A hedge fund is an investment vehicle that allows investors to pool their money with a fund manager who oversees the investment of that money. Hedge funds are not as readily available as other investment tools, such as mutual funds, and they offer participation to investors in private offerings. Hedge funds vary in their investment strategies and offer advantages and disadvantages for investors to consider.
The fees that investors pay are the most often cited disadvantage to hedge funds. Most hedge funds have the fee structure that is known widely as "2 and 20." In this structure, investors pay a 2-percent management fee for operations of the fund and a 20-percent performance fee to the fund manager for any profit made that year. These fees are much higher than many other investment vehicles; mutual funds often have management fees below 2 percent without a performance fee. The high fees mean that growth in an investment in a hedge fund needs to be robust and above the performance of the status quo in order to outperform an investment in a low-fee fund that is an average performer.
Risk and Returns
Hedge funds are widely regarded as taking larger risks in their investment strategies in pursuit of larger returns, according to the SEC. This aspect of hedge funds showcases both a strength and weakness. The greater risks can lead to high returns and "boom" years for investors where their investments grow at much stronger rates than the stock market as a whole, but they can also lead to "bust" years where returns fall below the market. For instance, 2011 was a disappointing year for the hedge fund industry with the average fund falling 4.8 percent, while more conservative mutual funds performed much better, according to Reuters. The top hedge funds, though, can perform considerably better than the stock market.
Hedge funds also differ from mutual funds on a regulatory level. Mutual funds must register with the SEC and operate under its regulatory control. Hedge funds, meanwhile, do not have to register with the SEC and are not subject to the same level of regulation and oversight. That can be a benefit or a drawback, depending on the investor's perspective. Some investors might prefer the hedge fund's flexibility for innovative investment strategies, while others might prefer the transparency and oversight that regulation offers. Many major hedge funds do register with the SEC, and the SEC can investigate hedge funds for certain suspected bad behaviors, such as fraud.
Hedge funds tend to have a much higher threshold for investment than other comparable investments. For a well-heeled investor, this can be an advantage because the best-performing funds often limit participation to investors who only can make investments that reach well into the millions of dollars. It also amounts to a big disadvantage to hedge funds for the average investor because they simply are not accessible to the bulk of investors. For instance, some hedge funds require that individuals hold at least $5 million in investments. In exchange for the exclusivity, hedge fund investors often have limited windows during the year to withdraw their funds.