While it is a great way to diversify your portfolio, hedge funds are not the type of investments where you can dive into with little to no knowledge in investing. Here are some you should know some things about hedge funds before you invest in them.

Hedge Fund Managers are Paid

If you profit from your fund, a portion of this profit goes to the manager of the hedge fund. This is because the manager oversee decisions and investments of the fund, which can be tricky and complicated. A fund manager is paid is based on what is called “two and twenty”, where they are paid 2% of total asset value as management fee, and an additional 20% of any profits that are earned through the hedge fund. However, not every hedge fund manager get paid based on this, some charge 1.5% of assets and 17.7% of profits earned.

Hedge Funds Can be Risky

Hedge funds are known to be quite risky to any practicing investor. There are not a lot of regulation or supervision given by agencies — including the Securities and Exchange Commission — when it comes to hedge funds, thus investing in the fund (usually in the millions) can be incredibly risky. Despite this risk, hedge funds are continuously invested in due to flexible investment strategies as well as the chances of extremely high returns.

Hedge Funds are Limited to those with a Certain Economic Status

Those who invest in hedge funds are usually of a higher class, as hedge fund managers tend to seek out those who have at least $1 million in net assets, primary residence not included, when they are building hedge funds.

Those of the middle class have a chance to invest in hedge funds if they are a part of an exchange-traded fund, however this is not always the case. In additional to this, qualified purchasers can also invest in hedge funds — however they need a minimum of $5 million in investments in order to do so, primary residence or properties used for business not included.

Hedge Fund Managers use a Variety of Strategies

In order to have flexibility, diversification, as well as risk management, hedge fund managers will use a number of different strategies. This is in part to gain profit for investors as well. The strategies that hedge fund managers use are generally split into four categories: global macro, directional, event-driven, and relative value arbitrage. Managers invest in different things depending on which strategy they work with.

Hedge Funds use Borrowed Money

In order to put even more money into a stock that the fund manager believes will do well, hedge funds will borrow money from investors. This is called leverage. Leverages are risky because there can only be one of two outcomes: boosting returns significantly or completely destroy profits. It is even more of a loss if the lender demands back their money without it having made profit — fund managers must sell the stocks and other securities of the investors in a falling market in order to pay the lenders back. This is what happened in 2008 when the market crashed.

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