# Hedge Funds, basic facts ?



## samfarrell (14 Jun 2007)

I was in the US recently and they seem so bullish about Hedge Funds and the great returns they are showing. my question is how exactly does a hedge fund differ from a normal managed fund, or where could i get more information on these ?


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## tiger (14 Jun 2007)

have a look at wikipedia to start with.


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## tiger (14 Jun 2007)

A link to a link lead to [broken link removed] article on how mutual funds & hedge funds differ. 





> U.S. mutual funds are among the most strictly regulated financial products. They are subject to numerous requirements designed to ensure they operate in the best interests of their shareholders. Hedge funds are private investment pools subject to far less regulatory oversight.


(Again, both articles are US focused)


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## samfarrell (14 Jun 2007)

thanks for the info Tiger
People with the time and inclination maybe would be better off setting up their own trading clubs , manage their own money. hedge funds seem to be an elaborate version of this


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## charttrader (14 Jun 2007)

A quick summary from www.investopedia.com

_Hedge funds are managed much more aggressively than their mutual fund counterparts. They are able to take speculative positions in derivativeoptions and have the ability to short sell stocks. This will typically increase the leverage - and thus the risk - of the fund. This also means that it's possible for hedge funds to make money when the market is falling. Mutual funds, on the other hand, are not permitted to take these highly leveraged positions and are therefore typically safer._ 

http://www.investopedia.com/ask/answers/173.asp

I'm not sure why people in the US would be "so bullish about Hedge Funds and the great returns they are showing", however.  In the early days of hedge funds,  managers were able to easily exploit market inefficiencies and enjoy outsized returns.  It's a lot more competitive these days and the proliferation of hedge funds has eroded returns.  Hedge fund returns in 2006 lagged the overall market.


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## ClubMan (14 Jun 2007)

There are some existing threads on _AAM _discussing hedge funds that might be worth seeking out.


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## Guest126 (14 Jun 2007)

samfarrell said:


> thanks for the info Tiger
> People with the time and inclination maybe would be better off setting up their own trading clubs , manage their own money. hedge funds seem to be an elaborate version of this


 
I could not agree with this statement.

Hedge funds are perhaps the most sophisitcated and technically involved form of fund management - they are about as far removed from a trading club as you can get!


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## Fintan (14 Jun 2007)

samfarrell said:


> thanks for the info Tiger
> People with the time and inclination maybe would be better off setting up their own trading clubs , manage their own money. hedge funds seem to be an elaborate version of this



Where I can sort of see where you are coming from, comparing a hedge fund to a trading club is like comparing an F1 car to a go-kart.


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## RedJoker (15 Jun 2007)

Hedge funds are different to both mutual and index funds.  I'll explain why in a sec.  First there are two terms you need to understand, alpha and beta.  

Beta is matching the market.  If you invest in an index fund you will get the beta return less fees.  If you invest in an ETF (Exchange Traded Fund) then you'll make the beta return less commissions.  Passive investors should always look to get the beta return by investing in index funds or ETFs.  Beta investing is positive sum, the market has risen historically.

Alpha is beating the market or underperforming the market.  This is what active investors try to achieve.  Alpha investing is a zero sum game, when one person beats the market another person underperforms by the same amount.

Index funds/ETFs are long only and get beta return only.  They do not attempt to get alpha return.

Mutual funds are long only so they get the beta return and attempt to get alpha returns as well.  Once fees are taken into account the majority fail to get a positive alpha return for their clients, and hence underperform the market.

Hedge funds on the other hand, are 50% long and 50% short, hence the term hedge in the name.  They get zero beta return.  They attempt to achieve alpha returns and, because they have the best managers, usually do.  Hedge funds are far less volatile then mutual funds/index funds/ETFs because they suffer much, much less of the volatility of the market (which is approx 17-18% standard deviation I think).

Hedge funds are a low risk asset.  If you leveraged Hedge funds to the same risk as the market then Hedge funds have consistently outperformed the market historically.  Or, in other words, Hedge funds outperform the market on a risk adjusted basis.  However, Hedge funds shouldn't really be compared to standard market benchmarks, such as the SP-500, in this way because they are very different investment vehicles.

Hedge funds are less regulated then mutual funds, this means they have far more choice over what companies to invest in and can move money around easier, even taking it out of the market if it suits them.  This also means that they are a lot less transparent then mutual funds and there have been some notable blow ups.  Hedge funds (at least the best ones) have very high minimum investments (low millions) and often do not allow you to withdraw your funds for a certain length of time.

Links for more info on hedge funds:

http://www.hedgeworld.com/



http://www.vanhedge.com/


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## room305 (15 Jun 2007)

RedJoker said:


> Hedge funds are a low risk asset.  If you leveraged Hedge funds to the same risk as the market then Hedge funds have consistently outperformed the market historically.



