Rolling the Dice on Hedge Funds
Investing's hottest game can pay off big--even if you're not George Soros. But it's also a huge gamble. Here's how you can improve your odds.
By Jonathan Weber

(Business 2.0) – HEDGE FUNDS are the fad du jour on Wall Street, and the business press is filled with that classic cocktail of envious money porn ("George Soros made $750 million in one year") and anguished hand-wringing ("It's a bubble that's going to end badly").

I've been trying to figure out the practical implications of all this. If the smart money is in hedge funds (which it is) and the conventional wisdom says even shrewd individual investors should stay away (which it does), what's a poor punter to do?

You can approach this latest investment opportunity-cum-casino game thoughtfully. First off, just forget about getting into those funds you read about in the newspaper. Funds run by superstars like Soros and Eddie Lampert are usually closed to new investors, and even if they aren't, you need to either be mega-rich or bring some kind of extra-special cachet (like you're a high-flying CEO) to the table. While many hungry new funds are happy to take as little as $250,000 (you still must be an "accredited" investor with a net worth of at least $1 million), the entry price for proven funds starts at $1 million.

I'd also take a pass on what Wall Street is currently promoting as the best way for individuals with grubstakes as low as $25,000 to get in the game: the so-called funds of hedge funds. These are supposed to reduce risk and hand off the difficult task of picking a good manager to a professional, which would seem to make sense. But fund-of-fund investors are paying yet another set of management fees on top of the "1 and 20" (1 percent of assets and 20 percent of profits) that hedge fund managers take off the top. And while diversification may reduce risk, it also reduces reward. Funds of hedge funds underperformed the S&P 500 last year, returning just 7 or 8 percent on average.

With more than 6,000 funds to choose from, picking your own is no mean trick. Private bankers, brokers, and hedge-fund consultants can steer you to their favorites, and research services like HedgeWorld are good repositories of data. But before you wade into the shark tank yourself, think about two key issues.

First is strategy. Hedge funds were originally based on exploiting pricing discrepancies among related securities by taking a series of offsetting positions to produce a profit while limiting risk. But today's funds play many kinds of games. Most fall into one of about a dozen different strategy types, ranging from conventional arbitrage to short-selling. There are distress funds, which buy stocks and bonds in weak or bankrupt companies, special-situation funds, which deal in takeovers, and macro funds, which bet on interest rate and currency movements. Andrew Craighead, a managing director at JPMorgan Private Bank, notes that strategies based on hedging are generally less volatile than those tied to the direction of interest rates or equity, currency, or commodity markets.

The second key is the manager. Because hedge funds are mostly unregulated, there's little to prevent someone from hanging out a shingle and simply stealing people's money--or, as happens more commonly, losing people's money. Due diligence is everything when it comes to picking a manager. Firms such as Backtrack Reports will research a manager's background for a few thousand dollars; that's money well spent. Look for someone who was an underling at a successful fund and is just starting out on his own. And there's no substitute for meeting the man and going with your gut.

Whatever you do, make sure you don't do it with money you can't afford to lose. Unlike mutual funds, even honest hedge funds can wipe out your investment. Why take the risk at all? Because there aren't many ways to make a decent return if, as many pros believe, we're facing a long period of flat equity prices.

As they say, you can't win if you don't play.

Caveat Investor

It pay to dig before placing your bets on a hedge fund. Here are some good places to start.

Source: Business 2.0 research