• Hedge funds consist of fund managers and investors, with complex legal and tax liability structures.
• Hedge funds are “high-risk, high-reward” investments, which makes them accessible only to accredited investors and/or institutional investors.
• They often employ complex strategies to generate above-average returns on investment for their clients, and some tailor their strategies depending on their asset holdings and market.
• Investment in real estate and land through hedge funds is common, with distinct risks and opportunities.

Hedge funds comprise fund managers who make investment decisions and investors who contribute capital. They are typically structured as limited partnerships or limited liability companies (LLCs).

Hedge funds are known for their sophisticated and complex investment approaches to generate above-average returns. The Hedge Fund Research (HFR) classifies hedge funds into seven categories[1] based on their primary investment strategy:

1. Equity hedge
2. Event-driven
3. Fund of funds
4. Macro
5. Relative value
6. Risk parity
7. Blockchain

In general, hedge funds are risky and volatile investments. As such, they target high net-worth individuals (HNWI), institutional investors, and accredited investors (qualified individuals with at least a $1 million net worth and $200,000 of income in each of the last two years). The Dodd-Frank Act later granted the Securities and Exchange Commission (SEC) to adjust the threshold and qualifications for investing in hedge funds[2].

The name “hedge funds” is often attributed to Alfred Winslow Jones in 1949[3], who described what it does as hedging strategies against market risks.

Unlike traditional investment firms publicly trading in securities, hedge funds are subject to unique standards and regulations, along with some additional rules that apply specifically to them.

For example, the Investment Company Act of 1940 prohibits hedge funds from making public offerings[4]. They are also subject to the anti-fraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934.

The Securities and Exchange Commission (SEC) is the main regulatory body overseeing hedge funds in the U.S., with specific compliance and reporting requirements. The Commodity Futures Trading Commission (CFTC)[5] may also oversee certain aspects of hedge funds.

Reporting requirements involve frequent disclosures, such as Form ADV, detailing investment strategies, and Form D, indicating exemption from securities registration[6].

RELATED: What It Really Takes To Be A Qualified Investor

Hedge funds may invest in real estate and land, providing capital for commercial properties or land development.

The United States’ geographical diversity offers unique real estate investment opportunities. For example, areas like Manhattan have attracted significant investments, while tech hubs like Silicon Valley have seen funds investing in commercial real estate for technology companies.

Hedge funds like Blackstone Real Estate Partners mainly focus on real estate investments[7]. These specialized hedge funds approach real estate investments with strategies tailored to the market, providing their clients opportunities for diversification and risk management.

However, investing through hedge funds in land and real estate presents both risks and opportunities. Market trends, such as the housing boom in the early 2000s or the commercial real estate shift during and after the COVID-19 pandemic[8], influence investment outcomes. Risk management tools and hedging strategies are crucial in balancing risks and rewards.

Due to the high minimum investment and risk level, hedge funds are usually more suitable for sophisticated investors, not the general public.

Therefore, understanding its nature, strategies, risks, and rewards is crucial before investing in a hedge fund. Potential investors should recognize that hedge funds often pursue aggressive investment strategies, including short selling, leverage, and derivatives, which can lead to significant gains or losses.

Assessing Suitability and Risk Tolerance

Investors should assess their financial situation, risk tolerance, and investment goals to determine if hedge funds align with their portfolio. Specifically, investors should read the fund’s prospectus[9], disclosures, and other materials related to the fund, its management (especially if the managers are qualified to handle your money), and its operations.

As with any investment, the higher the potential returns, the higher the risks you must assume.

Understanding Valuation and Fees

Would-be investors need to understand how the fund’s assets are valued. Some funds hold investments that may be challenging to liquidate, others have assets that are difficult to value, or a combination of both.

In addition, hedge funds have associated fees, generally based on a portion of your return on investment. Many hedge funds charge an asset management fee, ranging from 1% to 2% of the fund’s net assets, and a performance fee of 15% to 20% based on each investor’s total annual profit[10].

Consult With a Financial Advisor

Consulting with a financial advisor or investment professional experienced in hedge funds is recommended. They can provide insights into the specific hedge funds’ performance, strategies, fees, and potential fit within an investment portfolio. Professional guidance ensures alignment with U.S. regulations and individual investment goals.

