How to Invest in Hedge Funds: First Steps and Examples

Hedge funds are proving hugely popular with institutions and wealthy individuals – but should you get involved with these controversial financial products?

Total hedge fund assets have surged past $4 trillion after increasing for five consecutive quarters, according to the HFR Global Hedge Fund Industry report.

Risk-tolerant investors have been drawn by their flexibility and use of sophisticated financial strategies to perform in challenging environments.

But hedge funds have also been criticized for being largely unregulated, lacking transparency, and taking on too much risk in the pursuit of outsized returns.

So, what do hedge funds do? Is it worth learning how to invest in hedge funds, or is it better to stick with more traditional asset classes?

Our guide will look at what a hedge fund is, how to invest in hedge funds, and the requirements needed by would-be hedge fund investors.

Key Takeaways

  • Hedge funds are actively managed investments that typically have more flexible strategies than mutual funds and use a variety of sophisticated financial tools.
  • Total hedge fund assets have already surged well past the $4 trillion milestone after five consecutive quarters of increases, according to the HFR Global Hedge Fund Industry report.
  • The world’s 20 most successful hedge funds made record profits of $67 billion in 2023 – up from $65 billion the previous year, according to research by LCH Investments.
  • You can’t invest in a hedge fund unless you are an accredited investor. This generally means a net worth of more than $1 million and an annual salary above $200,000.
  • It can be a very lucrative business, with the top-earning hedge fund managers making more than $1 billion a year, according to Institutional Investor’s Rich List.

What Is a Hedge Fund?

These products have fascinated investors for decades, but what are hedge funds exactly? 

Hedge funds pool investors’ money and invest it to try and generate a positive return. They will generally have more flexible investment strategies than a mutual fund.

However, many hedge funds use complicated financial tools and strategies that are extremely difficult to understand unless you are an experienced investor. 

Their goal will be to seek profit in all kinds of markets by using techniques such as leverage, which means borrowing to increase investment exposure, according to the US Securities and Exchange Commission

They may also embrace short selling, the regulator pointed out, and other more “speculative investment practices” that aren’t used by mutual funds. 

Who Can Invest in Hedge Funds?

Technically, anyone can invest in a hedge fund. However, they need to be accredited investors, which requires a minimum level of income and assets.

In the US, an accredited investor will require a net worth of more than $1 million, excluding their primary residence, either individually or with a spouse/partner.

The other criteria are an individual income of more than $200,000 – or $300,000 with spouse/partner – in each of the last two years and an expectation of the same in the current year, according to the SEC.

The financial restriction placed on potential investors is why most hedge funds only attract funds from major institutions, such as pension and life insurance companies.

What Is a Hedge Fund Manager?

So, what is a hedge fund manager? This is the person responsible for making the investment decisions at the helm of a hedge fund.

The most successful enjoy remarkable incomes. The top 25 made a combined $21.5 billion in 2022, according to Institutional Investor’s annual ranking of the highest earners.

While the median manager earned an impressive $570 million, the seven highest earners all made at least $1 billion. The top was Ken Griffin, founder of Citadel, with $4.1 billion.

However, there’s not one specific definition of a hedge fund manager as they’re classified by the strategies they employ, such as global macro, long/short, and relative value arbitrage. 

There are also certain skills needed to be successful in this industry, according to Andrew Loo, Vice President, Capital Markets, at the Corporate Finance Institute. 

As well as advanced degrees in business, finance, economics, or accounting, hedge fund managers will also have strong financial modeling, data analytics, and other quant talents. 

“The most well-known hedge funds tend to attract graduates from the top schools globally with the right internship experience, so competition is fierce,” he wrote

They also need a comprehensive understanding of financial markets and instruments, as well as how to hedge or leverage risks to achieve top-drawer returns.

“This means that many hedge fund managers have cut their teeth working as traders or research analysts on the sell-side,” added Loo. “We also see hedge fund managers who come from other investment management roles or have moved up from more junior roles at the same firm.”

