On Hedge Funds

What is a hedge fund?

A hedge fund is an investment vehicle that is designed to take full advantage of financial instruments, and to pursue any investment strategy in today’s markets. There is very little government oversight of the hedge fund industry. Most hedge funds are not even required to register with the Securities and Exchange Commission and can do pretty much whatever they want free of government regulation. This means that investors should be very careful in committing their money to a hedge fund – the risks could be significant, and so are the potential returns.

What is the catch?

So how can the government be so careless not to oversee this potentially very risky corner of investment business? The answer is that hedge funds are primarily intended for very wealthy and sophisticated investors – you have to have a net worth of $1 million in order to invest in a hedge fund in the U.S. It is presumed that such investors can evaluate potential risks themselves, and that they do not need the government to watch for their best interest. So, that is exactly what the government does – it puts restrictions on who can join, along with an implied “investor beware” sign.

What is in it for you?

Now suppose that you have the required money, and that you have decided to join a hedge fund – what does it give you as an investor? The hedge fund gives complete freedom to its managers to go after superior returns in financial markets – it is a perfect arrangement for the managers to showcase their investment wizardry. You can even think that by investing in a hedge fund you invest in the talent and skills of the manager who runs your fund. If your manager is really smart, then you will likely get superior returns.

Show me the money…

Well, the question is – how to find a smart manager? I would like to quote a trader from Bear Stearns & Co. who said last year: “there are 9,000 hedge funds out there. There aren’t that many smart people in the world.” Another problem is that best hedge funds run by already recognized geniuses are closed for new investors. As a new investor you may need to find a “diamond in the rough” to get superior returns, and that may very well require more sophistication than most of us have…

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