Ask questions about the fund if all else fails (or if you’re still in doubt). If you find that the fund doesn’t align with your goals or have questions that remain unanswered, it might be best to park your money elsewhere.

Understanding the specific investment strategies, risks, fees, and lack of liquidity is essential for anyone considering hedge fund investment.

What’s the minimum investment for a hedge fund in the U.S.?

The minimum investment for a hedge fund varies significantly based on the fund’s strategy and target investors. In the U.S., the range often starts from $100,000 to as high as $2 million or more[11].

These thresholds ensure that participants are typically accredited investors, meeting specific income or net worth criteria defined by the SEC. This minimum investment requirement aligns with hedge funds’ high-risk, high-reward nature.

How are hedge funds taxed in the U.S.?

Hedge funds are considered pass-through entities[12], which means they are not taxed at the entity level but their investors are at the individual level. The fund typically issues a Schedule K-1 to each investor every year, which they must report on their individual tax return.

In addition, the 20% performance fee that fund managers get from investors may be treated as “carried interest” under certain conditions, which could be subject to long-term capital gains tax rates. This might provide a tax benefit to fund managers, since the capital gains tax ceiling is 20%, unlike income tax, which maxes out at 37%[13].

Are hedge funds suitable for average investors?

Hedge funds are generally not considered suitable for average investors in the U.S. Due to the high minimum investment requirements and complex, high-risk investment strategies, they are typically reserved for sophisticated or institutional investors. The relatively loose regulation compared to other investment products like mutual funds[14] adds to the risk.

1. Carelus, J.B. (n.d.) Capital Markets Bureau Primer. National Association of Insurance Commissioners. Retrieved from https://content.naic.org/sites/default/files/capital-markets-primer-hedge-fund.pdf
2. “Accredited Investor” Net Worth Standard. (n.d.) Securities and Exchange Commission. Retrieved from https://www.sec.gov/info/smallbus/secg/accredited-investor-net-worth-standard-secg
3. Coggan, P. (2010). Guide to Hedge Funds. London: Profile Books. ISBN 978-1-84668-382-4.
4. Hedge Fund Investing & Regulation. (n.d.) The CFA Institute. Retrieved from https://www.cfainstitute.org/en/advocacy/issues/hedge-funds
5. U.S. Commodity Futures Trading Commission (CFTC). (n.d.) USA.gov. Retrieved from https://www.usa.gov/agencies/u-s-commodity-futures-trading-commission
6. Regulation D Offerings. (n.d.) Investor.gov. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/glossary/regulation-d-offerings
7. DiLallo, M. (2022, April 21.) Blackstone Is Becoming a Real Estate Powerhouse. The Motley Fool. Retrieved from https://www.fool.com/investing/2022/04/21/blackstone-is-becoming-a-real-estate-powerhouse/
8. Cruise, S., Raitano, L., Jackson, L. (2023, July 31.) Commercial real estate investors risk painful losses in post-COVID world. Reuters. Retrieved from https://www.reuters.com/business/finance/commercial-real-estate-investors-banks-buckle-up-perfect-property-storm-2023-07-30/
9. Murphy, C. (2023, July 18.) What Is a Prospectus? Example, Uses, and How to Read It. Investopedia. Retrieved from https://www.investopedia.com/terms/p/prospectus.asp
10. What is the typical hedge fund fee structure? (n.d.) Investment Law Group of Davis Gillett Mottern & Sims. Retrieved from https://www.investmentlawgroup.com/faqs/what-is-the-typical-hedge-fund-fee-structure/
11. Tretina, K. (2023, January 11.) How To Invest In Hedge Funds. Forbes Advisor. Retrieved from https://www.forbes.com/advisor/investing/how-to-invest-in-hedge-funds/
12. Daugherty, G. (2022, November 25.) How Private Equity and Hedge Funds Are Taxed. Investopedia. Retrieved from  https://www.investopedia.com/articles/investing/072215/how-private-equity-and-hedge-funds-are-taxed.asp
13. IRS provides tax inflation adjustments for tax year 2023. (2022, October 18.) Internal Revenue Service. Retrieved from https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2023
14. Kilroy, A. (2023, August 22.) Hedge Funds vs. Mutual Funds: Key Differences. SmartAsset. Retrieved from https://smartasset.com/financial-advisor/hedge-fund-vs-mutual-fund