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Hedge Funds – What They Are & How These Managed Investments Work

When you do your stock market research as an investor, you’ll come across the term hedge fund quite often. You’ll hear about the fact that hedge funds are alternative investments that are generally attractive to investors with high net worth and to accredited investors.

With big-money investors piling into these funds, and retail investors generally having a desire to follow the money, it only makes sense to want to become a hedge fund investor.

But what exactly is a hedge fund? Who are the hedge fund managers behind these investment vehicles? And is it even possible for average investors to get involved in these funds?

What Are Hedge Funds?

Hedge funds are alternative investments that make use of pooled investing dollars from a group of investors. These funds are actively managed, unlike index funds which invest in all stocks listed on the underlying index they’re centered around.

Hedge fund managers actively follow the investment strategy laid out to the investors who invest in the fund. Some of these funds are relatively conservative, only investing in traditional asset classes like stocks and bonds. Others are aggressive, making use of traditional stocks and bonds as well as derivatives, short selling, and leverage designed to greatly expand returns for their investors.

Hedge funds come with high fees as a combined result of the management fees charged by the hedge fund managers at the helm of the funds plus the added costs associated with margins, derivative contract origination fees, and other expenses associated with active investing.

Regardless of how aggressive hedge funds are, they all have one goal. Hedge funds aim to achieve “alpha” for their investors — active returns that outpace the returns generated by the overall stock market when compared to specific benchmarks.

Who Manages Hedge Funds?

Hedge funds are usually managed by a large group of professionals. These professionals include:

  • The Hedge Fund Manager. The person in charge is known as the hedge fund manager. This is a financial advisor, investment advisor, or other financial professional who organizes and oversees the investment process. Hedge fund managers are often called fund managers, portfolio managers, or simply PMs.
  • Traders. Most hedge funds have a group of traders who follow the investment strategy laid out by the fund manager. These traders are the active participants in the stock market who constantly look for opportunities that align with the investment objectives set forth in the hedge fund’s prospectus. They make sure the fund’s asset allocation is on par with the prospectus and stocks and other investments are performing as outlined in the investment strategy. They are the active members of the fund who conduct the day-to-day asset management.
  • Analysts. Finally, most hedge funds have a group of analysts. While traders take a short-term view, assessing the market in real time, analysts take a long-term view, assessing the opportunities in the market that may lie ahead. Analysts also dive into market conditions to help determine the best asset allocation strategy. Hedge fund managers lean on information provided by their analysts when making adjustments to the fund and the investment strategy that acts as its heartbeat.

In general, when someone talks about hedge fund managers, they are talking about just that — the single manager in charge of the entire process. However, these fund managers simply couldn’t manage the fund without traders and analysts to help them through the process.

What Are Hedge Funds Used For?

Hedge funds are designed to achieve alpha, or active returns on investments that outpace the overall return seen in the stock market. Essentially, these funds use complex trading, portfolio construction, and risk management techniques to return a higher return of value than broad-market index funds and exchange-traded funds (ETFs) might provide.

Who Are Hedge Fund Investors?

Hedge funds are held to much less regulation than other funds, like mutual funds or ETFs. As a result, these funds are only accessible to accredited investors. Accredited investors are essentially high net-worth individuals who own assets worth at least $1 million excluding their primary residence or who earn at least $200,000 per year with the expectation to continue earning money at that level.

Because hedge funds are only available to you if you’re an accredited investor, the vast majority of investors simply won’t qualify for investing in these funds. Moreover, minimum investments for hedge funds tend to range between $100,000 and $2 million, further limiting access to the average investor.

Pro tip: If you’re not an accredited investor, you can looking into investing with a company like Titan Invest. It’s managed by hedge fund veterans and uses a hedge fund investing style, but it’s open to anyone.

How to Find a Hedge Fund

Hedge funds are relatively simple to find. If you qualify to invest in these alternative investment vehicles, all you need to do is type “best hedge funds” into your favorite search engine and you’ll be pointed to plenty of them.

Some of the most popular hedge funds on Wall Street today include Bridgewater Associates, Man Group, Two Sigma Investments, and Millennium Management.

Pros and Cons of Investing in Hedge Funds

As is the case with any investment vehicle, hedge funds come with their own lists of pros and cons. Before diving into these investments, you should consider the following:

Pros of Hedge Fund Investing

Some of the most significant benefits associated with investing in hedge funds include:

  • Potentially Significant Returns. Due to the constant adjustments that take place within hedge funds and their use of derivatives and aggressive trading strategies, it is possible for hedge fund investments to provide returns that outpace those of the overall market.
  • Flexibility. Hedge funds aren’t looked at closely by the Securities and Exchange Commission (SEC) or any other regulatory authority. These funds are not traded publicly, and with little-to-no regulatory oversight, they have the flexibility to take advantage of trading strategies, derivatives, and leverage that aren’t available through traditional, more heavily regulated funds.
  • Diversification. Although most funds are diversified investments, hedge funds take diversification to the next level. These funds not only diversify their holdings within asset classes — as index funds do with the mix of stocks they invest in — hedge funds actually diversify asset classes, and tend to be more heavily diversified than other types of funds.

