Hedge funds

If you become a multi-millionaire or billionaire one day, you’ll probably consider investing in a hedge fund. Hedge funds are named after how they started, not how they are today. Originally formed as investment vehicles used to protect their investors from risk, hedge funds evolved into a “wealthy person’s fund” full of high risks and rewards.

Most hedge funds require a minimum investment of $1 million or more. By limiting investment to wealthier investors, hedge funds avoid many regulations that publicly available securities are subject to. Hedge funds have little Securities and Exchange Commission (SEC) oversight and are not 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: a 2% annual management fee on assets under management and a 20% performance fee on profits earned. The management fee covers operating costs and is charged regardless of fund performance, while the performance fee is only collected on investment gains, often subject to a high-water mark to ensure investors aren’t charged for recovering past losses.

With little supervision and regulation involved, hedge funds seek investments with unique risks and returns. Many times, hedge fund managers are compensated and share the gains of the fund, creating an incentive for them to take on significant amounts of risk in hopes of making large returns. Hedge funds follow exotic strategies and have been known to turn bizarre items into investments.

For example, some hedge funds made significant gains on Madoff claims. If you recall, Bernie Madoff created a Ponzi scheme that defrauded investors of nearly $60 billion. Mr. Madoff’s investors were eligible for claims against his assets that were handled by bankruptcy court. However, bankruptcies are notoriously slow-moving with no guarantee of a payout. Some hedge funds purchased these claims from Mr. Madoff’s victims at deep discounts and waited until a settlement was reached. By buying the claims at a deep discount and waiting patiently, these hedge funds made large returns.

Hedge funds are known for their unique and risky trading strategies. Mutual funds cannot take part in this kind of investing due to strict regulations within the Investment Company Act of 1940. These laws generally do not apply to hedge funds because they’re only offered to wealthier clients and are not accessible by the general public.

Hedge funds are subject to risks that other types of pooled investments generally avoid. For example, hedge funds have a considerable amount of liquidity risk. Most hedge funds have lock-up periods that do not allow their investors to request withdrawals for lengthy periods of time. This structure allows hedge fund managers to invest their customers’ money without worrying about keeping cash available for redemptions. Hedge funds commonly allow their customers to request withdrawals only a few times a year.

Hedge funds are also subject to legislative risk. For years, politicians and regulators have threatened to write rules that govern hedge funds. If this were to occur, it’s possible new laws would reduce the value of the hedge fund or hinder its investing ability.