real assets, stocks, bonds, and derivatives. This way, an SME won’t risk losing all their accumulated wealth if their market sector crashes. 

Soften the Blow of Recessions and Downturns

Despite their reputation for high-risk investing, hedge funds, on average, beat out broad market benchmarks such as the S&P 500 when it comes to limiting downside losses. The graph below depicts how the Hennessee Hedge Fund Index outperformed the market during the 15 worst months of the S&P 500 decline between 1993 and 2015.

Source: HedgeFundamentals

In other words, hedge funds lose significantly less money for investors during down periods than if their money were invested in the stock market writ large. These data indicate that hedge funds live up to their name in the sense that they limit risk via hedging and risk diversification, even if at the expense of greater or more stable upside gains. 

Tax-Advantaged Retirement Saving

Typically employer-sponsored 401(k) retirement plans or individual retirement accounts (IRAs) provided by a brokerage aren’t designed for hedge fund investing. However, hedge funds can be added to top self-directed IRAs (Roth or Traditional) or a self-directed 401(k) to allow your gains to grow on a tax-free or tax-deferred basis. 

The Risks of Hedge Fund Investing

No hedge fund definition is complete without also touching on the risks assumed by this type of investment. Below, we’ve listed a few of the need-to-know risks associated with this kind of alternative investment.

Regulatory Risk and Oversight

Unlike other financial sectors, such as banking, hedge funds are relatively opaque and are given lighter regulatory obligations. Hedge funds are often not transparent with disclosing their financial status, since many funds cloak their positions in derivatives contracts. 

Packaging their trades in options and futures contracts without a centralized clearinghouse is one way that hedge funds obscure their financial positions. In short, hedge funds are often open about their trading philosophy but secretive about their specifics. This explains why funds such as Long Term Capital Management (LTCM) had to receive a $4 billion bailout by a government-arranged consortium of U.S. investment banks in 1998. 

Leverage and Margin Calls

Hedge fund strategies involve significant leverage, which poses benefits as well as drawbacks. For instance, highly leveraged hedge funds have to hold enough money in reserve to cover their margin payment if their creditors deem it necessary to initiate a margin call (i.e., compelling a borrower to close out their position). 

Margin calls occasionally take place when the market moves against the borrower whereby the investment drops in value and the lender asks for additional collateral. A margin call can collapse an over-leveraged hedge fund and, given the opaque nature of these funds, it can be impossible to know whether a fund is only a margin call away from failure. 

Inaccessibility and Capital Requirements

It’s not uncommon for hedge funds to have minimum capital requirements starting at $250,000 per investor before they will consider your buy-in. Also, as previously mentioned, direct investment in hedge funds requires formal accreditation by financial regulators. 

Upon investment, hedge funds usually include a lock-up period during which the monies invested cannot be withdrawn. Sometimes, hedge funds can include lock-up periods that last as long as a year. 

Hedge Fund vs. Mutual Fund: Key Differences Explained

Retirement investors often ask us which is the safer bet between hedge funds and mutual funds, and whether they serve the same purpose in a portfolio. The hedge fund vs. mutual fund debate, however, rarely has a conclusive winner since they both perform important functions in a portfolio and should therefore be given equal consideration separately. 

Often, hedge funds and mutual funds complement each other. Indeed, there’s room for both to exist in the same portfolio. Below, we’ll list a few of the main differences between hedge funds and mutual funds so you can decide for yourself how to prioritize each fund type in your retirement investing strategy. 

• Return Volatility: As opposed to mutual funds, hedge fund returns tend toward extremes. Hedge funds employ riskier strategies to seek out higher peak returns in bull markets and less severe losses in bear markets.
• Fees and Cost Structures: Hedge fund fees are usually steeper than mutual funds. Whereas your typical mutual fund charges only an expense ratio, hedge funds usually also tack on a performance fee. The average hedge fund performance fee currently sits at 16.36% as of Q1 2021.
• Exclusivity: Hedge funds have much higher barriers to entry and often include capital requirements starting at 250,000 USD per investor as well as net worth quotas. By contrast, mutual funds allow investors of all kinds to invest and often without having to meet a minimum contribution threshold.
• Active Management: Whereas all hedge funds are headed by professional money managers, many mutual funds are not actively managed. Some mutual funds do not exercise active discretion in selecting stocks or holdings, nor do they execute trades; rather, they merely track a stock index like the Dow Jones or S&P 500.
• Diverse Holdings: Mutual funds often concentrate their holdings in one particular asset type (e.g., U.S. large-cap tech equities) whereas hedge funds are more diversified by investing in a variety of asset classes and market sectors such as commodities, stocks, corporate and government bonds, and real estate.

