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By Selena Maranjian (TMF Selena)
June 10, 2002

Q. What are "hedge funds"?

A. Hedge funds became famous (and infamous) in the '90s, more than doubling in number. While the word "hedge" might conjure up images of investors cautiously hedging their bets, hedge funds are often extra-risky, extra-volatile investment vehicles that demand huge up-front investments, sometimes in the millions. You're unlikely ever to invest in one, but it's good to understand what they are and aren't -- if only to impress colleagues at the water cooler.

Let's review some of their qualities. Like mutual funds, hedge funds comprise the pooled money of multiple investors, which is then invested by a professional money manager. However, unlike mutual funds, hedge funds are not subject to many Securities and Exchange Commission (SEC) regulations (although that may change in the near future), are not permitted to advertise, and their managers don't have to be registered investment advisers. In addition, they're not open to any investor: Only "accredited investors" need apply. These are folks who generally earn upwards of $200,000 per year and who are worth more than a million smackers.

Since hedge fund managers are relatively unfettered by restrictions, they can and do take many more risks than ordinary investors or mutual fund managers. They frequently invest aggressively in options and futures, short stocks, buy on margin (use borrowed money), and make currency bets. These are generally strategies that mutual fund managers aren't permitted to use and that the Fool recommends investors use with extreme caution or avoid entirely. Because of their frequent trading, hedge funds can also rack up considerable taxable capital gains.

In the right hands, hedge funds can work. Billionaire philanthropist George Soros' Quantum Fund, for example, reportedly returned an average of 33% per year over some three decades, before stumbling a bit in recent times. More often, though, hedge funds don't fare nearly as well as the Quantum Fund did. According to Van Hedge Fund Advisors, the Van U.S. Hedge Fund Index underperformed the Standard & Poor's 500 between 1995 and 1999 and outperformed it between 1997 and 2001. Poorly performing managers still have reason to smile, though, as they typically take a big chunk of fund profits -- as much as 25%. Regardless of fund performance, they also command an annual management fee of roughly 1% to 3% of assets under management. Not a bad deal -- for them.

Learn more about hedge funds at HedgeFundCenter.com, HedgeWorld, VAN Hedge Fund Advisors, and HedgeFund.net. You may find more objective info on them at Harvard Business School, and these BusinessWeek articles: "Before You Jump into a Hedge Fund" and "Will Hedge Funds Be Overrun by All the Traffic?"

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This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource.