Hedge Funds and You: What Individual Investors Need to Know

Updated from 11:49 a.m. EDT

Hedge funds have been one of the fastest growing investment vehicles over the course of the last two decades. However, for many individual investors who cannot invest in hedge funds (see "Want to Try Hedge Funds? First, Get Rich"), these funds appear to operate in a cloak-and-dagger manner, and remain an enigma.

Nonetheless, hedge funds do have an impact on the individual investor -- both directly and indirectly. So let's peel back the hedge fund onion and expose what makes hedge funds unique and how those funds' activities can affect the market and you.

First, What Are Hedge Funds?

Originally, hedge funds were designed to enter into long/short transactional strategies like the ones I described in "Five Arbitrage Techniques Every Investor Needs to Know." Over time, hedge funds have perverted the original concept of arbitrage and are now just very highly leveraged private investment vehicles.

Hedge funds have several characteristics that distinguish them from separately managed investment accounts (like the ones I manage) or mutual funds . Here are some of those distinctions that individual investors should be concerned with:

Hedge funds are structured as limited partnerships. A limited partnership has two types of owners: a general partner (typically, the hedge fund manager) and the limited partners (the investors). The limited partners/investors have no say in the day-to-day management of the hedge fund. Limited partnerships are a "pass-through" entity, which is to say that the entity itself is not taxed but the income and expense is passed onto the general and limited partners.

Hedge funds charge investors not only an asset management fee but an incentive fee. Sometimes this is referred to as the "1&20" fee structure. The asset fee, say it is 1%, is a flat charge on the assets of the hedge fund. The incentive (or performance) fee is earned by the hedge fund manager if the hedge fund makes money. This is a very important aspect of the hedge fund and one that I will discuss later in greater detail.

They can operate in a domestic (U.S.) environment or an offshore environment.

The hedge fund and its manager are not required to register with the SEC or a state regulatory body.

Reporting to investors is sporadic, delayed and limited in nature.

They can obtain favorable leverage, financing and brokerage rates.

In order to invest in a domestic hedge fund you must be an accredited investor .

Hedge Fund Incentive Fees and You

If the hedge fund starts its first year with $100,000,000 and ends that year valued at $125,000,000, the hedge fund manager will be eligible to share in a percentage of the fund's earnings. So if the incentive fee is 20%, then the hedge fund manager will earn 20% times the difference between $125 million and $100 million, which is $5 million ($125 million less $100 million multiplied by .20).

So why should an individual investor care about these incentive fees?

To earn these potentially huge amounts of money, hedge fund managers will take huge risks -- many of which are highly leveraged -- in the hope that their big bets pay off. By taking these huge levered risks, hedge funds will push stocks, bonds, commodities and other securities to extreme levels (either up or down). All too often these days, some (not all) of these hedge funds' "piling on" activity is referred to as bubbles. An individual investor could be impacted as the "ramp up" occurs, by getting sucked in to the trade. Or when the hedge funds head for the exits, it's the individual investor who is often caught holding the bag (see "Liquidity Crisis Goes Global" and "Goldman Hedge Fund Investors Pull $3 Billion").

Two notorious names that come to mind are Long-Term Capital Management and Amaranth Advisors. Both racked up huge incentive fees for years then went on to lose a substantial amount of their investors' money in a short period of time.

Some unscrupulous hedge fund managers will play the game racking up huge incentive fees and then once they have a down year they will close the fund and start a new one with fresh investor money.

Hedge Fund Taxation and You

One can argue -- as do some members of the U.S. Congress -- that all individual tax payers carry the burden of hedge fund managers and their investors' beneficial tax rates. Why? Simply put, the U.S. Treasury needs to raise the money it's not getting from those big hedge fund gains from somewhere.