A hedge fund is type of private investment fund. When you buy shares in a hedge fund, you gain an ownership stake in a pool securities and other types of assets. Due to minimum investment requirements, hedge funds are out of reach for many ordinary investors. However, despite these restrictions, redemption rules mean it is easier to get cash into a hedge fund than out of one.
Mutual funds and other registered investment companies are subject to state and federal securities laws. Among other things, these laws require fund companies to provide investors with detailed information about investment strategies and fund assets. By comparison, hedge funds are opaque, as investors receive only limited disclosures. Hedge fund managers often have free rein to change the fund's strategy and holdings without consulting shareholders. Alongside stocks and bonds, hedge fund portfolios often contain illiquid securities such as real estate contracts, mineral exploration rights and commercial contracts. Many funds also invest heavily in speculative investments such as credit default swaps, which are basically unregistered insurance-like agreements between investment banks.
When you redeem shares in a hedge fund, traders must sell some of the fund's underlying assets. You can easily sell stocks and bonds but contracts and real estate are harder to unload. A hedge fund could run into financial problems if a large number of investors attempted to redeem their shares at the same time. Consequently, hedge fund investments are normally subject to redemption restrictions. During so-called "lock-up" periods, you cannot cash in your shares. Some funds impose a lock-up period during your first year as a shareholder. Other funds have an ongoing lock-up and occasional windows of opportunity for redemption.
Some hedge fund managers attempt to generate huge levels of return by purchasing highly speculative investments that may yield results years down the line. For example, some funds acquire delinquent national debts in the hope that the government in question will eventually pay up. In the short term, such debt may have little or no tangible value. The fund could miss out on potential future earnings if the debt is sold in order to raise cash for share redemptions. To mitigate against such losses, funds often impose hefty surrender penalties. You can avoid the fees if you keep your money in the fund for a set number of years.
During a market downturn, stocks and bonds drop in value. Speculative investments lose value even more rapidly because panicked investors have a reduced appetite for risk. Due to the nature of its portfolio, a hedge fund may struggle to sell its assets during a downturn. Consequently, many funds reserve the right to suspend shareholder redemptions during tough economic times. This means investors have little or no access to cash precisely when they may most need it.