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Hedge funds are generally regarded as non-traditional funds that posses different characteristics and utilize different investment strategies from traditional funds. There is no standard definition of a hedge fund, but most industry insiders would agree on the following key points:

• Non-institutional and evolutionary nature

• Incentive based compensation

• Absolute return or non traditional market correlated return

• Superior risk adjusted returns

Know about Hedge Funds There are a number of different classifications of hedge funds. Some simultaneously buy stocks that are thought to be undervalued while selling short (selling stock not actually owned yet) other stocks thought to be too expensive. Other hedge funds seek out complex strategies on borrowing money in one currency to buy fixed income investments in other currencies.

In every strategy, the process is opaque. Each hedge fund manager claims to have a special talent and insight into the process of investing that they utilize. Disclosure of investments and the costs of investing are poor.

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In addition, trying to determine whether hedge funds are good investments is difficult. Funds that do poorly and close (estimated by some at 20% of all hedge funds yearly) are removed from the databases that track fund performance-lending to what is called subtraction bias. If only the funds that do well are left to monitor, the results are falsely tilted as showing good performance as an asset class.

Hedge fund fees are very high. The standard fee is known as “2 and twenty.” This means that the yearly fee is 2% of all assets under management plus 20% of all profits.” The 2% yearly fee is charged regardless of fund performance, and the 20% of profits only are assessed on profitable years. Some funds won’t charge the 20% of profits until prior losses are made up. However, remember that almost 1/5th of funds close each year-suggesting that in many cases investors pay their 2% in fees only to lose money.

Like the rare actively managed mutual fund, some hedge funds markedly outperform the “markets.” These funds are news for that very reason-they are unusual. Much as is the case with the mutual funds, knowing which hedge funds will do well in advance is impossible.

Most hedge funds are not registered with the SEC. For this reason, they are only open to investors with a large amount of assets and/or income who sign appropriate waivers. Brokerage houses have attempted to get around these barriers by packaging “funds of funds” in which a mutual fund composed of various hedge funds is packaged in smaller chunks for the “average investor.” Unfortunately, another layer of fees is now added to the already extraordinary cost of the underlying hedge funds. You don’t have a chance to do well.

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