What Is a Hedge Fund And Should I Invest In One?

Hedge funds can be thought of as private mutual funds that employ various strategies to see returns, but they're not for everyone. Here's why.

magnifying glass hovering over phrase "hedge fund" in dictionary
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Hedge funds. The words evoke mental images of pirates in designer suits … of backroom deals over cigars and single malt … or of Gordon Gekko's iconic line from the 1987 movie Wall Street: "Greed is good."

But what exactly is a hedge fund, and why should you consider investing in one?

Let's start with the basics. A hedge fund is a pooled investment vehicle, similar in principle to the mutual funds you'd find in your company 401(k) plan. Multiple investors contribute their cash to the fund, and it is run professionally by a manager or a team of managers. 

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But while mutual funds are highly regulated and available to the general public, hedge funds are loosely regulated and thus limited to "accredited investors." The definition of who exactly qualifies as an accredited investor is evolving, but for our purposes here we can summarize them as a person with a net worth excluding their home of $1 million or an annual income of $200,000 (or $300,000 including their spouse). The rationale here is that a high-net-worth or high-income person should have the financial sophistication to accept the higher potential risk that comes with lack of regulation. 

To keep it simple, you can think of a hedge fund as a private mutual fund available only to wealthy people. 

Structurally, most American hedge funds are limited partnerships, and the investors are limited partners. Some hedge funds are organized as LLCs (limited liability companies), and many offshore or non-U.S. hedge funds are structured as corporations. But the look and feel to the investor tends to be very similar across the board. 

What do hedge funds do?

There is a common perception that hedge fund managers are high-risk gunslingers, and some of the high-profile managers you see on TV match that description. For example, Pershing Square's Bill Ackman fits that mold. He tends to run a concentrated portfolio with large positions in just a handful of stocks.

But many hedge funds are distinctly conservative and pursue low-volatility strategies. Even the name "hedge fund" implies hedging, or risk reduction.

There are literally infinite strategies that hedge funds can pursue, and some combine different ones into "multi-strategy" portfolios. But here are some of the more common strategies you're likely to see in a hedge fund:

Long/Short: A long/short strategy is a relative value strategy in which a manager buys assets they believe will rise in value and sells short strategies that they believe will fall. For example, a manager might be long Microsoft (MSFT) and short Apple (AAPL) in the belief that Microsoft will perform better than Apple regardless of which direction the general market moves. This strategy aims to profit from both rising and falling markets.

Global Macro: Global macro funds take a big-picture approach, making bets on major economic and geopolitical trends. These bets can include currency positions, interest rate plays, and commodity investments. The legendary George Soros was the prototypical global macro manager, as his most famous trade was "bankrupting" the Bank of England by shorting the British pound in the early 1990s.

Event-Driven: Event-driven hedge funds focus on specific corporate events, such as mergers and acquisitions, bankruptcies or restructurings. These are closely related to "activist" funds that buy controlling positions in companies in order to force changes to management or the board of directors. 

Arbitrage: Arbitrage strategies involve taking advantage of price discrepancies in different markets or securities. For example, a manager could buy gold in London and sell it in Shanghai if gold were trading cheaper in London.

Be careful with hedge funds 

There are a few warnings that come along with investments in hedge funds. 

The first is cost. Hedge funds often have high fees. A 2% management fee and 20% performance fee are not uncommon. Of course, those fees might be absolutely justified if the manager is doing something unique and the returns are within your expectations even after paying the fees. But if the manager is executing a strategy you could just as easily replicate in an exchange-traded fund (ETF) or mutual fund, it's hard to justify paying a premium. 

You should also be aware of potential lockups. Unlike mutual funds, which generally have daily liquidity, and ETFs, which can be sold any time the market is open, hedge funds may only offer liquidity on a monthly or quarterly basis, and even this can be subject to conditions. 

Should you invest in hedge funds?

Hedge funds earn their keep by offering strategies that are hard to find in the world of regulated mutual funds and ETFs. But should you invest in them?

That question is going to depend on several factors. To start, you have to qualify by being an accredited investor. And along those same lines, you should be able to properly evaluate the risks involved. If you don't understand the strategy or aren't comfortable reading the often dense legal documents or auditor reports, then you should probably walk away.

Assuming you qualify and are reasonably able to evaluate them, the right fund or funds can potentially add real diversification to your portfolio and lessen your dependence on the market. Adding strategies to your portfolio with a low correlation to your existing strategies can lower your overall risk and improve your returns. 

Hedge funds offer the potential for high returns and diversification benefits, but they also come at the cost of higher fees and less regulatory oversight. As with any investment, you should do your own research to determine whether they make sense for your portfolio.

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Charles Lewis Sizemore, CFA
Contributing Writer, Kiplinger.com

Charles Lewis Sizemore, CFA is the Chief Investment Officer of Sizemore Capital Management LLC, a registered investment advisor based in Dallas, Texas, where he specializes in dividend-focused portfolios and in building alternative allocations with minimal correlation to the stock market.