Hedge Funds

FOR MANY YEARS, hedge funds were the status symbol of the investment world, promising superior returns to the lucky few who could afford the price of admission. But more often than not, the superior returns haven’t materialized—and lately hedge funds have lost some of their luster.

These lightly regulated investment funds use a broader array of strategies than the typical mutual fund. For instance, a hedge fund might try to boost returns by borrowing money and then using that money to purchase additional investments. It might also buy some investments, hoping they will rise in value, while also selling short other investments, in a bet that they’ll fall. The hope: If a hedge fund manager is truly skillful—a big “if”—these various strategies will take that skill and convert it into even fatter returns.

While hedge funds have a reputation for delivering outsized returns, that isn’t always the objective. Yes, some funds gun for big gains, making large, leveraged bets. But others are focused on “absolute returns,” meaning they aim to generate healthy returns year after year, no matter what’s happening in the financial markets.

To invest in a hedge fund, you need at least a $1 million net worth, excluding your primary residence, or to have earned $200,000 in each of the past two years (or $300,000 together with your spouse). Many hedge funds, however, set the bar even higher, demanding huge initial investments that are only affordable by institutional investors and the extremely wealthy.

Hedge-fund ownership may be an exclusive club—but the membership fees are, alas, equally rich. Historically, hedge funds have typically charged 1% or 2% of assets each year, while also taking 20% of any gains. But this fee structure has come under pressure amid mediocre returns and managers have been experimenting with different fee arrangements. What if you buy a fund of funds, which is a hedge fund that invests in other hedge funds? You will have to deal with a second layer of fees, which might take an additional 1.5% of assets and 10% of gains. Weighed down by fees with like that, it’s hardly surprising that most hedge funds turn out to be poor investments.

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