Hedge funds can buy investments and use strategies that are not permitted for other funds – and this makes them highly risky.
Like mutual funds, hedge funds pool people’s money to invest. The difference is that hedge funds can buy investments and use riskier investment strategies that are not permitted for typical mutual funds. Examples: short selling, using leverage, and investing in derivatives, high yield bonds and distressed companies.
Not everyone can invest in hedge funds: There are rules about minimum investments for hedge funds. In Ontario, you must have $150,000 to invest in the fund, or be an accredited investor. These rules exist because if you can afford to buy a hedge fund, you can likely afford the possible losses. You should also be able to afford to get expert advice, which is key to understanding the higher risks of these investments.
6 types of hedge funds
Long only – Buys and sells investments it owns. Does not short sell investments.
Long/short – Buys some investments and short sells others. The proceeds from the short sales can be used to buy further long positions.
Market neutral – Aims for zero market risk by investing in both long and short positions.
Distressed securities – Invests in companies that are close to failure in hopes of making money on a recovery.
Event driven – Aims to profit from events like company mergers, takeovers or break-ups.
Hedge fund of funds – Invests in a basket of other hedge funds to diversify among various strategies.
3 key risks
Lack of liquidity – Many hedge funds only allow redemptions at certain times during the year and limit the number of redemptions you can make in a year. This is because the hedge fund may not be able to easily sell its underlying investments. Once you've made a redemption request, it could take 90 days for you to get your money.
Lack of public information – Some hedge funds don't have to report to the public in the same way that publicly listed stocks and mutual funds do. But even if information was regularly available, it might be out of date because the investments in a fund can change frequently.
Use of complex, high-risk strategies – Hedge funds often use strategies that are difficult to understand and are highly risky.
Warning: Hedge funds can make big gains, but they can also suffer big losses. For example, according to the Dow Jones Credit Suisse Hedge Fund Index, in 2010, the best performing event-driven hedge fund gained 40.1%. But the worst-performing event-driven hedge fund lost 76.9%. Learn more about Dow Jones hedge fund indexes.
4 things to know about hedge fund fees
Sales commissions – You’ll pay a sales commission of up to 5% of the amount you invest to the adviser who sells you the hedge fund.
Management and performance fees – Hedge funds charge a 2% management fee and a 20% performance fee based on how well the fund does. This is known as a “2 and 20” approach.
Hurdle rate – This is the rate of return a hedge fund needs to achieve before it can calculate its performance fee. The hurdle rate can be a static number (like 5%), or it can be based on a dynamic number (like the return of the S&P/TSX Composite Index).
High water mark – This means that the performance fee only applies to any profits the hedge fund makes after it has recovered losses from previous years. This prevents the fund’s managers from “double-dipping” on performance fees or being rewarded for volatile performance.
Example – Say a hedge fund returns 20% in year 1 and collects performance fees. In year 2, it loses all of those gains. In year 3, it delivers strong returns and gets back to its previous high. Even though the performance in year 3 may have beaten the hurdle rate, the net return to investors over the 3 years is nil. Without a high water mark, investors would have to pay a performance fee for overall poor returns.
You pay twice with a fund of funds: If you invest in a fund of hedge funds, you’ll pay fees on the fund you buy, as well as fees on the underlying funds. Before you invest, consider these extra costs against the benefit of spreading your risk across a number of hedge funds.
How hedge funds are taxed
You’ll pay tax on any capital gains you make when you sell your investment.
You’ll also pay tax yearly on any distributions you receive from the fund. Most hedge funds will reinvest your distributions to buy additional shares.
Learn more about how taxes affect your investments.
Warning: Some hedge funds may be eligible for RRSPs and RRIFs, but that doesn’t make them a good choice for retirement savings. Hedge funds can be very risky. You should not invest in a hedge fund unless you can afford to lose the money.
Content in this section is provided in partnership with Investor Education Fund, a non-profit organization founded and supported by the Ontario Securities Commission that provides unbiased and independent financial tools to help Canadians make better money decisions. To find out more, go to: GetSmarterAboutMoney.ca
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