I think these statements are misleading. Hedge funds are not "low risk", there is a very real chance of incurring significant loss of capital as there is with any highly leveraged vehicle. Most hedge funds _underperform_ the market. To all intents and purposes, they are the market now, it is impossible for them all to outperform.

What you failed to mention is the huge fees that they charge. Usually they work on a 2/20 rule - they charge 2% management fees on capital invested and keep 20% of profits generated. Only the very best hedge funds can return alpha returns for investors with these kinds of fees.


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## Guest126 (15 Jun 2007)

I agree that the term hedge is misleading - a lot of them now specialise in 'Special Situation' companies (amongst other things)...there is no hedging going on at all, and they are often high risk.


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## Sunny (15 Jun 2007)

RedJoker said:


> Hedge funds on the other hand, are 50% long and 50% short, hence the term hedge in the name.


 
Well, thats just not true. 



redjoker said:


> Hedge funds are a low risk asset.
> Hedge funds are less regulated then mutual funds, This also means that they are a lot less transparent then mutual funds and there have been some notable blow ups.


 
Do you not contradict yourself there? I would never describe hedge funds as low risk assets. I don't know many people who would.


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## samfarrell (15 Jun 2007)

wow, 20% seems a lot to take off profits. I would assume from this that, initially at least, hedge funds were far outperforming the market return. maybe some still are


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## CCOVICH (15 Jun 2007)

The theory (with most funds with higher charges) is that they will outperform the market.  This isn't always the case of course.

Bear in mind that in order to invest directly in a hedge fund you would need to be a 'high net worth individual', i.e. you can't just call them up and invest €10k-minimum investments are generally much higher.

There may be other ways to get exposure, e.g. through ETFs etc.


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## efm (15 Jun 2007)

RedJoker said:


> Passive investors should always look to get the beta return by investing in index funds or ETFs. Beta investing is positive sum, the market has risen historically.



That is a gross generalisation for two reasons - one, index funds or ETF's are not the only vehicle for passive investors and are not suitable for all investors and two Beta investing is only positive sum if returns are greater than costs and also you're assuming that markets will continue to rise.



RedJoker said:


> Mutual funds are long only so they get the beta return and attempt to get alpha returns as well. Once fees are taken into account the majority fail to get a positive alpha return for their clients, and hence under perform the market.



Further gross generalisation - mutual funds are not all long only and I would like to see the backup for your claim that the majority fail to get positive alpha



RedJoker said:


> Hedge funds on the other hand, are 50% long and 50% short, hence the term hedge in the name. They get zero beta return. They attempt to achieve alpha returns and, because they have the best managers, usually do. Hedge funds are far less volatile then mutual funds/index funds/ETFs because they suffer much, much less of the volatility of the market (which is approx 17-18% standard deviation I think).



This has got to be the daftest thing I have ever heard.  Hedge funds are not 50% long / 50% short (some may be but I doubt if they are in the majority).  Hedges do get beta against hedge indices.  Can you categorically say that the majority of hedge funds achieve positive alpha? - I think not!  Hedges are not less volatile than non-hedges



RedJoker said:


> Hedge funds are a low risk asset



Saving the best 'till last - hedges are not a low risk assets - by their definition they invest in riskier investments and are not as closely regulated as mutual funds so for the investor the risk when investing in hedges is much higher than when investing in mutuals


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## samfarrell (15 Jun 2007)

just getting back to the question, i found some good info 


*Key Characteristics of Hedge Funds*

Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. 
Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.). 
Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded. 
Many hedge funds have the ability to deliver non-market correlated returns. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns. 
Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent. 
Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns. Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage. 
Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund


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## RedJoker (15 Jun 2007)

Sigh, it looks like I've got my work cut out for me, I will try to answer as much as I know.



room305 said:


> I think these statements are misleading. Hedge funds are not "low risk", there is a very real chance of incurring significant loss of capital as there is with any highly leveraged vehicle. Most hedge funds _underperform_ the market. To all intents and purposes, they are the market now, it is impossible for them all to outperform.



I'm using low risk to mean low volatility, as far as I'm aware the majority of hedge funds are low volatility.  As I mentioned, comparing Hedge funds to the market is not the best way of thinking about them.  Yes; I think a lot of  hedge funds underperform the market but not on a risk (volatility) adjusted basis.



room305 said:


> What you failed to mention is the huge fees that they charge. Usually they work on a 2/20 rule - they charge 2% management fees on capital invested and keep 20% of profits generated. Only the very best hedge funds can return alpha returns for investors with these kinds of fees.




Yes; I did forget to mention this.  I was planning to include it in the last paragaph but forgot, nice catch.



CapitalCCC said:


> I agree that the term hedge is misleading - a lot of them now specialise in 'Special Situation' companies (amongst other things)...there is no hedging going on at all, and they are often high risk.



