Hedge Funds

If you want to try an unconventional method of investing, with the possibility of making an extraordinary return you could invest in hedge funds.  Hedge funds are private investment funds, that use out of the ordinary investment methods and tax shelters.  They are only regulated lightly; considered a limited partnership typically, and only allow businesses or institutional investors.  A savvy investor with some knowledge could profit off hedge funds.

Hedge funds are considered aggressive, and use unconventional investment strategies including long, short and derivative positions in a variety of markets.  Investments are made in both domestic and international markets, and the ultimate goal is for those investments to result in high returns.

There are two reasons why people would consider an investment in a hedge fund: in an effort to receive a higher return and for portfolio diversification.

The Potential for High Returns

Most hedge funds actually invest funds into the same securities that are available to individual investors.  The reason for hedge funds to have the potential for a higher return than a typical investment is due to superior fund managers that pick timely strategies for investing. 

The advantages of investing in hedge funds is that they include automatic diversification (funds are invested into a minimum of 8 funds, but sometimes up to 15 or more).  The diversification means the failure or underperformance of a single fund does not ruin the entire hedge fund investment.  Hedge funds are known for monitoring the efficiency of each fund, and the investors are known for their selection expertise.  This results in a theory that you should only ever be investing in reputable hedge funds.  It also means that if the fund manager makes a bad selection, the hedge fund is not going to perform as predicted.

Disadvantages of Hedge Funds

The primary disadvantage of investing in a hedge fund is the cost to do so.  Hedge funds create what is called a double-fee structure, which means you pay a fee to the manager of the fund, in addition to normal fees paid to each of the included hedge funds.  A typical fee is 1% to the fund manager, and 1% to each of the underlying hedge funds.  In some cases, hedge funds will also charge a performance fee- of 20-30% of the gains the funds make.  Some investors consider that the price to pay for high performance, but with no guarantees other investors feel the risk is too high for that fee structure.

Hedge funds also present the possibility of over-diversification!  If an investor uses a large number of single hedge funds (in an effort to create a diversified portfolio), the management benefits are undermined, and you are paying double-fee structure on each fund.  Some hedge fund investors recommend investing in 8 to 15 hedge funds.

Regulation of Hedge Funds

Hedge funds are not as regulated as a typical mutual fund.  Hedge funds are basically marketed to the super rich, and you have to earn a minimum annual income, as well as have net worth of over one million dollars.