What Is a Hedge Fund?
Hedge funds used to be available for only the wealthiest and most sophisticated
investors. But no anymore. Today, just about anybody can invest in hedge
funds through so-called “fund of funds” (FOF) and other alternative
products that are sold by the nation’s largest brokerage firms.
Webster’s Dictionary defines “hedge” as something that
provides protection or defense. Many investors purchase hedge funds with
that in mind, thinking that they’re protecting or defending their
portfolio from bad markets. Unfortunately, that simply is not true. In
fact, hedge funds are often incredibly risky, underperform against the
market, and not worth the high cost.
Like mutual funds, a hedge fund is an investment pool that is managed with
the goal of achieving positive investment returns. Unlike mutual funds,
hedge funds typically have more flexible investment strategies, and use
risky tactics like leverage, short selling, and other speculative strategies.
In doing this, hedge funds often promise that they can achieve better
results with less risk than conventional funds that purchase only stocks.
Hedge funds regularly use terms like “low volatility” or “low
correlation with the market” to sell that promise to investors.
The reality is very different. In terms of performance, studies have shown
repeatedly that hedge funds over promise and under deliver. On top of
that, they’re incredibly expensive. Hedge funds typically charge
annual fees of 2 percent plus 20 percent of profits. With such exorbitant
fees, it’s little wonder why hedge funds often perform so poorly.
Moreover, not only do hedge funds engage in risky strategies, they’re
also exempt from most federal and state securities laws.
Because of that, hedge funds are not required to follow even the most basic
disclosure protections that apply to most other investments. This means
that investors are kept in the dark about what they’re invested
in and how their investments are performing.
In short, unless you have a lot of money and can afford the risk of losing
a substantial portion of your investment, don’t invest in hedge
funds. In my opinion, they’re risky, perform poorly, and not worth the cost.