George Soros
George Soros, one of the world’s most well-known hedge fund managers. Source: georgesoros.com

 

George Soros is arguably the world’s most well-known hedge fund manager and someone who managed to generate years of excellent returns. 

Born in Hungary in 1930, he lived through the Nazi occupation and moved to London in 1947 to study at the London School of Economics.

By the mid-1950s, he’d emigrated to the United States and embarked on his journey to fame and fortune in the world of finance.

Soros Fund Management, his first hedge fund, was launched in 1970. His financial success over the decades has seen him give away more than $32 billion of his fortune for charity.

How Do Hedge Funds Work?

Hedge funds embrace more sophisticated investment strategies, so there are a lot of factors to consider.

Here, we cover some of the main issues for would-be hedge fund investors to be aware of.

Stricter Shareholder Requirements

Hedge funds are restricted under Regulation D of the Securities Act, 1993, to raising capital in non-public offerings and only from accredited investors, according to the CFA Institute.

An accredited investor has a minimum net worth of $1 million and has achieved an annual income of $200,000 in each of the last two years – as well as an expectation of the same in the current year.

Hedge Funds Fees and Minimums

Hedge fund investors can also expect to pay for the privilege. 

Management fees typically cost 1%-2% of managed funds. On top of that, there will be a performance fee of up to 20%.

However, while these figures are extremely high, the argument in their favor is that hedge fund managers will be financially motivated to perform.

Riskier Trading Strategies

Hedge funds will embrace more sophisticated – and riskier – investment strategies in their pursuit of bumper returns for investors.

Investors must pay close attention to which strategies are employed. 

For example, leverage often sees borrowed money and investors’ capital used to try and increase potential returns, pointed out the SEC.

“The use of leverage will magnify both the potential gain and the potential loss from an investment,” it explained. “The use of leverage can turn an otherwise conservative investment into an extremely risky investment.”

Here are some examples of hedge fund strategies and techniques.

Short SellingLeverageRelative Value ArbitrageLong/ShortDirectionalGlobal Macro

Short Selling

This is when you open a position in an asset that you believe will decline in value. It can enable investors to take advantage of bear markets and declines.

Leverage

It’s the use of borrowed money to invest. The hedge fund may use both the borrowed money and investors’ capital to try and increase returns.

Relative Value Arbitrage

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Long/Short

This can involve making pair trades by betting on two securities in the same industry. They will go ‘long’ by investing in the one they believe will outperform, then ‘short’ the other.

Directional

This is betting on the directional moves of the market based on a combination of recent movements, trends, and inconsistencies.

Global Macro

Managers make bets based on global macroeconomic trends, such as moves in interest rates and currencies.

Other Issues to Consider

Hedge funds can also be less liquid, with lock-in periods being put in place. This means investors may face a wait for any redemptions. 

It’s also worth looking at hedge funds vs mutual funds. The similarities are that both types want to generate returns for their investors.

However, hedge funds are focused on generating outsized returns. This means they’ll be far more willing to embrace riskier areas in pursuit of their goals.

Mutual funds tend not to use leverage, as they usually invest in assets such as bonds and stocks and are usually far easier for private investors to access.

Benefits and Risks of Investing in Hedge Funds

Here is an at-a-glance look at the main benefits and risks involved in hedge funds.

Benefits and Risks of Investing in Hedge Funds

Top Hedge Funds Performance

The world’s 20 most successful hedge funds made record profits of $67 billion in 2023 – up from $65 billion the previous year, according to research by LCH Investments

The top performers, which include Sir Christopher Hohn’s TCI, Ken Griffin’s Citadel, and Andreas Halvorsen’s Viking, will be of interest to those wanting a hedge fund example.
Field Street Capital Management was the largest hedge fund firm in the world as of 2023, managing assets worth $297.96 billion, according to figures compiled by Statista.

Assets Under Management of the Largest Hedge Funds Worldwide in 2023

How to Invest in Hedge Funds: Main Steps to Take

If you are wealthy enough to consider a hedge fund as part of your wider portfolio, how do you turn this into reality? 

