Photo: Flickr user Son of Groucho.

Have you ever wondered what a hedge fund is or whether you should invest in one? If so, read on. Hedge funds are interesting beasts with some surprising characteristics, but the few of us who are permitted to buy into them would probably be better off passing up the opportunity. 

Just like a mutual fund, a hedge fund is a pile of money that investors have pooled together so that it can be managed by professionals -- presumably super-savvy ones who will deliver great returns. They differ from mutual funds in some key ways, though. For example:

  • While mutual funds are highly regulated, hedge funds are not. Mutual funds, for example, face caps on the sales loads they can charge you. Hedge funds offer fewer state and federal protections and are required to disclose less than other kinds of investments, such as mutual funds.
  • While just about any investor can buy shares of a mutual fund, hedge funds are restricted to "accredited" (or "qualified") investors, who qualify mainly through being wealthy -- i.e., having a net worth of at least $1 million or income of at least $200,000 (for single people). Therefore most of us aren't eligible to invest in these funds.
  • While mutual funds generally invest in stocks and/or bonds and are open about the size and allocation of their portfolios, hedge funds can be much more secretive and can invest in a wider range of investments, some of which might be considerably risky.
  • With a mutual fund, you can sell your shares within a day if you want to. But with hedge funds, you're often limited to selling some or all of your investment only once per month, quarter, or year, and sometimes your initial investment is "locked up" for the first year.

There are walls keeping most investors out of hedge funds. Photo: via Flickr.

Jumbo fees

One of the key distinguishing characteristics of hedge funds is their fee structure, which tends to be quite costly. The typical fee structure for hedge funds is the "2 and 20" model, where investors are charged 2% of their assets each year for the fund's management and 20% of profits for a "performance" fee. There have even been some "3 and 30" fee structures!

It's worth noting that when a fund underperforms the market or loses money, investors don't get a break. Note, too, the contrast with mutual funds, which don't take a chunk of your profits and charge annual fees (known as "expense ratios") that are often below 1%. Index funds often charge less than 0.25%.

Hedge funds' 2 and 20 models have come under attack in recent years, with the average management fee reportedly falling to 1.6% last year and some investors negotiating lower performance fees.

Paying for poor performance

The main justification for such high fees is high performance. And some hedge funds have indeed performed very well over many years. That's not necessarily the norm, though -- and even great funds can have bad years and rough stretches. According to Bloomberg data, in 2014, only 22 hedge funds outperformed the S&P 500. And a Financial Times review of funds added, "From 2008 to 2013, the average hedge fund managed to generate returns after fees of only 3.6% each year, according to HFR, significantly less than a simple collection of stocks and bonds over the same period."

Many hedge funds perform poorly while charging arms and legs.

Before you leap...

If you remain interested in investing in one or more hedge funds, do your due diligence. Read the fund's prospectus with a critical eye and find out as much as you can about how the fund's money is invested. Review information on the fund's past performance, but remember that solid past performance doesn't guarantee good future performance. Any hedge fund, as well as any stock or mutual fund, can have an exceptionally good year or an exceptionally bad one -- and that can skew its average returns.

Learn about the fees you'll face and the rules you'll have to follow, such as when you can redeem shares. Read up on the managers of the hedge fund, too, to learn what you can about their investment philosophy and their track record. To do that, the Securities and Exchange Commission offers this advice:

Make sure hedge fund managers are qualified to manage your money, and find out whether they have a disciplinary history within the securities industry. You can get this information by reviewing the advisor's Form ADV, which is the investment advisor's registration form. You can search for and view a firm's Form ADV using the SEC's Investment Adviser Public Disclosure (IAPD) website. If you don't find the investment advisor firm in the SEC's IAPD database, call your state securities regulator or search FINRA's BrokerCheck database.

Some hedge funds might serve you well, but finding those particular funds is easier said than done, and most of us don't qualify to invest in hedge funds, anyway. Fortunately, we can do as well or better in regular managed mutual funds, index funds, and individual stocks.