Ask Stacy: What the Heck is a Hedge Fund and How Do They Work?

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Hedge fund -- you've probably heard the term. But you should know what they are and why they may be the dumbest thing you can do with a million bucks.

When people on Main Street hear the word “hedge,” they think bushes. Wall Street types, on the other hand, might picture something entirely different.

Here’s this week’s reader question:

What is a hedge fund and how do they work? — Dee

Before I answer Dee’s question, take a look at this video. It’s about things every beginning investor should know.

What’s a hedge fund?

A hedge fund is an investment partnership. Limited partners cough up money, and the general partner, also known as the manager, invests it.

The manager has very wide latitude when choosing how to invest the partners’ money. They can invest in securities, like stocks and bonds; physical assets, like office buildings and gold; or derivatives, like commodity futures and options. They often attempt to optimize their returns with sophisticated strategies and borrowed money, which is called leverage.

In short, the sky’s the limit. They can invest pretty much however they choose.

An easy way to think of a hedge fund is to compare them with a mutual fund. Like a mutual fund, investors pool their money, hire a manager, then own a commensurate share of a portfolio. But mutual funds typically have strict guidelines as to allowable investments. For example, they might invest only in the stock of big companies, or government bonds. Hedge funds, on the other hand, have much more latitude and often take much more risk.

The “hedge” in the name refers not to bushes but to having the ability to profit from both rising and falling prices, as in “hedging a bet.” For example, if you own a $100 million worth of real estate, you might throw a few million to a hedge fund manager like John Paulson, who made $15 billion in 2007 by betting against real estate. Then, if your real estate holdings drop, you’re potentially making up part of those losses with your hedge fund investment.

Ready to play? Bring lots of money

Some mutual funds require minimum initial investments as low as $50. But if you’re thinking hedge fund, think six figures.

The minimum investment for hedge funds is typically at least $1 million.

And if you think your mutual funds charge too much in management fees, wait till you see the fee structure at hedge funds. According to The Wall Street Journal, the average hedge fund charges its investors 2 percent annually on money under management, plus 20 percent of profits.

A low-cost, low-minimum mutual fund like Vanguard’s S&P 500 Index Fund, on the other hand, has a minimum of only $3,000, charges 0.17 percent annually and gives all the profits to the investors.

To put that in perspective, if you invested $1 million with the typical hedge fund, and it made 10 percent in a year, you’d pay $20,000 as a management fee and $20,000 more as a percent of the profits, for a total of $40,000. For the same million, Vanguard would have charged only $1,700.

Obviously, no one-percenter in their right mind would hand over the equivalent of a luxury car for investment management, unless justified by performance.

Or would they?

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