What is a Hedge Fund?

by Catherine Rein
(last updated April 6, 2009)

Hedge funds have gained a lot of publicity in the last few years. In 2006-2007 it was for their amazing investment returns and in 2008 it was for their incredible losses. Hedge funds vary widely in their investment goals and methods. They are primarily for wealthy investors and institutions with significant capital to invest hoping to reduce risk and achieve higher than average returns. They are by law restricted to 100 investors per fund and therefore often set extremely high minimum investment amounts, some as high as $1 million.

Hedge funds use a number of different strategies and invest in many different markets. Because of the unique strategies used, investors are often required to keep their money in the fund for a year or more. The difficulty in getting money back out of a hedge fund makes it very important to research and ask lots of questions before getting in. Investors in hedge funds follow these guidelines before investing:

  • They understand the risks. Not all hedge funds register with the SEC, meaning there is very little oversight of these investments. Also, hedge fund investors do not have all the same state and federal protection available to other investors. Hedge funds are not required to provide regular pricing or valuation information and they often include complex tax structures. This can delay getting tax statement distributions, meaning you might have to file a tax extension.
  • They ask questions. Any time you are trusting your money with someone else you have the right to know how the money will be managed, how it will be invested, who is managing the investment and how you can get your money back.
  • They research the fund managers. Knowing everything about the fund managers will reduce the risk of investing in a hedge fund. Make sure they are qualified to manage your money and find out if they have any judgments against them.

Certainly hedge funds are not for the average investor. The minimum investment amount limits them to only the wealthiest of individuals and institutions. Though they are designed by definition to limit risk (or hedge) their investments, many often require high performance fees and some use highly risky investment strategies. These strategies include short selling (selling a security you do not own), arbitrage (simultaneous buying and selling of securities in different markets), investing in derivatives such as options or futures contracts and investing in volatile international markets.

Author Bio

Catherine Rein

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