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Here's a short piece I penned for our newspaper feature on hedge funds about two years ago. (Again, for info on where it runs and how to get it in your local paper:


The Fool School

Clipping Hedges

Hedge funds have grown quickly in popularity in the '90s, more than doubling in number. While the word “hedge” might conjure up images of investors cautiously hedging their bets, hedge funds are often extra-risky, extra-volatile investment vehicles that demand huge upfront investments, sometimes in the millions. You're unlikely ever to invest in one, but it's good to understand what they are and aren't -- if only to impress colleagues at the water cooler.

Let's leaf through some of their qualities. Like mutual funds, hedge funds comprise the pooled money of multiple investors, which is then invested by a professional money manager. However, unlike mutual funds, hedge funds are not regulated by the Securities and Exchange Commission, are not permitted to advertise, and their managers don't have to be registered investment advisers. In addition, they're not open to any investor: Only “accredited investors” need apply. These are folks earning upward of $200,000 per year and who are worth more than a million smackers.

Since hedge fund managers are relatively unfettered by restrictions, they can and do take many more risks than ordinary investors or mutual fund managers. They frequently invest aggressively in options and futures, short stocks, buy on margin (in other words, using borrowed money), and make currency bets. (Interestingly, these are generally strategies that Fools avoid and mutual fund managers aren't permitted to use.) Because of their frequent trading, hedge funds can also rack up considerable amounts in taxable capital gains.

In the right hands, hedge funds can work. Billionaire philanthropist George Soros' Quantum Fund, for example, has reportedly returned an average of 33 percent per year over some three decades. But more often, hedge funds don't fare too well. According to Van Hedge Fund Advisors, the Van U.S. Hedge Fund Index underperformed the Standard & Poor's 500 between 1993 and 1997. Poorly-performing managers still have reason to smile, though, as they typically take a big chunk of fund profits -- as much as 25 percent. Regardless of fund performance, they also command an annual management fee of roughly one to three percent.
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