Yes; because they have far more investment tools to work with, [SIZE=-1]including selling short, leverage, program trading, swaps, arbitrage, and derivatives,[/SIZE]  there are a number of aggressive funds.  Many of these would not be 'hedged' and may be higly leveraged as well. These funds serve a different purpose for the investor and I think this is the main reason for my differing opinion.  I'm focusing on the 'hedged' funds.   An investor should be well aware what type of fund they are getting into before they invest.  



Sunny said:


> > Hedge funds on the other hand, are 50% long and 50% short, hence the term hedge in the name.
> 
> 
> Well, thats just not true.



Well you've certainly proved your point and it's hard to argue with that logic.

Allow me to rephrase my sentence:
Most hedge funds are 50% long and 50% short, I'm assuming that's where the term hedge in the name comes from.



Sunny said:


> > Hedge funds are a low risk asset.
> > Hedge funds are less regulated then mutual funds, This also means that they are a lot less transparent then mutual funds and there have been some notable blow ups.
> 
> 
> Do you not contradict yourself there? I would never describe hedge funds as low risk assets. I don't know many people who would.



I meant low risk as in low volatility, I can see how this looks like a contradiction.



efm said:


> > Passive investors should always look to get the beta return by investing in index funds or ETFs. Beta investing is positive sum, the market has risen historically.
> 
> 
> That is a gross generalisation for two reasons - one, index funds or ETF's are not the only vehicle for passive investors and are not suitable for all investors
> ...





efm said:


> > Mutual funds are long only so they get the beta return and attempt to get alpha returns as well. Once fees are taken into account the majority fail to get a positive alpha return for their clients, and hence under perform the market.
> 
> 
> Further gross generalisation - mutual funds are not all long only and I would like to see the backup for your claim that the majority fail to get positive alpha



Please forgive my generalisations but I can't go in to every specific detail without making this thread extremely long, and some of the finer points are outside my field of knowledge.





efm said:


> > Hedge funds on the other hand, are 50% long and 50% short, hence the term hedge in the name. They get zero beta return. They attempt to achieve alpha returns and, because they have the best managers, usually do. Hedge funds are far less volatile then mutual funds/index funds/ETFs because they suffer much, much less of the volatility of the market (which is approx 17-18% standard deviation I think).
> 
> 
> 
> ...





efm said:


> > Hedge funds are a low risk asset
> 
> 
> Saving the best 'till last - hedges are not a low risk assets
> ...





samfarrell said:


> just getting back to the question, i found some good info
> 
> 
> *Key Characteristics of Hedge Funds*
> ...



I would agree with this and a lot of it backs up some of my points.


It seems that a lot of our disagreements here stem from definition of certain words.


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## Nermal (15 Jun 2007)

efm said:


> I would like to see the backup for your claim that the majority fail to get positive alpha


 
Conceivably the majority of mutual funds could get positive alpha, but only if the non-mutual fund part of the market got negative alpha. There's no reason to think this would be the case.


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## RedJoker (15 Jun 2007)

Nermal said:


> > I would like to see the backup for your claim that the majority fail to get positive alpha
> 
> 
> Conceivably the majority of mutual funds could get positive alpha, but only if the non-mutual fund part of the market got negative alpha. There's no reason to think this would be the case.



Not to take this thread too far off topic but the reason mutual funds underperform is because of excessive fees and poor execution.  Some out perform the market but it is very hard to find those that will continue to do so because:

1) the best managers will get snapped up by the hedge fund industry and
2) because the fund is outperforming it will have more money than it used to have, especially if new investors are allowed to come in.  Getting market beating returns on a small fund is far easier then it is on a large fund.


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## Fintan (15 Jun 2007)

Hi RedJoker 

To say a hedge fund is 50% long and 50% short is completely innacurrate, while some trading strategies still employ some sort of arbitrage using this technique, due to the large number of active hedge funds these techniques are less effective, therefore hedge funds have to become even more leveraged to makes gains which leads nicely onto my second point

To say hedge funds are low risk / low volaility again is extremely innaccurate eg. due to their high leverage small movements in prices will cause huge swings in P&L 


Maybe a read of a book on Long Term Capital Management would be in order. (LTCM was an Uber hedge fund that went bust and nearly collapsed the world econonmy).


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## RedJoker (15 Jun 2007)

Fintan said:


> Hi RedJoker



Hi Fintan, I've linked a lot of material here but there's some good reading in there.



Fintan said:


> To say a hedge fund is 50% long and 50% short is completely innacurrate,



It seems I've been focusing on market-neutral long/short equity hedge funds.  According to Investopedia there are a number of other types of hedge funds.  However, the ones I'm describing appear to be in the majority.



Fintan said:


> while some trading strategies still employ some sort of arbitrage using this technique, due to the large number of active hedge funds these techniques are less effective, therefore hedge funds have to become even more leveraged to makes gains which leads nicely onto my second point



If it's pure arbitrage then it doesn't matter how much you leverage it because, by definition, it is zero risk.  The hedge funds I was describing weren't arbitrageurs.



