By Dave GoodboyNEW YORK ( StreetAuthority) -- What do Larry Ellison, Sean Combs, Ted Turner, Bono and Saudi Prince Alwaleed have in common with thousands of other very wealthy people? It certainly isn't their style of dress, philosophy or even how they made their money. In fact, these folks couldn't be more different in terms of just about anything. The one common thread between these billionaires and many other members of the wealthy class is that they either are or have invested in hedge funds. Hedge funds are the common denominator that separates how the wealthy invest compared to the rest of us. In fact, the majority of investors are prohibited by law to invest in hedge funds. Totally and completely unfair, I understand, but these wealth-building tools of the uber-rich are also very risky. The government sees fit to protect undercapitalized, unsophisticated investors from the risks of hedge funds, but at the same time prevents the average investor from benefiting from the massive rewards available in this investment arena. Until now, that is. But more on that in a moment. So what exactly is a hedge fund? Briefly stated, a hedge fund is a lightly-regulated investment partnership that can use any strategy or invest in anything you can possibly think of. There are hedge funds that invest in real estate, art, collectibles, lawsuits and even water rights. It's a broad universe of potential investments, but the majority of hedge funds invest in equities, bonds, derivatives and currencies. Hedge funds have an advantage since they have the capital to hire the best investment-picking talent, computer power, knowledge and information on Earth. Unlike mutual funds, hedge funds can usually make investments based on whatever the manager thinks is best at the time. Hedge funds are not permitted to advertise, so the only way an investor can discover funds, other than the obvious big names, is by way of introduction. So not only do you need to be personally introduced to most of the top performing funds, the manager can decide whether to accept your investment.
While there is no official minimum investment for hedge funds, very, very few accept anything less than $100,000. Many hedge funds require a minimum of $1 million, and a few demand a minimum investment of $25 million. Obviously, these minimums really eliminate everyone but the very rich from investing in hedge funds. Not only are the minimums high, but most hedge funds require lock-up periods for your investment ranging from six months to several years. Although there are ways to get your money out, despite the lockup, it can be very costly. As you can see, hedge funds are only investments for those with a substantial tolerance for risk -- not to mention a fat bank account.
How It's DoneBut it is possible for investors like you and me to mirror their performance. A new exchange-traded fund has just been launched that tries to replicate equity hedge fund performance. The ETF is the Global X Top Guru Holdings Index ETF ( GURU). GURU has just launched, so it has very limited history. However, back testing reveals the GURU ETF would have climbed roughly 30% annually during the past three years, beating the Standard & Poor's 500's 22% average yearly gain. The ETF invests in the single largest holdings of 68 top hedge funds, including John Paulson's Paulson & Co., Bill Ackman's Pershing Square Capital Management, David Tepper's Appaloosa Management, David Einhorn's Greenlight Capital and Daniel Loeb's Third Point. As you can guess, there is much duplication in the holdings of the top hedge funds. Therefore, the fund consists of just 51 stocks, all equally weighted at 1.96%. Technology, financial and industrial stocks comprise nearly 55% of the fund, with holdings including Apple ( AAPL), Microsoft ( MSFT), Google ( GOOG), J.P. Morgan Chase ( JPM), American International Group ( AIG) and Sallie Mae owner SLM Corp. GURU charges a fee of 0.75% of assets to cover expenses. It's important to note that most hedge funds charge a 2% management fee and 20% of profits on an annual basis. So what secretive method does GURU use to determine what are the top holdings of hedge funds? Well, it's really no secret at all.
Every quarter, all funds with over $100 million in assets are required to file a form 13-F with the Securities and Exchange Commission. This form is publicly discloses the holdings of these funds. GURU then uses proprietary methodology to determine the highest conviction ideas among this list for the underlying assets of the ETF. Risks to Consider: Despite all their advantages, hedge funds can and do lose money. Consider Long Term Capital Management and other high-profile fund blow-ups. As you know, just because professionals are invested in the same stocks does not guarantee performance by any stretch. In addition, GURU is a brand new ETF with no historical track record. Action to Take I'm bullish on the future of hedge funds, therefore very excited about this new ETF that opens up the world of equity hedge funds to everyday investors. It's about time that the hedge fund world starts to become democratized. This ETF and another recently launched one, AlphaClone Alternative Alpha ETF ( ALFA), are the first steps in this process. If you are bullish on hedge funds as well as stocks in general, taking a long position in hedge fund-replicating ETFs makes sense.