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Hedge Funds Described: What You Need To Know!

An Excerpt from the book Do-It-Yourself Hedge Funds by Wayne P. Weddington III.

Structurally, hedge funds are a type of mutual fund whose shares are available strictly by invitation. If you like a particular mutual fund, you can find it at Charles Schwab--call your broker, and the next day it can be in your account. Mutual funds are regulated by the SEC, so there are restrictions on what they can do, which purportedly protects the investor from risk. Hedge funds are mutual funds without the rules.

They are considered mutual because all investors commingle their funds in one account. Given that hedge funds are unregulated, you cannot look for data on them. You cannot even find evidence of their performance, because it is against U.S. securities law for an unregulated investment pool to advertise its performance.

Hedge funds are usually organized offshore to minimize tax implications for their investors and to minimize regulatory scrutiny, although that is slowly changing, as funds have voluntarily begun to register with the SEC. Some of the secrecy that surrounds them is in place to protect the efficacy of their investment ideas. And some of it is in place as a type of "client management"--a stiff-arm to those clients who would look over the shoulders of their managers.

Hedge funds represent the "velvet rope" of the investment community. Yes, you can be invited to the party, but the guest list is predicated on your having a bank balance of more than $5 million. Few small investors can fill those shoes. But let's look at how, without being invited to these exclusive parties, you can create your own hedge fund-type investment opportunities.

Hedge funds employ four basic techniques: 1. short selling, 2. using leverage (borrowing money to increase the number of investments you can make) 3. making a wide range of investments, and most important, 4. hedging!

I assure you that these are the only differences between a hedge fund and your own portfolio. Below is a short examination of the above points.

1. Short selling: An extremely important tool in the hedge fund manager's tool kit. What would you do if you knew that the shares of a company would decrease in value and you didn't own any shares? How would you profit? The answer is that you would sell the shares short.

A short is making a bet that the price of the security will decline by selling a security that you do not own, which you will be able to buy back at a lower price at a later date and make a profit. It is a "sell high, buy low" proposition for the investor, the opposite of the traditional "buy low, sell high" axiom-- but it can be just as profitable. By selling a security short, you are literally borrowing it ( usually from a bank or a broker) at ostensibly no cost, and selling those borrowed shares in the market.

2. Leverage: Leverage is a key element in the profitability of hedge funds. This is especially true today, as the drive for returns has intensified and the fat, obvious opportunities have significantly declined due to the surge of speculative capital. Since the opportunities are less profitable for the same risk, adding leverage enhances profits, so it has become popular.

Average individuals do not have the same access to leverage as the big players because their accounts are not of sufficient size for their brokers to actually pay attention to them. But individual investors can access leverage in other ways. Leverage is available, for example, through some investment instruments by default, such as options or futures.

3. Making a wide range of investments: Your investment universe can be one of the most important choices you will make in devising your own hedge strategy. There is no universally ideal portfolio. It all depends on what you can handle in terms of research and data. Some hedge fund managers trade as few as twelve to fifteen stocks total, but they know those stocks really, really well. Other funds, like global macro funds, trade in virtually anything that experiences trends, from cattle futures to currencies. In their case, as long as a trend or profit potential exists, any financial instrument is a potential profit maker.

For new investors, it is safest to start in a universe that you know well, perhaps the industry in which you work. If you know your job and your company, you are likely to know how your company, its competitors, and the industry as a whole are performing. As your expertise and confidence grow, you can expand your universe to include other industries and asset classes.

4. Hedging: Hedging is the most important part of your hedge strategy. It sounds obvious, but in practice it is not. You have a choice: invest in a security and hold on for the ride, or find a way to hedge your investment, eliminating some of the volatility while still holding the security long term.

Contrary to popular belief, hedging and hedge strategies are specifically intended to reduce risk by hedging one's exposures. Hedging is a technique that seeks profit by buying a "long" position while reducing the investor's overall risk exposure by hedging, selling against it. The hedge may return more or return less than would holding the long security outright. It will depend on the relative performance of the "legs" of the hedge.

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