Hedge Funds 101

WHAT ARE HEDGE FUNDS?

Private pools of capital usually limited to 100 investors and run by a money manager, who has his own money in the fund.

WHY ARE THEY CALLED "HEDGE" FUNDS?

A misnomer, really. True hedging recalls the practice among commodity producers and processors of buying or selling futures contracts to limit or "hedge" exposure to price movements. Most hedge funds don't hedge in the strict sense. Rather, they use a variety of trading strategies to limit exposure to the overall market.

WHAT STRATEGIES DO THEY USE?

Everything from sophisticated arbitrage to growth-stock picking. While some funds invest only in ordinary stocks and bonds, others focus on arcane derivatives. What is common to almost all of them is the use of leverage and shorts.

HOW MANY ARE THERE?

No one knows; the guess is 4,000 hedge funds controlling about $400 billion.

WHO CAN INVEST IN THEM?

"Accredited" investors, those who have $1 million or more in investable assets or an annual income of $200,000 for the past two years--although some funds, structured more along the lines of traditional mutual funds, have lowered the bar.

WHAT'S THE MINIMUM INVESTMENT?

Until recently, it was $1 million; however, some funds accept as little as $100,000, and that number is coming down.

WHAT ARE THE FEES?

Funds charge 1% to 2% management fees and around 20% of the profits a year.

HOW LONG IS MONEY TIED UP FOR?

A year, usually, but up to three years at some firms.

ARE THE FUNDS REGULATED?

They are largely unregulated, on the assumption that wealthy investors are also sophisticated and can do their own due diligence. In fact, hedge-fund investors are limited partners in the fund. However, the SEC can become involved in the event of fraud.

WHAT'S THE "HIGH-WATER MARK"?

An incentive for performance. Suppose a fund begins with $100 million and grows to $200 million. Result: 99 happy investors and a manager $20 million richer. The next year, the fund sinks and assets shrink. Result: 99 angry investors and a manager who won't see another dime until assets top $200 million, the high-water mark.

By Robert J. Rosenberg

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