Can you afford Wall Street's riskiest bet?

Hedge funds are hot now, but they're also exclusive -- you need a net worth of $1 million just to be allowed in. The risk can be high, but so can the payoff.

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By Annie Logue, MSN Money

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?

You need to be REALLY rich

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.

Lack of regulation is important

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.

How do hedge funds perform?

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

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risks associated with individual funds. Rothschild and his colleagues structure their portfolio for absolute return.

Hedge funds can be sold only to investors who are accredited under Securities and Exchange Commission rules, which generally means the investor has a net worth of at least $1 million and an annual income of $200,000 or more ($300,000 for a married couple).

Too risky for regular investors

"The assumption the SEC makes is that if you have more net worth, you have more sophistication," Rothschild says, and thus are better able to assess the special risks associated with hedge funds.

Because most hedge fund investors are endowments or pension funds that are not subject to taxation, most hedge funds are managed without regard for tax liabilities. "They are so inefficient from a tax perspective," Morningstar's Farkas says.

Even an investor who meets the accredited standard might not be able to buy into a hedge fund, explains Grenier, of Cutler Capital. Legally, a hedge fund investor is entering a business partnership with the fund manager, and the manager can turn down the money.

The fund may not want to get larger, or it may want only investors who can put in very large amounts of money. An accredited investor with $2 million in assets would not be able to invest in a fund with a minimum investment of $5 million, for example. The hedge fund manager may also be concerned that the prospective investor does not understand that fund's risk, cannot bear the fund's risk or would be too difficult to deal with. These are the realities of dealing with private partnerships.

"It's in the best interest of the hedge fund manager and the client to understand each other," Grenier says. "Not everyone has the ability to understand which hedge fund managers are right for them."

But even if you can't get into a hedge fund, you can learn from them. For example, most hedge funds require patience, a key quality for investors who want to be successful, requiring that investors keep their money in for at least a year.

"We're more patient and more disciplined about having an eye for the long term," Grenier says.

If you're lucky enough to one day be eligible for this sort of investment, you'll have plenty of funds to choose from. In making decisions of this sort, Rothschild looks at a fund's history.

"Past performance is not indicative of future performance," he says, but quickly adds that past performance can give a sense of how the fund does in different market cycles. "We like managers that aren't trying to knock our socks off. They're protecting their downside."

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And, of course, most successful hedge fund investors are big believers in diversification. Diversification can generate the absolute returns that many of them look for. It's also why many hedge fund investors opt for funds of funds instead of a investing in a single fund.

"Diversification is extremely important to individual investors," Rothschild says. A hedge fund is just another way to diversify, says Astor Partners' Stein, and any investor can reap the benefits by allocating money across a broad array of asset classes.

"You have stocks; you have bonds; you have all kinds of ETFs," Farkas says. The disciplined, patient and unaccredited individual can get many of the benefits of a good hedge fund without the taxes or the fees.

As for the hedge fund headlines?

"Obviously, it's an incredibly lucrative business at a certain part of the food chain," Stein says. But very few hedge fund managers are taking home billion-dollar bonuses. Stein doesn't have much to say about huge profits. His focus is simple, he says: Make money grow into more money.

Published Aug. 18, 2008