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Hedge Fund Wizards

There's no other business on Earth like the hedge business. In 2005, according to Institutional Investor, the average top-25 hedge fund manager made $363 million. James Simons, head of hyper-quant Renaissance Technologies, made $1.5 billion! Renaissance's black box speed-trades any public, liquid security, which it can put into its math models. The flagship fund produced remarkable returns (60% before fees) and even more remarkable fees -- 5% of assets and 44% of the gain.

Hedge funds come in every flavor, except vanilla. They're lightly regulated private investment funds for institutions and wealthy individuals. There are 8,000 funds worldwide managing a trillion dollars. For the taxonomic, they use many investment strategies with fancy names: convertible arbitrage, dedicated short-seller, emerging markets, equity market-neutral, event-driven, fixed-income arbitrage, fund of funds, global macro, long/short equity, managed futures, and multistrategy. Charlie Munger of Berkshire Hathaway skeptically boils the styles down to two: (1) funds that make leveraged relative value (long one stock, short another) trades in equities, or (2) funds that make leveraged convergence trades (betting that correlations between securities go back to historical norms) in all kinds of securities and derivatives.

New hedge flavors keep appearing. One of the strangest is "tape-sniffers." SAC Capital, whose investment philosophy is to get to the information before anyone else, is a leader. Headed by Steve Cohen, SAC Capital is one of Wall Street's biggest customers. According to BusinessWeek, Cohen's firm accounts for 3% of the trading volumes at the New York Stock Exchange (NYSE: NYX  ) and 1% of the Nasdaq (Nasdaq: NDAQ  ) . In return, SAC demands preferential insight into analyst upgrades, downgrades, and trading flow. Keeping his nose to the tape has made Mr. Cohen a billionaire; he made $550 million in 2005 alone.

Harry Potter on hedge funds
Even superwizard Harry Potter (whose creator, J.K. Rowling, the most successful author in history, only reached billionaire-land in 2004) would be impressed with the spells cast by hedge fund managers. Indeed, his next adventure may be set in a hedge fund. Here are the big ones.

Spell No. 1: Pay me first. For an investment manager, becoming a "hedgie" is irresistible. In a long-only fund, such as a typical mutual fund, a manager might earn 1% (usually much, much less) of the assets under management. Create a hedge fund, short a few stocks, and income triples or even quadruples. The source of this magic? The industry-standard salary scheme of charging for 2% of assets under management and 20% of performance gains.

Spell No. 2: See no market risk. The root principle of modern finance is William Sharpe's insight that the return on any portfolio is made up of a market part (beta) and a non-market part (alpha). Many hedge funds claim they are market-neutral (no beta), but they'll take big risks in other, less obvious ways, such as volatility and correlations between securities. Return without risk is improbable and unreliable. The biggest risk of hedge funds may be the funds themselves. Each individual hedge fund has its own unique risks. Extreme due diligence is required before making any hedge fund investment, as investment strategies are complex. The range of strategies and performance in hedge funds is much greater than in traditional asset classes, and there's a significant risk of investing in poorly performing or dying funds. Despite adding another layer of fees, a fund of funds offers due diligence and a diversified set of hedge funds. Hedge funds may pose a risk to the financial system. On some days, they account for half of the trading volume on the New York Stock Exchange. Total hedge fund assets have tripled since 1998, when Long Term Capital Management had to be rescued by the Federal Reserve Bank of New York, along with $3.5 billion raised from 15 American and European banks. And with their taste for leverage, hedge funds can deliver a super-sized crisis.

Spell No. 3: Hide your dead. Around 9% of hedge funds go out of business each year -- three or four times the rate for mutual funds. Returns of dead hedge funds are politely dropped from industry performance databases -- painting a too-rosy view of hedge fund performance.

Spell No. 4: Behold my skill, not my luck. The high priest of randomness, Nassim Taleb, in his book Fooled by Randomness, warns against confusing luck with skill. Unlike dentistry, he argues, where relief of pain comes from the dentist's skill, much of the trading success in the financial markets comes from randomness, not skill.

Lessons for mortals
How much do investing mortals need to worry about hedge funds? In short, not much. The exceptional funds with long track records and unique skills -- such as Renaissance and Tudor Investments -- are closed or require multimillion-dollar investments and long lock-up periods. Accessing mere multimillionaire hedge fund managers still requires eye-watering fees and extreme due diligence. And beware -- six hedge managers in the top 25 highest earners produced single-digit returns.

If you still believe in the wizardry of hedge funds and want to invest in their growth, but you're missing a few million, there are a couple of alternatives. First, mutual funds are adding hedge-type techniques like short selling. It's easy to see a future where most mutual funds offer their richest customers hedge fund strategies for a premium fee. Charles Schwab (Nasdaq: SCHW  ) offers a Hedged Equity Fund, and JPMorgan Chase (NYSE: JPM  ) has the Highbridge family of Statistical Market Neutral funds. Second, you can invest in the hedge fund boom indirectly by buying investment banking stocks. As prime brokers, investment banks provide middle- and back-office services to hedge funds. The top three prime brokers are Morgan Stanley (NYSE: MS  ) , Goldman Sachs (NYSE: GS  ) , and Bear Stearns (NYSE: BSC  ) .

But keep an eye out for billionaires with wand-bending spells!

Further Foolishness:

This article was originally published on June 2, 2006. It has been updated.

JPMorgan Chase is a Motley Fool Income Investor recommendation, while Charles Schwab is a Motley Fool Stock Advisor recommendation. Take the newsletter that best fits your investing style for a30-day free spin.

This article was updated by Fool sector head Joey Khattab. He does not own shares of the companies mentioned. The Fool has a disclosure policy.

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