What is a Hedge Fund Investment?

Fees, Due Diligence and How They Work

Although the actual definition of a hedge fund is hard to pin down to one simple explanation, these unique investment vehicles are identifiable by several key characteristics involving the size, style, fees and leverage options involved.

How Do Hedge Funds Work?

Hedge funds use different strategies to compensate against losses. Like mutual funds, these are private pools of money that can be invested in many different legal investments to maximize their returns. However, they differ from mutual funds in that there are no restrictions as to where or in what they can invest. Because hedge funds are complicated and often involve investments beginning with $400,000 - $500,000, they are not for the beginning investor. In fact, only the sophisticated, experienced investor will attempt to succeed with hedge funds. Beginner investors may want to start with lower risk investments such as fixed income investments. Those craving greater risk with potentially higher returns might try forex.

Hedge Fund Due Diligence

As with other types of investments, the level of risk involved in hedge fund investment varies considerably depending on the fund. Those offering short-term, high return investments are typically either uninformed and inexperienced or worse, fraudulent. It is quite possible to lose the entire initial investment if the hedge fund manager makes the wrong decision. Although hedge funds do not have to register with the US Securities Exchange Commission, they are prohibited from engaging in fraudulent activities.

Availability is limited to those able to afford the loss, should the hedge fund go belly up. Accredited and institutional investors can take their chances on a hedge fund; the average-Joe stock market player cannot. Understand that hedge funds are not allowed to advertise themselves; investors approached via the Internet, cold calling or in person and given an opportunity to invest in a hedge fund should be aware that it is probably not legitimate.

Understand Hedge Fund Fees

Before investing in any hedge fund, an investor must understand several important factors. Hedge funds are subject to two different types of fees: management and performance fees. Each fund will have a minimum investment level. A new player has also surfaced recently in the hedge fund game: the Multi-Manager Hedge Fund, or fund of funds. While the risk involved is reduced by the fact that the fund is invested in many other diverse funds, investors also pay greater management fees. The risk is less and so are the returns. Offshore hedge funds may also be an attractive option, as they are subject to different (or no) taxes. However, as with any investment, the potential for massive returns increases with the degree of risk.

Hedge funds are a great option for high net worth investors, provided they have done their homework and understand the terms and practices involved.