Mutual Funds: Hedge Funds

Steve Martin used to tell a joke about the simple steps you need to take to become a millionaire. After pumping up the crowd in Tony Robbins fashion -- asking "Are you ready?" -- he'd rattle off his first step: "Okay, first you get a million dollars."

His answer also provides the first step needed to have access to the tony, exclusive world of hedge funds. Hedge funds are private investment partnerships for institutions and wealthy individual investors that, unlike mutual funds, are largely unregulated by securities industry cops. This doesn't mean they can break the laws, it just means that they can engage in lots of legal but risky investing strategies.

But, before the nonmillionaires tune out, take heart and read on: As we'll see, more and more firms are offering funds with hedge-like characteristics for the masses. But a warning for both rich and poor alike: Hedge funds often tread into very risky waters.

What are the characteristics of a hedge fund? These funds aim for outsize, upside returns, often through a number of fairly sophisticated investment strategies such as short selling stocks (an attempt to profit from a stock's decline by selling borrowed stock in the hopes of buying the stock back later at a lowered price), investing in derivatives (hybrid securities, such as crude-oil futures, whose value is pegged to an underlying investment, such as crude-oil prices) and leveraging (investing borrowed money). They get their name from the strategies, such as simultaneous buying and shorting of stocks, they enlist as a hedge against potential market downturns.

Hedge funds have a high entry barrier: The minimum investment is typically in the seven-figure area. Further, because hedge funds are run by money managers who are, in theory, the best in the business, investors pay a pretty penny in annual expenses, often in the double-digit levels compared with low single-digit fees for regular old mutual funds. In fact, most hedge-fund managers are paid based on their performance, typically putting 20% of a fund's profits into their pockets.

Because of the success of hedge funds (or maybe just because people always want what only the rich people have), many firms are rolling out hedge-like funds that use the same investing strategies. Of course, these funds face greater regulation and disclosure rules than hedge funds, which enjoy the luxury of keeping their investment strategies close to their vest.

For investors dipping into the hedge fund or hedge-like fund waters, it is critically important to know the reputation, investing style and performance record of your manager. Since this is a game for high rollers, you don't want a greenhorn handling your green.

A Bustle in Your Hedge Fund

There's a great deal of activity in the hedge-fund arena, and for investors thinking of getting in, it's best to keep up with the Joneses. These articles are a good starting point:

The Difference Between Mutual Funds and Hedge Funds

More Funds Are Hedging Their Bets