What Are Hedge Funds?

Traditionally, a hedge is an investment that minimizes the risk associated with another investment. The hedge is designed to increase in value when the value of the original investment declines.

In 2007, Jordan’s Furniture, a Boston-area retailer, held a sale in which customers who bought certain items of furniture were promised they would get their money back if the Boston Red Sox won the World Series that year. Jordan’s then purchased an insurance policy from an insurer willing to pay out the money needed if the Sox actually won. If the Sox had not won, Jordan’s would have paid out the insurance premium, but gained lots of sales. When the Red Sox won the Series, the insurance company paid the bills, and Jordan’s presumably generated excess sales from the promotion. Jordan’s use of insurance to address the possibility of facing a large obligation if the Sox won is a great example of a traditional hedge.

Recently, the phrase “hedge fund” has taken a new meaning. There is clearly confusion about the term, but here are some general characteristics of current-day “hedge funds:”

• Hedge funds can invest in almost anything – stocks, bonds, options, mortgage-backed securities, commodities, currencies, insurance policies – there is practically no limit.

• Many, but not all, hedge funds attempt to increase their returns by investing borrowed money (using leverage).

• Hedge fund managers generally receive much higher levels of compensation than mutual fund managers. Mutual fund managers are prohibited from charging a fee that’s based on investment performance; hedge funds can charge an investment-performance fee. This provides a heavy incentive for successful investment managers to start hedge funds instead of mutual funds.

• Only “accredited” investors are permitted to invest in hedge funds. Individual investors must have a net worth of at least $1 million or income of at least $200,000 per year.

• Hedge fund Investors are often not permitted to withdraw invested funds at will. There are periods when withdrawals cannot be made at all or there may be a fee for withdrawals.

• Hedge funds are often organized in tax havens like the Grand Cayman Islands in order to provide tax benefits for the fund (though investors still have to pay tax on their returns).

• Because hedge funds must invest large amounts without other investors discerning the strategy they are using, the funds typically operate under a good deal of secrecy.

Hedge funds are obviously rather complicated investment vehicles. This is another reason investing in hedge funds is limited to people who have substantial assets. Speak to a fee only financial planner to learn more about these risky investments.

I would like to thank and give credit to Thomas Fisher, CFP® of Fisher Financial Strategies, an independent fee-only planning firm in Cambridge, MA, for his research and writings on hedge funds. Thomas runs The FFS Blog, a personal finance web log, and has been quoted in various publications, including The New York Times, The Washington Post, Financial Planning magazine, and Bloomberg.com.