Fintan said:


> To say hedge funds are low risk / low volaility again is extremely innaccurate eg. due to their high leverage small movements in prices will cause huge swings in P&L


According to [broken link removed] article market neutral funds "in general, leverage no more than three or four times capital, with most using significantly less leverage than that."



Fintan said:


> Maybe a read of a book on Long Term Capital Management would be in order. (LTCM was an Uber hedge fund that went bust and nearly collapsed the world econonmy).



From the same article:

"Quantitative funds were recently the target of negative media coverage following the severe losses by Long Term Capital Management, Ltd., a U.S. hedge fund. The negative attention focused on the fact that Long Term Capital failed despite the technical wizardry of its management team, which included Nobel Prize winners Robert Merton and Myron Scholes, and despite its claim of being market neutral. In fact, Long Term Capital was not market neutral in the sense in which I am defining the term. Rather than balance long and short equity positions, Long Term Capital bet on a convergence of spreads between various fixed income sectors, which is not a truly market neutral strategy, as prices of bonds can - and, in fact, did - diverge.         Further, Long Term Capital Management’s losses were caused by the use of an extreme amount of leverage, up to 30 times its capital, which is atypical of market-neutral long/short equity funds."

TBH I have too many books I need to read before I could get to this.  I checked up on Wikipedia though.

"As LTCM's capital base grew, they felt pressed to invest that capital _somewhere_ and had run out of good bond-arbitrage bets. This led LTCM to undertake trading strategies outside their expertise."

This is another problem, diligent investors would have seen the signs in time and gotten out.  I'd guess that most hedge fund blow-ups are caused by funds trading outside their area of expertise.  Investors should have been able to see this beforehand.


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## room305 (15 Jun 2007)

RedJoker said:


> If it's pure arbitrage then it doesn't matter how much you leverage it because, by definition, it is zero risk.  The hedge funds I was describing weren't arbitrageurs.



I think very few hedge funds employ this kind of strategy. With so many hedge funds, finding arbitrage opportunities is difficult.

A good example of the kind of hedging hedge funds do employ is the relatively recent GM credit downgrade. With rumours doing the rounds that GM debt was to be downgraded, GM bonds sold-off and the spread above US treasury bonds rose to a fairly juicy level. Hedge funds stepped in to pick up the attractive cashflow. However, they knew that if GM debt was actually downgraded they would be looking at a significant loss of capital. No problem they thought, if GM debt is downgraded the common stock will suffer correspondingly. Lets go long GM debt and short the common stock. This will cover our losses in the event a downgrade. They 'hedged' their position in GM debt.

The downgrade came but octogenarian billionaire Kirk Kerkorian launched a takeover bid at the same time and the shares rallied even as the bonds sold-off ... not a good day for hedge funds that one ;-)


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## Guest126 (16 Jun 2007)

RedJoker said:


> "As LTCM's capital base grew, they felt pressed to invest that capital _somewhere_ and had run out of good bond-arbitrage bets. This led LTCM to undertake trading strategies outside their expertise."
> 
> This is another problem, diligent investors would have seen the signs in time and gotten out. I'd guess that most hedge fund blow-ups are caused by funds trading outside their area of expertise. Investors should have been able to see this beforehand.


 
You have dropped more than a few clangers, but this one beats the lot.

A "diligent investor" would not have the time nor knowledge to monitor the investment strategy of a hedge fund manager - that is the whole risk with them, they do not need to disclose information about their strategies.

These guys (LTCM) were financial academic geniuses, and they cost a fortune, so no "diligent investor" would have had the time nor level of knowledge to monitor their strategies.


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## RedJoker (16 Jun 2007)

CapitalCCC said:


> You have dropped more than a few clangers, but this one beats the lot.
> 
> A "diligent investor" would not have the time nor knowledge to monitor the investment strategy of a hedge fund manager - that is the whole risk with them, they do not need to disclose information about their strategies.
> 
> These guys (LTCM) were financial academic geniuses, and they cost a fortune, so no "diligent investor" would have had the time nor level of knowledge to monitor their strategies.



Mutual funds are just as opaque with their holdings as well.  Of course Hedge funds disclose their strategy, who would invest with a fund that didn't tell you what type of strategy they were using.

Again I haven't done much reading on LTCM but there are always signs.  It's not like they blew up overnight,  any diligent hedge fund investor would have spotted Amaranth well before they blew up as well.  People are always shocked when big companies, Enron for example, blow up but you really have to be paying absolutely no attention not to realize there are problems.



> Can you categorically say that the majority of hedge funds achieve positive alpha? - I think not!
> 
> I don't have any papers to back it up but I'd be confident saying yes; the majority of hedge funds achieve positive alpha.



According to Ibbotson's Study, Hedge Funds create a net alpha of 3.04% per year.  For L/S only it's 5.41%



> This has got to be the daftest thing I have ever heard. Hedge funds are not 50% long / 50% short (some may be but I doubt if they are in the majority).
> 
> As far as I'm aware the majority are 50% long, 50% short.


