Taking the Mystery Out of Hedge Funds

When the dollar amounts AT stake are in the billions, even trillions, it should come as no surprise that hedge funds continue to generate a lot of buzz.

Indeed, assets in the exclusive investment pools total more than $1 trillion, and a recent study by Deutsche Bank estimates another $110 billion will flow into hedge funds this year. And of course where there’s demand, there’s supply. As wealthy individuals, endowments, pension funds, and others have poured money into hedge funds, their number has swelled to 10,500 worldwide.

Yet experts say hedge funds remain poorly understood: Most investors know them as the funds that make headlines by either delivering eye-popping returns or dramatically imploding. Investors are puzzled, however, by what exactly hedge funds are, how to get access to them, and how to choose between them. Even the term “hedge fund” is murky because it encompasses an enormous range of investment types.

While many hedge funds still require a minimum initial investment of $1 million, it has become increasingly possible for investors with more modest assets to jump on the bandwagon. “Hedge funds have become more accessible,” says Gareth Lyons, a hedge fund analyst for Morningstar Inc. “You need certain assets and income to qualify, but a lot of them are lowering their investment minimums.” In some cases, investors are accessing hedge fund strategies for as little as $2,500 through mutual funds that employ a similar approach.

What is a hedge fund?
“Using the term ‘hedge fund’ is sort of like saying, ‘I’m a doctor,'” says Rick Brooks, a financial planner in Solana Beach, California. Just as physicians run the gamut from brain surgeons to podiatrists, hedge funds vary widely in terms of investment strategy and risk level.

However, hedge funds do share some broad similarities. For starters, like a mutual fund, a hedge fund pools its investors’ money and puts it to work in the market. But an important difference is that hedge funds are private and generally fall beyond the reach of government regulation. (Though they do not have to register with the Securities and Exchange Commission, hedge fund managers have certain fiduciary responsibilities to their investors.) What’s more, because hedge funds are not allowed to advertise, their operations are commonly perceived as secretive. There’s not a lot of widely available information on particular hedge funds, in part because managers don’t want to inadvertently do something that might trigger an SEC inquiry.

They’re dubbed “hedge” funds because managers can invest in several financial instruments to help reduce–or hedge–risk or to bolster returns. One of the key differences between a hedge fund and a mutual fund is that many hedge fund managers are able to take short positions in a stock, which allows them to benefit if a stock’s price drops. When a manager “shorts” a stock, he or she is borrowing shares from a broker and selling them at the current market price. The hope is that the share price will fall, allowing the hedge fund manager to repurchase the shares at a lower price