Many people would do well enough investing solely in index funds, but most wonder whether extra returns can be had from hedge funds and other alternative investments. I’ve invested in one before, and the experience was like hanging out with the cool kids for the first time in high school. There was a certain level of excitement at the beginning, and I won’t lie – it gave me a sense of “finally making it in life”. But I ultimately pulled my money out of the fund, because that particular fund just wasn’t for me. Here’s what I learned from the experience:
I have no idea what I’ll be investing in. Some hedge funds don’t even tell you what they invest in, but I actually knew exactly where my money was in real time, all the time. The problem, though, is that the go anywhere and do anything mandate meant that the manager could sell everything on hand and just buy whatever he wanted whenever the markets were open. One minute I owned shares of an individual company, the next I was short the S&P 500 and 30 year treasuries. All asset allocation strategies I’ve deployed to control risk went out the door, because I couldn’t pinpoint my exposure when someone else changes which investments the overall portfolio holds on any given day. In fact, there were times I was invested in the S&P 500 in one part of my portfolio while the hedge fund simultaneously shorted the S&P 500!
Taxes make hedge fund returns much more modest. Hedge funds are expected to invest in only the ideas that would work in the current investing environment. You expect him/her to keep selling and buying different securities as times change, but this triggers a ton of capital gains. The returns looked good on the surface, but the taxes I had to pay to cover the capital gains incurred basically cut my return by 2-3% each year. I live in California, where state tax for even middle class investors are 9.3% on any type of taxable investment income. This means that the minimum for just about anybody is to pay 20% or so of long term capital gains and 30% for short term gains. High earners may have to pay more than half of the gains. That 15% you hear about from legendary hedge funds returns, even if it’s possible year in and year out, all of a sudden turns could really be more like 7% in your pocket.
It’s still only for accredited investors. The Securities and Exchange Commission (SEC) allows hedge funds to remain opaque as long as they only offer these investments to accredited investors. Basically, you can’t invest in one unless you have a net worth of at least $1 million (excluding the value of your primary residence) or have income exceeding $200,000 in each of the last two years. This practically rules out just about everyone in the United States.
Times Could Be Changing Though…
The traditional way of investing in hedge funds didn’t work for me, but some recent developments in the space perked my interest again.
The minimums to get started have drastically been reduced. Companies like Sliced Investing lowered the minimums to invest in hedge funds. You can now invest in one for as low as $20,000. The amount is still a good chunk of change, but the commitment to get your feet wet is much smaller.
You can also construct a mix of funds more easily now with the lower minimum. Instead of having enough money to just invest with one manager, the lower minimums mean that you can more easily buy a bunch of funds and have a portfolio of alternative investments. You are playing the averages rather than betting that one particular fund manager will make a killing with this approach. This is an important distinction, because there are still reasons to invest in the fund even if it never beats the standard S&P 500 index. This is because hedge funds as a whole will perform differently than equity and bond investments, creating rebalancing opportunities that can boost returns and/or reduce volatility.
Fees are being lowered. I am amazed why hedge funds can justify such high fees. In practice, they are sort of like a mutual fund with a more relaxed investment objective without the need for much transparency. Still, they can charge high fees because people are willing to pay them. The good news for us retail investors is that the industry is slowly changing from a 2% annual fee + 20% of profits to a 1% annual fee + 10% profit. Sliced Investing is claiming to charge only 0.50% – 1.25%, which will only put more pressure on existing offerings.
I wish the SEC could come up with a better definition of an accredited investor, because having higher income or net worth doesn’t actually mean they are a better informed investor. Still, recent developments are a good push in the right direction.
Do you qualify to invest in a hedge fund? Would you if you did qualify? If not, what needs to change before you will consider?
Disclosure: This blog post was written for Sliced Investing pursuant to a paid content arrangement I have with the company’s representatives as part of an effort to raise awareness about alternative investment options. All views expressed are entirely my own, and were not influenced or directed by Sliced Investing. You can learn more about alternative investing at SlicedInvesting.com. Learn more about this effort to raise awareness by following hashtag #Invest2015 on Twitter.