Like mutual funds, hedge funds pool people’s money to investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition. The difference is that hedge funds can buy investments and use riskier investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition strategies that are not permitted for typical mutual funds. Examples: short selling, using leverageLeverage A way to make a larger investment by using borrowed money to invest. The more you invest, the more money you can make. But if things don’t work out, you will have bigger losses.+ read full definition, and investing in derivatives, high yield bonds and distressed companies.
Also, hedge funds are typically sold to individuals under a prospectus exemptionProspectus exemption An exemption that allows a company lawfully to sell securities without providing a prospectus.+ read full definition. Because of this, they are referred to as “exempt securities”. There are risks involved when purchasing “exempt securities”, which are described in more detail below.
Not everyone can invest in hedge funds
Not everyone can invest in hedge funds.
There are rules about who can invest in hedge funds in Ontario. Typically, individual investors must qualify as accredited investors. Companies can also invest as accredited investors.
Not everyone can sell hedge funds
Not everyone can sell hedge funds. Check the registration of the person offering hedge funds before you invest.
6 types of hedge funds
- Long only – Buys and sells investments it owns. Does not short sell investments.
- Long/short – Buys some investments and short sells others. The proceeds from the short sales can be used to buy further long positions.
- Market neutral – Aims for zero market riskMarket risk The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk and currency risk.+ read full definition by investing in both long and short positions.
- Distressed securities – Invests in companies that are close to failure in hopes of making money on a recovery.
- Event driven – Aims to profit from events like company mergers, takeovers or break-ups.
- Hedge fundHedge fund A lightly regulated fund that pools people’s money to invest in different investments. Hedge funds can invest in almost anything. They often mix different approaches to investing as a way to hedge’ or protect investors from poor results.+ read full definition of funds – Invests in a basket of other hedge funds to diversify among various strategies.
3 key risks
- Lack of liquidityLiquidity Refers to how easy it is to change an investment or asset into cash, without affecting the price. Liquid assets include most stocks, money market instruments and government bonds. Your home or other property is not very liquid.+ read full definition – Many hedge funds only allow redemptions at certain times during the year and limit the number of redemptions you can make in a year. This is because the hedge fund may not be able to easily sell its underlying investments. Once you’ve made a redemption request, it could take 90 days for you to get your money.
- Lack of public information – Hedge funds don’t have to report to the public in the same way that publicly listed stocks and mutual funds do. But even if information was regularly available, it might be out of date because the investments in a fund can change frequently.
- Use of complex, high-risk strategies – Hedge funds often use strategies that are difficult to understand and are highly risky.
Hedge funds can make big gains, but they can also suffer big losses. For example, according to the Dow Jones Credit Suisse Hedge Fund IndexIndex A benchmark or yardstick that lets you measure the performance of a stock market, part of a stock market or a single investment. Examples: S&P/TSX, S&P/TSX Canadian Bond Index.+ read full definition, in 2010, the best performing event-driven hedge fund gained 40.1%. But the worst-performing event-driven hedge fund lost 76.9%. Learn more about Dow Jones hedge fund indexes.
4 things to know about hedge fund fees
- Sales commissionsCommissions What you pay to a broker or agent for their services. Often called a “sales commission”. For example, you pay a fee to someone who buys or sell stocks or real estate for you.+ read full definition – You’ll pay a sales commission of up to 5% of the amount you invest to the adviser who sells you the hedge fund.
- Management and performance fees – Hedge funds charge a 2% management feeManagement fee A charge that you pay for having an investment professional manage an investment fund. The fee pays the managers for their time and skills. It may also cover things like communicating with investors and doing all the paperwork needed to run the fund.+ read full definition and a 20% performance fee based on how well the fund does. This is known as a “2 and 20” approach.
- Hurdle rate – This is the rate of return a hedge fund needs to achieve before it can calculate its performance fee. The hurdle rate can be a static number (like 5%), or it can be based on a dynamic number (like the return of the S&P/TSX Composite Index).
- High water mark – This means that the performance fee only applies to any profitsProfits A financial gain for a person or company. Equals the money left over after you subtract your costs from the money you made.+ read full definition the hedge fund makes after it has recovered losses from previous years. This prevents the fund’s managers from “double-dipping” on performance fees or being rewarded for volatile performance.Example – Say a hedge fund returns 20% in year 1 and collects performance fees. In year 2, it loses all of those gains. In year 3, it delivers strong returns and gets back to its previous high. Even though the performance in year 3 may have beaten the hurdle rate, the net returnNet return The amount you make from an investment after you pay fees and other costs, including taxes.+ read full definition to investors over the 3 years is nil. Without a high water mark, investors would have to pay a performance fee for overall poor returns.
You pay twice with a fund of funds
If you invest in a fund of hedge funds, you’ll pay fees on the fund you buy, as well as fees on the underlying funds. Before you invest, consider these extra costs against the benefitBenefit Money, goods, or services that you get from your workplace or from a government program such as the Canada Pension Plan.+ read full definition of spreading your risk across a number of hedge funds.
How hedge funds are taxed
You’ll pay taxTax A fee the government charges on income, property, and sales. The money goes to finance government programs and other costs.+ read full definition on any capital gains you make when you sell your investment.
You’ll also pay tax yearly on any distributions you receive from the fund. Most hedge funds will reinvest your distributions to buy additional shares.
Learn more about how taxes affect your investments.
You should not invest in a hedge fund unless you are able to do your own due diligence, and/or speak with a registered professional and understand the potential losses you may incur.