Beyond the movies: Unveiling the mystery of hedge funds

Most of us have our own opinions of Wall Street and the financial services industry. Movies like “Wolf of Wall Street” and “Wall Street: Money Never Sleeps” definitely did not help the reputation of industry. I believe there is a particular reputation that hedge funds have earned over the years that have led these investments to have an air of exclusivity, greed and mystery. I’m here to lift the veil back a little and help you understand what this type of investment is really all about.

What is a hedge fund?
A hedge fund is simply pooled money from investors that can be invested in a wide variety of investments with the goal of having a positive return. In its most basic definition, it’s not as scary anymore, is it?

Hedge fund vs. mutual fund
You might be thinking “Isn’t that the same thing as a mutual fund?” A mutual fund is a company that also pools money from investors to invest in securities such as stocks and bonds. But the difference is that hedge funds are not regulated as heavily as mutual funds, and they can invest in much riskier investments. There are also a few other characteristics that differentiate hedge funds from mutual funds:

• Accredited investor: In general, you have to be an accredited investor to invest in hedge funds. An accredited investor has a minimum level of income or assets to qualify. This is the main contributing factor that has led to the exclusiveness of hedge funds.
• Valuation: Mutual funds have a net asset value (NAV) that is computed once per day. NAV is the total value of the securities in the portfolio minus liabilities and divided by the number of shares outstanding. Often, investments in a hedge fund are difficult to value, and therefore, it makes it hard to know what the value of your investment truly is.
• Redemption: With a mutual fund, as long as it is open-ended, you can redeem your shares any day or time that you would like. With a hedge fund, there is a lock-up period. You cannot redeem your shares within that period, which is often at least one year long. Then, after that period expires, you have to give a 30-, 60- or 90-day notice that you would like to redeem your shares.
• Initial buy-in: With a mutual fund, you can buy in with often as little as $25 or $50. With a hedge fund, the buy-in is often at least $500,000 or $1 million. But it is not uncommon to see initial investment minimums of $5 million or even $10 million.
• Fees: In 2016, average expense ratios ranged from 0.5 to 0.75 percent, depending on the type of mutual fund. For a hedge fund, managers are compensated generally on a “2 and 20” schedule. This means you pay 2 percent for the management of the fund, plus the manager keeps 20 percent of the fund’s profits. However, each manager has a unique compensation package, so this can vary.

Why invest in hedge funds?
After all of this, you might be questioning why anyone would want to invest in a hedge fund. The two main appeals are performance and diversification.

Adding a hedge fund does provide another way to diversify a client’s portfolio. And, hedge fund performance does tend to have an allure because of its legendary numbers. We have all heard stories about that one fund that had a 400 percent increase. I hate to burst your bubble, but the average fund just does not have the crazy performance that the rumor mill has spread. In fact, the HFRI Fund Weighted Composite Index has earned an average of 6.1 percent each year since 2003. So, just because an investment has a high minimum investment or requires a certain level of income doesn’t mean that it is guaranteed to have a high return.

Ultimately, hedge funds may or may not be the right investment for you. Be sure you understand what you’re investing in and don’t always believe what you see in the movies.

Jennifer Pagliara is a senior vice president and financial adviser with CapWealth, LLC, and a proud member of the Millennial generation. Her column speaks to her peers and anyone else that wants to get ahead financially.