What is a Hedge Fund?

The devil is always in the details.

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The positive and tempting performance of the stock market in general in 2013 is on the minds of investors and, we expect, greed will likely follow. While Hedge funds were originally created to hedge downside risk, they more recently have become associated with trying to capture an even higher share of market performance. So you might ask “What is a hedge fund?”

A hedge fund is a pool of money that is managed by one or more individuals who may share in the profits as a form of compensation. Investments in these types of funds can be illiquid and may require investors to be accredited. The term illiquid refers to limiting the investor’s ability to withdraw funds to, perhaps, only once a year. Accredited investors are those that have a liquid net worth of more than one million dollars and should have extensive investment knowledge. These entry requirements are meant to ensure that the investor could afford to withstand higher investment risk than the average investor. Investments can also be leveraged (i.e. bought with margin) and can also reflect alternative investments such as timber, gold, and other commodities. Derivatives, or magnifiers of return, can also be used to attempt to control risk and return. Expenses, including the manager fee, are often very high in hedge funds — sometimes exceeding 3.5%. These expenses can include bonuses to traders, special technology, and additional sales charges to sell the fund. Over time, these exorbitant expenses can actually negate the potential upside in investment return.

To prove this point, Warren Buffet challenged Protégé Partners that the average returns to investors (after all fees) of 5 hedge funds of funds could not beat the performance of the S&P 500. The hedge fund managers were selected by Protégé and the decade long bet runs from January 1, 2008 to December 31, 2017. So far, Warren seems to be right as he stated in the annual Berkshire Hathaway shareholder’s meeting in May, 2013 in Omaha, Nebraska.

The devil is always in the details. If investors are considering investing in these types of funds, they should carefully read the full prospectus to make sure the allure of higher returns will not be gobbled up by added expenses. For more information, see our February 25th blog post Are Hedge Funds Worth the Risk?

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