Hedge Funds Still Risky

Are hedge funds now investments for the masses? Not so fast.

Long reserved for the ultra-rich and the institutional investor, these private and risky investments have grown explosively in the past few years, in part because it's become much easier for the typically wealthy investor to participate.

Since 2000, the number of such funds has doubled to more than 8,600 with total assets now $1.1 trillion, according to Hedge Fund Research Inc. of Chicago. That's the same ballpark as the mutual fund total.

Many hedge funds have lowered their minimum investments from $1 million or more to $100,000 or even $25,000. And to lower risks, banks and brokers are selling so-called funds of funds — essentially mutual funds made up of hedge funds. Meanwhile, new government rules have introduced an element of oversight into a previously unregulated field.

All this appears to make hedge funds, which pursue spectacular returns through tactics off limits to mutual funds, such as short-selling and heavily leveraged buying, a tempting gamble for the investing public.

But don't be fooled. Hedge funds are as risky as ever, particularly for the small investor.

For one thing, returns have fallen as fees are increasing, so investors see less profit.

For another, Securities and Exchange Commission rules requiring fund managers to register with the SEC are designed less to ensure security across the whole business and more to combat a rising tide of individual hedge fund fiascos like Bayou Management LLC, according to Robert Plaze, an associate director in the SEC division covering hedge funds. Bayou's collapse last year cost investors $450 million.

The rules, passed in late 2004, gave managers until Feb. 1 to register with the SEC. That provides a modicum of transparency and allows SEC regulators to perform inspections of hedge funds.

Even so, some funds are skirting the regulations by holding onto investors' money for a minimum of two years, making them exempt from the registration requirement.

The increasingly popular hedge fund products sold by retail banks and brokers are also an area of concern. Funds of funds (there are even funds of funds of funds) allow investors to spread their money over a number of hedge funds just as a mutual fund that buys stocks, supposedly decreasing the risk they'll lose their investment.

But the National Association of Securities Dealers is looking into whether its members market funds of funds to clients for whom they are not suitable.

The funds of funds should also make investors ask how much they're paying in fees, says James Cox, a professor of corporate and securities law at Duke University. A typical hedge fund charges one to two percent of assets and up to 20% of returns. The more fund managers you add to the equation, he reasons, the more of that return will be eaten up.

"I think hedge fund investing and certainly leveraged investing and speculating in various derivative forms are hugely risky propositions," says Cox. Regulation, he adds, hasn't changed the overall picture but may reduce the amount of damage any one fund collapse could cause.

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