New Investors Buying Into a Hedge Fund

You may have seen news headlines sharing stories of massive windfall profits and terrible losses with hedge funds. With so much money being moved around and so many people using the funds to grow their wealth, you may have wondered how to get in on a piece of the action. New investors are able to buy into a hedge fund, but it is not as simple as putting money into a stock or ETF.

Learn how hedge funds work, whether you can invest in one, and if you should invest.

What Is a Hedge Fund?

A hedge fund works similarly to a mutual fund but does not have the same restrictions on how managers can invest fund assets. Unlike a mutual fund, investors cannot easily buy into or sell positions in a hedge fund. In most cases, hedge funds are open-ended and allow investments or withdrawals on a monthly or quarterly basis.

Hedge funds can invest in nearly any asset class. This includes risky short-sales, real estate, equities, buying and selling entire firms, or using a specific investment ethic or rule. Many members of the Billionaire Club made their money as hedge fund managers. Members of this elite club include George Soros, David Einhorn, Bill Ackman, John Paulson, and a handful of other well-known wealthy people.

Unlike public mutual funds, hedge funds only allow wealthy investors who can stomach high risks and high fees. Typical hedge fund fees include a 2% management fee. They also include a performance fee, which can be around 20%, paid to the manager for investment gains over the prior year. With fees like that, it's no wonder there are so many wealthy people in the hedge fund arena.

Rules to Protect Inexperienced Investors

No specific rules forbid new investors from putting money into a hedge fund. The big hurdle new investors have to overcome is to qualify under the Securities and Exchange Commission (SEC) rules as an accredited investor.

To qualify as an accredited investor, you must have an income of at least $200,000 in each of the past two years. This bumps up to $300,000 if you include a spouse's income. You must expect the same for the current year or have a net worth of over $1 million, excluding the value of a primary residence. If you do not meet these rules, you do not qualify to invest in hedge funds no matter how much experience you have with investments.

Accredited investor rules are not limited to hedge funds. They apply to most any private placement investments that are not open to the public on a major stock market or exchange. To buy regular stocks, bonds, and other investments, you need the cash to cover the investment. To invest in private placements, you must meet the accredited investor threshold.

Just Because You Can, Doesn’t Mean You Should

If you qualify as an accredited investor and you find a hedge fund that will take your money, you have nothing holding you back from giving your money to a fund manager to do what he will with it. But as Dr. Ian Malcolm said in "Jurassic Park," "Your scientists were so preoccupied with whether or not they could, they didn't stop to think if they should." The same holds for people looking at hedge funds.

Unlike passive index fund investing, hedge funds come with plenty of risks. There is a good chance you could double your money or more. Still, you can just as easily lose every dollar. Unlike a business failure, which often leads to turning assets into cash and paying back investors to some extent, hedge fund failures are often all or nothing. They can lead to huge losses. New investors are far better off with a low-risk investment that will offer more stable returns. Even if you can afford to invest in hedge funds, they may not be the right fit for your needs.

Decide If You Can Afford the Risk

In the world of investing, higher risk often means higher returns. Nowhere is this more true than the world of hedge funds. With high-risk plans, hedge funds can earn your money back many times over a short period.

Hedge funds can also suffer huge losses and failures. A failure can cost people every dollar they have on the line. One reason that so many rich people invest in hedge funds is that they can afford to take on the risk, but that may not be true for you. If you are a new investor that meets accredited investor rules, you can invest in hedge funds. Still, you may decide it's a risk you don't want to take.