Investing 101: Hedge Funds

(Welcome back my friends, to the column that never ends, we’re so glad you could attend, come inside, come inside!  Indeed, it’s that time of the week again, to cover some basic investments that you might be considering.  Today, we’re going to go a little outside our typical range of covered investments, and talk about Hedge Funds!)

Q: So, what are hedge funds?

A: In a nutshell, hedge funds are specialized investment arrangements, which tend to be rather aggressive, taking on an array of investments in order to maximize return and minimize risk.  The managers attempt to achieve alpha, return above the return that could achieved without the manager’s skill.

Q: So, how do hedge fund managers achieve alpha?

A: They can use a variety of methods; hedge funds are lightly regulated by the Securities and Exchange Commission (SEC), meaning they can do things that other mutual funds or investments can’t do in order to achieve their goals of maximizing their return.  They can employ leverage (borrowing money to purchase investments) and shorting (selling shares of stocks they don’t own, and then buying them back at lower prices) as well as unconventional investments in order to achieve their returns.

If they are successful, the managers usually get compensated by the 2 and 20 formula; an annual fee of 2 percent of the assets under management and 20 percent of the profits that result.  A high price to pay, but it could be worthwhile if the manager exceeds the profits possible with other investments.  On the other hand, hedge funds that lose money tend to close down, skewing the performance of the remaining ones to look higher.

Q: Even so, I’m still intrigued.  How can I get in on this?

A: Chances are, you can’t.  Remember that ‘lightly regulated by the SEC’ part?  That refers to the actions taken by the hedge fund itself.  Because the hedge fund could be quite risky, potentially losing much of an investor’s money, the SEC tries to ensure that only well-off investors take part in hedge funds.  This means that if you want to invest, you need to meet one of the following conditions:

-Have a net worth of $1 million or more
-Have earned $200,000 or more in each of the past two years ($300,000 if combined with a spouse)
-Have a reasonable expectation of making the same amount in the future.

Q: Well, piff.  Why cover hedge funds if most of the investing public (especially us whippersnappers getting investment ideas online) can’t even invest in them?

A: A few reasons, actually.  First, hedge funds are one of those terms that gets tossed around in discussions of finance, and having a better idea of what they are is helpful to your financial education.  Next time you hear a financial commentator talk about what hedge funds are doing, you’ll have a better idea of what they mean.

Also, you might at some point in the future, find yourself in one of the categories listed above someday, or the SEC could relax their regulations; either way might mean that you have the needed resources to consider hedge funds as part of your portfolio.

Q: Alright, any last advice on investing in hedge funds?

A: Don’t put all of your eggs in one basket, especially if the basket tends to be secretive and not very closely monitored (as is the case with hedge funds).    A good rule of thumb is the same as with individual stocks; don’t invest any money you can’t afford to lose and don’t invest more than 10% of your total holdings in any one hedge fund.  That way, if it does go under (or you find out your fund manager was doing a Bernie Madoff impression), you would still have most of your money in other places, safe from that investment loss.

That’s it from the wonderful world of Investing 101; hopefully, you have a better idea of what these ‘Hedge Fund’ thingies are all about, and know whether they’d be right for you.

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