Hedge Fund FAQs
- What is a hedge fund?
- What does it mean to "hedge"?
- Are all Hedge Funds hedged?
- Are all hedge funds highly aggressive?
- What Types of Strategies do hedge funds employ?
- Who typically invests in hedge funds?
- Are there restrictions as to who can invest in hedge funds?
- What is an accredited investor?
- What is a qualified purchaser?
- How many investors may invest in a hedge fund?
- What is the minimum investment in a hedge fund?
- What are the tax implications of becoming a limited partner/investor in a hedge fund?
- What kind of fees do most hedge funds charge?
- Can an qualified client place IRA or ERISA assets in a hedge fund?
- Are hedge fund returns reported before or after fees?
- What are 'offshore' hedge funds?
- Who can invest in offshore hedge funds?
- Do I still pay fees even if the fund loses money?
- What are hurdle rates?
- What are lock-up periods?
Hedge funds are defined by their structure rather than any specific investment method. These pooled investment vehicles are commonly set up as limited partnerships in which the manager acts as the general partner while the investors act as the limited partners. Oddly, the term ‘hedge fund’ is a misnomer. Not all hedge funds are hedged. Hedge funds invest in any number of strategies regardless of the common term that attempts to corral them. These strategies include investing in asset classes such as stocks, bonds, commodities, currencies, and return enhancing tools such as leverage, derivatives, and arbitrage. Some funds, however, are simply 100% long equity securities.
"Hedging" roughly means managing risk. Typically, a money manager employs a particular hedging technique in order to mitigate a particular type of risk. For instance, market risk - the risk of a decline in the overall market - can be hedged against by selling a broad collection of securities short in equal proportion to one's long exposure. The same end could also be accomplished by buying put options on an index like the S&P500. Other types of risk often hedged against include interest rate, inflation, and large weightings in a sector, region, single company, or currency. Tools and techniques of hedging include: raising cash, selling short, buying or selling options, futures, commodity and/or currency futures, etc.
No. Not all hedge funds are hedged. Many are simply long stocks, and may even use leverage. One must ascertain on a case by case basis, therefore, whether a fund hedges, how, and how much. This is absolutely crucial to understanding a fund's performance. Without this information, one cannot gauge how much risk produced its return.
Are all hedge funds highly aggressive?
No. This is the greatest misconception regarding hedge funds. Although some funds are aggressive, many other funds emphasize consistency of returns or protection of investors' capital. Recall that hedge funds cover a wide variety of investment strategies including fixed annuities and other conservative strategies.
What types of strategies do hedge funds employ?
Every investment strategy in existence is probably used by at least one hedge fund, from the basic buy-and-hold to more esoteric strategies such as currency arbitrage or CMO derivatives. The majority of hedge funds are fairly straightforward, long-bias equity funds. Of these, most fall into the same categories one applies to mutual funds: micro- to large-cap, value, growth, momentum, etc.
Who typically invests in hedge funds?
Qualified clients, institutions, endowments, fund of funds, family offices and pensions invest in hedge funds.
Are there restrictions as to who can invest in hedge funds?
Yes. Hedge Funds are restricted from accepting partners who are not " qualified clients." Presently, if you can meet one of the following criteria, you are an qualified client:
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You have an individual net worth, or you and your spouse have a combined net worth, in excess of $1.5 million.
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You had individual income, excluding any income attributable to your spouse, of more than $200,000 in the previous two years, and you reasonably expect to do the same this calendar year.
- You and your spouse had joint income of more than $300,000 in the previous two years and reasonably expect to do the same in this calendar year. Institutions and pension accounts are subject to more complex criteria, and should consult an accountant.
What is an accredited investor?
Presently, if you can meet one of the following criteria, you are an accredited investor:
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You have an individual net worth, or you and your spouse have a combined net worth, in excess of $1 million.
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You had individual income, excluding any income attributable to your spouse, of more than $200,000 in the previous two years, and you reasonably expect to do the same this calendar year.
