With all the media buzz about private equity, clients ask us more than ever about lesser known, riskier investment options. At some point, "hedge funds" usually enter the discussion. In response, here's our quick analysis of this emerging investment option.

What is a Hedge Fund?
Hedge funds are private investment vehicles that manage money for institutions and wealthy individuals. They generally are organized as limited partnerships, with the fund managers as general partners and the investors as limited partners. The general partner may receive a percentage of the assets, additional fees based on performance, or both.

Hedge funds originally derived their name from their ability to hedge against a market downturn by selling short. Though they may invest in stocks and bonds, hedge funds are typically considered an alternative asset class because of their ability to implement complex investing strategies that involve many other asset classes and investment options.

How do Hedge Funds Differ From Mutual Funds?
Quite simply, hedge funds are not available to the public.

Unlike mutual funds, hedge funds traditionally have not been offered for sale to the public at large; they are available only to a limited number of wealthy investors. The demand to participate in the most successful hedge funds can be so high that many funds are able to pick and choose who is permitted to invest.

Middle-Income Investors Need Not Apply
Investors normally must have a significant amount of money available to invest or have a high level of financial sophistication. For example, to invest in a hedge fund, an individual must have at least $1 million or an ongoing income of at least $200,000 in each of the two previous years ($300,000 if a spouse's income is included). Depending on how the hedge fund is structured and the demand to participate, the minimum requirement can be much higher. Also, hedge funds usually require an investor to invest in the fund for a period of one year or longer and may limit transferability, making them a less liquid investment than mutual funds.

By contrast, mutual fund minimums are typically $1,000 or less, and investors may typically sell at any time (though some funds impose a fee for short holding periods).

Hedge Funds are not Required to Register with the SEC
Because they are not offered publicly and have limits on who may invest in them, most hedge funds are exempt from much of the regulation to which mutual funds are subject, though some hedge funds have registered with the SEC. Thought there have been attempts in recent years to increase supervision of hedge funds, their reporting requirements are minimal, though they are still subject to general prohibitions against securities fraud.

As a result, investors in hedge funds do not receive some of the protections that investors in mutual funds enjoy. In particular, hedge funds:

• Are not required to maintain a certain degree of liquidity
• Are not limited in how much they can invest in a single investment
• Are not limited in their use of leverage
• May take great latitude in determining the value of the fund's investments, which does not have to be verified by independent sources
• Are not required to disclose information regarding the fund's management, fees and expenses, holdings, or performance

As a result of this lax environment, hedge funds have a great deal more latitude in how they invest funds. They use a variety of investment types and strategies to try to minimize risk and maximize return including:

• Hedging: buying an investment that has the potential to offset losses in other investments
• Selling short: borrowing shares and selling them immediately, hoping that the price will drop and the shares can be replaced at a lower cost, thereby generating a profit.
• Arbitrage: simultaneously buying and selling the same security to take advantage of different prices
• Leverage: investing with borrowed money to try to maximize profitability
• Concentrating positions: making big investments in relatively few securities that are expected to be highly profitable
• Investing in distressed or bankrupt companies
• Investing in derivatives, such as options or futures contracts
• Investing in privately issued securities

How a given fund employs any or all of these techniques constitutes its unique investing strategy. Many of these techniques involve unique risks and pitfalls, and there have been some spectacular crises with hedge funds--notably Long Term Capital Management in 1998 and Amaranth Advisors in 2006--that used them.

Are Hedge Funds a Good Investment Option?
Since we deal with middle-market consumers, Lightship Mutual does not recommend hedge funds to our clients as an alternative asset class. Actually, even if we did work with a high-net worth individual, we would likely still not recommend investing in this ultra-risky asset class. We would likely construct an aggressive internationally-focused portfolio of low-cost mutual funds to accomplish a similar risk/return model.

The Downside of Hedge Funds
You could easily lose your entire investment.

As mentioned previously, hedge funds are able to use higher-risk investment strategies. Because of these risks and others, investors may lose their entire investment.

Second, because of the lack of regulation, a hedge fund's investing strategy and performance can be difficult to research, verify and compare to other investments. Hedge funds are notoriously private about how they achieve their results, and may not disclose that information even to their own investors.

You may be able to check into the background of a hedge fund's manager--for example, whether the manager has a disciplinary history in the securities industry-by going to the SEC's web site and looking up the firm's Form ADV. Depending on how the hedge fund is registered, you may be able to get information from the National Futures Association's web site, your state securities regulator, or the Financial Industry Regulatory Authority (FINRA).

Third, hedge funds are typically more costly than mutual funds. Management fees for hedge funds are typically higher than actively managed mutual funds or separately managed accounts. Also, unlike mutual fund or other money managers, hedge fund managers generally receive a share of the fund's gains. These added costs are passed on to the fund's individual shareholders in the form of higher management and administrative fees when compared to mutual funds or separately managed accounts.

Fourth, hedge fund investments may lack liquidity. In most cases, hedge fund shares are not traded on any public exchange, so you may not be able to redeem your investment when you want to or at the price you paid.

Alternative Ways to Take Advantage of Hedge Funds
If you still have a burning desire to go forward with hedge fund investing--and have tens of thousands of dollars to potentially lose--then you may be able to invest in a fund that invests not in securities but in multiple hedge funds. In most cases, the minimum investment is lower than that of a hedge fund--as low as $25,000--though that is still higher than the minimum of many mutual funds.

By investing in a variety of investing styles, managers and strategies, a fund of funds may provide greater diversification than a single hedge fund, though diversification alone cannot guarantee a profit or ensure against a loss.

As with hedge funds, a fund of funds may or may not be registered with the SEC; make sure you find out its status. Even if it is registered, remember that any SEC protections apply only to the fund of funds, not to the underlying hedge funds in which it invests.

Even if a fund of hedge funds is registered with the SEC, there may not be a secondary market and you could have difficulty selling your shares readily. Also, a fund of hedge funds is not required to redeem your shares at any time, as an open-ended mutual fund is.

Remember that you will be paying a double layer of fees: one set of fees to the fund of funds and, indirectly, another set of fees charged by each of the underlying hedge funds.

Good luck!