This article talks about the benefits and challenges associated with hedge funds to help investors decide if they are a good addition to a self-directed IRA portfolio.
In this article:
- What Is a Hedge Fund?
- Pros of Hedge Funds
- Cons of Hedge Funds
Hedge Funds: Pros and Cons Self-Directed IRA Owners Should Know
What Is a Hedge Fund?
This type of investment has several distinct characteristics that set it apart from other types, such as:
- Hedge funds pool together funds of many different investors and assign professional fund managers to actively manage those pooled investments.
- They’re available to a select group of high-profile investors only (i.e. high net worth individuals) and certain types of financial institutions.
- They’re not regulated by the United States Securities and Exchange Commission (SEC).
Hedge Funds and Self-Directed IRAs
Individuals who qualify as accredited investors under Regulation D of the SEC can use their self-directed IRAs to invest in hedge funds. They can use their tax-beneficial IRAs to enjoy potentially high returns and grow their investments in tax beneficial ways.
Traditional and Roth IRAs have different rules when it comes to taxes associated with distributions. If the self-directed IRA is a Traditional IRA, it will only pay taxes on hedge fund income upon distribution. Meanwhile, if it’s a Roth IRA, it will not pay any taxes on qualified distributions from the account.
Another key difference between the two is liquidity. Hedge fund investors don’t have the luxury of liquidating their shares in the fund anytime compared to mutual fund investors.
Because hedge funds normally have a target rate of return within a specific time frame, they require a lock-up period. This means hedge funds compel investors to keep their investments in the fund for a specific period of time.
Pros of Hedge Funds
One of the benefits investors can enjoy with hedge funds is flexibility in terms of investment vehicles and strategies.
Because they aren’t publicly traded financial securities, the SEC has no authority to regulate them. As such, hedge funds can invest in all kinds of legal investment assets and can employ higher-risk investment strategies like leveraged investments, derivatives, and short-selling.
Derivatives Definition: Financial securities whose values or prices change according to the prices or value of other financial assets. These financial assets include stocks, bonds, interest rates, foreign currency exchange rates, and market indexes.
Short-Selling Definition: Selling financial assets that an investor doesn’t own and buying them back at much lower prices. This is a strategy that seasoned investors often use when prices of financial assets are going down.
2. Aggressive Investing Strategies
Another benefit of investing in hedge funds is the ability to use aggressive investing strategies. “Aggressive”, in this context, means that hedge funds can take on more complex financial assets, which can bring potentially higher returns.
Aggressive investment strategies include short-selling, leverage, and investing in higher-risk financial assets like cryptocurrencies, derivatives, or stocks of start-up companies.
Definition of Leverage: A strategy investors use where they borrow money to fund their investments.
Investors also enjoy the benefit of greater diversification by investing in hedge funds. By simply adding hedge fund investments to their portfolio, investors can instantly spread their investible funds in more financial assets that can provide opportunities for higher returns or fewer complexities, depending on the hedge fund’s portfolio composition.
4. Minimize Losses or Make Money in Bear Markets
Bear Market Definition: A bear market means that the prices of financial assets of a specific market are going down and are expected to continue doing so over the foreseeable future.
Remember how a hedge fund enjoys the flexibility of using aggressive investing strategies? One of those aggressive investing strategies is short-selling, which can help investors minimize losses or make money during bear markets.
- With a short-selling strategy, investors can sell financial assets they don’t own yet by borrowing these assets from other investors.
- Investors can buy back the assets later at much lower prices and return them to those they borrowed them from.
The usual way to profit is by buying financial assets at low prices then selling them at high prices. With short selling, the order is reversed — sell financial assets at high prices before buying them at low prices.
5. Investment Expertise
The last benefit associated with hedge funds is investment expertise.
Because hedge funds only cater to very rich investors, they can pay top dollar for the best fund managers. With some of the best fund managers in the industry handling hedge funds, investors can be confident that their investments are in very capable and expert hands.
Cons of Hedge Funds
Despite all the benefits associated with hedge funds, investors may still encounter some challenges when investing in this kind of financial asset.
1. High Fund Management Fees
One of them is the high fund management fees.
Most hedge funds employ a “2 and 20” fee structure. Under this structure, hedge funds charge investors two fees:
- Fund Management fee (2%) — For the operations of hedge funds
- Performance fee (20% ) — Given to fund managers when they’re able to handle the funds profitably every year
These are higher compared to fees associated with mutual funds, which are also pooled funds. The former only charges fund management fees, which are often less than 2%. They also don’t charge performance fees to investors.
That being said, the 20% performance fee can be more than enough motivation for hedge fund managers to manage the funds well and achieve their investors’ expected annual rates of return. Given that it’s contingent upon achieving high rates of return, the 20% performance fee may be considered a positive.
2. Risk Tolerance
The last challenge associated with this type of investment is risk tolerance. In particular, investors interested in hedge funds need a higher tolerance for complexities when it comes to investing in hedge funds.
One reason is that hedge funds aren’t regulated by the SEC. As such, they can get into more alternative investments that can provide higher potential returns, but with more complexities. And because of the risk-return principle, this means hedge funds often invest their funds in higher risk financial assets for opportunities to earn superior returns.
Another reason is that hedge funds only cater to very high profile investors. Hedge funds often require a minimum investment of $100,000.
Not a lot of investors have $100,000 or more to spare for relatively higher-risk investments even if they offer high potential returns. In terms of both the amount and nature of investments, investors who wish to invest in hedge funds need to have a high level of tolerance for complexities.
Hedge funds are investments that have the potential to provide higher returns and diversification to qualified holders of self-directed IRAs. The key to making the most out of them is understanding their pros and cons, and more importantly, how they align with one’s investment goals and preferences.
Given the pros and cons listed in this article, do you think hedge funds are a good addition to your self-directed IRA portfolio? Tell us what you think in the comments section below.
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