If you're a wealthy investor looking for alternative investments, hedge funds are a popular choice. A hedge fund pools and invests money from investors. Hedge funds generally aren't subject to the same regulations as other types of investment funds, and they use more complex investing strategies.
On the surface, a hedge fund seems like a smart way to get a better return on your portfolio. Since hedge funds are more exclusive and aimed at wealthy investors, one would expect that they also provide better performance than everyday investments. That's not actually the case, and you could almost assuredly do better with funds offered by any of the top stock brokers. One major drawback makes hedge funds an investment you're better off avoiding.
Hedge fund managers make more money than investors
The problem with hedge funds is the expensive fees involved. Hedge funds normally charge an asset management fee of 1% to 2% and a performance fee taking 20% of the profits, according to Investor.gov.
Investing strategy resource Market Sentiment shared a useful example of how much this could cost you. Let's say when you're 25 years old, you give a hedge fund manager $100,000 to invest for you. The hedge fund takes a 1.5% management fee and a 20% performance fee. The manager is able to get you an annual return of 8%, which is realistic given the stock market average.
When you're ready to retire at 65, your portfolio will be worth $764,000. That probably sounds great -- until you learn that your hedge fund manager, who didn't put in any money, will have $1.24 million.
Because of fees, hedge fund managers don't just make money. They become richer than the clients who are actually investing the money. The amount of time it takes just depends on the fee structure. If a hedge fund charges a 2% asset management fee and a 20% performance fee, it will only take about 17 years on average before it beats the investor.
Why do investors use hedge funds?
Considering how much hedge funds cost, it raises the question of why anyone would choose this type of investment. Market Sentiment found two explanations.
The first is that hedge funds tend to be far less volatile than the stock market. For wealthy investors who are more concerned with preserving their wealth than maximizing returns, lower volatility is a significant advantage. This is the most compelling reason to invest in hedge funds. They often provide reasonable returns, even during market downturns.
Another explanation is exclusivity. Many investors mistakenly believe that more exclusive investments are better. The research doesn't support that notion. In all likelihood, you'd make much more long term by choosing investment funds with lower fees. But not every investor realizes this, and wealthy investors aren't immune to these kinds of mistakes.
Better ways to invest your money
For most investors, hedge funds aren't the best option. If your goal is growing your portfolio, then it doesn't make sense to pay the hefty fees that hedge fund managers charge. So, what should you do instead?
You can still put your money in investment funds. The key is to find funds with low fees. One of the most popular and effective options is investing in index funds. An index fund attempts to track the returns of a market index, such as the S&P 500, the index for 500 of the largest publicly traded companies on U.S. stock exchanges.
There are also target-date retirement funds. A target-date fund is an investment fund built around a retirement year. It's automatically rebalanced as time goes on, shifting the asset allocation based on how close you are to retirement.
There's always the option to build your own portfolio, as well. You could do this by picking individual stocks or putting together a combination of stocks and investment funds you like. This takes more time, but you get full control of your investments.
