Every sales pitch I have ever heard on hedge funds sounds impressive. New strategies, technologies, and financial instruments are buzz words to convince investors that hedge funds can deliver returns in any market, even a bear market. While the sales pitch can be convincing, you must take the time to do your homework if you are buying hedge funds. Here are some of my generalizations on the world on hedge funds:

What is a hedge fund?

In its origins, the term hedge fund was designed to ‘hedge’ against a bear market. Today, hedge funds are known as funds that can access alternative investment strategies that mainstream conventional products cannot. For example, a hedge fund can sell short, betting that stocks will fall in value instead of an increase in value.

In the last three years, an equity mutual fund manager has had little to no defense against market drops. With most equity funds, they are mandated to hold stocks and the manager is limited to the universe of stocks as investment opportunities. When the stock market falls, all equity funds will fall unless they have moved to cash (which most funds will not) or unless they have access to alternative investment strategies. This is precisely why hedge funds have attracted a lot of attention recently. The bottom line is a hedge fund is simply a financial tool.

Generalizations are dangerous

Every hedge fund is different. Thus it is dangerous to make generalizations and compare two hedge funds with each other. If you are buying a hedge fund, make sure you do your homework. There is just too much diversity in terms of what a hedge fund manager can do. Each hedge fund must be judged on its own merit.

Hedge funds are complex

I’ve often thought in the car industry, the more options you have, the more that could go wrong with the car. Hedge funds are no different. If you think mutual funds are complex, hedge funds increase in complexity exponentially. The reasons, some say that hedge funds are risky is that there are fewer regulations and more opportunities to make mistakes and bad investment decisions.

The world of absolute returns

A hedge fund, with access to alternative investment strategies, can make money in good times and bad. An open mandate does not tie a hedge fund manager into holding a specific investment into preset boundaries. Typically, hedge funds have an absolute benchmark as opposed to a relative benchmark. Simply put, hedge funds try not to lose money in any environment and make money in every environment. Most mutual funds try to lose less than the index and other funds in bear markets and when times are good, they try to do better relative to the index and other funds.

Complex fee structures

One of the most complex aspects of the hedge fund is how fees are paid. Typically, they have the same management fees that a regular mutual fund has, but they also have something called performance fees. Performance fees are fees over and above the management fees and they are only paid if the fund reaches certain performance incentives. If you are buying a hedge fund, make sure you take the time to read the small print on fees. This performance fee could be the biggest variable in your returns.

Understand risk

The hedge fund’s most attractive feature is the ability to protect capital and even make money in down markets. However, it is important that every investor knows that most hedge funds come with significant risk. With added investment strategies, there are also added opportunities to make bad decisions and mistakes. In a hedge fund, mistakes can be magnified without risk controls. One of the key risk factors in understanding a hedge fund’s potential exposure to leverage. Before buying a hedge fund, try to get some idea of how much leverage they can and will do, and what their worst-case scenario is? Under what conditions could they lose money? What are the risk controls?

Little to no track record

Although hedge funds have been around for a long time, their track records are pretty tough to find. At this time, a five-year track record is considered long term. Not only are the track records short but also their track records do not guarantee that hedge fund managers will not blow up with a big mistake in the future. The problem is, one mistake can be devastating for the investor.

My two cents

Hedge funds definitely have piqued my interest. Keep in mind; just like anything else, there are good hedge funds and bad ones. It is important to do your homework and understand the strategies that hedge funds employ. My personal bias is to invest in hedge funds that have good risk controls. As we have all learned, the risk does matter.