Hedge funds dominate the most glamorous corner of high finance, hogging the spotlight with tales of fabulous performance and billion-dollar paydays for the people who manage them.
Of course, the headlines focus on the few that stand out. Hedge funds may be exciting, but they aren't for everybody. Nor are they the only way to get a good investment return.
"There are some hedge funds that are just great, and if you get into the right one at the right time, you can make a killing," says Daniel Farkas, a hedge fund analyst at Morningstar in Chicago.
But what's the right one? When is the right time?
For that matter, what exactly is a hedge fund? "It's a generic term," says Rob Stein, a managing partner at Astor Partners, a hedge fund in Chicago.
There is no simple definition of a hedge fund. The term applies to private investment partnerships that are designed to avoid registration with the Securities and Exchange Commission. Because they are not registered, hedge funds do not have to disclose their holdings to the public, nor do they have to take money from any investor who wants to get into the fund. Hedge funds tend to use aggressive investment techniques to get better returns, including leverage, short-selling and derivatives trading.
Hedge funds may sound exotic, but they aren't necessarily risky. Still, because they are unregulated, investors need to know what they're getting into.
"The original hedge fund was designed to take risk out of investing," says David Grenier, the president of Cutler Capital Management in Worcester, Mass.
In fact, the name derived from a particular strategy for reducing risk. The idea was to hedge the risk entailed in one investment with a second investment that would tend to act differently. For example, to hedge an investment in airlines, you might have bought oil futures, as the two would frequently move in opposite directions.
Hedge funds fall into two broad categories. Directional funds take on market risk and have the goal of beating the market, frequently through the use of market timing. Absolute-return funds are designed to offer steady returns year in and year out, no matter which direction the market is headed.
But despite the name "hedge fund," few funds of any style actively hedge all risk.
"We like to say that we manage the risk first, then optimize the return second," says Mark Rothschild, the CEO of Iron Partners, based in Chicago. Iron Partners invests in several hedge funds to minimize some of the