The Problem with Hedge Funds

Hedge funds are an appropriate investment for qualified purchasers with a net worth above one million dollars and an annual income exceeding two hundred and fifty thousand dollars. Purchasers are often required to sign an acknowledgement confirming their qualifications to invest in hedge funds. However, just because one is qualified to invest in a hedge fund doesn't necessarily mean they should do so. There is a major problem with this type of investment. Oftentimes, the risk associated with the fund is misrepresented, leading to investors being misguided into skewing their qualifications.

The term "hedge fund" is a generic term used to describe many unique investments. Put simply, the phrase is derived from the purpose - hedging the risk of investing. Hedge funds provide lower long-term returns in exchange for less volatility. The form of investment is not new, but their popularity certainly is. The newfound popularity of hedge funds has left many investors wondering what they are all about.

To shed a little light on a decidedly illusive investment tool, a quick run down is necessary. A hedge fund is typically a privately organized pooled investment fund, predominately invested in publicly traded securities. They are normally created as limited partnerships, consisting of one general partner and up to one hundred limited partners. The general partner usually receives a management fee and 10-20% of the profits from the fund. The success or failure of a hedge fund is often dependant on the competency of the fund manager, since they are more aggressively managed and traded than traditional mutual funds.

It should be noted that hedge funds have a higher failure rate than traditional funds. Numerous hedge funds fail by the second or third year of operation. Also, hedge funds are less transparent than traditional funds because some hedge fund managers do not reveal the securities they hold, or the extent to which they are leveraged. Hedge funds may have a higher turnover rate and be less tax efficient than traditional funds.

Along with the aforementioned downfalls associated with hedge funds, several more negatives should be noted. The management and performance incentive fees charged by the hedge fund manager, together with the trading costs and administrative fees can quickly add up, making B share mutual funds seem like a bargain. As stated earlier, only "qualified" purchasers are eligible to invest in hedge funds, leaving many would-be investors out in the cold. And liquidity, if available, is limited to quarterly release, and even then, investors are left at the mercy of the hedge fund manager.

The bottom line is, when dealing with hedge funds, get educated about your investment before jumping in. Discuss the option, both pros and cons, with your dealer, and know what you are getting into.

Here is a resource for more information on hedge funds and hedge fund attorneys.