I was wrong on this point, according to the ISI weekly survey of L/S equity hedgefunds over the past 5 years, the avg hedge fund is btw 50-52% net long, with a range of 37-62% net long.  So they are 50% net long and hence do get beta returns.

Another interesting thing to note from this is that if you were to use 2x leverage then they would be 100% net long, hence getting all beta returns and twice their alpha returns, i.e. 6.08%, hence comfortably beating the market with an approx net return after fees and leverage of 14.8%.  10.82% alpha with 23% net return for L/S only.


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## RedJoker (16 Jun 2007)

samfarrell said:


> *Key Characteristics of Hedge Funds
> *.............................
> 
> Many hedge funds have the ability to deliver non-market correlated returns. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.
> .......................



This is why they shouldn't be compared to standard market benchmarks.

This is why they are low risk (volatility).


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## Guest126 (16 Jun 2007)

Garbage (again)!

It is why, when included as part of an overall portfolio (i.e. 10% of a portfolio) they can reduce rather than increase total volaitility.

On their own, they are exceptionally volatile.

Most hedge funds do not disclose their individual shareholdings - mutual funds do.

So, to say that they are equally transparent is another fallacy.


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## charttrader (17 Jun 2007)

_Mutual funds are just as opaque with their holdings as well. Of course Hedge funds disclose their strategy, who would invest with a fund that didn't tell you what type of strategy they were using.

_Hedge funds are very secretive, they have to be to as a strategy loses its edge once others get wind of it. 

"With LTCM, they split their trades among numerous banks so that no-one could see their trading strategies.  It might do one side of a trade with one bank and another with a different bank.  It told its investors very little about its strategies and never released the details of specific trades." (taken from 'Infectious Greed' book by Frank Partnoy.


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## samfarrell (18 Jun 2007)

the general consensus seems to be that hedge funds are quite risky and not for the cautious investor. Just out of interest does anyone know what hedge funds are available in Ireland (if any) and how are they accessed?


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## River (18 Jun 2007)

samfarrell said:


> the general consensus seems to be that hedge funds are quite risky and not for the cautious investor. Just out of interest does anyone know what hedge funds are available in Ireland (if any) and how are they accessed?



Hedge Fund's are usually restricted to allowing professional investors invest. The definition can change dependent on fund but generally it means that one would need an indept knowledge and understanding of hedge funds & a net worth of over 1 million. Basically you need to be able to afford to lose your investment. Both these points are due to the high risk & complex nature of hedge funds. It should also be mentioned that minimum subscriptions start at around $100,000 but can often be much more. 

I do believe it is possible to have a Custodian invest on your behalf though and this may alleviate some of the minimum restrictions in place. I'm not too sure how this process works as would not have the funds myself to have looked into investing before. There is a large dutch bank in the IFSC though that would have more information on this.


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## River (18 Jun 2007)

RedJoker said:


> This is why they shouldn't be compared to standard market benchmarks.
> 
> This is why they are low risk (volatility).




Joker by name......


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## RedJoker (18 Jun 2007)

Looking at pages 18, 24 & 25 of Kazemi and Schneeweis 2001, the standard deviation of nearly all types of hedge funds studied was lower than the SP-500 for the 5 year period 96 - 00.  Specifically only CSFB Managed Futures had a higher standard deviation over the period.  If anybody can find data for more recent years or data over longer time frames I'd be interested in reading it.


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## RedJoker (18 Jun 2007)

CapitalCCC said:


> Garbage (again)!



I really don't see the need for people to make meaningless remarks like this at the start of posts.  Please just attack the content with reasoned arguments in future.



CapitalCCC said:


> It is why, when included as part of an overall portfolio (i.e. 10% of a portfolio) they can reduce rather than increase total volaitility.



This is true but is also true of all non-correllated assets.  Is your 10% figure here an arbitrary one, did you mean e.g. instead of i.e.?



CapitalCCC said:


> On their own, they are exceptionally volatile.



Please link proof of this statement.



CapitalCCC said:


> Most hedge funds do not disclose their individual shareholdings - mutual funds do.



Mutual funds only do this at the end of the month and only to people who fit certain criteria:

as long as the recipient has a legitimate business need for the information and the disclosure of Fund portfolio holding information to that third party is: 
- approved by an individual holding the title of Executive Vice President or above;
- approved by an individual holding the title of Chief Counsel or above; and 
- subject to a written confidentiality agreement that includes provisions that restrict trading on the information. 

Link 

As you can see the information is not exactly an easy thing to get hold of.



CapitalCCC said:


> So, to say that they are equally transparent is another fallacy.



I never said that.  In fact I said exactly the opposite in my first post in this thread.


