Once dismissed as secretive, risky and only for the well-heeled, hedge funds represent a growth industry. They can promise higher-than-average market returns in a downtrodden market, but despite the allure of these alternative investment vehicles, investors should think twice before taking the hedge fund plunge.

Tutorial: Hedge Fund Investing

What Are Hedge Funds?
Hedge funds are privately offered investments that use a variety of non-traditional strategies to try to offset risk, an approach called - you guessed it - hedging.

One such technique is short selling. Hedge fund managers identify a stock in which price is likely to decline, borrow shares from someone else who owns them, sell the shares and then make money by later replacing the borrowed shares with others bought at a much lower price; buying at this lower price is possible only if the share price actually falls.

Hedge fund managers also invest in derivatives, options, futures and other exotic or sophisticated securities. Generally, hedge funds operate as limited partnerships or limited liability companies and they rarely have more than 500 investors each. (For more read Getting To Know Hedge-Like Mutual Funds.)

Arguments for Hedge Funds
Some hedge fund managers say these funds are the key to consistent returns, even in downtrodden markets. Traditional mutual funds generally rely on the stock market to go up; managers buy a stock because they believe its price will increase. For hedge funds, at least in principle, it makes no difference whether the market goes up or down.

While mutual fund managers typically try to outperform a particular benchmark, such as the S&P 500, hedge fund managers disregard benchmarks. They aim instead for absolute returns; in most cases a return of a certain percentage, year in and year out, regardless of how well the market does.

The argument goes like this: since hedge funds don't track the market, they, at the very least, protect the investor's portfolio. At the same time, as several successful hedge funds have demonstrated, they can also generate very high returns. The multibillion dollar Quantum Fund managed by the legendary George Soros, for instance, boasted compound annual returns exceeding 30% for more than a decade. (You can read more about George Soros in the Greatest Investors tutorial.)

Why Investors Should Think Again
The arguments are certainly compelling, but be warned. For starters, there is a big catch: most hedge funds require a minimum investment of $1 million. Granted, investors can now choose from a growing number of "lite" hedge funds, which have more affordable minimum investments. The lowest ones, however, start at $100,000. For most investors, that is hardly spare change. Lack of liquidity is another drawback. Investments may be locked up for as long as five years.

What about the risk? High-profile collapses are reminders that hedge funds are not immune to risk. Led by Wall Street trader John Meriwether and a team of finance wizards and Ph.D.s, Long Term Capital Management imploded in the late 1990s. It nearly sank the global financial system and had to be bailed out by Wall Street's biggest banks. In 2000, George Soros shut down his Quantum Fund after sustaining stupendous losses. (For more on this, read Massive Hedge Fund Failures.)

For nearly every hedge fund that opens its doors to investors, another is forced to liquidate after poor performance. While some funds have delivered spectacular gains, many others have performed so poorly that average hedge fund returns have fallen below market levels.

A Closer Look at the Risks
A study by Yale and NYU Stern economists suggested that during that six-year period, the average annual return for offshore hedge funds was 13.6%, whereas the average annual gain for the S&P 500 was 16.5%. Even worse, the rate of closure for funds rose to more than 20% per year, so choosing a long-term hedge fund is trickier than even choosing a stock investment.

Management inexperience may explain the high rate of attrition. Remember, there are thousands of hedge funds in the U.S., a dramatic increase from 880 in 1991. This means that many of the managers are brand new to the hedge fund game. Many have come from traditional mutual funds and are not experienced with selling "short" or with the other sophisticated securities instruments at their disposal. They must learn by trial and error. Veterans are quick to point out that successful shorting involves a long learning curve, which is also difficult to execute. Short selling, moreover, typically relies heavily on leverage, making the manager's job even tougher.

Even investors comfortable with risk should still be aware of other drawbacks. For one, hedge fund fees are much higher than those of traditional mutual funds. Hedge funds typically charge 1 to 2% of assets plus 20% of profits. Given the profits that managers take, hedge funds often don't deliver to investors the promise of market-beating performance.

Another sticking point is poor transparency. The Securities and Exchange Commission doesn't dictate the same strict rules for hedge funds that it does for traditional mutual funds. Managers can make up the portfolios as they please, and there are no rules for providing information about holdings and performance. Although hedge funds are subject to anti-fraud standards and require audits, you should not assume that managers are more forthcoming than they need to be. This lack of transparency can make it hard for investors to distinguish risky funds from tame ones.

Finally, hedge funds can bring a big tax bite. Because managers buy and sell so frequently, investors incur high capital gains, which are normally taxed at the ordinary income tax rate.

The Bottom Line
The logic behind hedge fund investing is compelling, but before piling in investors should take their time and do the necessary due diligence on the fund and its managers. Finally, they should remember to weigh the risks. It might be wise for them to consider if they aren't better off with an index fund. (To learn more read Offset Risk With Options, Futures and Hedge Funds.)

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