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A look at hedge funds and how they work

Date: Monday, October 26, 2009
Author: Candice Choi, Indystar.com

Investment tool seen as mysterious and exclusively for wealthy.

The arrest of a billionaire in an insider trading case last week drew new attention to hedge funds -- investment firms that, for many, evoke an exclusive world where the super rich use exotic investing techniques to grow yet richer.

The understanding usually stops there.

In the case against Raj Rajaratnam, federal prosecutors accused the portfolio manager for Galleon Group of using a powerful Rolodex of contacts to acquire insider information to trade securities. Others were charged in the case, and prosecutors suggested the problem could be more widespread.

On Thursday, a lawsuit was filed claiming that Rajaratnam also used his money to help finance Sri Lankan rebels.

Most people who've heard about hedge funds know a whole lot of money is involved. But what exactly are they, and how do they work? Here are some questions and answers.

Question: First of all, what is a hedge fund?

Answer: Hedge funds are privately held investment partnerships that are exempt from regulation by the Securities and Exchange Commission because of their limited size and the profile of their investors. Unlike mutual funds, which are generally restricted to trading select securities such as stocks and bonds, hedge funds may invest in pretty much any financial instrument on the market.

Hedge funds also aren't required to disclose details of their assets and liabilities to regulators or investors. Mutual funds such as Vanguard and Fidelity, in contrast, must regularly issue financial reports.

All that may soon change. The details are up in the air, but Congress is debating legislation to bring hedge funds and other private pools of capital under government supervision.

Q: Why do the funds have such an exclusive reputation?

A: To be exempt from securities laws, hedge funds generally are limited to no more than 99 or 499 investors.

Investors in smaller funds need to have a net worth of $1 million or an income of at least $200,000 ($300,000 for married couples). The requirement is intended to ensure only experienced investors participate, said Meredith Jones, a managing director at PerTrac, which tracks the hedge fund industry. For the larger hedge funds, clients must be worth $5 million.

Also, securities law prohibits them from advertising. So many rely on word-of-mouth for clients.

Q: Aren't there different kinds of hedge funds?

A: Yes. Hedge funds vary greatly in size and investing style. To give you a sense, PerTrac estimates there were 22,350 hedge funds at the end of last year. The majority had less than $25 million in assets under management, while a small slice had more than $5 billion.

Hedge funds typically will build their reputation on a specific investing strategy. For instance, a firm might specialize in "merger arbitrage," which means the manager trades stocks of companies that are being taken over or bought out. Different hedge funds will vary in how much disclosure they give clients about investing tactics.

Q: What are the risks of investing with a hedge fund?

A: If you follow the adage that you should only trade in what you understand, hedge funds probably aren't a good fit for the average investor.

Q: If they're not regulated, why would anyone risk putting their money in a hedge fund?

A: Because they can employ a greater arsenal of financial instruments, hedge funds say they have the ability to bring greater returns and minimize losses -- or even turn a profit -- when the market declines.

Mutual funds, meanwhile, are generally dependent on the performance of equity and bond markets, Jones said.

Hedge fund managers also typically get 15 percent to 20 percent of a fund's profits. That's on top of the manager's fee of about 1 percent to 1.5 percent.

"It's a case of heads, every one wins. Tails, and only the investor loses. The manager still gets the management fee of 1 to 1.5 percent," said Eric Tyson, author of the book "Mutual Funds for Dummies" and a former management consultant to financial services companies.

Q: What role did hedge funds play in the meltdown?

A: Hedge funds no doubt traffic in the complicated and even risky financial instruments that hastened the financial crisis. But few would place the blame for the economic meltdown on hedge funds alone.

It should also be noted that the crisis has altered how the hedge fund industry operates. In the wake of all the financial scandals, many now make a point of offering greater transparency, Jones said.