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## RedJoker (18 Jun 2007)

charttrader said:


> _Mutual funds are just as opaque with their holdings as well. Of course Hedge funds disclose their strategy, who would invest with a fund that didn't tell you what type of strategy they were using.
> 
> _Hedge funds are very secretive, they have to be to as a strategy loses its edge once others get wind of it.
> 
> "With LTCM, they split their trades among numerous banks so that no-one could see their trading strategies.  It might do one side of a trade with one bank and another with a different bank.  It told its investors very little about its strategies and never released the details of specific trades." (taken from 'Infectious Greed' book by Frank Partnoy.



I'm going to accept defeat on this LTCM argument as I do not know enough about the specifics to discuss it properly, and ye are probably right.  It did lead to some interesting reading though, so thanks for that.


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## Guest126 (18 Jun 2007)

Joker, at this stage I can only presume you are joking, you are making so many uninformed statements about hedge funds, I have neither the time nor the inclination to correct them.


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## RedJoker (18 Jun 2007)

CapitalCCC said:


> Joker, at this stage I can only presume you are joking, you are making so many uninformed statements about hedge funds, I have neither the time nor the inclination to correct them.



I suppose the articles, surveys, studies and websites I've linked/cited are uninformed too.

Most of my 'uninformed' opinions on hedge funds have come from hedge fund managers I know.  One retired hedge fund manager, who ran a global long/short equity fund, said that most of the hedge funds he knew where way underleveraged and had much less risk than the market.  I trust his opinion but obv can't expect you to do the same which is why I tried to back up what I said.  Fwiw his funds results (approx) after fees were:

95 +30%
96 +25%
97 +18%
98 +10%
99 +20%
00 +29%
01 +8%
02 +2%
03 -1%
04 +8%

They broke $1B in 99 and $3B in 2002, obv bigger is much harder so that explains some of the drop off in results.


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## Guest126 (18 Jun 2007)

Ask your hedge fund manager friends about LTCM - the fact you know so little about LTCM would indicate you have done very little research into hedge funds...other than listen to what your hedge fund manager friends tell you.


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## Sunny (19 Jun 2007)

room305 said:


> A good example of the kind of hedging hedge funds do employ is the relatively recent GM credit downgrade. With rumours doing the rounds that GM debt was to be downgraded, GM bonds sold-off and the spread above US treasury bonds rose to a fairly juicy level. Hedge funds stepped in to pick up the attractive cashflow. However, they knew that if GM debt was actually downgraded they would be looking at a significant loss of capital. No problem they thought, if GM debt is downgraded the common stock will suffer correspondingly. Lets go long GM debt and short the common stock. This will cover our losses in the event a downgrade. They 'hedged' their position in GM debt.
> 
> The downgrade came but octogenarian billionaire Kirk Kerkorian launched a takeover bid at the same time and the shares rallied even as the bonds sold-off ... not a good day for hedge funds that one ;-)


 
A perfect example of the danger of hedge funds and why trying to describe them as plain long/short or market neutral is completely mis-leading. Each one of those funds would have said to their investors that they were hedged. Good day alright!


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## room305 (19 Jun 2007)

RedJoker said:


> One retired hedge fund manager, who ran a global long/short equity fund, said that most of the hedge funds he knew where way underleveraged and had much less risk than the market.



Interesting that your friend seems to have only performed well from 00-02. Perhaps his fund leans on the bearish side too much? Nevertheless, this is a pretty strange statement to come out with. The definition of an "underleveraged" fund is of course, very subjective, but surely _any_ leverage whatsover increases your risk? Even a market neutral, low volatility seeking strategy does not imply the absence of risk.

Subprime CDOs and corporate junk bonds may have low volatility (many subprime CDOs are not even marked-to-market) but that does not imply they have less risk than the general market.


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## z108 (19 Jun 2007)

room305 said:


> Interesting that your friend seems to have only performed well from 00-02..



Was that a typo ? Did you mean *before* 00 ?


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## CCOVICH (19 Jun 2007)

samfarrell said:


> the general consensus seems to be that hedge funds are quite risky and not for the cautious investor. Just out of interest does anyone know what hedge funds are available in Ireland (if any) and how are they accessed?


 
I see a link on the Dolmen website for hedge funds-might be worth looking at if you are still interested.


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## room305 (19 Jun 2007)

sign said:


> Was that a typo ? Did you mean *before* 00 ?



No, I definitely meant from 00 to 02. In 00, the S&P 500 returned negative 10% whereas RedJoker's friend returned nearly 30%. That's phenomenal outperformance but is not matched in any other years. Hence my wondering if the fund was very bearishly inclined.


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## RedJoker (19 Jun 2007)

room305 said:


> Interesting that your friend seems to have only performed well from 00-02. Perhaps his fund leans on the bearish side too much? Nevertheless, this is a pretty strange statement to come out with. The definition of an "underleveraged" fund is of course, very subjective, but surely _any_ leverage whatsover increases your risk? Even a market neutral, low volatility seeking strategy does not imply the absence of risk.
> 
> Subprime CDOs and corporate junk bonds may have low volatility (many subprime CDOs are not even marked-to-market) but that does not imply they have less risk than the general market.



