The current vogue for hedge funds has caused this once arcane corner of investments to grow exponentially; after the three-year bear market of 2000-2002, investors were looking for ways to avoid repeating their mistakes. The investment banking industry listened to what the investors were asking for and figured out a way to market a long-short strategy in hedge funds and make it available to the average investor.

Because they’re unregulated, hedge funds can pursue all kinds of strategies that are off limits to conventional mutual funds (and for good reason). Some of the more common risks associated with hedge funds:

  1. Lack of transparency and disclosure–You don’t know what you are invested in. Moreover, hedge funds use leverage (borrowed money) to lend money to junk-rated companies.
  2. Lack of liquidity–Hedge fund investors may face significant periods during which they are denied access to their money, in some cases, up to two or more years.
  3. Steep fees–Generally these start at 2% annually on assets under management in the fund and 20% of profits (hedge fund managers, however, do not share in your losses).
  4. Lack of diversification–The managers are making large, focused bets, assuming a high level of risk (an unacceptable level, in my opinion), in their hope to outperform and justify their fees.
  5. Potential loss of capital–Remember the $9 billion Amaranth Advisors meltdown?
  6. Do you know your hedge fund manager?–That manager may have recently closed a failed fund or may have run afoul of regulatory authorities. In fact, hedge fund managers don’t have to be registered investment advisors, after the courts overturned an SEC requirement that they do so.

Now that we understand some of the risks associated with hedge funds, let’s address an even more fundamental issue: What can we do, as fiduciaries, to achieve the performance necessary to meet our clients’ long-term financial objectives?

Although some of our clients might express interest in investing in hedge funds–just as some of them have expressed interest in investing in Google–first and foremost we need to remember that all of our clients’ assets should be allocated in a balanced way among stocks, bonds, and cash. The point of diversification is to avoid having all your eggs in one basket.

Yet the underlying premise of hedge funds–to reduce volatility in a portfolio–is not in itself flawed. For instance, you may want to consider using mutual funds that employ hedged strategies. There are mutual funds that use strategies that may be similar or identical to those of hedge funds, but without all the negatives. There are many benefits to such mutual funds, including full disclosure, full transparency, a public track record, regulation by the Securities and Exchange Commission, a smaller potential for loss due to diversification, lower fees, and generally improved potential for realizing your clients’ long-term investment goals.

While it’s useful to highlight the issues associated with hedge funds, this exercise also serves to underscore the challenges for ordinary investors who may be tempted from time to time to allow emotion to cloud their judgment. So as always, do your homework and exercise a healthy degree of skepticism. Remember, if it sounds too good to be true, it probably is.

Ronald W. Rog?(C), MS, CFP

R.W. Rog?(C) & Company

Bohemia, New York