What’s Hedge Funds (1)—Higher Costs and Risks for Higher Potential Returns

Hedge funds are growing in both number and total assets under management. What are they? What’s the difference between Hedge funds and mutual funds?

There is no exact definition of the term "hedge fund" in federal or state securities laws. Hedge funds are basically private investment pools for wealthy, financially sophisticated investors. Traditionally, they have been organized as partnerships, with the general partner (or managing member) managing the fund's portfolio, making investment decisions, and normally having a significant personal investment in the fund.

Hedge funds are like mutual funds in two respects: (1) they are pooled investment vehicles (i.e. several investors entrust their money to a manager) and (2) they invest in publicly traded securities. But there are important differences between a hedge fund and a mutual fund. These stem from and are best understood in light of the hedge fund's charter: investors give hedge funds the freedom to pursue absolute return strategies.

Mutual Funds Seek Relative Returns
Most mutual funds invest in a predefined style, such as "small cap value", or into a particular sector, such as the Internet sector. To measure performance, the mutual fund's returns are compared to a style-specific index or benchmark. For example, if you buy into a "small cap value" fund, the managers of that fund may try to outperform the S&P Small Cap 600 Index. Less active managers might construct the portfolio by following the index and then applying stock-picking skills to increase (over-weigh) favored stocks and decrease (under-weigh) less appealing stocks.

A mutual fund's goal is to beat the index or "beat the bogey", even if only modestly. If the index is down 10% while the mutual fund is down only 7%, the fund's performance would be called a success. On the passive-active spectrum, on which pure index investing is the passive extreme, mutual funds lie somewhere in the middle as they semi-actively aim to generate returns that are favorable compared to a benchmark.

Hedge Funds Actively Seek Absolute Returns
Hedge funds lie at the active end of the investing spectrum as they seek positive absolute returns, regardless of the performance of an index or sector benchmark. Unlike mutual funds, which are "long-only" (make only buy-sell decisions), a hedge fund engages in more aggressive strategies and positions, such as short selling, trading in derivative instruments like options and using leverage (borrowing) to enhance the risk/reward profile of their bets.

This activeness of hedge funds explains their popularity in bear markets. In a bull market, hedge funds may not perform as well as mutual funds, but in a bear market - taken as a group or asset class - they should do better than mutual funds because they hold short positions and hedges. The absolute return goals of hedge funds vary, but a goal might be stated as something like "6 to 9% annualized return regardless of the market conditions".

Investors, however, need to understand that the hedge-fund promise of pursuing absolute returns means hedge funds are "liberated" with respect to registration, investment positions, liquidity and fee structure. First, hedge funds in general are not registered with the SEC. They have been able to avoid registration by limiting the number of investors and requiring that their investors be accredited, which means they meet an income or net worth standard. Furthermore, hedge funds are prohibited from soliciting or advertising to a general audience, a prohibition that lends to their mystique.

In hedge funds, liquidity is a key concern for investors. Liquidity provisions vary, but invested funds may be difficult to withdraw "at will". For example, many funds have a lock-out period, which is an initial period of time during which investors cannot remove their money.

Lastly, hedge funds are more expensive even though a portion of the fees are performance-based. Typically, they charge an annual fee equal to 1% of assets managed (sometimes up to 2%), plus they receive a share - usually 20% - of the investment gains. The managers of many funds, however, invest their own money along with the other investors of the fund and, as such, may be said to "eat their own cooking".

Many hedge fund Strategies
To get positive investment performance, hedge fund managers use sophisticated investment strategies and techniques that may include, among other techniques:
· short selling (sale of a security you do not own)
· arbitrage (simultaneous buying and selling of a security in different markets to profit from the difference between the prices)
· hedging (buying a security to offset a potential loss on an investment)
· leverage (borrowing money for investment purposes)
· concentrating positions in securities of a single issuer or market
· investing in distressed or bankrupt companies
· investing in derivatives, such as options and futures contracts
· investing in volatile international markets
· investing in privately issued securities

Managers are paid based on the fund's performance. Performance fees of 20% of profits are common, along with a fixed annual asset-based fee of 1 to 2%.

Because they are usually only open to limited numbers of wealthy, financially sophisticated investors and do not advertise or publicly offer their securities, private hedge funds are usually not required to register with the SEC. As a result, unregistered private hedge funds do not provide many of the investor protections that apply to registered investment products, such as mutual funds. For example, hedge funds generally are not subject to numerous mutual fund rules, such as regulations:
· requiring a certain degree of liquidity
· limiting how much can be invested in any one investment
· requiring that fund shares be redeemable
· protecting against conflicts of interests
· assuring fairness in pricing of the fund shares
· requiring disclosure of information about a fund's management, holdings, fees and expenses, and performance
· limiting the use of leverage

The general prohibitions against securities fraud do apply.