Yes; but it's not really surprising since long/short hedge funds are designed to protect you from capital loss during a bear market. In 2000, for example, they had little to no net exposure.

Here is the S&P from 2000 on

00 -9.1
01 -11.9
02 -22.1

During that three year period his fund was +42% while the S&P was down 38%.

Having taken the risk of on average around 6% volatility vs like 17% for the S&P 500.  From 95 to 02 their worst down month was like 2-3%.  They were way underlevaged and probably didn't use enough capital, those results should be far higher.

Anyway I think it's funny that some people here have said that hedge funds underperform the market (which as far as I'm aware is true), have way more volatility than the market (not true) and according to river are only available to professional investors (don't think this is true but might depend on how he's defining professional).

So.....professional investors would choose an asset which underperforms the market with more volatility.  Anybody else see the break in logic here?


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## RedJoker (19 Jun 2007)

RedJoker said:


> > *Key Characteristics of Hedge Funds
> > *.............................
> >
> > Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.
> ...



I feel I should clarify this.  I didn't mean for this to be a proof or anything, my point was that if the best investment managers in the world have as an objective consistent returns and capital preservation, chances are that's what they're going to get, hence low volatility.


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## room305 (19 Jun 2007)

RedJoker said:


> Having taken the risk of on average around 6% volatility vs like 17% for the S&P 500.  From 95 to 02 their worst down month was like 2-3%.  They were way underlevaged and probably didn't use enough capital, those results should be far higher.
> 
> Anyway I think it's funny that some people here have said that hedge funds underperform the market (which as far as I'm aware is true), have way more volatility than the market (not true) and according to river are only available to professional investors (don't think this is true but might depend on how he's defining professional).



Didn't borrow enough capital you mean! I'm no expert but my understanding is that hedge funds in general tend towards low volatility, low risk trades but then try to beef the correspondingly poor returns with heavy gearing. I've heard tell of 50:1 in many cases - certainly the leverage on top of leverage LTCM applied could result in almost 1000:1 leverage in some trades.

As I said though, referring to a fund as "underleveraged" can only be a very subjective assessment. Any leverage would be too much for a fund I would invest in.

So if you like, you can view it that there is both risk and there is exposure to risk. Hedge funds might be low risk but the exposure they have to that risk generally greatly exceeds the capital of the fund. Look at the mess Bear Sterns is in - here for example.

I think this is where to confusion is arising regarding the risk involved in hedge fund investments.



RedJoker said:


> So.....professional investors would choose an asset which underperforms the market with more volatility.  Anybody else see the break in logic here?



I'm not sure if you see too many professional investors investing in hedge funds - as Bill Bonner puts it, there is something almost noble in their ability to relieve the rich of vast sums of money in exchange for relatively poor returns.



> No one likes the highwayman who robs the poor of their last pennies. But, who can fail to appreciate the polished society burglars, who pass among the rich only to relieve them of their diamonds and gold? What these super-rich hedge fund managers do is almost respectable: they separate the rich from their money! You can verify this for yourself. Just read from the Forbes list of rich people, where you will find hedge fund managers in droves, but we can guarantee you, not one hedge fund investor.


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## RedJoker (19 Jun 2007)

room305 said:


> Didn't borrow enough capital you mean! I'm no expert but my understanding is that hedge funds in general tend towards low volatility, low risk trades but then try to beef the correspondingly poor returns with heavy gearing. I've heard tell of 50:1 in many cases - certainly the leverage on top of leverage LTCM applied could result in almost 1000:1 leverage in some trades.



There seems to be a heavy fear of leverage on this board for some reason.  My point was if you leveraged his fund to the same risk as the S&P he would have vastly outperformed the market.



room305 said:


> As I said though, referring to a fund as "underleveraged" can only be a very subjective assessment. Any leverage would be too much for a fund I would invest in.



Many leveraged hedge funds are lower risk than the S&P.  Would you invest in the S&P, a higher volatility investment?  



room305 said:


> So if you like, you can view it that there is both risk and there is exposure to risk. Hedge funds might be low risk but the exposure they have to that risk generally greatly exceeds the capital of the fund. Look at the mess Bear Sterns is in - here for example.
> 
> I think this is where to confusion is arising regarding the risk involved in hedge fund investments.



Ok I think I see where you're coming from here.  You're point is that hedge funds have a greater risk of ruin?  I don't know the answer to that but a lot of mutual funds disappear as well.  This line of reasoning might also explain why people keep referring to LTCM even though it's just 1 hedge fund out of approx 10,000 (I think).



room305 said:


> I'm not sure if you see too many professional investors investing in hedge funds - as Bill Bonner puts it, there is something almost noble in their ability to relief the rich of vast sums of money in exchange for relatively poor returns.



I already showed that hedge funds create positive alpha.  I also showed they are low volatility.  Therefore they are creating relatively (compared to the market) good returns on a risk adjusted basis.

