If you're a wealthy investor looking for alternative investments, hedge funds are a popular choice. A hedge fund pools and invests money from investors. Hedge funds generally aren't subject to the same regulations as other types of investment funds, and they use more complex investing strategies.
On the surface, a hedge fund seems like a smart way to get a better return on your portfolio. Since hedge funds are more exclusive and aimed at wealthy investors, one would expect that they also provide better performance than everyday investments. That's not actually the case, and you could almost assuredly do better with funds offered by any of the top stock brokers. One major drawback makes hedge funds an investment you're better off avoiding.
Hedge fund managers make more money than investors
The problem with hedge funds is the expensive fees involved. Hedge funds normally charge an asset management fee of 1% to 2% and a performance fee taking 20% of the profits, according to Investor.gov.
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Investing strategy resource Market Sentiment shared a useful example of how much this could cost you. Let's say when you're 25 years old, you give a hedge fund manager $100,000 to invest for you. The hedge fund takes a 1.5% management fee and a 20% performance fee. The manager is able to get you an annual return of 8%, which is realistic given the stock market average.
When you're ready to retire at 65, your portfolio will be worth $764,000. That probably sounds great -- until you learn that your hedge fund manager, who didn't put in any money, will have $1.24 million.
Because of fees, hedge fund managers don't just make money. They become richer than the clients who are actually investing the money. The amount of time it takes just depends on the fee structure. If a hedge fund charges a 2% asset management fee and a 20% performance fee, it will only take about 17 years on average before it beats the investor.
Why do investors use hedge funds?
Considering how much hedge funds cost, it raises the question of why anyone would choose this type of investment. Market Sentiment found two explanations.
The first is that hedge funds tend to be far less volatile than the stock market. For wealthy investors who are more concerned with preserving their wealth than maximizing returns, lower volatility is a significant advantage. This is the most compelling reason to invest in hedge funds. They often provide reasonable returns, even during market downturns.
Another explanation is exclusivity. Many investors mistakenly believe that more exclusive investments are better. The research doesn't support that notion. In all likelihood, you'd make much more long term by choosing investment funds with lower fees. But not every investor realizes this, and wealthy investors aren't immune to these kinds of mistakes.
Better ways to invest your money
For most investors, hedge funds aren't the best option. If your goal is growing your portfolio, then it doesn't make sense to pay the hefty fees that hedge fund managers charge. So, what should you do instead?
You can still put your money in investment funds. The key is to find funds with low fees. One of the most popular and effective options is investing in index funds. An index fund attempts to track the returns of a market index, such as the S&P 500, the index for 500 of the largest publicly traded companies on U.S. stock exchanges.
There are also target-date retirement funds. A target-date fund is an investment fund built around a retirement year. It's automatically rebalanced as time goes on, shifting the asset allocation based on how close you are to retirement.
There's always the option to build your own portfolio, as well. You could do this by picking individual stocks or putting together a combination of stocks and investment funds you like. This takes more time, but you get full control of your investments.
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FAQs
The reasons for individual investors to steer clear of hedge funds include: Not diversifying – hedge funds repackage investment risks you already have. Vanished skill-based return – better to obtain similar investment exposure in a low cost way. Not “absolute return” – will experience losses, often at the worst times.
Why do people not 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.
What is the problem with hedge funds? ›
Lack of transparency / Failure to comply with legal and regulatory agencies. Poor hiring and training practices. Being understaffed or overstaffed. Unethical and dishonest employees (embezzlement, fraud, misrepresentation of assets, unauthorized trades, conflicts of interest)
What is one disadvantage of a hedge fund? ›
Key Takeaways. Hedge funds employ complex investing strategies that can include the use of leverage, derivatives, or alternative asset classes in order to boost return. However, hedge funds also come with high fee structures and can be more opaque and risky than traditional investments.
Why are hedge funds considered a high risk form of investment? ›
Hedge funds are risky because they use borrowed money to be able to buy as many assets as possible. After all, more assets mean higher profit multiplication. Also, hedge funds invest in derivatives such as options and futures, which are generally risky forms of an asset.
Do rich people use hedge funds? ›
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.
Do hedge funds hurt the economy? ›
The influence of hedge funds on the global economy is undeniable. Their investment decisions can affect asset valuations, stock prices, and market stability. Furthermore, their ability to invest in a wide range of assets and markets can translate into a unique perspective on the world's economic health.
What is risky about a hedge fund? ›
The biggest and most obvious risk is the risk of investors losing some or all of their investment. A key quality of hedge fund investment risk is the virtual Wild West landscape of the hedge fund industry (though strides have been made since the 2008 financial crisis).
What is the biggest hedge fund scandal? ›
Madoff investment scandal
| Bernard L. Madoff |
|---|
| Criminal charge | Securities fraud, investment advisor trust fraud, mail fraud, wire fraud, money laundering, false statements, perjury, making false filings with the SEC, theft from an employee benefit plan |
| Penalty | 150 years in federal prison and $170 billion in restitution |
6 more rowsSome hedge funds manipulate stock prices on key reporting dates. The authors find that the returns of stocks with significant hedge fund ownership exhibit an increase of 0.30% on the last day of the quarter and a decrease of 0.25% the following day.
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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.
What is the average return of hedge funds? ›
All hedge funds tracked by BNP Paribas returned an average of 7.66% in 2023, differing from the survey results released on Feb. 12. In 2022, these hedge funds returned an average of 0.42%, said a BNP spokesperson. However, survey respondents said their hedge fund portfolios returned an average of 1.1% in 2022.
How many hedge fund billionaires are there? ›
In total, Forbes counts 47 hedge fund billionaires who have a combined net worth of $312 billion, up slightly from the same number in 2022 who were worth $310 billion.
Are hedge funds aggressive? ›
Overall, hedge funds are usually managed much more aggressively than their mutual fund counterparts. Many seek to take globally cyclical positions or to achieve returns in markets that are falling.
How do hedge fund managers make money? ›
Hedge funds take a management fee of between one and two per cent of the amount you invest. In addition, the hedge fund manager will receive a performance fee (usually around 20 per cent on any profit).
Why companies choose not to hedge? ›
If we hedge the market risk, we lose all these sources of profit. Our expected liability costs will increase because we will reduce the investment return available to meet those liabilities. Lower future profits will in turn put us at risk of a credit downgrade.
Why don't more people start hedge funds? ›
The downsides of starting a hedge fund are so massive that they outweigh the potential upside in ~95% of cases: It's extremely difficult to raise enough capital to scale and become institutional quality. Management and performance fees are falling.
Why can't regular people invest in hedge funds? ›
Restrictions and Limitations
For example, the U.S. Securities Act of 1933 bars non-accredited investors from certain private securities transactions, including hedge funds. Only qualified clients with $2.2 million in Managed assets can participate due to minimum hedge fund investments.
