Why Do You Need a Lot of Money to Invest in Hedge Funds?

by Iggy Paulsen 9 months ago in investing

Everyone knows you need a lot of money if you want to invest in hedge funds, but why?

Why Do You Need a Lot of Money to Invest in Hedge Funds?

Hedge funds are the kind of investments that are equal parts passive income vehicle and bragging rights. Everyone knows it, especially those who love the idea of letting money work for them. Even the term "hedge fund" has a fancy ring to it.

It's easy to see why saying you have a hedge fund sounds like a bragging right; it's because you need a ton of money in order to invest in them. But, to a point, it almost doesn't make sense.

A hedge fund is a large slush of different investments ranging from fine arts to real estate to stocks. Why would anyone need to be a millionaire in order to invest in hedge funds, considering how many of the fund's "ingredients" are easily obtained solo?

Well, believe it or not, there are reasons why hedge funds are so exclusive. Here's the scoop, in case you've been wondering.

Before we begin, let's talk about what you really need in order to start investing in a hedge fund.

Most people assume that you just need to be a millionaire in order to have a hedge fund account. Those people don't understand what a hedge fund is. This is only really partially true. Technically, you don't need tons of money to invest in hedge funds. What you need, though, is to be an accredited investor with the SEC.

A bigger issue that you may find is trying to find funds that are worth investing in if you do have the money. But, I digress. This article should remain focused on the financial constraints of hedge fund investing.

Let's talk about the requirements you need to meet before you invest in hedge funds.

Accredited investors are people who are vetted by the Securities Exchange Commission, and have shown they can handle the risk that comes with certain investments.

Getting accreditation means that you will be able avoid many of the protective laws that prevent high-risk investments from hurting others. The idea behind it is that accredited investors will be more able to handle high-risk investments without suffering serious losses.

To be an accredited investor, you need to have one of the following things be true:

  • You make over $200,000 a year solo, with expectations to keep up those wages in the future. You have to have consistently earned this much money over the past two years. If you are filing jointly, you both have to make at least $300,000.
  • You have a net worth over $1 million. It's an "easy" way to make it work.
  • You have a private business development company worth $5 million or more. This would include brokers, lenders, and specialty groups.
  • You are a registered broker or advisor. If you can advise others, it's assumed that you can figure out what's best for you.

You need accreditation to invest in hedge funds due to the high risk they carry.

Though you would never guess it from the stereotype, hedge funds are not your "one way ticket to easy street." Though many hedge funds offer great returns, the very foundation they are built on is one of risk.

The reason why hedge funds are called that is because hedge fund managers are literally "hedging their bets" on investments that could potentially produce high rewards, but will very likely incur major losses.

Moreover, you might not get as much information about a hedge fund as you would regular stocks.

It's important to remember that hedge funds are NOT publicly-traded stocks. They are not even open to the public, really. Since they are technically private investment vehicles, the rules to investing in a hedge fund are different.

Many hedge funds don't really flesh out the full details of what they're investing in. Some also might not be as upfront about fees as they should be.

Part of the reason why you need a lot of money to invest in hedge funds deals with fees.

If you thought those dinky little fees Stash charges you were bad, wait until you see hedge fund fees. It's not unheard of for hedge funds to charge thousands of dollars in fees, especially if they charge extra for good performance.

The fees can easily eat through an average person's wages, which is why most people who know about hedge funds don't advise a typical guy to have one. As the old adage goes, "Just because you can, doesn't mean you should!"

Along with high fees and high losses, investors also have to be wary of tax-related issues.

Let's say that you somehow managed to navigate the world of hedge funds and you found a nice fund that you were able to invest in painlessly. Said fund has a huge return—like, think 150 percent returns.

Well, now you have to figure out how to handle this income on taxes. You might also have a performance fee that just knocks your income off kilter. You might even wonder if positive returns are worth it.

You also have to figure out whether you want to stay in the fund or pull out money. Since even the biggest hedge funds in the world are very volatile, this can be harder than you think.

It's also worth pointing out that hedge funds have a very high failure rate, particularly in "hot markets."

Remember when we were seeing the massive Bitcoin boom? This was a time when many people started to invest in hedge funds that dealt with cryptocurrencies. Many such funds were created, too!

Unsurprisingly, most failed.

When a hedge fund fails, you lose pretty much everything you invested. Hedge funds fold pretty quickly and regularly. If you don't have money to cushion your blow, you could end up in serious financial trouble.

Sometimes, it's actually the fund itself that puts minimums on investors.

It's not always the Securities Exchange Commission that prevents you from being able to invest in hedge funds—though they are the ones who establish the bare minimums as far as accreditation.

In many cases, it's the managers of the hedge fund itself that set the minimums. This is done to make sure that you are safe if the fund folds, or to ensure that you can afford performance fees.

If you feel let down by the exclusivity of hedge funds, don't worry.

It's normal to want to have a bunch of different investment options in your portfolio, including private ones like hedge funds. I personally felt a little let down when I found out about the accreditation requirement.

However, there's often good reason why private investments are barred to the public. They are just not that safe, and in many cases, the risk isn't worth the reward.

A better option for most would be to look into mutual funds and index funds.

You know, there are a lot of different ways to get similar returns to what you'd receive if you invest in hedge funds. A wide array of different investments; such as index funds, ETFs, real estate, and mutual funds; can all do amazingly well for you.

After all, the only way to really lose on investments is not to play the game.

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Iggy Paulsen

Iggy Paulsen is a fan of anything and everything wholesome. He loves his two dogs, hiking in the woods, traveling to Aruba, building DIY projects that better humanity, and listening to motivational speakers. He hopes to eventually become a motivational speaker himself.

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