Hedge Fund: The Advantages and Disadvantages of Investing. Part 2: Disadvantages

Published on: 15th January 2015

Hedge funds have significant benefits, such as higher returns, low correlation to traditional investment products and access to a wide range of assets and unusual trading strategies. At the same time, there are several limitations and disadvantages which you should keep in mind when considering hedge funds as an investment.

High minimum amount

Although hedge funds are generally less tightly regulated compared to mutual funds, their relative freedom comes at a cost. In order to avoid some of the regulatory requirements, hedge funds can only accept so called “qualified investors”, which simply said means rich investors who are able to withstand losses from the often risky trading strategies.

In practice this translates into higher minimum investment amount that a typical hedge fund would accept. While it is possible to invest as little as a hundred dollars in a mutual fund, for hedge funds the minimum is usually tens or hundreds of thousands and often much more. Furthermore, investing all your capital in one hedge fund is rarely a good idea and if you want to diversify and invest in at least 5 or 10 different funds, you need to multiply the minimum amount by that.

Low liquidity

Mutual funds typically offer daily or weekly liquidity. You decide one day that you want to withdraw money from the fund and a few days later the cash is in your bank account. It is less simple with hedge funds. Their trading strategies often involve thinly traded assets and therefore liquidating a position quickly (to get cash for investor withdrawals) can cut into profits. In order to avoid that, hedge funds place various restrictions on redemptions:

• With many funds you can’t withdraw money during the first few months (and sometimes years) after your investment. This is called lock-up period.

• You often have to notify the fund manager well in advance (several weeks or months) when you wish to withdraw money, in order to allow sufficient time for liquidating positions. This is called notice period.

• Many funds only allow redemptions on specific dates or with a particular frequency, such as at the end of each quarter.

High fees

The cost of hedge fund investing is much higher than with mutual funds. Typically a hedge fund management firm makes money from two sources.

Firstly, like with mutual funds there is management fee, charged as a fixed percentage of the invested amount.

Secondly, there is performance fee (also called incentive fee), charged as a percentage of profits. Its calculation often follows additional rules, for example the fee only applies to returns over a minimum rate (called hurdle rate), which is either fixed (e.g. 5%) or linked to a benchmark (e.g. a stock index).

For illustration, let’s say the management fee is 2% per year and the performance fee is 20% (this is a very popular fee structure in the hedge fund industry, referred to as “two and twenty”), with a fixed hurdle rate of 10%. Let’s say you have invested one million dollars in the fund and it returns 30% in the first year, which is 20% or 200,000 dollars above the hurdle rate. Out of that the fund management company gets 20,000 (2% of 1,000,000) in management fee and 40,000 (20% of 200,000) in performance fee.

Limited transparency and costly due diligence

Compared to mutual funds, it is more difficult to collect and analyse information on hedge funds. The reasons are fewer reporting requirements and the secretive nature of hedge fund managers, who want to keep their trading methods and positions hidden from the competition.

Furthermore, it is not easy to find investment professionals who really understand hedge funds and provide unbiased advice at the same time. The process of hedge fund investing, when done right with proper due diligence, requires substantial amount of time and money. We take a look at the advantages of investing in hedge funds in our previous post.