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What Are Hedge Funds and How Do They Work?

By Laurel Tincher · May 17, 2021 · 5 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Are Hedge Funds and How Do They Work?

A hedge fund is an investment vehicle that invests in securities and other assets with money pooled from investors. They’re similar to mutual funds or exchange-traded funds, but they are riskier and more expensive.

Because of this, they’re subject to different government regulations and only open to wealthy, sophisticated investors.

What Is a Hedge Fund?

Hedge funds are set up by a registered investment advisor or money manager, often as a limited liability company (LLC) or a limited partnership (LP).They differ from mutual funds in that they have more investment freedom, so they’re able to make riskier investments.

By using aggressive investing tactics, such as short-selling, debt-based investing, and leveraging hedge funds can potentially deliver higher-than-market returns, but they also have higher risks than other types of investments In addition to traditional asset classes, hedge funds can a diverse array of alternative assets, including art, real estate, and currencies.

Hedge funds tend to seek out short-term investments rather than long-term investments. Of course assets that have significant short-term growth potential can also have greater short term losses.

Historically, hedge funds have not performed as well as safer investments such as stock market indices. However, the goal of hedge funds isn’t necessarily to outperform the stock market. Investors also use hedge funds to provide growth during all phases of market growth and decline, providing diversification to a portfolio that also contains stocks, cash, and other investments.

Only wealthier investors and institutional investors are able to invest in hedge funds, due to their risks and the high fees that get paid to fund managers.

Types of Hedge Funds

Each hedge fund has a different investing philosophy and invests in different types of assets. Some different hedge fund strategies include:

•  Real estate investing
•  Junk bond investing
•  Specialized asset class investing such as art, music, or patents
•  Long-only equity investing (no short selling)
•  Private equity investing, in which the fund only invests in privately-held businesses. In some cases the hedge fund gets involved in the business operations and helps to take the company public.

What Is a Hedge Fund Manager?

Hedge funds are run by investment managers who make investment decisions and manage the risk level of the fund. If a hedge fund is profitable, the hedge fund manager can make a significant amount of money, up to 20% of the profits.

Before selecting and investing in a hedge fund, it’s important to look into the fund manager’s history as well as their investing strategy and fees. This information can be found on the manager’s Form ADV, which you can find on the fund’s website as well as the SEC’s Investment Advisor Public Disclosure Database .

Who Can Invest in a Hedge Fund?

Hedge funds are not open to the general public, and there are several requirements to be able to invest in them. In order for an individual to invest, they must be an accredited investor. This means that they either:

•  Have an individual annual income of $200,000 or more. If the married investors must have a combined income of $300,000 per year or more. They must have had this level of income for at least two consecutive years and expect to continue to earn this level of income.
•  Or, the investor must have an individual or combined net worth of $1 million or more, excluding their primary residence.

If the investor is an entity rather than an individual, they must:

•  Be a trust with a net worth of at least $5 million. The trust can’t have been formed solely for the purpose of investing, and must be run by a “sophisticated” investor, defined by the SEC as someone with sufficient knowledge and experience with investing and the potential risks involved.
•  Or, the entity can be a group of accredited investors.

How to Invest in a Hedge Fund

Investing in hedge funds is risky and involves a deep understanding of financial markets. Before investing, there are several things to consider:

The Fund’s Investing Strategy

Start by researching the hedge fund manager and their history in the industry. Look at the types of assets the fund invests in, read the fund’s prospectus and other materials to understand the opportunity cost and risk. Generally speaking, the higher the risk, the higher potential returns.

In addition, you need to understand how the fund evaluates potential investments. If the fund invests in alternative assets, these may be difficult to value and may also have lower liquidity.

Understand the Minimums

Investment requirements can range between $100,000 to $2 million or more. Hedge funds have less liquidity than stocks or bonds, and some require that money stays invested in the fund for a specific amount of time before it can be withdrawn. It’s also common for there to be lock-up periods for funds and for there to only be certain times of year when funds can be withdrawn.

Confirm You Can Make the Investment

Make sure that the fund you’re interested in is an open fund, meaning that it accepts new investors. Financial advisors can help with this research process.

Each hedge fund will evaluate an individual’s accreditation status using their own methods. They may require personal information about income, debt, and assets.

Understand the Fees

Usually hedge funds charge an asset management fee of 1-2% of invested assets, as well as a performance fee of 20% of the hedge fund’s profits.

The Takeaway

For accredited investors, investing in a hedge fund may be one part of a diversified portfolio, although it depends on the investor’s risk tolerance, time horizon, and investing goals. If you’re not an accredited investor, or you’re worried about the risks associated with hedge funds, it may make more sense for you to consider other types of investments or to stick with ETFs, mutual funds, or funds of funds that emulate hedge fund strategies.

If you’re looking to start building a stock portfolio, one great tool is the SoFi Invest® brokerage platform. The investing platform lets you research and track stocks, and you can buy and sell right from your phone.

The app gives you the ability to invest in stocks, ETFs, cryptocurrencies, and other types of assets. There are no commission fees. If you need help getting started, SoFi has a team of professional financial advisors available to answer your questions and help you build a personalized investing plan.

Photo credit: iStock/gece33

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