If your only reference point for hedge funds is pop culture, it can be easy to misunderstand what they are and how they work. From Game Stop to George Soros and the Big Short, Hollywood and pop culture love to focus on eye popping stories about isolated funds.

Most active hedge funds are less dramatic than Hollywood would have you believe, although they do tend to be both exclusive and more opaque than traditional investments. That doesn’t mean hedge funds should be avoided, however. Let’s dig into what hedge funds are, how they’re different from other investment funds, and whether you should consider adding hedge funds to your portfolio.

 

What are hedge funds?

Hedge funds started because investors wanted to “hedge their bets” on the stock market. 

A classic hedge involves short selling, which takes the basic investing principle of buy low, sell high and flips it on its head. In a traditional short sale, an investor borrows shares of an investment, sells them at a high price with the assumption that the investment will lose value. If it happens, the investor buys the shares back at a lower price and returns them. Of course, the reverse can happen, forcing the investor to buy the shares back at a higher price (a loss) before returning them. 

Short selling is riskier than a long (buy and hold) investment because there’s usually a time component at play (you can’t borrow shares indefinitely) and a fee involved in the process.

Short selling isn’t the only way to hedge. Traders and investors also use derivative investments, including options and futures, to hedge various positions. 

Some fund managers also engage in arbitrage—exploiting the price difference between different markets. For example, if a Bitcoin costs $10,000 in the US but $15,000 in Korea, a fund manager could buy Bitcoins in the US then sell them on Korean exchange and pocket the difference. (This is how some early crypto billionaires made their fortunes.)

All of these strategies—short selling, derivatives, and arbitrage—tend to involve leverage, or trading on margin. When this type of trading works, it can significantly amplify potential gains. On the flip side, it can amplify potential losses as well.

Because these investment strategies carry higher risk, the government seeks to limit who can invest in hedge funds. 

 

How are hedge funds different from mutual funds?

Hedge funds differ from more traditional investments, like mutual funds in a few key ways.

Investment strategies. As we just discussed, hedge funds tend to use a more complex assortment of investment strategies than mutual funds. They’re also free to pivot their strategies based on changing market conditions in a way that many mutual fund managers cannot.

Regulation. Hedge fund managers must disclose their long holdings at the end of each quarter (in other words, what they own). While these public disclosures provide a line of sight into some of what a hedge fund is doing, other positions, like shorts, derivative investments, and more likely won’t appear on those statements. There is generally far less oversight of hedge fund managers than of mutual fund managers and investment advisors.  (It’s worth noting that some hedge fund managers can apply for confidential treatment to avoid disclosing even this information to the public.)

Performance. How often hedge fund managers report performance to their investors (and what specifically they share) tends to depend on the terms of the fund. Sometimes it’s monthly, sometimes quarterly. Mutual funds, on the other hand, must report their net asset value (NAV) every day, letting investors assess performance in real time.

Who can invest. The combination of riskier strategies and less regulation means the government limits who can invest in hedge funds. Only accredited investors, qualified purchasers, and/or institutional investors can put money into hedge funds. (Some funds only allow institutions, others only allow qualified purchasers, and so on.) The government reasons that these investors can better tolerate any potential losses.

Fees and minimums. Most mutual funds charge a percentage of assets under management ranging from 0.5% to 2% regardless of performance. Hedge funds tend to have more creative fee structures, the most common being “2 and 20”—a 2% management fee like any other fund plus 20% of any profits, known as a performance fee. Of course, fees vary based on the fund itself (this applies to both mutual funds and hedge funds) and it’s important to look up the specifics before investing. Many hedge funds also include a higher investment minimum.

“Should I invest in hedge funds?”

We get this question a lot at Quorum Private Wealth, and as with most things tied to your personal finances, the answer is highly personal. The first thing we’ll do is make sure you qualify to invest—either as an accredited investor or qualified purchaser.

Next, we’ll look at the specific hedge fund in question alongside the rest of your investment portfolio. Hedge funds tend to invest in a wide array of assets that you may not have exposure to otherwise. For instance, some hedge funds invest in distressed debt, natural resources, real estate, and so on. 

This means hedge funds tend to provide diversification and the returns may be uncorrelated to other areas of your portfolio.

Finally, we’ll consider your goals. Hedge funds tend to have a high minimum investment; they may also have a lockup period (where you can’t withdraw funds) or other hurdles that make it harder to access your money quickly. Before investing, we’ll want to ensure you have other liquid assets to support any shorter-term goals.

If you want to discuss hedge funds and how they might fit into your portfolio, let’s set up a time to discuss.