The primary investors in hedge funds areinstitutional investors. These are professional investors who manage large amounts of money. They work forpension fundsfor corporations, government workers, and labor unions. They also managesovereign wealth fundsfor entire countries. They handle the cash assets of insurance companies, other corporations, and trusts. Institutional investors provide 65%of the capital invested in hedge funds.
Key Takeaways
- Hedge fund investors must meet minimum wealth requirements, and they must be willing to pay high management fees.
- Many who invest in hedge funds do so to diversify their portfolios—they don't necessarily seek higher returns than broad index funds offer, and they might invest in index funds in addition to hedge funds.
- Pension funds have experimented with investing in hedge funds, but some of them have reversed course after underwhelming returns.
Qualifications
Hedge fund investors are required to have at least $1 million in net worth or must have earned income above $200,000 in each of the two preceding years. They also must reasonably expect to earn that amount for the current year. They need this cushion to weather significant downturns in their portfolio in their quest for higher returns. They also must be able to keep their money tied up for the three or more months, as may be required by hedge funds. Three years is a typical time frame to evaluate the success of a hedge fund’s performance.
Investors often must be willing to pay 2%of the assets they invest and 20%of any profits. This high fee is worth it to them tooutperform the market.Some are still tryingto recover losses incurred during thecrash of 2008.
These are sophisticated investors. They understand how leveraging works through options, futures contracts, and the other derivatives that hedge funds use to boost returns. They are willing to endure the risk of the investment going south.
They also need to be good judges of character. Most hedge funds don't reveal what they do to get their returns. That lack of transparency means that they can actually be Ponzi schemes, such as the one run byBernie Madoff.
Why They Invest in Hedge Funds
Those big investors put less than 20%of their assets into hedge funds. More conservative investors—like insurance companies, pension funds, and sovereign wealth funds—allocate less than 10% of their total investments.
Hedge fund investorsare looking for an investment that is uncorrelated with the rest of their investments. If the stock market loses value, the hedge fund investment might rise.In other words, investors use hedge funds to increase their diversification. They know that a diversified portfolio will increase total returns over time byreducing overallvolatility.
Note
Investors don't compare the performance of their hedge fund investments to standard indexes like the , the NASDAQ, or the Dow Jones.
Surprisingly, most hedge fund investors aren't looking for higher-than-average returns. Only 6% think they could achieve 10% or more annual returns. They just aren't willing to endure the risk that higher returns entail. Instead, 67%are looking for annual returns of between 4% and 6%. That's probably because they have to report to boards that might fire them if they sustain losses.
Family trusts use hedge funds to gain access to the best minds in the investment world. Why do hedge funds attract the smartest investors? Because they pay the most. But many investors may limit or even avoid hedge funds due to the high fees.
Investor Trends
Pension funds recentlystarted investing in hedge funds to boost returns. Theyrealized that they might not have the capital needed to cover the mass of retiring seniors and are trying to outperform the market to cover those obligations. Unfortunately, the risky nature of hedge funds and their lack of regulation means that these pension funds are less likely to cover their commitments.
There is some indication that hedge funds are becoming less popular. In 2014, they returned only 3.3% on average, much lower than the S&P 500. Almost as many hedge funds are liquidated each year as are created. Many savvy investors realize that they are taking all the risk, while the hedge funds aren't producing rewards to offset or justify that risk.
The California Public Employees' Retirement Systemannounced that it would withdraw all of its $4 billion in hedge funds in 2014. It had only received a 7.1% return in the past year. That sounded good until it was compared to the 12.5% return of a comparable investment, the Vanguard Balanced Index Fund, with an asset allocation of 60%stocks and 40% bonds.
It appears that institutional investors are continuing to view hedge funds as a source of alpha and diversification.
FAQs
Therefore, an investor in a hedge fund is commonly regarded as an accredited investor. This means that they meet a required minimum level of income or assets. Typical investors are institutional investors, such as pension funds and insurance companies, and wealthy individuals.
Who typically invests in hedge funds? ›
You generally must be an accredited investor, which means having a minimum level of income or assets, to invest in hedge funds. Typical investors include institutional investors, such as pension funds and insurance companies, and wealthy individuals.
