Hedge funds are known for their riskier investments, attracting wealthier investors who are seeking greater returns and willing to take larger bets.
The goal is to deploy strategies that generate returns that are uncorrelated to traditional markets, says Jeffrey Fulk, a managing director at Alvarium Investments, an investment boutique that supervises $17 billion in assets for clients.
"We believe that hedge funds provide exposure to unique return streams that can't be accessed in traditional investment vehicles," he says.
Well-known hedge fund firms have hundreds of billions of dollars under management and include Bridgewater Associates, AQR Capital Management, J.P. Morgan Asset Management and Renaissance Technologies.
Hedge funds are also known for taking a more aggressive strategy by using leverage or investing in alternative asset classes such as private companies, real estate, distressed assets, currencies and commodities, says Ali Hashemian, president of Kinetic Financial in Los Angeles.
This fund structure lends itself to more efficient capture of alpha sources that come from behavioral, analytical, informational and technical mispricing, Fulk says.
"They do this by using complex investment strategies that include investing both long and short, deploying leverage, and using derivative securities," he says.
For those interested in this type of fund investing, here's what you need to know:
-- How to start with hedge funds.
-- Are hedge funds right for you?
-- Hedge funds typically have a lock-up period.
-- Hedge funds offer diversity in portfolio allocation.
-- There are barriers to entry.
How to Start With Hedge Funds
A hedge fund traditionally was an investment fund for wealthy investors that invested both long and short through equities and options, says Eric Chung, chief investment officer of Lighthaven Capital Management based in San Francisco.
"That is no longer the case as today the term is a catch-all for any private fund that is not a private equity, venture or real estate fund," he says. "For that reason, investors must look carefully at each fund to understand its strategy, the types of assets it invests in, whether it uses leverage or derivatives and other important factors."
The minimum investment can vary greatly from one hedge fund to another. Many of them will have minimums between $500,000 to $1 million but some can be much higher, Hashemian says.
"This is part of the reason why hedge funds are mostly reserved for wealthy individuals that can invest the minimum without becoming too concentrated in one fund," he says.
The institutionally focused hedge fund managers could have higher minimums, Fulk says. There are also third-party feeder fund vehicles that provide access to hedge funds at lower minimums.
Are Hedge Funds Right for You?
Hedge funds have varying strategies, returns and fees and managers usually have the ability to alter the fund's strategy or assets without alerting shareholders. Some of the managers of these funds focus on improving your returns while others offer diversification such as including exposure to cryptocurrencies.
"Once an investor is clear on what they are seeking, they can more easily analyze the fund to determine whether the fund will help achieve their objective," Chung says.
High-net-worth investors should conduct research on the management team, past performance, risk exposure and the fund's forward-looking strategy, Hashemian says.
Fees are an important consideration and part of the equation. Hedge funds are traditionally more expensive than other pooled investment vehicles.
A common hedge fund fee is "two and 20" which means 2% per year of the assets that are being managed and another 20% of the profits, he says.
"This can sound expensive but the performance can make it worthwhile," Hashemian says.
Some hedge funds lowered their fees -- charging 1.5% annual management fees and a 17.5% performance fee, Fulk says.
"However, access to the best hedge fund managers remains around 2% and 20% and can be higher for hedge fund managers that are highly differentiated," he says.
Hedge Funds Have Lock-up Periods
Unlike a stock or exchange-traded fund, the majority of hedge funds require investors to leave their money in the fund for a certain period before making any redemption. This is known as lock-up periods, notice periods or restrictions on redemptions and are detailed in the legal documents.
Hedge funds often invest in real estate or mineral exploration rights but offer less liquidity than ETFs, which can be sold the same day they are purchased.
While the period varies, it is typically at least one year, Hashemian says.
Experts say hedge funds are most likely suited for high-net-worth investors who are seeking high-risk investments and volatility to generate larger returns.
Hedge Funds Offer Diversification
Hedge funds can be a worthwhile investment because the assets allow them to diversify and provide a lack of correlation to the stock market.
"Wealthy people often want to access private investments and alternative investment strategies," Hashemian says. "They can hedge against traditional, systematic market risk by investing in noncorrelated assets."
Some investors prefer hedge funds because they can take additional risks that mutual funds, index funds and ETFs can not because the law imposes fewer restrictions and rules on them, Chung says.
But choosing the right hedge fund manager is not an easy task.
"Some hedge funds can be truly exceptional and you might find the next superstar," he says. "Warren Buffett started out managing investors' money through a hedge fund. Hedge funds can attract the best and the brightest."
There Are Barriers to Entry
Only accredited investors who meet the fund minimums can invest with a hedge fund. One of the main strategies that managers in hedge funds use include leverage and invest in private or alternative assets, the downside risk can be very large, Hashemian says.
Investors pay high fees for hedge fund managers to manage their assets and must also contend with their performance and whether it beats benchmarks such as the S&P 500 or the Dow Jones Industrial Average.
"Hedge funds have the reputation of underperforming the market but this is a bit of a misleading argument since many hedge funds are trying to maximize risk-adjusted returns," Chung says.
One major con: The number of players in the hedge fund universe has been stretched thin by too many new entrants, Fulk says. In return, it has made it more difficult to identify truly exceptional investment managers, he says.