What are Hedge Funds?

The sums racked in by hedge-fund managers dwarf even the incomes of top corporate CEOs and Wall Street bankers. The average among them earned nearly $1.5 million a day, every day, for the entire year, or over $1,000 every minute. The top three pulled in over $1 billion each. Meanwhile, wages for the majority continue to stagnate or decline.

So, what are hedge funds?

A hedge fund is a private investment fund charging a performance fee and typically open to only a limited number of investors. A hedge fund can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously — many hedge against downturns in the markets — especially today with volatility and anticipation of corrections in overheated stock markets. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.

Hedge funds are not currently subject to any direct regulation by the SEC, the NASD, or other federal regulating commissions, unlike mutual funds, pension funds, and insurance companies.

Because of the substantial risks involved in unregulated, complex, and leveraged investments, hedge funds are normally open only to professional, institutional or otherwise accredited investors. This restriction is often implemented through limits on participating investors or minimum investment amounts.

Investors are attracted to hedge funds for a variety of reasons. This includes their potential to deliver positive returns under all market conditions, low correlation to traditional asset classes, and access to highly specialized strategies not typically available through traditional money management.

And why do hedge fund managers make so much money?

Usually the hedge fund manager will receive both a management fee and a performance fee. As with other investment funds, the management fee is computed as a percentage of assets under management. Management fees might typically be 1.5% or 2.0%.

Performance fees, which give a share of positive returns to the manager, are one of the defining characteristics of hedge funds. The performance fee is computed as a percentage of the fund’s profits, counting both paper profits and actual realized trading profits. Performance fees exist because investors are usually willing to pay managers more generously when the investors have themselves made money. For managers who perform well the performance fee is extremely valuable.

Managers argue that performance fees help to align the interests of manager and investor better than flat fees that are payable even when performance is poor. However, performance fees have been criticized by many people including notable investor Warren Buffet for giving managers an incentive to take risk, possibly excessive risk, as opposed to seeking high long-term returns.

What have these individuals done to justify their incomes? In a word, nothing. Their wealth derives overwhelmingly from financial speculation, short-term bets on stocks or derivatives, and similar operations that produce no real value.

Laurence Siegel, director of investment policy research at the Ford Foundation says “We can separate the manager’s contribution from the part due to market exposure, and the manager’s added value is often smaller than what hedge funds would like you to believe.”

Evidence is growing that these private pools of capital, known for using sophisticated strategies off-limits to many mutual funds, aren’t performing as well as they did in the past, and hedge-fund flaws have become more apparent recently, under the microscope of newly developed evaluation techniques.

If you are considering investing in a hedge fund (and you can afford it), be sure to do the following: Read a fund’s prospectus or offering memorandum and related materials; understand how a fund’s assets are valued; Ask questions about fees; Understand any limitations on your right to redeem your shares; And research the backgrounds of hedge fund managers.