- You and your spouse had joint income of more than $300,000 in the previous two years and reasonably expect to do the same in this calendar year. Institutions and pension accounts are subject to more complex criteria, and should consult an accountant.
What is a qualified purchaser?
An investor is a "qualified purchaser" (sometimes referred to as a "super accredited" investor) if the investor is a(n):
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individual who own $5 million or more in investments, including investments held jointly with a spouse.
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family-held business that owns $5 million or more in investments.
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business that has discretion over $25 million or more in investments
- trust sponsored by qualified purchasers
How many investors may invest in a hedge fund?
100 "accredited investors" or an unlimited number of "qualified purchasers" may invest in a single Hedge Fund. Typically, the hedge funds with which we associate have considerably fewer than 100 investors.
What is the minimum investment in a hedge fund?
The minimum investment varies from fund to fund, and is set by the General Partner (GP). It is common for new hedge funds to open up with minimum investments of $250,000 or $500,000. Established funds can have much higher minimums; $10,000,000 is not unheard of. In most cases, the GP can waive the minimum at his sole discretion. This is often done to accommodate investors who intend to make an investment equal to or greater than the stated minimum over time, but do not want to start that high.
What are the tax implications of becoming a limited partner/investor in a hedge fund?
At the end of each year a Hedge Fund as a limited partnership reports in a K-1 form gains or losses for the trades the fund made that year. These gains or loses are treated as are any other capital gain. It is important to note that the return of a fund is separate from the taxable gains and losses the fund has made over the course of the year. For example, it is possible that a fund may have "realized" a loss for tax purposes but have reported positive performance (capital appreciation) through unrealized gains. The opposite is also possible.
What kind of fees do most hedge funds charge?
The majority of U.S. hedge funds charge the standard "one-and-twenty": 1% of assets and 20% of profits, annually (more precisely, the 1% fee is usually charged in .25% increments quarterly, in advance while the 20% is usually calculated annually). These are known as the "management fee" and "performance fee" respectively. There are many variations and embellishments, some fairly common. For instance, most funds observe a "high-water mark". This simply means that if, in a given performance fee period, a fund loses part of its investor's money; the investors will not be charged in later periods until the losses have been recovered. Another common variation is the "preferred return." This means that a fund will not collect a performance fee until a certain return is achieved. This is often fixed, say at 10%, or ‘floats’ along with some risk-free interest rate indicator.
Can a qualified client place IRA or ERISA assets in a hedge fund?
Usually qualified clients may invest IRA or ERISA assets in hedge funds; however, funds are limited in the amount of these assets they may accept. IRA investments in hedge funds makes a great deal of sense because of the deferral of taxes on capital gains. The details of this deferral should be discussed with an accountant before making an investment.
Are hedge fund returns reported before or after fees?
Most funds report their returns from previous years "net of all fees." This means net of management fees and net of incentive/performance fees. However, don't assume this; look carefully and if you are not sure, ask. Some funds report gross returns or returns net of management fees but gross of incentive /performance fees. Still others will report audited net of all fees returns with estimated/pre-audited net of all fees performance for the current year's performance. But regardless of which method is used, almost all funds state that their pre-audit figures are subject to adjustment by the partnership's auditor after the end of the year. These adjustments are almost always minor. If the adjustments are large, you should look for an awfully good explanation.
What are 'offshore' hedge funds?
Offshore hedge funds are designed to allow non-U.S. citizens to invest in U.S. securities.
Who can invest in offshore hedge funds?
Primarily, non-U.S. Citizens or non-taxed entities can invest in offshore hedge funds.
Do I still pay fees even if the fund loses money?
This is dependent on the fund’s policy. Some funds have a "high water mark." This means that if you lose more than your initial investment, the fund will not charge you their incentive fee until you at regain the initial investment back. You WILL however, pay a management fee on your assets that remain in the fund. This management fee is typically 1-2%, but can go as high as the manager deems appropriate.
The minimum investment return a fund must exceed before a performance allocation/incentive fee can be taken.
Lock up periods signify the time period that you must hold your assets in the fund before they can be removed.
