The financial side of retirement contains many buzzwords, including the term hedge fund. Although many retirees have heard this phrase, most aren’t sure what it means or if they need one.
A hedge fund is an investment that presents an alternative to stocks and bonds. They use pooled funds and multiple shareholders, similar to a mutual fund, and use a variety of different strategies to earn an active return (called alpha). Hedge funds generate high returns, often using aggressive management tactics.
Investing in a hedge fund can be a great retirement portfolio diversifier, because it is completely different from traditional stocks and bonds. Hedge funds use several investment strategies, but all of them are geared toward demanding a high return. Deciding whether a hedge fund is the right investment for you depends on your net worth and your long-term retirement plans.
Is a Hedge Fund Right for Me?
According to U.S. law, investors in hedge funds have to be accredited – meaning they must earn a minimum amount of money annually and have a net worth of at least $1 million. They also have to have substantial knowledge about investments, even though hedge funds are managed professionally.
Hedge funds are very flexible in their investment strategies, and are largely unregulated since they cater to experienced investors. Risk can run high, since a hedge fund’s main goal is to create returns, not make a safe investment. In fact, hedge fund managers often make speculative investments, subject to high risk of loss. However, the higher the risk, the higher the rate of return on investments – keeping investors coming back for more.
While mutual fund managers are not very invested in the funds, hedge fund managers are heavily invested. This difference gives hedge fund managers incentives to gain positive returns. Hedge funds are especially popular among institutional investors and wealthy individual investors. The number of hedge funds has increased by about 20% every year for the last nine years, speaking to its increased popularity.
Benefits of hedge funds include:
● The ability to generate positive returns, regardless of stock market rises or falls
● A variety of investment styles, providing many choices to meet investment objectives
● Increasing returns and reducing overall risks in portfolios
● An ideal long-term investment, since market entry and exit time doesn’t matter
● Ability to reduce losses during share-market sell-offs
Potential risks of hedge funds include:
● High fees, often not justified by high returns
● Lack of liquidity, or the ability of a fund to abide by normal redemption terms during economic crashes
● Unregistered private investments, since hedge funds are not subject to registration requirements
● Risky investment strategies
● Negative tax consequences, often caused by delays in receiving important tax information
Weighing the benefits against the risks of investing in a hedge fund is even more important than with other investments, since the value of both can be significantly greater.
Different Styles of Hedge Funds
There are dozens of styles of hedge funds available, each with their own levels of risk and volatility. Here is one style from each level of volatility:
● Emerging markets: invests in less mature markets that have higher inflation. Expected Volatility: Very high.
● Aggressive growth: invests in equities expected to grow in earnings per share. Expected Volatility: High.
● Distressed securities: buys equity, debt, or trades at discounts and resells them. Expected Volatility: Moderate
● Income: invests with a focus on yield rather than capital gains. Expected Volatility: Low
There are also different investment strategies used by hedge funds, depending on which is expected to gain the greatest return. Hedge funds can use short selling, arbitrage, hedging, leverage, and derivative techniques, among others. This is one of the appealing attributes to investors, since hedge funds offer higher flexibility than other investment opportunities.
Understanding the very variable nature of hedge funds is the first step in deciding if a hedge fund investment is right for you.
Why Choose a Hedge Fund?
Including a hedge fund in your retirement portfolio can greatly increase your overall investment diversification, since many of the strategies it uses are uncorrelated with other common strategies. This will provide risk management and enhance your chances of yielding high returns. It will also smooth out unsystematic risk events in your portfolio, so that negative performances from some of your other investments will be neutralized.
The heightened flexibility of a hedge fund grants shareholders bond-like returns, impervious to market inflation and completely bypassing the risk that makes most people avoid the stock market. Overall returns on a hedge fund are also generally much higher than on other investments, making them appealing despite the risks.
You also have the option of adding a hedge fund with a high-return strategy, such as global macro, to generate high returns. While this can be exciting, it must not be done without due diligence, since the volatility rate is high with macro strategies, and there is no guarantee you won’t suffer a major loss. The more risky strategies used in hedge funds is what attracts so many large investors – drawn to the idea of making enormous ROI.
As with any investment, hedge funds are a gamble. It’s important to discuss the prospect of joining a hedge fund with a professional financial advisor to see if it’s a safe choice for your retirement portfolio and to see if you qualify to be an investor. Once you’ve weighed your options carefully, you can join a hedge fund without being in the dark about its risks and benefits.