Although hedge funds have become more popular as an investment vehicle in recent years they have actually been around for quite some time. Simply defined, a hedge fund is a pooled investment vehicle, often in the form of a limited partnership (LP). A pooled investment is one where assets from a variety of individuals (or institutions) are "pooled" and invested together (for example, a mutual fund is a pooled investment vehicle).

What Makes A Hedge Fund A Hedge Fund?
The investment manager of a hedge fund has the flexibility to invest in a very wide range of securities and financial instruments and is not limited to one investment strategy or technique. The name hedge fund comes from the fact that one tactic the manager may employ is to "hedge" a "long" position, by selling short. For example, a manager may like certain stocks, but also be concerned over a general decline in the market. To hedge against some (or all) of that market risk, he could buy his favored stocks, but also sell short S&P 500 futures.

With hedge funds, you often hear the term, "net long position," which takes into account the funds "net" market exposure after subtracting the effects of any short positions from the fund’s long positions. So in the example above, the fund might be 65% net long, meaning it has hedged away 35% of the market’s risk.

However, hedging is just one of the numerous techniques that a hedge fund may employ; it’s not actually a defining trait. In fact, there are many hedge funds that do not use hedging at all. And of course, mutual funds can use certain hedging strategies, as well. You often hear us talk about hedged or un-hedged international mutual funds. An international mutual fund that does not want to be exposed to fluctuations in the value of a foreign currencies versus the dollar, can hedge away that risk.

Another strategy commonly associated with hedge funds is leverage. By borrowing money (margin debt) against the fund’s assets, a manager can purchase additional securities. In this case, a fund might be say, "150% net long," meaning the fund has borrowed an amount equal to half its assets to purchase more securities. This technique obviously increases the fund’s potential volatility. However, many hedge funds do not use leverage – or use only minimal leverage.

What is typical of most hedge funds is that they tend to be far more concentrated (i.e. less diversified) in their holdings than mutual funds. The managers of hedge funds tend to focus the majority of their assets on a few favored ideas. And, while the majority of mutual funds are managed with an eye towards good returns "relative" to a benchmark index, hedge funds typically seek to generate strong absolute returns. This may take the form of aggressive pursuit of high long-term returns with a lot of volatility, or lower, but more consistent absolute returns.

Hedge Funds Are Not "Investor Friendly"
Historically hedge funds have operated in an environment with moderately low regulation. Unlike mutual funds or individual investment advisors (such as Kobren Insight Management), they are not typically registered with the SEC. As such, they are not required to give their investors the kind of investment disclosure that mutual funds have to provide. In fact, they may not provide their investors with any information on their holdings at all!

Hedge funds are also far less "liquid" than mutual funds. Most hedge funds have an initial "lock-up period", during which time your investment may not be redeemed, without a penalty fee. Even after the lock-up period expires, many hedge funds offer limited liquidity in that you may only redeem your investment on a quarterly, semi-annual or even annual basis. Additionally, rather than the daily valuation of your investment that you get with mutual funds, hedge funds are only valued on a monthly basis.

The benefit of all this for the hedge fund manager is that they don’t have to spend a lot of time and money on compliance issues and more important, they don’t have to worry about disruptive cash flows in or out of their fund which could play havoc with their investment strategies.

Vehicles For The Wealthy
Given their potentially aggressive (and changeable) strategies, their lack of regulation, and lack of transparency, the law requires that most hedge funds participants be "accredited" (essentially wealthy) investors. An accredited investor is an individual with a net worth in excess of $1 million or with an annual income in excess of $200 thousand (or $300 thousand with spouse). For institutions or trusts, in order to be "accredited" total assets must exceed $5 million.

Recently the SEC has required certain hedge funds to register as investment advisors, which has received both negative and positive publicity. With assets approaching an estimated $1 trillion and possibly over 8000 hedge funds in existence (since hedge funds are unregulated, there is no precise way to account for the exact number of hedge funds) some believe that this asset class needs more regulation. Obviously the potential for fraud is greater in their current unregulated state.

The flip side of the argument, which we alluded to earlier, is that their freedom from the demands of regulation is necessary in order that they can effectively pursue many of the complex strategies that in effect, make hedge funds, hedge funds.

Pay For Performance
Hedge funds typically charge an asset-based management fee of between one and two percent, along with a performance-based fee, which is normally 20% of any profits made each year. These additional fees are designed to be an incentive for the manager to achieve high absolute returns. The rest of the expenses are spread across the partnership based on percentage ownership of the fund.

This fee structure is unquestionably high, but it has two advantages for investors. First, the chance to earn a substantial income from managing a hedge fund attracts some of the "best and brightest" managers in the investment world. And second, with such a high bonus for performance, the managers’ interests match those of the investors.

Given the lack of public information about hedge funds, it can be difficult for an investor to know which hedge fund to invest in. A recent development to address this issue has been the rise of the fund of hedge funds (FOHF). As the name suggests, FOHFs pool multiple hedge funds into one fund, building a diverse portfolio. A FOHF manager’s job is to perform the due diligence and extensive screening on the prospective hedge fund managers and construct the portfolio of managers to fit with a specific investment objective. A FOHF can be made up of different hedge fund strategies, (multi-strategy fund), or it focus on one particular strategy.

Why invest in a hedge fund?
Hedge funds generally attempt to produce returns that have a low correlation to traditional assets classes. They may, in fact, utilize complex strategies in order to deliver returns that are independent of the results from conventional asset classes. Since a hedge fund’s returns are not as tied to the performance of the general market as other investment vehicles, adding some hedge fund exposure to a portfolio can offer valuable diversification and reduced overall portfolio volatility.

With the increasing attention to the hedge fund industry, and total assets almost doubling in the past 4 years, hedge funds could gain even more popularity in the years ahead. Hedge funds come in as many different types as mutual funds – some are very aggressive and risky, but others are not terribly risky at all. But you should fully understand all the risks involved with a hedge fund before investing.