Hedge funds: It's all about the manager

Key Points

Q. I keep hearing about hedge funds, but don't understand how they work. Isn't it the same as a mutual fund, but with more risk?

A. A hedge fund is a private investment corporation or partnership that provides investors the ability to participate in specialized trading strategies designed to take advantage of potential opportunities in the stock, bond, and commodity markets. The primary objective is typically to preserve investors' capital by taking positions where the returns are not closely correlated to those of the broader financial markets.

In most situations, the overall performance of the hedge fund is driven by the unique skill of the hedge fund manager, as opposed to overall market movements. Another difference when compared to mutual funds is that hedge funds are usually established by principals, who typically invest a significant amount of their own personal investment assets within the fund. In addition, most hedge fund managers use an incentive fee structure in which the higher the actual investment returns, the higher the fee paid to the fund managers.

Since hedge funds are complex investments, it is important to be fully aware of the fund's objectives and the level of risk taken within the fund before you make a commitment. There are many other aspects to research prior to making an investment. As with mutual funds, it is important to ascertain the track record of the portfolio manager during varying market periods, although it is no guarantee of future results. To learn more about investment style, you will also want to know if the fund's investment strategy is based on fundamental or technical analysis, and what types of in-vestment assets are being used.

You should also be aware of the fee structure, the frequency of the fund's reporting periods, and any liquidity constraints that may prevent you from accessing those dollars for other needs. The use and amount of leverage are also important factors because more leverage, while increasing the potential for gain, also increases the potential for loss.

While the hedge fund industry has seen tremendous growth, you must keep in mind that hedge funds are complex, risky investments, and that seeking advice and counsel from your tax and investment advisers is highly recommended.