While the word "hedge" conjures up images of investors cautiously hedging their bets, hedge funds are often extra-risky, volatile investment vehicles that demand huge upfront investments, sometimes in the millions.
Despite this, hedge funds have more than quadrupled their assets since 1999, managing close to $1 trillion today. By contrast, U.S. mutual funds hold some $7.4 trillion. It's estimated that there are more than 8,000 mutual funds in existence and some 7,000 hedge funds.
Like mutual funds, hedge funds consist of the pooled money of multiple investors, which is then invested by a professional money manager. However, unlike mutual funds, hedge funds are not regulated by the Securities and Exchange Commission, are not permitted to advertise, and their managers don't have to be registered investment advisers. In addition, they're not open to just any investor; only "accredited investors" -- folks earning upward of $200,000 per year or those worth more than a million smackers -- need apply.
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 (in other words, using borrowed money), and make currency bets. (Interestingly, these are generally strategies that Fools avoid and mutual fund managers aren't permitted to use.) 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. Billionaire philanthropist George Soros' Quantum Fund, for example, reportedly returned an average of 33% a year over some three decades. But Soros is not average. And with more and more hedge funds opening for business, the quality of their average returns is likely to suffer.
Some hedge funds do deliver. But those most assured of doing well in them are their managers, who frequently take around 20% of all fund profits for themselves, on top of charging investors 1% to 2% per year in fees. Learn more courtesy of the SEC and also from these articles, most written by Whitney Tilson, who actually runs some hedge funds himself: