Determine Financial Goals before Investing in Hedge Funds

Before you invest in a hedge fund, you need to answer two key questions: When do you need your money and what do you need your money for?

Your answers influence the risk you can take, the return you need to shoot for, the asset classes that are open to you, and how much time you can allocate toward the investment.

Generally speaking, investable money falls into three categories:

  • Temporary (or short-term) funds that you’ll need in a year. Hedge funds charge high fees. Because fund managers need time to earn these fees, they want money that investors can set aside for long periods.

  • Matched assets that you invest to meet a specific liability, like a college education. Whether a hedge fund is an appropriate match for an upcoming financial need depends in large part on the risk profile of the hedge fund.

    An absolute-return fund, which is designed to have low risk and a steady, low return, is usually a good match with an intermediate-term obligation, for money that you don’t need until after you meet any lockup periods on the fund. Directional funds, which pursue high-risk strategies in exchange for higher expected returns, are a better match for financial needs that reach far into the future.

  • Permanent funds that you invest for such a long term that, for all practical purposes, you’ll never spend them. Instead investors plan to spend only the income generated from the investments’ interest and dividends. They can then reinvest the capital gains so that the initial amounts invested get larger, which causes the amount of income that the investments can generate to grow.

    Permanent funds are often great investment candidates for hedge funds. Most hedge funds are designed to generate steady capital gains, and they limit withdrawals, so your fund’s money should build up over time.

Keep in mind that few managers structure hedge funds to generate income, so if producing income is one of your key investment objectives, you should allocate your funds to other types of investments, like bonds or dividend-paying stocks.

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