Hedge fund investing: How does it work?
Ever wondered what it is like to invest in a hedge fund?
To explain how they work, today I’m playing the role of hedge fund manager, Mr. Moneybags, and I’m opening my fund, The Get Rich Quick Fund, to a select group of investors, including YOU. Do you want to invest in my hedge fund?
Here’s what you need to know:
First, don’t even talk to me unless you’re an accredited investor. In other words, you’ve made at least $200k in each of the last couple years and plan to do so this year, $300k if you’re married filing jointly, or, if you don’t fit that criteria, we can still talk about investing in my fund if your net worth is north of $1,000,000, not including your income or primary residence.
Second, I’m not just investing in stocks and bonds. I'm going to invest in all kinds of alternatives - I’m going to buy futures contracts, I’m going to include some venture capital investing, I’ll have some real estate in my fund, and I’m going to buy a lot on leverage to get us more bang for our buck.
My strategy may change over time, but you don't need to know what I'm investing in, just cut the check and I'll handle the rest. The industry calls this "blind pool" investing, but I call it Moneybags Magic. Whether the stock market goes up or down, we are making money...I hope.
Third, the SEC regulates my fund, but not as strictly as the mutual funds you’re used to investing in. You’re worth over $1,000,000, or you’re making hundreds of thousands of dollars per year. In the SEC’s eyes, you are sophisticated and savvy enough to understand the risks involved in investing in my fund, so they don’t hold me to the same standards as they do those mutual fund managers you invest with.
Fourth, I’m charging you 2% of the total dollars you invest with me to manage the fund, and I’m charging you 20% on the gains once I surpass a 5% hurdle rate. My industry friends refer to that fee structure as "two and twenty."
How does that work?
My fund has $1B in it among 100 qualified investors. Each investor contributes $10M. Off the top, I’m charging everyone $200k/year to manage their money, making my total annual management fee $20M.
Then let’s say the fund earns 25% this year (which it will because I’m such a great hedge fund manager).
That’s $250M in gains, $230M after my management fee. I’m not charging anything for the first $11.5M in gains (my 5% hurdle rate), but I’m taking 20% of that remaining $218.5M in profit, another $43.7M to me, making my annual take home pay $63.7M. Don’t worry, you’ll make plenty, too. In one year you’ll earn $1.863M, or 18.63% after my fees. We all win!
I just win a lot more than you.
Thanks for investing in the Get Rich Quick Fund - here’s to year two being just as lucrative!
Key Takeaways...hedge funds:
-are only available to accredited investors
-invest in more than just stocks and bonds, often using leverage, aka borrowed money
-are typically set up, aka “hedged," to make money in both up and down markets
-are less regulated by the SEC
-have a fee structure often referred to as “two and twenty,” where the investor is charged a % of AUM plus a % of profits
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