Last week, we explored Opportunity Zones, a powerful investment strategy that offers tax advantages for long-term investors. As we continue our deep dive into Advanced Market Strategies, this week we’re examining a high-stakes investment vehicle used by institutional investors and high-net-worth individuals: Hedge Funds.

Hedge funds have a reputation for delivering high returns, but they also come with higher risk and complexity. Unlike traditional mutual funds, hedge funds use aggressive strategies such as short selling, leverage, derivatives, and alternative assets to generate returns. While they can offer substantial upside potential, they are not for everyone.

Why Are They Called Hedge Funds?

The term “hedge fund” comes from their original purpose: hedging against market downturns. Early hedge funds would take both long and short positions, aiming to protect (hedge) against losses by making profits whether the market went up or down.

Today, not all hedge funds hedge in the traditional sense. Many focus on maximizing returns rather than just reducing risk, leading to higher volatility and greater complexity.

How Are Hedge Funds Regulated?

Hedge funds operate differently from mutual funds in terms of regulation. Here’s how they compare:

✔️ Mutual Funds – Heavily regulated by the Securities and Exchange Commission (SEC), requiring transparency, liquidity, and investor protections. Open to the general public.

✔️ Hedge Funds – Lightly regulated, with fewer disclosure requirements. Only open to accredited investors (those with a net worth over $1M or an income above $200K per year).

Because of their looser regulations, hedge funds can use high-risk, high-reward strategies that wouldn’t be allowed in traditional funds.

How Do Hedge Funds Work? (A Simple Example)

Imagine an investor believes that Tech Company A will go up in value and that Retail Company B will go down. A hedge fund might:

1️⃣ Buy (Go Long) Tech Company A– Investing in shares, expecting them to rise.

2️⃣ Short Sell (Go Short) Retail Company B– Borrowing shares to sell at today’s price, hoping to buy them back later at a lower price.

3️⃣ Use Leverage to Amplify Returns – Borrowing additional money to increase position sizes, which increases both potential gains and risks.

If their predictions are correct, the hedge fund profits on both trades—the tech stock rises, and the retail stock falls. However, if the market moves against their bets, they could lose significantly more than a traditional investor.

Common Hedge Fund Strategies

Hedge funds are known for their flexibility and ability to pursue strategies that aren’t available to the average investor. Some of the most common approaches include:

• Long/Short Equity – Buying stocks expected to rise and short-selling stocks expected to decline.
• Global Macro – Making bets on macroeconomic trends, such as interest rates, inflation, or currency movements.
• Event-Driven – Investing based on corporate events like mergers, bankruptcies, or restructurings.
• Market Neutral – Hedging exposure to minimize market risk while capturing small price inefficiencies.
• Quantitative Strategies – Using computer models and algorithms to identify trading opportunities.

Hedge Fund Fees – Understanding “2 and 20”

One of the biggest drawbacks of hedge funds is their high fee structure, commonly known as “2 and 20”:

✔️ 2% Management Fee– Charged annually on total assets under management (AUM), regardless of fund performance.

✔️ 20% Performance Fee – Charged on any profits the fund generates, meaning fund managers take a significant share of the upside.

Example: The Cost of Investing in a Hedge Fund

Imagine you invest $1 million into a hedge fund with a 2 and 20 fee structure. Here’s how the fees break down:

🔹 Management Fee: The fund charges 2% of AUM per year, so if the fund makes zero profit (remains flat), you still pay $20,000 annually just to stay invested (2% of $1 million).

🔹 Performance Fee: Let’s say the fund earns a 15% return, growing your investment to $1.15 million. In addition to the annual fee, the hedge fund manager takes 20% of the $150,000 profit, which equals $30,000.

🔹 Updated Management Fee Calculation: Since the fund grew to $1.15 million, the 2% management fee is now based on this new amount, resulting in a charge of $23,000 instead of $20,000.

Total Fees for the above example:

✅ $23,000 (2% management fee on $1.15 million)

✅ $30,000 (20% performance fee on the $150,000 in growth)

Total Cost for this example: $53,000 in fees for the year

After fees, your actual return is reduced from 15% to around 11.7%, highlighting a common reality in professional investing—more sophisticated strategies and hands-on management often come at a higher cost, and hedge funds are no exception.

Why This Matters for High-Net-Worth Investors

Hedge funds offer unique diversification because they often perform independently of traditional stock and bond markets. This makes them an attractive option for investors seeking alternative sources of returns.

For high-net-worth individuals looking to:

✔️ Diversify beyond traditional investments

✔️ Reduce portfolio volatility using non-correlated assets

✔️ Access exclusive investment strategies used by institutions

…hedge funds can be a valuable addition to a well-structured portfolio.

Potential Risks and Considerations

While hedge funds can offer strong returns, they come with significant risks:

⚠️ High Fees – The “2 and 20” fee structure means managers get paid handsomely, even when performance is mediocre.

⚠️ Limited Liquidity – Many hedge funds have lock-up periods, meaning investors cannot withdraw their money for a set time.

⚠️ Complexity and Transparency Issues – Some strategies involve derivatives and leverage, making it harder to assess risk.

⚠️ Accredited Investor Requirement – Hedge funds are typically only available to high-net-worth individuals and institutions.

Because of these risks, hedge funds are best suited for experienced investors who understand the complexities and can tolerate higher levels of risk.

Key Takeaways

Hedge funds are an exclusive investment tool that can offer strong returns and diversification for sophisticated investors. However, they come with higher fees, risks, and complexity, making them unsuitable for the average investor.

✔️ They can diversify a portfolio beyond traditional stocks and bonds

✔️ They offer access to advanced trading strategies used by institutional investors

✔️ They require a high-risk tolerance and a long-term commitment

Next week, we’ll explore Private Equity and Venture Capital—investment strategies that allow investors to participate in high-growth private companies. Don’t miss it!

Warmly,

Jeff Perry

Partner, Quest Commonwealth

Co-Host of Safe Money Mindset on WWJ-TV CBS Detroit

Author of Safe Money Mindset – Available on Amazon or DISCOUNTED HERE

👉 Watch our latest TV episodes of Safe Money Mindset on YouTube

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Weekly Tip

This article about hedge funds talked a lot about growth potential, risk, and fees—but when was the last time you reviewed the growth, risk, and fees in your own portfolio?

✅ Action Item: Take a moment to evaluate your investments. Are you on track to meet your goals? Are you taking on more risk than you should? Are you paying too much in fees?

Remember: You can’t get a second opinion from the same person or company that gave you the first. If you’re unsure about your portfolio’s performance, it may be time for an outside perspective.

Jeff Perry is an Investment Advisor Representative registered with Foundations Investment Advisors, LLC, an SEC-registered investment adviser. Investments include the risk of loss, including the loss of principal.