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Hedge Funds: More Than Just a Cool Name

Matt Nesto
Hedge Funds: More Than Just a Cool Name

They are notoriously secretive yet still get tons of press coverage. They flaunt their success but often won't allow you to play in their game. They are also elusive and lucrative and, not surprisingly, experiencing rapid growth.

I'm talking about the $2.4 trillion hedge fund industry, an exclusive corner of the professional investment community that is little more than a mystery to most market watchers. In this installment of Investing 101 we take a closer look at the workings of these high stakes portfolio players and brought in Reuters hedge fund correspondent Katya Wachtel to walk us through some basics.

1. What is a hedge fund?

"On a very basic level, it's a private investment vehicle," Wachtel states in the attached video, referring to hedge funds as a "pooled group of capital" from very rich people, pensions and endowments. Unlike a traditional mutual fund, she says hedge funds tend to be more aggressive and take more risk in pursuit of high returns.

"You have to accept the fact that there is a fair amount of risk involved," she says. "You give your money to the manager and he or she can invest it whichever way they see fit and there's a lot of risk involved in that. That's the reason they can make so much money, but they can also lose a lot as well."

Because hedge funds frequently deploy specific strategies or focused bets, their investments tends to go beyond simple stocks and bonds. For example, hedge fund manager John Paulson made billions of dollars by correctly predicting the collapse of the mortgage market.

"The idea of hedge funds is that they should be up in an up-market and up in a down-market as well," Wachtel says of their ability to seek out profits regardless of what the economy or stock market is doing at a given moment.

2. Are Hedge Funds Available and Suitable For Most Individual Investors?

In the past, hedge funds were largely the private domain of the the elite or super rich, and often carried minimum investments of $1 million or more. But Wachtel says "that's changed over the years" as these funds have become the favored vehicles of what she calls "big investment allocators," which essentially refers to pension funds and endowments that hand off a chunk of their assets to one of these aggressive outside managers.

One other difference between hedge funds and more traditional funds or ETFs is their cost and liquidity. Hedge funds are not cheap to run, and superstar managers not only charge 2% in fees, but also capture 20% (or more) of any gains achieved. At the same time, lock-up periods of a year or more to prohibit the withdrawal of funds are not uncommon.

3. How Do The Returns and Performance Stack Up to the Market?

Let the record reflect that none other than Warren Buffett considers a bet on any fund manager beating the market a long-shot, let alone a high rolling hedge fund manager, and urges all but the most sophisticated investors to simply use index funds. That said, Wachtel says the recent performance of hedge funds has been terrible compared to their long-term track record.

"Historically, the big hedge fund managers have had annualized returns of about 25%" she says, "but in the last few years, hedge funds, as an industry have really lagged the broader stock market."

For example, she says the average hedge fund lost money in 2011 when the S&P 500 was flat, and last year earned about 6% when the S&P 500 was up 13%.

Of course, group statistics have the effect of hiding individual standouts and laggards, of which there are many.

4. What Can Be Learned From These Superstar Hedge Fund Managers?

In short, that depends. As Wachtel says, following the musing that these celebrity investors make in the media can go either way.

"Sometimes they get it right and know what they're talking about" she says, courteously citing Third Point Advisors Dan Loeb's recent high profile stake in Yahoo! (YHOO).

At the same time, she mentions an equally high-profile but disastrous stake in JC Penney (JCP) made by investor Bill Ackman.

"They can also get it wrong and lose a lot of money as well."