In the world of investments, there are ways to make and lose money that are reserved for Accredited Investors (rich people). Hedge funds are one of these instruments.
A hedge fund is a pool of many investors’ money managed by a team of people who believe they are smarter than the market and certainly smarter than you. Where as most mutual funds invest in companies they believe will grow over time, hedge funds can invest in ways that make money on a company even if it goes down in value. Or up, or sideways or diagonal. Don’t ask me how. It has to do with derivatives and short selling and stuff I forgot immediately after passing the Series 7 exam 20 years ago.
When I think of hedge funds, I think of three things:
- High return (sometimes) and high risk. Some hedge funds swing for the fences, trying to beat the US Stock market making big bets on sometimes illiquid assets. According to statistics from Credit Suisse Hedge Fund Index, from January 1994 to October 2018—through both bull and bear markets the S&P 500 index outperformed every major hedge fund strategy by about 2.25% in annualized return. *
- High expenses: Many hedge funds charge performance-based fees. These are often 20% of profits in good years, 10% of your investment in bad years, and a 2% annual administration fee. Compare this to the actively managed Fidelity Contrafund (as just one example of a US large company stock fund) with an expense ratio of .85% or the passively Vanguard 500 Index fund at .04% to feel the full extent of the sticker shock.
- Illiquid: Money you put in a hedge fund will be there for at least a few months before you are allowed to redeem it. Over half of hedge funds require a 3 year time commitment.
So, should you feel sad if you are left out of the hedge fund club? It’s probably like being super-popular in high school. It looks great from the outside but maybe isn’t worth the headlines when you are living it. See a related article below about pensions suing hedge fund managers for onerous fees and taking too much risk.