Hedge funds were back in the news in recent months, for all the wrong reasons. General Motors' stock rose quickly and its bond price fell--putting a serious squeeze on hedge funds that used the popular strategy of buying GM bonds while selling its GM stock short.
The episode goes a long way toward explaining how hedge funds differ from mutual funds. Many stock mutual funds own shares of GM stock. To justify their sky-high fees, though, hedge-fund managers have to be more creative. They use leverage to their advantage and go deep into their financial toolbox for techniques to squeeze out the slightest bit of extra return. Sometimes, those creative techniques turn around on them disastrously.
Hedge funds have other problems, too. For starters, many have a $1 million minimum initial investment, and they aren't required to provide you with much information about their holdings or performance. They typically take 20 percent of profits on top of their regular fees, they're not as liquid as mutual funds, and as many as 1 in 10 closes up shop each year.
But hedge funds do have their uses. Good managers can level out the ups and downs of the market with their hedging techniques. Although hedge funds overall have performed about as well as the S&P 500 Index over the past decade, according to the CSFB/ Tremont Hedge Fund Index, they've done it with fewer peaks and valleys. They performed especially well after the stock market downturn of 2000, when many stocks and mutual funds fell off a cliff.
Do-it-yourselfers might have trouble evaluating hedge funds due to their lack of disclosure, so funds of hedge funds are probably the best way to test these particular waters. Some companies even offer indexed funds of hedge funds--meaning they buy a fixed number of funds in several investment categories, from distressed securities to market-neutral arbitrage.
Just don't go whole-hog. Hedge funds can make sense for some of your portfolio, but should never carry too much of the load. If you're ever in doubt, remember these four words: long-term capital management.
Scott Bernard Nelson is assistant business editor at The Oregonian and a freelance writer in Portland, Oregon.