April 27, 2021

How to Invest in Hedge Funds as a Retail Investor

HUDSONPOINT Team
Written by: HUDSONPOINT Team
Alternative Investment, Hedge Funds, Private Equity

 

Savvy investors are always on the lookout for their next best opportunity and new methods to improve their portfolio. No matter how complicated or straightforward your strategy is, we all want to maximize returns while managing our exposure to asset and market risks.

Part of that process involves implementing new asset classes and investment vehicles that offer returns less correlated to the most common investable assets, such as the major stock indices. There is an increasing need for alternative investments that hold up in an increasingly volatile world.

 

In the pursuit of wealth and preserving prosperity, it’s often a good idea to look at what the wealthy are already doing. We often hear of the success and tribulations of hedge funds, allocating them as playthings for the ultra-wealthy.

 

However, there may be a good reason wealthy individuals and institutions invest in these funds, and you might want a part of it as well. Hedge funds are becoming more accessible for retail investors. In light of that, let’s breakdown what hedge funds are, the types available, the risks involved, and the alternative methods to make hedge fund investing accessible for the middle-class retail investor.

 

What are hedge funds?

A hedge fund is a pooled investment vehicle that has a broad mandate of investable asset classes. Hedge funds may take advantage of riskier or more complex tools to generate an active return for their investors. These tools often include short-selling, derivatives, leveraged M&A, and other less traditional investment vehicles.

 

Their primary goal is to generate market-beating returns, and therefore they take on additional or unique risks. They also charge a significant fee for doing so, typically 2% or more per annum, plus a charge on any outperformance they generate over the benchmark index. They’re surging in popularity, growing substantially by a count of the number of funds and total funds under management over the last three decades.

 

Unlike public mutual or listed funds, hedge funds are usually limited to wealthy and sophisticated investors, such as institutions and what the SEC defines as ‘qualified purchasers (QPs).’ A hedge fund manager creates a prospectus, and those who back the manager’s ideology (and meet the criteria) invest their capital into the hedge fund.

 

They’re open-ended and allow investors to add additional capital and withdraw their funds periodically, depending on their specific investment policy and mandate. Most importantly, hedge funds hold complete freedom in their investment strategy, making many incredibly unique alternative investments.

 

Different types of hedge funds

When it comes to researching, understanding, and then potentially investing in hedge funds, you need to be cognizant of the different strategies employed by each. Lumping each into a general bucket, there are six main approaches but not limited:

 

  • Long/short: The fund holds both long and short positions across many or a few stocks. This strategy is one of the most popular as it allows fund managers to make plays on either direction of a stock’s movement. Paired techniques, such as shorting a stock then going long on its superior competitor in the same industry, are commonly used to leverage company-specific opportunities without the exposure to market risks, reducing the fund’s correlation to many other listed assets.

 

  • Event-driven: These funds make plays on future events that might impact a company. Common value-deciding corporate events include mergers, acquisitions, or even bankruptcies. Takeover bids often fall through or attract a bidding war. Hedge funds can make decisive plays in these situations.

 

  • Macro: Some fund managers excel at reading the general macroeconomic picture and seek to capture returns from doing just that. Hedge funds using this strategy might bet big on successful Covid-19 vaccinations or the precise opposite. When global markets are moving, someone’s making money.

 

  • Arbitrage: This strategy is often accomplished by high-frequency trades, buying a stock in one market and selling in another, to make money on the slightly different pricing at the time. Another form of arbitrage is throughout mergers, where each company’s stock may be bought or sold, depending on where a valuation gap presents itself.

 

  • Market neutral: As the name suggests, hedge funds employing this strategy look to eliminate market risk from the portfolio. Managers do this using long and short positions in almost parity to generate a return based on the quality of their selections, not the movements of the market. The benchmark is usually the long-term bond rate; since the risk is minimized, outperformance is valuable to a risk-averse investor seeking additional return.

 

  • Quantitative: Otherwise known as ‘quant’ funds, these hedge funds use mathematical models and rule-based trading to generate returns. The best performing fund of all time, the Medallion Fund, is a quantitative strategy created and employed by NSA code-breaker and mathematician Jim Simons.

 

Of course, each fund can mix and match their strategy depending on what opportunities present themselves. Some funds will maintain a strict mandate, executing only their disclosed strategy, whereas others will be far more adaptive. Whether or not a particular strategy is successful or not comes down to the fund manager’s skill, general market movements, and in the short term, perhaps an element of luck.

 

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Considerations when investing in hedge funds

Not every hedge fund is created equal. In fact, most hedge funds never make it past the fifth year of operation, with about a third shutting down every year. Therefore, the key to successful hedge fund investing lies in identifying the risks and doing your due research.

