Pros and Cons of Hedge Funds and Private Equity Funds
March 29, 2016 | Your Finances
Like mutual funds and exchange-traded funds (ETFs), hedge funds pool investor money to invest in stocks, bonds, currencies, real estate and commodities. They use flexible investment strategies that frequently involve borrowed money—known as leverage—with a goal of achieving positive returns.
In contrast, private equity funds invest directly in private companies and manage them. Frequently, private equity funds buy companies that aren’t doing well financially with a goal of turning them around and selling them for a profit.
Generally, both hedge funds and private equity funds require high investment minimums—as much as $1 million or more—and lock up investor money for years. They also pay their managers large fees in addition to a share of profits.
While institutions often have the inside track on fund access, hedge fund and private equity strategies are filtering down to individual investors in the form of liquid alternative mutual funds and ETFs. You may encounter these investments or wonder exactly what traditional hedge funds and private equity funds are all about.
Defining Hedge Funds and Private Equity Funds
Hedge funds employ strategies similar to those used by mutual funds and ETFs as well as other strategies. Hedge funds will buy individual securities in the hopes of profiting from those purchases when the value of those securities rises. They will also sell securities short, which is a strategy designed to profit if the value of those securities falls.
Besides short selling, many hedge fund managers use strategies that employ leverage, derivatives and illiquid securities. Leverage involves investing with borrowed money, while short selling involves selling borrowed stocks and then buying them back later with the intention of profiting from the difference.
Derivatives are contracts with a value that depends on an underlying security, asset or index and are used to speculate and to hedge risk. For example, a hedge fund could use a derivative contract to make a bet that the value of the dollar is going to increase. If the value of the dollar does go up, the hedge fund profits; if it falls, the hedge fund loses money.
Hedge fund managers strive to deliver a profit, reduce risk and protect investors from down markets. Their goal is to provide a positive return, otherwise known as an absolute return. This is in contrast to many mutual funds and ETFs that measure performance in contrast to market benchmarks, such as the S&P 500.
Private equity funds are very different from hedge funds, mutual funds and ETFs in that they invest directly in companies rather than the securities of companies. Here’s an example of how a private equity investment might work. Private equity funds invest in different stages of private company growth. This can include providing seed capital to start a company, investing in a company that is already in existence to spur growth or buying out a struggling company to turn it around.
The SEC reported that there were 8,635 hedge funds with $6.059 trillion in assets at the end of 2014. There were 8,407 private equity funds with $1.887 trillion in assets during the same period.1
Differences Between Hedge Funds, Private Equity Funds and Traditional Investments
There are many ways that hedge funds and private equity funds differ from traditional investment vehicles such as mutual funds and ETFs. Here’s an overview:
- Liquidity: Directly investing with hedge funds and private equity funds means losing access to your money for years. Hedge funds can lock up money for several years and private equity funds for longer given the time it can take for individual companies to grow or become profitable. When you invest in a mutual fund or ETF, you can sell your investment at any time.
- Regulation: Both hedge funds and private equity funds are lightly regulated, especially when compared to mutual funds and ETFs, which must regularly disclose their holdings, assets, strategies, returns and management.
- Fees: Management fees2 for hedge funds and private equity funds are two or three times higher or more than mutual funds3 and ETFs.4 Managers also keep a percentage of profits ranging from 17 to 20 percent, which mutual funds and ETFs aren’t allowed to do.
- Transparency: Hedge funds and private equity funds lack transparency because specific information about the expenses, strategies, performance and management of hedge funds and private equity funds is difficult to obtain. That’s in contrast to mutual funds and ETFs, for which data is widely available on company and financial websites.
- Availability: The vast majority of hedge funds and private equity funds are available only to investors who meet the definition of accredited investors. Such investors must have $1 million in assets that they can invest as well as $200,000 in annual income. In addition, private equity funds can come back to investors requesting additional money above and beyond the original investment.
Potential Risks and Rewards
Hedge funds and private equity funds are attractive to investors for several reasons, including their exclusivity and potential for high performance. They offer access to investment strategies that aren’t available in traditional formats such as ETFs and mutual funds. Many of these strategies perform differently than stocks and bonds.
Just as with traditional investments, selection of specific private equity and hedge funds is critical. Often, private equity funds and hedge funds with the best long-term track records restrict investment to ultra-high-net-worth individuals and institutional investors.
This means that even wealthy individuals can have a hard time finding long-term investing success in this niche of the market. As with other types of investments, returns vary among individual funds. As an overall investment strategy, hedge funds and private equity funds experience performance cycles.
These strategies are very risky. While you could make more money investing with hedge funds than with mutual funds or ETFs, you could also lose a lot of money.
Individual hedge funds and private equity funds, like individual mutual funds and ETFs, perform very differently. And because hedge funds and private equity funds aren’t very transparent, it isn’t easy to determine which funds might be the best fit for individual portfolios.
The Bottom Line
As with all types of investments, private equity and hedge funds offer opportunity and risks. In the vast majority of cases, individual investors can meet their goals and objectives with an asset allocation of traditional investments, tailored to their particular risk tolerance.
At Northwestern Mutual, we believe that you can achieve your financial goals with a traditional portfolio of stocks, bonds, cash and cash alternatives. Hedge funds and private equity strategies can be a useful supplement in certain cases but aren’t necessary. In many cases, institutions and high-net-worth individuals have the inside track on access to the best managers and strategies over individual investors.
1Securities and Exchange Commission Division of Investment Management, “Private Fund Statistics,” Dec. 31, 2015,https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2014-q4.pdf
2The Economist, “Fees for Hedge Funds and Private Equity: Down to 1.4 and 17,” Feb. 4, 2014, http://www.economist.com/node/21595942/print
3Morningstar, “2015 Fee Study,” https://news.morningstar.com/pdfs/2015_fee_study.pdf
4Bloomberg Business, “Don’t Get Ripped Off: An Investor’s Guide to Fees and Expenses,” Oct. 27, 2015, http://www.bloomberg.com/news/articles/2015-10-27/an-investor-s-guide-to-fees-and-expenses
Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee WI (NM) (life and disability insurance, annuities and life-insurance with long-term care benefits) and its subsidiaries. Northwestern Mutual Wealth Management Company®, Milwaukee, WI (NMWMC) (fiduciary and fee-based financial planning services), subsidiary of NM, federal savings bank. Northwestern Mutual Investment Services, LLC (securities), broker-dealer, registered investment adviser and member FINRA and SIPC.
All investments carry some level of risk including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss.
Hedge funds use leverage, a high-risk practice that magnifies both gains and losses.
Standard and Poor’s 500 Index® (S&P 500®) is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
An exchange-traded fund (ETF) is an investment that typically has an objective of striving to match the return of a particular market index or basket of securities, similar to a traditional index fund. The ETF will invest in all or a representative sample of the securities included in the index it is seeking to track.
Exchange traded funds (ETFs) are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. ETFs are traded on the secondary market, like stocks. As a result, shares of an exchange traded fund may trade at a premium or discount to the fund's actual net asset value, particularly during periods of market volatility. The performance of an exchange traded fund may vary from the market index it attempts to replicate due to market volatility, transaction costs, valuation differences, differences between the assets held in the exchange traded fund's portfolio relative to the market index, and other factors.
A mutual fund is an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.
Liquid alternatives are alternative investment vehicles such as mutual funds, ETFs and closed-end funds that provide daily liquidity.
You should carefully consider the investment objectives, risks, expenses and charges of the investment company before you invest. Your Northwestern Mutual Investment Services Registered Representative can provide you with a prospectus that will contain the information noted above, and other important information that you should read carefully before you invest or send money.