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What Is a Hedge Fund?

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What Is a Hedge Fund?

Hedge funds used to be available for only the wealthiest and most sophisticated investors. Today, just about anybody can invest in hedge funds through so-called “fund of funds” (FOF) and other alternative products that are sold by brokerage firms.

Webster’s Dictionary defines “hedge” as something that provides protection or defense. Many investors purchase hedge funds with that in mind, thinking that they’re protecting or defending their portfolio from bad markets. Unfortunately, that simply is not true. In fact, hedge funds are often incredibly risky, underperform against the market, and not worth the high cost.

Like mutual funds, a hedge fund is an investment pool that is managed with the goal of achieving positive investment returns. Unlike mutual funds, hedge funds typically have more flexible investment strategies, and use risky tactics like leverage, short selling, and other speculative strategies. In doing this, hedge funds often promise that they can achieve better results with less risk than conventional funds that purchase only stocks. Hedge funds regularly use terms like “low volatility” or “low correlation with the market” to sell that promise to investors.

The reality is very different. In terms of performance, studies have shown repeatedly that hedge funds over promise and under deliver. On top of that, they’re incredibly expensive. Hedge funds typically charge annual fees of 2 percent plus 20 percent of profits. With such exorbitant fees, it’s little wonder why hedge funds often perform so poorly. 

Not only do hedge funds engage in risky strategies, they’re also exempt from most federal and state securities laws. Hedge funds are not required to follow even the most basic disclosure protections that apply to most other investments. This means that investors are kept in the dark about what they’re invested in and how their investments are performing.

In short, unless you have a lot of money and can afford the risk of losing a substantial portion of your investment, don’t invest in hedge funds. In my opinion, they’re risky, perform poorly, and not worth the cost.

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