Are Hedge Funds High Risk? [Analyzing the Risk vs. Reward]


The information contained in this article not intended to be a substitute for legal or financial advice that can be provided by your own attorney, accountant, and/or financial advisor. 

Hedge funds are pooled investment funds that use complex trading strategies to maximize their return on investment. These fund managers often use strategies like options trading, short selling, or using leverage. So this begs the question: are hedge funds high risk? Or are they just more transparent about the trading strategies that they are using? 

When it comes to investing in hedge funds, you should know that they are inherently higher risk than your typical investments. If you know that you are a risk-averse investor, I do not recommend investing in hedge funds over traditional assets like ETFs or mutual funds. 

On the other side of the coin, hedge funds aim for outsized returns. If you manage to invest at the right time with the right hedge fund manager, you could see an incredible return on your investment.

Are you willing to take that risk? If you are then read on because I have all of the answers regarding both the risk and the rewards of investing in hedge funds. 

How Risky are Hedge Funds?

Hedge funds are a much riskier investment than most people might think. At first glance, they might seem more reputable and trustworthy because they are backed by institutional investors.

This may be true, but before you do decide to invest in a hedge fund, you should know all about the risks involved. This isn’t just investing in a riskier stock or ETF. There is always a possibility that you could lose your entire initial investment. 

When hedge funds take your money for an investment, they pool it in with hundreds or even thousands of other investors. While this might seem safer, the real risk comes with the strategies that they use. Rather than just a normal method of balancing a fund, hedge funds will often use advanced strategies. These include trading derivatives and options and even trading short positions in stocks. 

Another risky thing about hedge funds? A lot of them will trade on leverage which means that they borrow to increase their potential trading gains. Many people do not realize that shorting a stock means you are borrowing shares to pay back later at a cheaper price.

But what happens if the price doesn’t fall? This is exactly what happened to hedge funds like Melvin Capital during the Reddit GameStop short squeeze

Why do People Invest in Hedge Funds?

Let’s get one thing out of the way: most of the people who invest in hedge funds are institutional investors themselves, Many of them invest in hedge funds because historically they have performed better against market volatility. A lot of hedge funds have also provided oversized returns that beat the market, which is another attractive feature of investing in them. 

There is a reason they are called hedge funds as well. They are an excellent way to gain exposure to a potential contrarian style of investing. Most investors will hold assets like index funds or sector ETFs or even individual stocks. Well if most investors hold these same assets then we can also assume most portfolios are built in a similar fashion.

This is where hedge funds come in as a nice alternative, or hedge, against your existing investments. 

If you invest in a short-selling hedge fund, then you are hedging against the assets in your portfolio. Investing in short positions helps to minimize the total downside risk of your investments. Of course, shorting stocks can be risky, as is trading options contracts. When you invest in a hedge fund you must fully acknowledge that the investment could potentially go awry. 

What’s the Potential Reward for Investing in a Hedge Fund?

But many investors are results-oriented and are more interested in the potential return rather than the risk.

The potential reward for investing in hedge funds is outsized, market-beating returns on your investment. Beating the market sounds a lot more exciting and enticing than collecting an average annual return of about 9% from an S&P 500 index fund. 

Most hedge funds will actually provide an average annual rate of return that trails the benchmark S&P 500 index. So why take the risk of investing with a hedge fund? Well for one thing, as their name suggests, hedge funds are hedged to mitigate losses. This means that while their gains could trail that of a benchmark index the losses will as well. 

Another thing you need to consider is that hedge funds take high fees which eat into your total returns. While individual hedge funds will vary, typically the fund will take about 2% of your total investment and 20% of your total profits. Compared to an index fund with a MER of less than 0.1%, these fees are considerably higher. 

The Bottom Line: Are Hedge Funds Risky?

They can be! Let’s also keep in mind that for the most part, only institutional investors or those with an initial investment value of more than $1 million can invest in hedge funds. It is typically just an investment option for the wealthiest 1%.

So while hedge funds are inherently risky, we don’t really need to worry about it too much.

Why are hedge funds risky? They incorporate advanced trading strategies that most people wouldn’t use on their own. They also trade with leverage which means there is always a chance that the investment goes to zero.

With higher overall fees and the added risk, even Warren Buffett suggests sticking to a low-cost index fund to diversify your portfolio! 

Geek, out.

Noel

Noel is the founder and main contributor for his blog - Noel's passion for personal finance has helped him amass over 600k readers to his Financial Geek blog.

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