Why do some people invest in hedge funds? ›
Hedge funds originated as a vehicle to help diversify investment portfolios, manage risk and produce reliable returns over time. While hedge funds' investor base has evolved though the years – from individuals to institutions such as pensions, universities and foundations – their core goals have remained the same.
Why do people invest in hedge funds if they don't beat the market? ›
There are two basic reasons for investing in a hedge fund: to seek higher net returns (net of management and performance fees) and/or to seek diversification.
Who can invest in a hedge fund quizlet? ›
Traditional hedge funds are open to wealthy investors; generally those who have at least $1 to $5 million in liquid net worth.
Who is a qualified investor for a hedge fund? ›
3 In exchange, the Securities and Exchange Commission (SEC) requires a majority of hedge fund investors to be accredited, which means possessing a net worth of more than $1 million and a sophisticated understanding of personal finance, investing, and trading.
Where do hedge funds find investors? ›
Hedge funds are often marketed by the fund manager who networks with friends or business acquaintances or through third-party placement agents, who are individuals or firms that act as intermediaries for asset managers such as pension fund managers or investment managers for a foundation or endowment.
Why are hedge fund owners so rich? ›
Hedge funds make money by charging a management fee and a percentage of profits. The typical fee structure is 2 and 20, meaning a 2% fee on assets under management and 20% of profits, sometimes above a high water mark. For example, let's say a hedge fund manages $1 billion in assets. It will earn $20 million in fees.
Do hedge funds borrow from banks? ›
Investing in securities using credit lines follows a similar philosophy to trading on margin, only instead of borrowing from a broker, the hedge fund borrows from a third-party lender. Either way, it is using someone else's money to leverage an investment with the hope of amplifying gains.
Do hedge funds actually beat the market? ›
There are over 3,400 hedge funds in the U.S. It's a big business. But almost none of them consistently outperform the broader stock market. Investing in the S&P 500 is the most straightforward path to stock market riches.
“Hedge funds can pose a risk to financial stability when they use excessive leverage, adopt highly speculative strategies, or have a strong correlation with other market participants.
Why people don't like hedge funds? ›
Hedge funds have costly fees that normally include an asset management fee of 1% to 2% and a 20% performance fee on profits. Hedge fund managers eventually end up with more money than their clients because of those fees, so most investors are better off with other investment products.
Why are hedge funds disliked? ›
Hedge funds can be considered risky investments; the expected returns of some hedge fund strategies are less volatile than those of retail funds with high exposure to stock markets because of the use of hedging techniques.
Are hedge funds available to everyone? ›
Regulations: In most countries, like the US, investing in hedge funds requires being an accredited investor. This means meeting either an income ($200,000 annual income for individuals, $300,000 for couples) or net worth ($1 million) threshold.
Who can buy into a hedge fund? ›
Because of the higher levels of risk associated with hedge funds, the U.S. Securities and Exchange Commission (SEC) places regulations on who can invest in them. To invest in hedge funds as an individual, you must be an institutional investor, like a pension fund, or an accredited investor.
Who do hedge funds borrow stocks from? ›
In this case, a securities company - typically a brokerage firm - will lend some securities or some cash to the hedge fund and will hold other assets in the fund's account as collateral for the loan. The collateral in this case is termed margin and can be made up of cash, securities or other financial assets. lender.
What personality type is a hedge fund? ›
Hedge fund portfolio managers and analysts
“I'm right and I'm all over the details”… D & C personalities dominate hedge funds. Is are wonderful idea generators, but often get shaken out over the life of an investment as the market moves. S types tend to get runover in the hedge fund world.
Who do hedge funds recruit? ›
Hedge funds want people who are technically proficient and who demonstrate strong “fit” and passion for the markets because firms and teams are far smaller than in investment banking.
Do people invest in hedge funds? ›
Those investing in hedge funds are typically wealthy individuals who can invest in the minimum without becoming too concentrated in one fund. There are also third-party feeder fund vehicles that provide access to hedge funds at lower minimums.
