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The term “hedge fund” has taken on a certain air of mystery. For some, they have the allure of a forbidden fruit – outsized returns tantalizingly out of reach of the regular retail investor, and available only to institutions and the wealthy. For others, the mere existence of hedge funds is somewhat menacing. And there is a germ of truth to both views.

But the reality of hedge funds, though, is substantially more mundane – as are their long-term, aggregate risk-adjusted returns. Let’s take a look at what they are and what purpose they serve.

Hedge Funds 101

Hedge funds are, in a nutshell, mostly unregulated pools of capital. Like mutual funds, they are comprised of a group of investors who pool their money and hire a fund manager.

Unlike mutual funds, though, hedge funds have the unlimited ability to go long or short. to leverage to heart-stopping amounts (Long Term Capital Management was leveraged well over 90 times at the time of its collapse, which was why it was so spectacular). They can and frequently do employ arbitrage – that is, to try to exploit the price differences of the same asset in two markets by going long in one and short in the other, seeking to eke out a few points of return at no significant risk.

They also don’t have to disclose their portfolios. This is necessary to discourage ‘front runners’ and outsiders seeking to exploit fund decisions at fund shareholders’ expense.

They don’t have to diversify. Indeed, many hedge fund managers take extremely focused bets, with the entire fund leveraged to the hilt and focused entirely on one or two promising assets. Which means the potential for big returns, but also the possibility of huge losses.

Possible losses are so large, in fact, that the government doesn’t even want you, the individual retail investor, to know anything about them unless you’ve got money. It is illegal, in fact, for any salesperson to even speak to you about a hedge fund, or hand you a prospectus, unless you are an accredited investor. For individuals, that means you’ve got a net worth of at least $1 million, or you’ve got income of $200,000 or more two years running, or $300,000 if you’re married, and you have the expectation of similar income this year.

Hedge funds are, in fact, limited to accredited investors with substantial assets or income or to institutions. Furthermore, a single highly-leveraged hedge fund, Long Term Capital Management, nearly tore down the financial system with its spectacular collapse in 1998. And a single hedge fund manager, George Soros, famously targeted the British pound. selling short 10 billion pounds and leveraging the bet, costing the British government some £3.4 billion when it chose to devalue the pound rather than raise interest rates.

Challenges Hedge Fund Investors Face

Even if you clear the accredited investors’ hurdle, I’m not suggesting you run pell-mell to your friendly neighborhood hedge-fund dealer. Why? Because despite a few well-publicized successes, there are still some structural problems with hedge funds that put a damper on expected returns. And as you can see in this ‘periodic table’ of hedge fund returns going back to 1999, the average hedge fund returns for any single category of hedge fund over time are frequently not much to get excited about.

Hurdles to consider include:

1. Expenses. By long tradition, hedge fund managers get paid in two ways: 2 percent of the portfolio, and 20 percent of any profits at the end of the year. That’s a huge hurdle for any hedge fund manager to make up before beating the broad stock or bond market – especially in a low interest rate environment, where that traditional 2 percent is greater than the prevailing risk-free rate of return .

2. Ethics. Hedge fund industry pros are smarting from being negatively portrayed in the media as responsible for the financial crisis (it wasn’t their fault, anyway, but they’re being blamed for the actions of regulators and bankers who acquiesced to political and competitive pressures to make stupid loans. Hedge funds didn’t force them to do that.). Industry voices have been calling for a better PR effort. But the ethical problem is much more than PR: A recent study found that half of hedge fund professionals think their competitors have been cheating, and over a third have felt pressure to violate the rules at work according to a recent survey. So if the industry professionals don’t have much faith in the industry, why should you?

Granted, they cheat in the mutual fund world, too. But at least the cheating is kept to a dull roar by the disclosure rules and more stringent regulatory environment. As far as FINRA’s concerned, if you’re an accredited investor and you invest in hedge funds, you’re a big boy or big girl and don’t need regulators to hold your hand and wipe your nose for you while you invest.

3. Liquidity. Hedge funds frequently place restrictions on your ability to pull money out of the fund. They may lock funds up for a year and even longer. They do this so they can invest in ventures like limited partnerships, oil and gas developments, real estate developments and other longer-term ventures that need early stage capital with little chance of offering any significant returns for months or years. You should demand better returns to make up for the liquidity risk – but you won’t have any sure way of getting them, or even knowing what you will get, until it’s too late. And because disclosure requirements are limited, you may not even know much about where your money is invested in the meantime. This is a lot of trust to put in a hedge fund manager.

(Why) Do We Need Hedge Funds?

That said, hedge funds have their place. Their best use isn’t just to make money, but to make money in a way that isn’t closely correlated with the broad market. Viewed from this perspective, their volatility is a feature, not a bug. If you are wealthy and in a position to absorb the volatility and lack of liquidity – that is, you know for certain you won’t need the cash for a few years – you use the volatility in a hedge fund to counteract the volatility of the broad stock market, or whatever other core holdings you have. If you believe in Modern Portfolio Theory, then you know that even a very volatile asset, if judiciously applied to a broad portfolio, can actually boost expected returns while reducing overall portfolio volatility.

In other cases, hedge funds seek to minimize risk, or maintain a market-neutral posture, by combining long and short holdings or by using arbitrage strategies in a capital preservation strategy. This can be a good option, too – especially where arbitrage and leverage combined promise a better risk-adjusted return than just parking short-term funds in a money market or in short-term bonds. The problem: as the folks at LTCM can attest, risk-free arbitrage strategies aren’t always as risk free as originally contemplated.

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