Island Investing
Cale Smith, MBA
July 11, 2009
KeysWeekly.com

Q. What’s a hedge fund?

A. Think of a hedge fund as an unregulated mutual fund. While the word “hedge” might lead you to believe these funds cautiously hedge their bets, that is rarely the case.

Like a mutual fund, a hedge fund is a pool of investors’ money managed by a professional portfolio manager. Unlike mutual funds, however, hedge funds are not regulated by the S.E.C. and cannot advertise.

Because hedge funds have few restrictions, their managers are free to take many more risks than a mutual fund manager, often investing aggressively in options and futures, buying on margin, betting on currencies or shorting stocks. Most trade quite frequently and offer little transparency to their investors. Hedge fund managers don’t have to hold any certifications or registrations to start a fund, either.

Hedge funds are also only open to “accredited investors,” or people earning more than $200,000 a year or with a net worth of more than $1 million. These funds may also require very large initial investments and prohibit withdrawals for years.

In 2008, there were approximately 8,200 hedge funds in the world managing $2.5 trillion. Along with private equity firms, investment banks, and other specialized investment vehicles, hedge funds comprise a significant portion of the “shadow banking system” that helped create the recent global financial crisis.

To be clear, investing in a hedge fund run by a truly talented manager can be quite lucrative. Unfortunately, many hedge fund managers often appear more interested in enriching themselves than serving their investors. One manager described hedge funds as, “A compensation scheme masquerading as an asset class.” It’s easy to understand why, when even poorly performing managers take a large portion of a fund’s profits – usually 20%. In addition, regardless of performance, hedge fund managers typically receive an annual management fee of 2% of assets under management each year.

So while a small number of hedge funds are actually worth the exorbitant fees investors pay, most are not. Don’t believe the hype. You’ll likely outperform most Wall Street geniuses over the long-term with nothing more complicated than an index fund.

Cale Smith is the portfolio manager for the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.