I’ve been doing some reading about the hedge fund industry lately. You don’t hear them talked about much in the financial media because up until recently the SEC had laws prohibiting them from marketing themselves or advertising in anyway. These are funds generally reserved for the wealthy (or the “sophisticated investor”) who already has at least $1,000,000 to invest.
The purpose of a hedge fund is just what it sounds like – it’s goal is to ‘hedge’ against all possibilities of loss, while providing a market-beating return to investors. These funds are comprised of groups of analysts and investment professionals who work around the clock analyzing every possible angle of every possible investment opportunity that they come across. If there’s a good chance of a successful trade without a lot of risk, they’re going to go for it. This is not a ‘let’s buy a basket of blue chip stocks for our clients and sit on our hands’ kind of industry. These guys are doing arbitration, longs and shorts, looking at mergers, spinoffs, macro-economic trends, and other special situations.
So I’ve been wondering – if I had the money, would it be worth it to invest in a hedge fund? I’ve reached two different preliminary conclusions: Yes, and No. Let me explain.
First, I’ll explain the No position. Let’s now bring up the fact that hedge funds typically have a 2/20 fee structure. This means they take 2% of assets off the top, and then 20% of profits before you get your cut as the investor. So, if we know that the general market performs at about 10% per year over long periods of time, a hedge fund would at a bare minimum have to return over 12% in order to make it worth your while as an investor.
Now, hedge funds do do this – some make rates of return far in excess of 12%, 14%, and beyond. But, how can I know for sure that that’s going to happen? On the one hand, there are very sophisticated financial professionals who are working day and night to protect and grow my money, but on the other, they’re taking such a huge cut of the assets that I might just want to invest the money myself in a solid portfolio that is well-diversified and structured conservatively.
On the Yes side, I can see why say, a small business owner who has made it big and sold their business for a cool $5,000,000, would want to entrust a large portion of their wealth to a hedge fund. Maybe they aren’t that interested in managing their money and want someone to grow it reliably with a high level of skill – something they’re not sure that the typical wealth management firm would do as well.
There are incentives at work – if someone is willing to entrust their millions with you, you’d better produce some results. Capital attracts capital. For the DIY investor though, once you’ve made it to a few million, you’re likely to stick to your guns and keep investing the way you always have in the first place. For those who suddenly come into a lot of money, either through inheritance, business liquidation, or some other event, a hedge fund might make sense under the right circumstances.