If you become a multi-millionaire or billionaire one day, you might consider investing in a hedge fund. The name comes from how hedge funds began, not how they typically operate today. Early hedge funds were designed to hedge (reduce) certain risks. Over time, many evolved into investment pools aimed at wealthy investors, often using strategies that can involve both higher risk and higher potential reward.
Most hedge funds require a minimum investment of $1 million or more. By limiting participation to wealthier investors, hedge funds can avoid many regulations that apply to securities offered to the general public. As a result, hedge funds have little Securities and Exchange Commission (SEC) oversight and generally aren’t required to be registered. We’ll learn more about registration in the primary market chapter.
Hedge funds typically charge a “2 and 20” fee structure:
The management fee helps cover operating costs and is charged regardless of performance. The performance fee is collected only when the fund has investment gains and is often subject to a high-water mark, which helps ensure investors aren’t charged a performance fee just for recovering past losses.
With less supervision and regulation, hedge funds often pursue investments with unusual risk-and-return profiles. In many cases, hedge fund managers share in the fund’s gains, which can create an incentive to take on significant risk in pursuit of large returns. Hedge funds may also use exotic strategies and have been known to turn unusual items into investments.
For example, some hedge funds made significant gains on Madoff claims. If you recall, Bernie Madoff ran a Ponzi scheme that defrauded investors of nearly $60 billion. Madoff’s investors were eligible to file claims against his assets through bankruptcy court. However, bankruptcy proceedings are notoriously slow and don’t guarantee a payout. Some hedge funds bought these claims from victims at deep discounts and then waited for a settlement. By purchasing claims cheaply and waiting, these hedge funds were able to earn large returns.
Hedge funds are known for unique and risky trading strategies. Mutual funds generally can’t participate in this kind of investing because of strict regulations under the Investment Company Act of 1940. Those laws generally don’t apply to hedge funds because they’re offered only to wealthier clients and aren’t accessible to the general public.
Hedge funds are subject to risks that other pooled investments often try to avoid. One example is liquidity risk. Most hedge funds have lock-up periods that prevent investors from withdrawing money for long periods of time. This structure lets managers invest without needing to keep large amounts of cash available for redemptions. Hedge funds commonly allow withdrawal requests only a few times per year.
Hedge funds are also subject to legislative risk. For years, politicians and regulators have threatened to write rules that govern hedge funds. If that happens, new laws could reduce the value of a hedge fund or limit what it’s allowed to invest in.
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