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Week of 4.13.07

Hedge Funds 101

New York Stock Exchange floor If you're the kind of person who thinks hedge funds are some kind of subsidy for house shrubbery, you might want to review the basic what, why, and how of hedge funds below.

  • Hedge funds are private investment funds offering a way for people to invest money in stocks, bonds, short-term money market instruments, and/or other securities in order to make investments that may not be feasible for an individual investor. They usually generate higher total returns for their investors versus mutual funds by "hedging" against downturns in the market.

  • Hedge fund investors must be accredited, meaning that they have a net worth of at least a million dollars or meet some other minimum financial criteria. Further, the number of investors in a hedge fund is limited, and minimum investments (usually at least a million dollars) are required. These limitations are intended to help limit participation in hedge funds and other types of unregulated pools to highly sophisticated individuals.

  • Hedge funds are loosely-defined and encompass a variety of complex investment strategies. Many hedge funds generate profit by either "going long", i.e., the investor makes money if the price of the security goes up, or "going short", i.e. identifying overvalued shares that are likely to go down, and buying them when the price drops.

  • Hedge funds are private partnerships and are not required to register with the SEC or disclose their activities to third parties. Hedge funds are only slightly regulated compared to other investment funds, like mutual funds, partially because many hedge funds are based "off-shore," where they are not subject to much regulation.

  • Most hedge funds invest in very liquid assets, and permit investors to enter or leave the fund easily.

  • Hedge funds were invented in 1949 by Alfred W. Jones, a former financial journalist, who wanted to make his investors money, but also to make sure they didn't lose any. In other words, Jones wanted to "hedge" his bets.

  • Hedge funds are characterized by performance fees, which give a share of positive returns to the manager. Performance fees exist because investors are usually willing to pay managers more generously when the investors have made money themselves. For managers who perform well the performance fee is extremely valuable.

  • Hedge fund fraud has become an increasing problem, exceeding $1 billion in recent years. This has prompted the SEC to introduce regulations aimed at protecting the security markets.

  • One popular misconception is that all hedge funds are volatile—that they all use risky techniques and strategies and place large "bets" on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are of this sort. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no leverage.

  • The U.S. is the top location of hedge fund investments, although many come from London as well.

  • During the 1990s and the early 2000s, hedge funds experienced a five-fold increase in size.

  • Due to limited regulation, exact statistics on hedge funds are difficult to find. However, according to the Hedge Fund Research Inc., assets under management of the hedge fund industry totaled $1.225 trillion at the end of the second quarter of 2006.

Sources:

» U.S. Securities and Exchange Commission

» University of Iowa Center for International Finance and Development

» Investment Company Institute