Hedge Funds: Should They Be a Part of Your Portfolio?

77005560Mention the words “hedge funds” to most individual investors, and they might think of high-risk, potentially high-return investments that seem to invite trouble.1

In fact, most hedge funds are a diverse class of investments that use aggressive investment strategies to seek greater than average total return with lower levels of risk. Hedge funds may use many investment tactics not ordinarily available to the managers of regulated mutual funds, including unlimited short-selling, margin trading to leverage price movements, and the unfettered use of derivatives as direct investment vehicles. There are over 8,000 hedge funds — they come in all shapes and sizes.

Hedge funds are not required to register with the Securities and Exchange Commission, but they are subject to the same prohibitions against fraud as registered investments and their managers are subject to the same fiduciary duties as other investment managers.

Most hedge fund securities are issued in private offerings and are not available in the regular stock markets. Because of their complex nature, hedge funds are usually only accessible to sophisticated investors. Most hedge funds require their investors to be both “accredited” and “qualified.” An accredited investor is one with a net worth of $1 million or more. A qualified investor is one with a net worth of $1.5 million. The qualifications for investing in a particular hedge fund are found in its offering documents.

Hedge funds can be particularly appealing to individual investors for a number of reasons, including their abilities to:

  • Minimize overall portfolio risk and volatility.
  • Deliver non-market correlated returns.
  • Provide diversification otherwise unavailable in more traditional investing options.2

Hedge funds are typically engineered to seek a more favorable risk-adjusted return than their investors might obtain from a fund that follows a standard market benchmark. Additionally, their managers often seek to minimize the loss potential in their portfolios, the effects of which can be seen in the long-term return profiles of hedge funds.

Factors to Consider

When considering whether to invest, you should keep in mind some of the traits relating to hedge fund investing:

  • Individual risks include bankruptcy, the effects of competition, and changes in technology, among other things.
  • Market risks indicate the possibility that an entire broad category of assets will gain or lose value simultaneously.
  • The value of a hedge fund’s assets can sometimes be difficult to ascertain. As some hedge funds invest in highly illiquid securities, they may be hard to value.
  • Hedge funds do have higher fees than many other investments. Managers typically charge 1%-2% in fees, plus a “performance fee” of up to 20% of its profits.
  • Many hedge funds restrict the opportunities to redeem shares and often impose a “lock up” period of one year or more after your initial investment.

If you are contemplating the use of a hedge fund in your portfolio, consider that hedge funds are complex investments with limited liquidity compared with stocks and bonds or mutual funds. Contact your financial professional to learn more.

1Hedge funds often engage in speculative investment practices that may increase the risk of investment loss. Hedge funds can be highly illiquid; are not required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as mutual funds; and often charge high fees.
2Diversification does not ensure a profit or protect against a loss.