A hedge fund is an investment firm that utilizes complex strategies involving the use of short-selling, leverage, derivatives, and alternative asset classes to generate returns for their investors. Hedge funds are not only more complex than traditional mutual funds that invest in stocks and bonds, they are also less regulated and far more opaque - meaning that investors might not understand what they've bitten off to chew. Because of this, hedge funds tend to cater to high net-worth individuals and require large sums to invest - leaving the ordinary investor out of luck.

It is possible to invest in hedge funds, but there are some restrictions on the types of investors who comprise a hedge fund's investor pool. In general, it is extremely difficult for individual investors to gain access to a quality hedge fund. This forces many to either find indirect methods of investing in hedge funds or just give up trying.

Key Takeaways

  • Because they are not as regulated as mutual funds or traditional financial advisors, hedge funds are only accessible to sophisticated investors.
  • These so-called accredited investors are high net-worth individuals or organizations and are presumed to understand the unique risks associated with hedge funds.
  • For ordinary individuals, investing in the stock of a financial company that operates hedge funds could be a way to gain indirect access.

Regulation D

SEC Regulation D, specifically rules #504, 505 and 506, limit the total number of investors who can be admitted inside of a hedge fund. Hedge fund general partners and managers often create high minimum investment requirements. It is not uncommon for a hedge fund to require at least $100,000 or even as much as $1 million to participate.

Unlike mutual funds, hedge funds avoid many of the regulations and requirements within the Securities Act of 1933. In exchange, the Securities and Exchange Commission (SEC) requires a majority of hedge fund investors to be accredited, which means possessing a net worth of more than $1 million and a sophisticated understanding of personal finance, investing and trading. These requirements exclude the vast majority of the investing public.

Funds of Funds

Many mutual funds were established to mimic the investment strategy of famous hedge funds. These so-called "funds of funds" (FoF) are inexact replicas, however, since hedge funds have access to a much wider range of investment options. Some hedge funds are actually listed on exchanges and have shares that can be purchased individually or through a broker.

There are also "replication" equity funds that try to imitate the performance of hedge-fund benchmarks, similar to how an exchange-traded fund (ETF) aims to produce the same returns as an underlying index. Options such as these are good alternatives for investors who are interested in hedge funds but cannot gain access to them.

Publicly Traded Fund Companies

If you can't invest in a hedge fund directly, you might be able to capture some of that edge indirectly by investing in the companies that run hedge funds. Blackrock, for instance, has a large alternative investments segment that operates much like a hedge fund and handles billions of dollars for ultra-wealthy clients and organizations. By investing in Blackrock instead of its fund, you'll at least be able to capture (in theory) some of that segment's performance. There are several other publicly traded investment advisors and asset management firms that you can look at as well. (For more, see: Are there publicly traded hedge funds?)

So, can you invest in hedge funds? Let's see what an expert has to say:

Advisor Insight

Matthew J. Ure, RMA
Anthony Capital, LLC, San Antonio, TX

Yes, assuming you meet the fund’s criteria for membership. Those usually follow the SEC’s minimum-income rules: You must have a net worth of $1,000,000 or have made over $200,000 ($300,000 for married couples) for the last two years and this year as well. Those requirements are to ensure that you’re an “accredited investor” and therefore should have the acumen to understand, and the money to risk, on the advanced, aggressive strategies that hedge funds typically use.

Funds can and do make exceptions to these criteria, usually for the proverbial family and friends. The SEC allows them to accept up to 35 non-accredited investors over the life of the fund. But they will usually just stick to the accredited-investor guidelines; some set even higher net worth or earned-income levels minimums.