A BUYandHOLDer

There's lots of confusion about hedge funds -- what they are and who can invest in them. I'm going to spell out the basics and then, refer you to several sources for more details, since our space here is limited. You'll note I keep tossing in the words "generally", "typically" and "usually." That's because there are exceptions and variations on the theme. In other words, I'm hedging my information because it is so complex.

THE DEFINITION

A hedge fund is a private, unregistered investment portfolio, usually structured as a limited partnership -- with the investment manager acting as the general partner while the investors are the limited partners. The general partner, who determines the investment strategy of the fund, is typically a Wall Street veteran or pro who has decided to go into business, investing his or her own money along with a handful of clients.

These unregulated pools of money more often than not, involve a high degree of risk, investing most or all of their assets in publicly traded securities. Their aim is to achieve returns above those offered by mutual funds.

With the exception of antifraud standards, hedge funds, unlike regular mutual funds, are exempt from SEC regulations. In other words, a hedge fund's business is not public information. It is bound only by the investment agreement or contract that investors sign with the fund's sponsor.

OTHER KEY FACTS

o The sponsors of a hedge fund generally are not subject to any limitations in how the fund is managed. Nor are they required to disclose information about the fund's holdings or performance -- beyond what the sponsor voluntarily agreed to in the contract to provide.

o There are no limits on the fees a hedge fund can charge its investors. Typically, the manager takes a fee of 1% or 2% of net assets, plus 20% of the annual return. Some have additional sales charges.

o Hedge funds are also not subject to regulations that apply to mutual funds for the protection of investors. The two most important regulations that do not apply are (1) that they maintain a certain degree of liquidity and (2) that shares be redeemable at any time.

Investors often are unaware of this second point. Unlike mutual funds, most hedge funds insist upon what's known as a lock-up, which can run anywhere from one to three years. You can't get your money out during that lock-up period. Even after the lock-up is over, you may be able to exit on only a quarterly or semi-annual basis.

WHO CAN INVEST

In exchange for freedom from the SEC and the ability to pursue any investment strategy, including high-risk strategies, hedge funds generally must do three things: (1) remain private; (2) accept only accredited investors and (3) have no more than 99 investors.

In the eyes of the SEC, an accredited investor is one who is sophisticated and can take care of him or her self. More specifically that is someone who:

** Has a net worth of $1 million or more; or

** Has an annual income of $200,000 or more in each of the two most recent years (or $300,000 jointly with a spouse) and who has a reasonable expectation of reaching the same income in the current year

The cap of 99 investors doesn't apply to all funds. Some can have an unlimited number of "qualified purchasers." The requirements for this super accredited investor are even higher than for accredited investors -- a qualified purchaser must have $5 million or more in assets.

WHAT DOES IT MEAN "TO HEDGE?"

To hedge means to offset or manage risk. Hedge funds use any number of strategies to hedge against market declines and to boost returns. Among these strategies are using extensive leveraging, arbitrage, puts, call and options and selling short.

For example, to hedge against a declining market, a fund manager might sell securities short. (For the pros and cons of selling short, click here to read a previous Under The Oak column on the topic.) Or, the manager might buy put options on an index, such as the S&P 500.

(These hedging strategies are often not allowed at all or are severely restricted with mutual funds.)

By leveraging or using borrowed capital to increase returns, hedge funds can post substantial returns. However, if the manager makes the wrong decision, the losses can be considerable.

For example, back in 1998, the Long-Term Capital Management (LTCM) hedge fund run by a former vice president of Salomon, John Meriwether, collapsed. The well-known bond trader made the wrong bet on interest rates. At one point, the fund had returned slightly over 40% to its shareholders. Then, in August Russia defaulted on its debts and LTCM couldn't handle the crisis and pay back its own loans.

The Federal Reserve board stepped in to negotiate a $3.6 billion bailout. The fund eventually paid back $1.3 billion to investors. The result: investment houses that make loans to hedge funds became more conservative.

However, not all hedge funds actually hedge. Many use the basic buy-and-hold strategy. Known as long-bias equity funds, they fall into similar categories that you find with mutual funds: large cap, value, growth, momentum, etc.

HOW MUCH MONEY IS REQUIRED?

Minimums, which vary from fund to fund, are set by the general partner. Until fairly recently, hedge funds were only for the very rich, with $1 million minimums quite common. However, as asset managers and brokerage firms started setting up their own hedge funds, minimums have dropped to $100,000 or sometimes less.

FOR MORE INFORMATION

Check out the first two sources for in-depth details and basic facts about hedge funds:

(1) The Baker Library of the Harvard Business School at: http://www.library.hbs.edu/hedgefunds.htm

(2) The Hedge Fund Association at: http://www.thehfa.org/

You won't find hedge funds listed in the financial pages of newspapers, so for current performance figures and lists of top performing funds, log on to:

(3) The Hedge Fund Consistency Index Newsletter at: http://www.hedgefund-index.com/

(4) The Hennesse Hedge Fund Advisory Group at: http://www.hedgefnd.com/