Hedge Funds: Risky Investment or Portfolio Diversifier?

Mar 8, 2021

As an investor, do you embrace or avoid hedge funds? The recent activities of the Reddit traders and GameStop stock, no doubt, caused many investors to sit up and take notice. Hedge funds tend to have a negative reputation. Are they bad or just misunderstood?

Whether you follow the stock market or not, you undoubtedly have heard the recent news about the army of Reddit traders responsible for the surging stock price of GameStop, AMC, and a few others. This group of online traders targeted GameStop because it was one of the most heavily shorted stocks in the market, making it a prime candidate for a short squeeze that would drive up the price.

Who was shorting GameStop? Hedge funds. As the price of GameStop’s stock surged, some of these hedge funds lost a lot of money as they were forced to buy the stock at higher prices to cover their short positions.

What exactly are hedge funds and do they have a place in your overall portfolio?

Hedge Funds and Their Benefits

In general, hedge funds are actively managed investment vehicles with combined assets raised from outside investors. The funds will have a portfolio manager(s) that makes the daily investment decisions. This might sound a lot like an actively managed mutual fund or ETF on the surface. However, hedge funds traditionally have more flexibility in investments, opening the door to some niche or unique investment strategies.

Unlike typical mutual funds or ETFs that may only buy (or be ‘long’) a stock, hedge funds can also sell (or ‘short’) stocks, meaning that the fund makes money if a stock were to subsequently decline in value. It is also possible for hedge funds to utilize more aggressive strategies, such as derivatives and leverage, to boost performance. They are often looking for short-term, high-risk investment opportunities. However, hedge funds can offer diversification to your portfolio because of their often-unique strategies and alternative investments that would be tough to find elsewhere.

Can anyone invest in a hedge fund?

Because of the increased risk that hedge funds have the ability to take on, there are requirements by the U.S. Securities and Exchange Commission (SEC) on who can invest in them. If you are an individual, then you must be an accredited investor. This means a person must have an annual income exceeding $200,000 (or $300,000, if married) for the last two years and expect to earn the same amount, or more, in the current year. A person can also be considered an accredited investor if they have a net worth of over $1 million (single or married), excluding their primary residence value. It is important to note that there are other ways to be classified as an accredited investor, but these are the most common.

Hedge funds usually have high investment minimums. These can traditionally range from $100,000 into the millions, which further limits the universe of available investors. Because of these requirements, hedge funds are often considered to be investments for large institutions and wealthy individuals.

Potential pitfalls of Hedge Funds

One of the more evident pitfalls of hedge funds is their investment management fees. They are often known for the notorious “2 and 20” fee structure. This means that the fund receives a 2% management fee on assets under management and 20% of profits each year.

For example, let’s say a hedge fund manages $1 billion in assets and has a 10% return in one year. They would earn $20 million in investment management fees and another $20 million in performance fees. One feature many hedge funds have that mitigates the performance fee pitfall is called a High-Water Mark, which prevents the hedge fund from collecting the performance fee after a period of negative performance. Instead, the performance fee is only assessed on earnings above the investor’s highest investment in the fund.

Just as a hedge fund’s aggressive and unique strategies can be a positive, they can also be a pitfall. A recent example of this is the hedge fund Melvin Capital and its sizeable short position in GameStop. According to The Wall Street Journal, Melvin Capital lost about 53% in January, mainly due to the rally in GameStop shares.

Illiquidity can be another downside for hedge funds. They may only allow you to redeem your investment after a specific amount of time or only during certain times of the year - for example, once per quarter.

Summary

Hedge funds can be an appropriate investment option for some investors to add diversification to their overall portfolio. However, it is imperative that you do your research before investing in a hedge fund. You will want to be familiar with the investment strategy and understand the fee structure as well as their liquidation rules. It would help if you also have the stomach for potential wild return swings. Consider speaking with your financial advisor before investing in a hedge fund.

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Please remember that past performance may not be indicative of future results. Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.

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