Do the benefits outweigh the risks of this strange fund?
You’ve probably heard hedge funds mentioned over the years, and you’ve probably heard even more about them mentioned recently alongside the GameStop headlines where retail traders caused a big hedge fund to lose over half its value this past January of 2021. You’ve probably heard most about them in the headlines when something goes horribly wrong. Hedge funds seem to be associated with wealthy people as well as making strange investments, like in the GameStop example when Melvin Capital Management, the hedge fund bet against the video game retailer – and then GameStop skyrocketed in value.
Think of Hedge Funds this Way
If you buy $10,000 worth of a stock, it can go up or down, but you can’t lose more than the $10,000 you put in. When you bet against a company you effectively own negative shares of stock, and if it goes up 100 times in value, your $10,000 bet against the stock would put you on the hook for a full million dollars, and therefore at risk of losing far more than what you “invested.” This is just one of the ways things can get strange.
Still, I find hedge funds are often misunderstood. Hedge funds are essentially just a tool for being able to invest. Like all tools, they can be used for good or questionable purposes, but are not inherently one or the other. The reason why they occasionally create headlines is that they are extremely flexible about what they can invest in, and how they can invest. Much more than, say, a mutual fund or Exchange Traded Fund (ETF). There is simply not much restriction on what they can invest in – or against – which means sometimes bad decisions are going to happen, and they can really sting when you’re investing in odd things that go the wrong way.
So, what can you invest in anyway? It varies hugely based on the manager and their team’s preferences, but in concept: Cryptocurrency and NFT’s? Yes, that’s possible. Private Equity? Sure. Futures and Options? Absolutely. You can see that many of these are not traditional investment types. The risk and reward potential of brand-new technologies, emerging and startup companies, and traded derivatives is generally much greater than regular investments.
Why Do Things Go Wrong So Fast?
The answer lies in that hedge funds not only have access to more aggressive investments, but they can also borrow large amounts of money to invest, which turns many of these hedge funds into highly leveraged (even more risky and volatile) investments. This magnifies performance, but in either direction, which adds an incentive to make bigger and stranger investments in hopes of hitting that home run. And when that home run happens, almost everyone is quite happy. When investors can invest in abnormal investments (private equity, options, futures, cryptocurrency and more) as well as being able to leverage them, these can be one of the riskiest investments out there. Because of this high level of risk, regulators don’t allow most people to get into hedge funds for fear that they would risk their retirement savings, for example, without realizing the magnitude of the risk. Generally, you need to be able to lose the money you put in and still be financially okay, much harder to do so if you lose all your savings.
How is This Enforced?
Qualifying to buy into hedge funds often has two different thresholds of wealth required: (note these have been generalized for length and entities/trusts rules may differ)
- Income: Greater than $200,000 per year for the last two years of income (if filing single) or 300,000 in joint income (if filing joint)
- Net Worth: Greater than a $1 million dollar net worth (excluding primary residence and debts) either individually or jointly
- People with Ownership of $5 million or more in investments
Herein lies part of the public’s seemingly negative attitude to hedge funds. Only wealthy people can buy them, because regulations do not let people with lower income or wealth to buy in. Perhaps this protects people from risky investments, and perhaps it’s giving only wealthy people access to better opportunities.
The Costs of Investing in Hedge Funds
Another important aspect of hedge funds is the cost to invest. Like mutual funds and ETFs, hedge funds generally charge investors a fixed percentage management fee though hedge funds are often higher in cost. As an additional layer of cost, it is very common for hedge funds to have what is referred to as a performance fee on top of the management fee. This means that when profit is earned, it is shared between the hedge fund manager and the investor. In concept, this can be appealing to investors because the better the manager does, the more money everyone makes. When times are good, this can be just fine. But if times are bad, the manager would make less since the investor isn’t making money. Sounds reasonable, right? The factor that’s often missed is that this arrangement encourages risk-taking. The manager can make much more money if the investments do well, which often leads them to make out sized bets in hopes of a big win. Sometimes, this great outcome happens. But other times this can lead to the possibility of big losses occurring very quickly. There is also a meaningful benefit to this type of performance fee structure: managers that are really good can typically make far more money managing hedge funds than pretty much any other job. This has the effect of attracting the very best talent to this space. Good managers can be worth the expense if they are truly clever and proven to be successful through time. However, it’s simply impossible to know who might do best next year.
All in all, most hedge funds will continue to operate without ever making headlines, but it is also likely that you will continue to hear stories about a few strange investments, especially those that make large bets that end up going in the wrong direction.