Money Advice Service

Hedge funds are usually only open to the super-rich or to financial institutions with millions to invest – but other people can invest in certain funds which themselves invest in hedge funds. If you want to invest in such funds you need to understand what they’re about.

What are hedge funds?

Hedge funds invest money in anything that they believe will make a profit – so they can try to find profitable returns whatever the stock market or bond market is doing.

They don’t usually measure their performance against an index or benchmark.

Instead, they focus on trying to deliver a positive return whatever the circumstances.

Hedge fund managers invest in a wide range of assets, including:

  • Shares
  • Bonds
  • Futures
  • Options

And use a wide range of investment strategies.

Whether a hedge fund makes money depends more on what the fund manager does than on the current market conditions, so it’s not easy to predict what your returns might be.

How hedge funds work

It’s not easy to say how hedge funds in general work because they all use different investment strategies.

You should work out the risks of the funds you might be investing in based on their individual strategies.

However, there are a few things that most hedge funds have in common:

  • Hedge fund managers might use complex financial tools called derivatives. Types of derivative include futures, options, warrants and swaps.
  • You’ll often find references to terms such as ‘gearing’ and ‘short-selling’. Gearing means making a large investment with a small deposit (and borrowing the rest of the money), so profits and losses are magnified. Short-selling is selling something you don’t yet own, in the hope that the price will drop and you can buy it back at a cheaper price later.
  • If you invest in these funds you’re relying on the skill of the hedge fund manager to make good investment decisions. Even if your hedge fund specialises in particular assets such as bonds, there’s no guarantee that it will do well when the bond market goes up.
  • Most hedge fund managers charge performance fees and annual fees on the value of the fund, and these charges can be high. A common fee structure for the modern hedge fund is known as a “two-and-twenty” – a 2% management fee and a 20% performance fee.

Hedge funds for retail investors

Recently the hedge fund market has started to allow private investors to buy into hedge funds, though it’s still dominated by big companies.

Although there are controls on the marketing of many hedge funds to the public, retail investors can sometimes gain exposure to hedge funds by buying into a fund that itself invests in hedge funds (this can be known as a ‘fund of funds’).

This pools money from a large number of investors and spreads it over a number of different hedge funds to try and reduce the overall risk.

  • Make sure you read through fund prospectuses carefully before making such investments as hedge funds vary significantly in terms of risk, returns and volatility.
  • Investment managers can charge very high fees so you need to take care when choosing who you want to manage your fund.
  • You should check that the fund of hedge funds is suitable for your investment objectives and that you are aware of the risks before investing. If you are in any doubt you should seek independent financial advice.
  • Funds of hedge funds can be very expensive as you’re paying two sets of fees – one to the fund and one to each hedge fund it invests in.

The risks and returns of hedge funds

What are the risks?

  • Hedge funds can expose you to much higher levels of risk than other types of fund.
  • Many hedge funds are based overseas where regulation might be lighter than in the UK.
  • Hedge funds are typically aimed at professional investors and can’t be sold directly to the public. If you are in any doubt if the fund is suitable for you then seek independent financial advice.
  • The complex investment techniques used by hedge funds mean they can’t be listed alongside other funds or sold in the same way. Many funds that can be sold to the public are subject to controls on what they can invest in; these controls do not apply to hedge funds.
  • Funds of hedge funds can be very expensive as you pay charges to both the manager of the fund of hedge funds and the underlying hedge funds they invest in.

What are the benefits?

  • If you have enough money and find a skilled hedge fund manager, hedge funds can deliver profits.
  • Hedge funds are fairly unrestricted so investment managers have far more flexibility in what they’re allowed to buy.

If things go wrong

If the fund manager is regulated by the Financial Conduct Authority and you’re unhappy with the service you get or you want to make a complaint, read:

Sort out a money problem or make a complaint.

This article is provided by the Money Advice Service.