What if I told you about a secret, but reputable, $500 billion investment industry that offers an alternative to conventional stock-and-bond investing? OK, so hedge funds, or private investment funds, are not quite a secret - but they are certainly little-known and poorly understood, and typically not marketed to the general public.
Hedge funds are not for everyone. But for many high-net-worth individuals, they are worthy of consideration. And so, the following is a hedge fund primer for physicians.
What's a hedge fund?
A hedge fund is a type of fund that often uses investment techniques that are considered riskier in pursuit of greater returns. The fund is legally restricted to a small pool of investors who each invest a large sum of money.
The original hedge fund was a partnership started in 1949 by A.W. Jones, who is credited as the prototypical hedge fund manager. In fact, he gave the concept its name, as he attempted to "hedge," or protect, his partnership against market swings by "selling short" overvalued securities - meaning he made money if they faltered - while at the same time buying undervalued securities.
Later, physicians were among the most significant early investors in one of the century's most successful hedge funds - the Buffett Partnership, started by the legendary Warren Buffett, chairman of Berkshire Hathaway.
In general, only accredited investors are legally eligible to invest in hedge funds. To qualify, you (and your spouse, if you're married) must have a total net worth of $1 million or have had an annual income of at least $200,000 in each of the two most recent years ($300,000 if you're married). You can also qualify by demonstrating that you have a reasonable expectation of reaching that limit in the coming year.
These restrictions are intended to protect less-savvy and lower-income investors from the higher risks that may be associated with hedge funds. But fund managers also have the option of allowing up to 35 non-accredited investors into their funds. That's a pretty big number, since it is fairly common for the total number of investors to be fewer than 100, so maybe you can get in that way if you don't otherwise qualify.
Hedge funds are structured as either limited partnerships or limited liability companies (LLC). Since they are generally taxed as partnerships, investors should expect to receive a Schedule K-1, complete with all the appropriate information. Moreover, transparency - the ability to look into a hedge fund's portfolio to see its holdings - has not necessarily been the gold standard in structural integrity for some hedge funds.
What they cost
The vast majority of hedge funds are less than $100 million in size, but a few go into the billions, and minimum initial investments typically range from $50,000 to more than $1 million. Fund managers, though, often give themselves the flexibility to waive minimums, counting on larger investments at a future date.
Hedge funds are not as liquid as stocks or mutual funds, and often include "lock-ups," which restrict new investors from withdrawing all or part of their investment for a year or some other time period.
Fund managers usually take for themselves a portion of the fund's assets, typically about 1 percent, in fees. (Some managers don't charge this fee.)
Also, the vast majority of fund managers, whether they charge an asset-management fee or not, participate in the fund profits, often by taking a 20 percent cut. These "performance fee" arrangements, however, are limited only by the imagination of the manager. The goal of this compensation scheme is to give managers an incentive to earn higher profits for fund investors.
There may be other terms and conditions, too. For example, a "hurdle rate" provision protects investors by requiring that an individual's account must appreciate a certain percentage before it becomes subject to a performance incentive fee. Another investor protection is the "high-water mark" provision. The high-water mark is the greatest value of an investor's capital account, adjusted for contributions and withdrawals. The provision ensures that a performance incentive fee is charged only on the amount of appreciation over and above the high-water mark set at the time the performance fee was last charged.