  1. Step 1: Do Your Research

    Do background checks on potential hedge funds – and the managers at the helm. As part of this due diligence, ensure they’re qualified to manage your money and if they have a disciplinary history. This can be obtained from the SEC.
  2. Step 2: Read a Fund’s Investment Prospectus

    It’s crucial to understand how a hedge fund works – and the level of risk being taken. Whether it’s suitable will depend on your investment objectives and risk tolerance.
  3. Step 3: See How a Fund’s Assets Are Valued

    Hedge funds may invest in highly illiquid assets that can be difficult to value, according to the SEC. “You should understand a fund’s valuation process and know the extent to which a fund’s securities are valued by independent sources,” it stated. “Valuations of fund assets will affect the fees that the manager charges.”
  4. Step 4: Understand the Charging Structure

    The fees levied by hedge funds are usually significantly higher than mutual funds, even though they may vary. You can expect to pay up to 2% of assets for the basic management, as well as a performance fee on top. It’s worth asking what the threshold is for this bonus to kick in.
  5. Step 5: Be Clear on Restrictions

    Check to see if there are restrictions on redemptions – or what the hedge fund’s policy is on this subject. This is important as some will lock up your money and potentially limit the times at which it can be accessed. They may even charge you a redemption fee.

What the Experts Say

Hedge funds have been coming back into focus, particularly for institutional investors, according to Freddie Parker, co-head of prime insights and analytics for GS Capital Introductions.

In a report for Goldman Sachs Asset Management, he highlighted several reasons why such investors were being drawn to these products. 

“One reason is the strength of recent performance, including a record level of outperformance in 2022 versus the 60/40 portfolio as hedge funds protected capital against what was a very turbulent and dislocated market environment,” he explained.

He also believes they’re well-placed for the future. 

“The expectation — both from allocators and based on historic data — is that hedge funds will benefit from a higher rate environment going forward,” he added. 

However, not everyone is so enthusiastic, particularly those whose focus is more on smaller, private investors who are looking to place their wealth.

Although they may want to know how to invest in hedge funds, the reality is that many will not get the opportunity, according to Ben Yearsley, director of Fairview Investing.

“The simple answer is hedge funds aren’t accessible for most investors as the minimum investment level is too high and they’re not accessible on platforms,” he told Techopedia. “In most scenarios, the question of whether to invest in hedge funds will never actually arise.”

Yearsley pointed out that there were a few investment trusts in the UK that could be considered hedge funds, but it wasn’t an area for investors with smaller sums.

“On the whole, many hedge funds flatter to disappoint with high fees and very lumpy returns,” he added. “Investors shouldn’t worry about missing out and not having hedge funds in their portfolio as they don’t need them.”

The Bottom Line: Should I Invest in Hedge Funds?

This will largely depend on your wealth. If you are a high-net-worth individual with a broad portfolio of assets, then it may be worth considering.

However, this will depend on your investment objectives, existing assets held, and overall attitude to risk. It’s an area where seeking financial advice is essential.

For the right person, hedge funds can be a potentially lucrative investment, although it’s an area that requires thorough research to understand an individual manager’s strategy.

Would-be investors need to carefully research the funds – and their managers – to ensure they are comfortable with their backgrounds and strategies in place.

Do your own research and always remember your investment decision depends on your attitude to risk, your expertise in the market, the spread of your portfolio, and how comfortable you feel about losing money.

The information in this guide does not constitute investment advice and is meant for informational purposes only.

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Rob Griffin
Financial Journalist

Rob is a seasoned journalist with over three decades of experience spanning across business and finance journalism. Before embarking on a freelance career in 2002, he contributed his expertise to the business desks of notable publications such as the The Guardian, Yorkshire Post, Sunday Business (now Business Post), and Sunday Express. Throughout his freelance journey, Rob has been a regular contributor to a wide range of national newspapers, consumer magazines, trade publications, and websites. His work has appeared in titles such as The Independent, Citywire, Daily Express, FT Adviser, and Sunday Telegraph, covering an array of subjects from market trends…