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What is a Hedge Fund?

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If you read the financial news long enough, you'll probably hear about hedge funds and hedge fund managers. (You'll probably hear that hedge fund managers are terrible people who avoid taxes and are responsible for half of the country's woes.) Is that true? What is a hedge fund? What does a hedge fund manager do? It's easy to get caught up in hyperbole, so let's demystify all of this.

What is a Hedge Fund?

In simple terms, A hedge fund is a private partnership formed to invest money.

Easy, isn't it? Think of a group of twenty people who pledge a million dollars each, hire a manager, and tell that manager "Get us 20% returns every year on our investment." At its core, that's all hedge fund investments are.

The details are a little more interesting.

A Hedge Fund is Private

Unlike a mutual fund or an ETF or an index fund, the average investor can't place a trade with a broker and buy into the hedge fund. Because the fund is structured as a limited partnership, membership is not open to the public.

A Hedge Fund is Exclusive

Hedge funds are huge; they start with a lot of money and try to build ever bigger assets. The average investor with several tens of thousands of dollars in a 401k won't have the kind of money necessary to buy into a hedge fund.

Moreover, it's unlikely that even the few regulations applied to a hedge fund would allow such a small investor. SEC regulations generally require that members be accredited investors (PDF link). In simple terms, these investors need a net worth of at least a million dollars (excluding the value of their primary residence) or must meet a minimum earned income level for the past couple of years, with reasonable expectation to continue to do so.

That leaves out most people.

A Hedge Fund has Few Regulations

Unlike a mutual fund, a hedge fund has far fewer regulations (at least in the United States). Part of this comes from privacy and exclusivity. Part of it comes from lobbying. The few regulations on hedge funds tend to prohibit outright fraud and to promote the idea of fiduciary duty to treat member money with care.

Hedge funds are free to borrow money to invest (investing using leverage), to use short-selling, and to engage in other speculative investment practices. See the SEC's hedge fund investor alert (PDF link) for more information.

Where do Hedge Funds Invest?

A hedge fund may invest in almost anything. In practice, they tend to follow more exotic financial instruments than boring stocks and bonds. Because of their size and their appetite for high returns, they tend to take higher risks and speculate on distressed companies, futures and options, high-frequency trading, and arbitrage.

In other words, many hedge funds try to predict financial trends, whether it's changes in value of currencies in relationship to each other, the prices of commodities such as gold, silver, and oil, or differences in prices between financial assets at the sub-second level.

Some hedge funds spend time and assets performing corporate takeovers. Several talking points in the 2012 US Presidential elections focused on Mitt Romney's work at Bain Capital, a hedge fund known (and widely criticized) for its leveraged buyout operations.

Criticisms of Hedge Funds

One persistent criticism of hedge funds is that their underregulation has created a financial instrument which sucks available capital out of more productive uses. For example, given the choice of investing $100,000,000 in a factory to produces things to sell, which can generate a 6% return, and investing that $100,000,000 in a hedge fund which promises a 9% return (for substantially more risk), the global trend has been to invest in the hedge fund. Unlike investing in a factory which produces real goods and services (and jobs....), the hedge fund investment will likely deal with moving money between banks and other funds, making financial busy work but not producing anything of productive value.

Further, due to the structure of compensation for these funds, fund overseers may make hundreds of millions of dollars every year and pay a fraction of the taxes of a factory worker. In specific, a hedge fund manager can pay capital gains taxes—15%—on a significant portion of his or her income instead of the 30%+ the rest of us would have to pay.

This costs the US Treasury millions of dollars of revenue every year (if not billions).

Finally, due to limited regulation and oversight and reporting duties, it's easier for an unethical hedge fund manager to report false returns and defraud his or her clients. Kirk Wright and Bernie Madoff are two extreme examples.

Hedge Funds versus Value Investing

Most people don't have the kind of money needed to buy into a hedge fund—accredited investors are rare—so there's little reason to wonder about this kind of financial instrument. There aren't really any hedge funds for small investors, by definition. With that said, analyzing hedge funds can be instructive.

A hedge fund probably fails to deliver value to a value investor for a few reasons. It's difficult to analyze. Unlike a business which must produce real cash, what does the hedge fund invest in? (If investment growth comes from derivatives and other non-productive vehicles, you can't use standard modeling techniques, like free cash flow analysis or owner earnings projections.)

It's run by a professional money manager. What does a hedge fund manager do? Besides charging exorbitant fees, the same thing any other investment manager, except riskier, to justify charging higher fees. Keep in mind that the definition indicates some degree of hedging; no matter the direction the market or the underlying securities go, the fund attempts to make a positive return. (If stocks go down, the fund is supposed to make money. Think about what that means for derivatives and other more exotic investments.)

It's underregulated, so the risks of fraud and mismanagement are higher and the odds of having those detected are lower.

You may not be able to buy in and out of the fund at your discretion. Many hedge funds require members to invest their money for at least a year at a time.

There are better opportunities elsewhere. Comparing an index fund versus a hedge fund is easy; the index fund is better for most investors.

Unfortunately, global investors can't avoid the market and taxation distortions of hedge funds—corporate takeovers, tax avoidance, and derivative liquidity chasing are all effects of the current US hedge fund structure—but that is a problem which needs a political solution.

You're probably better off on your own, investing in businesses you understand. While hedge funds may promise big rewards, their lack of transparency (and inaccessibility) make them inadvisable for most investors.