Cons of Hedge Fund Investing

Although there are plenty of reasons to be excited about potentially investing in hedge funds, they aren’t a one-size-fits-all investing option. Here are a few drawbacks that should be considered before diving into hedge funds:

  • Not Accessible to New Investors. Hedge funds are only accessible to accredited investors. Even if they were open to the public, the minimum investment requirement of between $100,000 and $2 million is far more than the average investor would have to start investing with.
  • Less Regulation Isn’t Always a Good Thing. Sure, with the Securities and Exchange Commission turning a relatively blind eye to hedge funds, fund managers have the ability to make more aggressive moves, potentially increasing your capacity for gains. However, less regulatory oversight also means higher risk, which is one of the major reasons the average investor simply doesn’t qualify to invest in these investment vehicles.
  • Liquidity Issues. Terms will vary from one hedge fund to another. However, unlike other, more liquid investments, cashing out your hedge fund investments may not be so easy. Some hedge funds come with lock-up periods, which are the initial periods of time that investors aren’t able to withdraw their funds.
  • Hedge Funds Create Losses Too. Hedge funds are managed by human beings, and human beings can’t see into the future. According to Business Insider, Bridgewater Associates, one of the most popular hedge funds on Wall Street, lost $12.1 billion in 2020. Hedge funds are far from a sure bet despite their professional management.

Alternatives to Hedge Fund Investing

There are obvious roadblocks for the average investor when it comes to an entrance into hedge funds. There are good reasons for these roadblocks. It’s the same reason you can’t day trade with less than $25,000 in your investing account. These rules are set in place to prevent market participants from making risky investments that may result in a significant loss of capital.

There are other, less risky options for the average investor looking for a diversified fund that can provide solid returns, including:

Exchange Traded Funds (ETFs)

Exchange-traded funds, or ETFs, are bucket investments that provide investors access to a specific sector or group of assets. Certain ETFs have the potential to provide access to market-beating returns with much lower risk than hedge funds. Not to mention, they’re available to the average investor. Some types of ETFs you may want to consider in lieu of hedge funds include:

  • Emerging Markets ETFs. Emerging markets are markets that are just in their infancy. This can relate to emerging economies or technologies. For example, China is one of the world’s fastest growing emerging markets. So, too, is the emerging cryptocurrency market. These markets are known for providing compelling growth that often outpaces the overall market.
  • Small-Cap ETFs. Small-cap companies have a lot to prove, and if things go well for them, the market rewards them with valuations that go on serious upward trends. There are several small-cap ETFs that give you access to a diversified group of opportunities in the small-cap category that have the potential to yield returns far larger than average.
  • Technology ETFs. The tech sector has been on a tear lately. While some experts argue that technology valuations are far higher than they should be, others argue that the high valuations are warranted as a result of the compelling innovation in the space and strong revenue and profit growth that this innovation is resulting in. No matter how you see it, one thing is certain: tech stocks are one of the highest growth sectors on Wall Street today.

Mutual Funds

If you’d prefer investing in an actively managed fund, but you don’t qualify for investments in hedge funds, mutual funds may be a great fit. These funds are actively managed with the goal of executing on the investment objectives outlined in the prospectus for the fund.

When investing in mutual funds, it’s important to pay close attention to expense ratios. As actively managed funds, the mutual fund’s managers will want their cut, and expenses will generally be higher than those of ETFs.

Because mutual funds are actively managed, you can find funds based on styles of investing. In particular, growth investing funds are the perfect alternatives to hedge fund investments.

Index Funds

Index funds are designed to track entire stock market indexes. For example, a Nasdaq index fund would invest assets in every constituent of the Nasdaq index with a goal of producing results that correlate with the Nasdaq.

Because investors who would be interested in hedge funds are looking for strong growth, there are two types of index funds that would fit as strong candidates as hedge fund alternatives:

  • Russell 2000 Index Funds. There are multiple index funds centered around the Russell 2000, which lists the 2,000 smallest companies listed on the Russell 3000 by market capitalization. Because small-cap companies are known for producing compelling growth, Russell 2000 index funds are a great way to invest in a diversified portfolio with the potential to beat major benchmarks like the S&P 500.
  • Nasdaq Index Funds. The world is going through a technological revolution. There’s also a medical revolution taking place. As such, the technology and biotechnology markets are seeing compelling growth. The Nasdaq is a tech-heavy index that’s heavily weighted toward technology and biotechnology stocks. As such, Nasdaq index funds give investors yet another opportunity to beat the market.

Final Word

Hedge funds are an alternative investment vehicle that was designed for wealthy investors with a high risk tolerance. Although they may seem appealing, they are not available to the average investor because of the increased risks that come with investing in derivatives, short selling, and taking advantage of leverage.

Most investors would be well served investing in ETFs, mutual funds, and index funds that provide extensive diversification, while still giving the opportunity to beat the returns generated by the S&P 500 and other broad-market benchmarks.

No matter how you invest, always keep in mind that quality research is the basis of quality investments. Always take the time to learn the pros and cons associated with an investment before risking your hard-earned dollars.

Joshua Rodriguez has worked in the finance and investing industry for more than a decade. In 2012, he decided he was ready to break free from the 9 to 5 rat race. By 2013, he became his own boss and hasn’t looked back since. Today, Joshua enjoys sharing his experience and expertise with up and comers to help enrich the financial lives of the masses rather than fuel the ongoing economic divide. When he’s not writing, helping up and comers in the freelance industry, and making his own investments and wise financial decisions, Joshua enjoys spending time with his wife, son, daughter, and eight large breed dogs. See what Joshua is up to by following his Twitter or contact him through his website, CNA Finance.

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