 

Have a look at what the fund owns or intends to own. Many hedge funds hold unlisted assets or derivatives that are both hard to sell and to value. If the fund is in the process of launching, understand their prospectus and performance history the managers bring to the table.

 

Take a laser-eyed view of what fees you’ll owe. Hedge funds are notorious for charging high fees – often between 1%-2% of assets under management, plus a 20% performance fee. Also, take a look at when you can access your money. In many cases, it’s only possible to redeem your capital at certain times throughout the year, usually quarterly.

 

The potential risks involved

There are four main risks that come with investing in hedge funds. Risks are not a reason to avoid an investment, in fact, they are often the biggest drawcard. However, you do need to assess any risk against the expected benefits. The most common risks investors face include the potential for:

 

  • Large losses: Hedge funds may use significant leverage via derivatives and other financial tools to generate returns. It’s possible that many of these bets can go very wrong, sometimes costing the entire position.

 

  • Illiquidity: While most funds will have regular withdrawal opportunities, some are few and far between. Some implement lengthy lockup periods that restrict client funds for a pre-agreed upon duration. In addition, unlisted, illiquid assets are challenging to offload during volatile markets, impacting the fund’s performance and flexibility.

 

  • High fees: Hedge funds aren’t cheap, and a large portion of them don’t perform. Given their massive cost relative to traditional funds or ETFs, you need to be sure the fees are justified by performance. If they’re not, you cost yourself money.

 

  • Taxes: Complicated as they are, tax-time might be even more of a headache, depending on their structure. Fortunately, sophisticated investors usually have the right accountants in their corner, but retail investors, without additional help, may not.

 

These reasons, and many more, traditionally limit access to hedge funds from the regular retail investor by investor choice, fund rules, and government regulations.

 

What are the requirements to invest in a hedge fund?

Investing in hedge funds is significantly restricted to investors that meet specific criteria. Traditionally, it has been very difficult for individual retail investors to access quality hedge funds. Primarily, this is a result of the SEC’s Regulation D which limits the total number of investors that can be part of a specific hedge fund. As a result, hedge fund managers put in place high minimum investment requirements.

 

It’s common for a hedge fund to have a $5 million dollar minimum. Most retail investors cannot commit this much capital, making it a significant barrier when it comes to investing. Also, the SEC also requires the majority of hedge fund investors to meet their qualified purchaser criteria, meaning you need to have net investments worth more than $5 million.

 

Of course, most retail investors will not meet these criteria, making it difficult for the average person to access the benefits hedge funds may offer. Fortunately, there are now many ways retail investors can gain exposure to quality hedge funds as part of their wider portfolio.

 

How retail investors access hedge funds

There are three main ways to access hedge funds as a retail investor: listed alternatives, publicly-traded fund companies, and pooled investment platforms.

 

There are many mutual funds that have been created solely for the purpose of replicating the strategy and exposure of famous hedge funds. These listed investments may aim to track the hedge fund’s underlying holdings, where possible, or invest in a portfolio of multiple hedge funds on behalf of their shareholders. While they are a good alternative for many investors, keep in mind that they cannot truly replicate the investments of the underlying hedge fund. They don’t have the same freedom to invest in different asset classes and must meet the requirements of being listed on the public exchange.

 

Another option is to invest in the companies that run the hedge funds. Many large investment management firms run hedge funds as part of their overall strategy and product offering. Top examples include BlackRock, Vanguard Group, and UBS, which have over $15 trillion in assets under management between them.

 

However, the best way to truly access hedge funds as a retail investor is through a pooled investment platform.

 

Accessing an investment in a hedge fund is best done with the help of knowledgeable advisors that know the industry inside and out. Investing in hedge funds as a retail investor is more accessible than ever before. HUDSONPOINT Capital provides retail investors with the platform they need to access a wide range of alternative investment opportunities, If you would like to learn more about Hedge Funds and to determine if you are eligible to participate, please contact HUDSONPOINT Capital. If you’re interested in adding Hedge Funds to your portfolio, please schedule a call to learn more.

 

 

 

 

 

 

Please note that any investment involves risk including loss of principal. Some risks of investing directly or indirectly in real estate include declining real estate values, changing economic conditions and increasing interest rates.
This is for informational and educational purposes only and should not be construed as investment advice or an offer or solicitation of any products or services. Opinions are subject to change with market conditions. The views and strategies may not be suitable for all investors and are not intended to be relied on for legal or tax advice.
Securities offered through National Securities Corporation Member FINRA/SIPC

 

 

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