From the Expert: Hedge Funds - The Good, the Bad, the Ugly

Hedge funds claim to make big money whether the market goes up or down. Should you be looking at these investments to make money for you, beyond your usual stock investments?

Many hedge funds are legitimate and perform well for their clients. The bulk of their investments are often in real estate, stocks, futures, commodities, and other mainstream holdings. Some hedge funds have made as much as 100 percent or more during a 12-month period in which the S&P returned a fraction of that. In addition, although most aren't regulated by the SEC, many hedge funds follow strict guidelines about what they'll invest in.

So, how are hedge funds different from mutual funds? Hedge fund managers invest using a myriad of strategies that traditional fund managers can't. They use all the classic investing methods such as buying stocks, bonds, and real estate. But they're also allowed to short (betting that a certain stock or an entire index is heading down rather than up).They can buy the highest-yielding, riskiest bonds offered by the most backward of third-world countries, or they can try to hedge the currency game by, say, going long on the yen and short on the rupee. They can buy Nigerian wheat (if there is any) and sell Italian sausage (there's probably a lot).

Nothing's off limits. Rare stamps and fine wines may take their place in these portfolios. Managers have bet on the rise or fall in the contractual value of a future soccer star or Nascar driver. Moreover, as if they weren't already taking sufficient risk, they can supercharge the whole works by borrowing (otherwise known as leveraging) and doubling down on all bets. There's little downside for the manager or promoter. They usually get paid both a 2 percent fee on all the assets they gather (from you) plus 20 percent on each and every dollar of profit. Your gain is shared with them. Alas, this sharing arrangement doesn't extend the other way. Your loss is 100 percent yours (less their 2 percent).

In years past, hedge funds were heralded as diversification havens for the wealthy, sophisticated investor. Today, they're touted to nearly every investor. Soliciting-agent commissions are huge. New funds crop up monthly while relatively unsophisticated money floods into them.

But what about those outsized returns you've heard about? Maybe you're heard the promises of 50, 60, 70 percent annual returns. On that score, they may be more illusion than reality. A study in the Financial Analysts Journal's Nov./Dec. 2005 issue found that from 1996 to 2003 average hedge fund returns lagged behind those of the S&P 500 index. In other words, the typical hedge fund underperformed while charging a lot more, to boot.

You need to be careful if you're considering investing in a hedge fund. A few have quietly gone out of business. Apparently, their shorts must have gotten confused and wound up long. The wheat is turning up as rice, the yen got zonked by the rupee, and that soccer player quit to join a rock band.

And you know, at the end of the day, it's really the same-old, same-old. There never seems to be any shortage of hucksters, but there's never been any secret path to riches, either. So I'd advise you to approach hedge funds with caution, eyes wide open. It's your money, of course, but, as with any investment, do your homework and understand what you're getting into.

The author is president of RS Crum, Inc. (www.rscrum.com) and is a certified financial planner (CFP) and a long time member of NAPFA. RS Crum is a fee-only financial and investment advise firm since 1976 and is based in Newport Beach, California. The views expressed are those of the individual contributor and do not necessarily reflect those of Medical Economics magazine.