A fairly advanced topic for the College of Weakonomics. hedge funds are shrouded in mystery. Much of this is thanks to a lack of regulation which leads to a lack of transparency, which leads to most people not really understanding what hedge funds are.

For all intents and purposes, the best way to describe a hedge fund is that its a mutual fund. Mutual funds usually have a focus such as stocks, bonds, or a blend of the two. Hedge funds have a focus, but they also have a lot more liberties. Their strategies can be narrowly focused, or very broad. The idea is to make a return no matter what the market is doing. In fact, many funds dont even think about an index because their investment options are wide open.

Hedge funds are usually limited to a small number of investors, many through large institutions. Investors are also limited in terms of liquidity. For example: in order to get into a certain hedge fund you must commit to keeping your money locked up for 5 years or more. This is because hedge funds often invest in assets that are much less liquid than typical stocks, like certain junk bonds.

The fee structure for hedge funds is also somewhat different than mutual funds. Whereas you might expect to pay 0.50% in fees at an S&P500 index fund, you can expect at least 2% for a hedge fund. And if your mutual fund makes lots of money they dont really get a bonus from new fees. However a hedge fund can also lay claim to 20% of the profits. Thats a big chunk of change.

So how do they get away with charging so much more than a mutual fund? The potential for bigger profits. I good year for a mutual fund might be after a stock market crash with a recovery of 50% or so. But when the market goes down 50%, some hedge funds actually double in size by gaining 100% returns or better. If you find a good hedge fund manager (such as John Paulson) you could have made some amazing returns from 2007-2009. Not many people have such a holding in their portfolios.

And what exactly are hedge funds investing in? ANYTHING. Some hedge funds just buy stocks and use debt to leverage returns. Some buy stocks and short others. Others buy bonds at new issue and then sell them for a premium. Many hedge funds purchased mortgage backed securities. John Paulson bought insurance on these securities so when they failed, he hit paydirt. But hedge funds dont stop here. A company in the UK just announced a new hedge fund that seeks to make money on sports betting. Hedge funds arent limited to their invesment options, they just collect funds and invest in whatever they think they can use to get a good return. A general strategy is outlayed in most hedge funds, but they are sometimes liberal in their policies.

Who invests in hedge funds? If youre reading this blog you probably arent. Institutions such as pensions, insurance, and banks often do. Private investors do as well, but youre looking at people with a few million to invest. You can get access to hedge funds through wealth managers, who pool all their clients money to invest in hedge funds.

And how much money should go into hedge funds? If you and I were able to invest in hedge funds, Id probably limit my exposure to one fund to 5% max. There are funds of funds that invest in many hedge funds at once, and with that kind of diversification Id consider 10%. But make no mistake, hedge funds are very risky investments with no guarantee of return. Its definitely not an asset class really worth consideration until your nest egg is 7 digits long and approaching 8. And even if you are so fortunate, hedge funds are just now starting to get regulated (certain funds must now regis