Hedge Funds, Explained

The popularity of hedge funds grew quickly in the '90s, when their numbers more than doubled. 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 may be 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 are made up of the pooled money of multiple investors, and the pooled money then gets invested by a professional money manager. However, unlike mutual funds, hedge funds are not subject to many regulations from the Securities and Exchange Commission (although that may change in the near future), and their managers don't have to be registered investment advisors. But they are not permitted to advertise the funds. And they're not open to just 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 do. They frequently invest aggressively in options and futures, short stocks, buy on margin (use borrowed money), and make currency bets. (Interestingly, 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 amounts in taxable capital gains.

In the right hands, hedge funds can work well. 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 its last years. More often, though, hedge funds don't fare nearly as well. Poorly performing managers still have reason to smile, though, since 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 in these Fool articles:

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