Hedge funds: Should everybody ante up?

Hedge funds are like mutual funds in one way: They pool money from a group of investors and put it into publicly traded securities. More important are the differences. Unlike mutual funds, which make only buy-and-sell decisions, a hedge fund usually engages in aggressive strategies like leveraging. Leveraging increases the value of an investment without increasing the amount of funds invested, meaning that both gains and losses are potentially greater than they would be otherwise.

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Not everyone can participate

Hedge funds are available to "accredited” investors – that is, individuals whose minimum annual income is at least $200,000 or whose net worth totals $1 million or more. (Some hedge funds require an investor to have a minimum of $5 million in assets.) Usually, offers are limited to 100 or fewer investors. Hedge funds are prohibited from selling to the general public. For that reason, they cannot advertise or solicit business, and this contributes to an accredited investor’s feeling of being a particularly savvy insider.

No official SEC oversight

Unlike mutual funds, hedge funds are not required to register with the U.S. Securities and Exchange Commission (SEC). However, the funds are subject to antifraud provisions of federal securities law. Numerous regulators – the Commodity Futures Trading Commission, the Federal Reserve Board, the SEC and others -- remain watchful.

Funds of hedge funds

A fund of hedge funds is an investment operation that invests in hedge funds -- typically 15 to 25 of them to help ensure diversification and lowered risk -- instead of individual securities. Some but not all of these funds register with the SEC. Many set investment minimums that are much lower than those of hedge funds.

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Two reasons to consider investing in a hedge fund

There are two basic reasons for investing in a hedge fund:

• High net returns. Most hedge funds invest in securities that are available to individual investors as well as to groups of investors through mutual funds. Question: So why go the hedge fund route? Answer: The aggressiveness and creativity of a superb hedge fund manager and management team can lead to higher returns than a mutual fund could ever promise.
• Diversification. Because of the types of investments the fund makes and how it does so, it can insulate itself to some extent from the volatility of the stock market. Funds of hedge funds increase this diversification: Poor performance of one hedge fund in the fund of hedge funds’ portfolio will probably not destroy your entire investment.

The homework you must do

If you feel you might qualify to invest in a hedge fund or fund of hedge funds, the first thing to do is thank your lucky stars. After that, do some research.

• Examine the fund's prospectus and all related materials.
• Be sure you know the risk level of the fund's investment strategies.
• Determine how a fund values its assets. Try to find independent sources that can confirm or refute the valuation of these assets. Some funds invest in securities that are difficult to put a dollar value on.
• Explore the fund’s fee structure, since this will affect your return on investment. Hedge funds and funds of hedge funds typically charge an asset management fee as well as a performance fee (a percentage of the fund's profits).
• Know how and when you will be able to cash in your shares. Hedge funds often limit this to four times a year and impose a lock-up period during which you cannot redeem shares. If you’re looking for liquidity, this could be a problem.
• Investigate the fund managers. Call your state securities regulator to make sure these people are qualified to manage your money.
• Obtain references.
• Ask a lot of questions.

Top 10 hedge funds worldwide

JPMorgan Asset Management
(800) 242-7324

Bridgewater Associates
(203) 226-3030

Farallon Capital Management
(415) 421-2132

Och-Ziff Capital Management Group
(212) 790-0000

D.E. Shaw Group
(212) 478-0000

Goldman Sachs Asset Management
(800) 526-7384

Paulson & Co.
(212) 801-0990

Barclays Global Investors
(415) 597-2000

GLG Partners
(212)-224 7200

Man Investments
(312) 443-7480