Private Equity and Hedge Funds

Hedge funds and private equity investment firms are hardly alike. In the latter, these funds invest directly in mature companies by buying them outright or taking a controlling interest in the firm. Then, they initiate structural changes and reutilize assets to return a company to profitability or to enhance existing profits. 

The key difference between a hedge fund and a private equity firm is that the latter is mostly concerned with sustainable long-term growth. The former, on the other hand, is largely interested in short-term profit maximization on liquid assets that can be cashed out quickly.

Despite their differences in core philosophy, private equity versus hedge fund returns are not too far off from each other. During Q4 2020, the aggregate hedge fund returns in 2020 were 10.05%. Private equity, however, returned 10.48% on an average annual basis for the 20-year period ending in June 2020 in the U.S. 

The Role of Short Selling

A key component of a hedge fund strategy is short selling, which is the practice of betting against a stock or any other financial instrument. In finance, to short sell is to profit off the declining price of an asset by predicting the downward price movement in advance. 

Shorting is fundamental to hedge funds’ risk management strategy. The fact that they frequently take concurrent long and short positions makes hedge funds a more interesting, secure, and unique alternative investment option. Via short selling, hedge funds make it possible, at least in theory, to profit regardless of future market directions. However, short positions do not guarantee positive returns. 

Can Investors Start a Hedge Fund?

We’re often asked if it’s possible to start one’s own hedge fund. Indeed, ambitious investors can create their own hedge fund, assuming they raise sufficient capital to meet the federal requirements. Knowing how to start a hedge fund begins with knowing how to incorporate a business. From there, you’ll be tasked with writing the fund’s bylaws and filing the relevant Articles of Incorporation. Last, the hedge fund founders will have to register the company with the SEC and their various advisors as Investment Advisor.

The more challenging side of things has to do with raising investment capital. Building relationships with accountants and lawyers who are well-versed in hedge fund administration can assist with facilitating relationships between your nascent fund and potential donors or investors. Networking at conferences is another potential avenue for sourcing donors, particularly if your fund has a proven track record of success in the market.

Indirect Exposure to Hedge Funds for Non-Accredited Investors

Given their high-risk, high-reward nature, formally investing in hedge funds is restricted to registered accredited investors. Essentially, regulators want to ensure that investors know what they’re doing and what kind of risks they’re involving themselves in before they invest in hedge funds. 

Still, there are ways that non-accredited investors can gain indirect exposure to hedge funds. The most common method is to simply invest in publicly traded hedge fund companies, which are subject to much greater Securities and Exchange Commission (SEC) scrutiny. Below is a list of some of the biggest public hedge funds on the market:

• Apollo Global Management (NYSE: APO)
• Sculptor Capital Management (NYSE: SCU)
• Blackstone Group (NYSE: BX)
• Kohlberg Kravis Roberts (NYSE: KKR)

The companies listed above issue shares to the public, so that regular retirement investors can buy equity in the company and gain exposure to the underlying assets they manage. Therefore, these hedge funds are structured similarly to mutual funds but abide by different investing strategies.

Second, investors can purchase shares of hedge fund ETFs. A hedge fund ETF is a publicly-traded entity that tracks the performance of several hedge funds in one conveniently securitized package. Examples of hedge fund ETFs include RPAR Risky Parity ETF (NYSE: RPAR) and Xtrackers MSCI EAFE Hedged Equity ETF (NYSE: DBEF).

How to Invest in a Hedge Fund

The global economy is volatile and moves in ways that are rarely predictable. Hedge fund investing takes some of the uncertainty out of the equation by allowing risk to work for you instead of against you. Although often inaccessible and opaque, hedge funds are vital risk management tools for wealthier retirement investors. 

In a down year, hedge fund investing can make the difference between posting a profit or a loss. In a good year, they can take your gains from good to great. A well-managed hedge fund provides investors with an additional layer of risk management by preventing overconcentration in any specific type of asset—and, by extension, any one type of risk. 

Whether you’re an SME owner, an accredited investor, or a regular retirement investor looking to mitigate risk in your portfolio, hedge fund investing can be a beneficial move for your financial security. Check back later for our exclusive review of the best hedge funds for sophisticated retirement investors. 

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