Your point about risk of ruin is worth considering but I don't have any data or statistics to argue it one way or the other.


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## Nermal (19 Jun 2007)

RedJoker said:


> I already showed that hedge funds create positive alpha.


 
You showed that a particular hedge fund created alpha at some point in the past, which is not the same thing.

Lovely quote by the way Room305.


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## RedJoker (19 Jun 2007)

Nermal said:


> You showed that a particular hedge fund created alpha at some point in the past, which is not the same thing.



No; if you recall I linked a study which showed that Hedge funds created an alpha of 3.04% and L/S Hedge funds created an alpha of 5.41%.  Here it is again.


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## room305 (20 Jun 2007)

RedJoker said:


> There seems to be a heavy fear of leverage on this board for some reason.  My point was if you leveraged his fund to the same risk as the S&P he would have vastly outperformed the market.



Leverage increases risk. Hence the fear. I can produce market beating returns by borrowing to buy units in a passive index tracker but there is a greater risk of significant loss of capital.



RedJoker said:


> Many leveraged hedge funds are lower risk than the S&P.  Would you invest in the S&P, a higher volatility investment?



Volatility in itself isn't necessarily an issue. I have investments in a number of highly volatile instruments - silver for example. However, if I use leverage I am putting a greater amount of my capital at risk. How many geared investors (via the so called carry trade) received margin calls during the US bond sell-off recently? I'll bet 30-yr US treasury bonds are normally considered a low volatility instrument.



RedJoker said:


> Ok I think I see where you're coming from here.  You're point is that hedge funds have a greater risk of ruin?  I don't know the answer to that but a lot of mutual funds disappear as well.  This line of reasoning might also explain why people keep referring to LTCM even though it's just 1 hedge fund out of approx 10,000 (I think).



Ruin is a bit strong and LTCM is the extreme example that can be used to push the general point - increased leverage increases your exposure to risk and hence results in a greater risk to your capital. The fund doesn't necessarily have to go bankrupt but a 20% loss of capital in one year will take years to recover from.



RedJoker said:


> I already showed that hedge funds create positive alpha.  I also showed they are low volatility.  Therefore they are creating relatively (compared to the market) good returns on a risk adjusted basis.
> 
> Your point about risk of ruin is worth considering but I don't have any data or statistics to argue it one way or the other.



There are simply too many hedge funds now for it to be argued that they all beat the market. Some have incredible returns spanning decades but these are the exception not to rule. Remember past volatility is no guarantee of future volatility and heavily leveraged hedge funds run a very real risk of significant loss of capital. The fact that they are leveraged means that one wrong bet often forces margin calls that must be met by liquidating profitable positions - this is what happened with Amaranth and more recently Bear Sterns. I'm pretty sure I've seen signs of similar things happening in certain markets as well.

I'd go along with CapitalCCC's suggestion that hedge funds could form part of an investment strategy but not all. Depends on the fund though obviously.


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## Sunny (20 Jun 2007)

room305 said:


> There are simply too many hedge funds now for it to be argued that they all beat the market. Some have incredible returns spanning decades but these are the exception not to rule. Remember past volatility is no guarantee of future volatility and heavily leveraged hedge funds run a very real risk of significant loss of capital. The fact that they are leveraged means that one wrong bet often forces margin calls that must be met by liquidating profitable positions - this is what happened with Amaranth and more recently Bear Sterns. I'm pretty sure I've seen signs of similar things happening in certain markets as well.


 
I agree. Merrill Lynch did a research piece this year saying that Alpha had practically dissapeared from the hedge fund industry or at least to the extent that it was almost impossible to justify fees like 2% management fee plus 20% of profits. They argued that most hedge fund returns are coming from the broader market and can be replicated by indices. Not sure I fully agree but I certainly think it is harder for the hedge funds.

Hedge Funds are like any asset. They have their advantages and disadvantages and it comes down to individual investment decisions. I work on the buy side for an investment bank and we have invested money with hedge funds. However, the due dilligence that we go through before putting money in is quiet time consuming and we have access to the managers that the man on the street wouldn't have and there is no way that we would invest a cent without going through the process. I think that is what people mean when they say that the funds are probably not suitable for the ordinary Joe Soap investor who is used to long only mutual funds.


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## Nermal (20 Jun 2007)

RedJoker said:


> No; if you recall I linked a study which showed that Hedge funds created an alpha of 3.04% and L/S Hedge funds created an alpha of 5.41%. Here it is again.


 
From the abstract: 'We analyze the performance of a universe of about 3,500 hedge funds from the TASS database from January 1995 through April 2006'. Particular hedge funds, over a particular period in the past.


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## zephyro (20 Jun 2007)

RedJoker said:


> No; if you recall I linked a study which showed that Hedge funds created an alpha of 3.04% and L/S Hedge funds created an alpha of 5.41%. Here it is again.


 
Did this study use traditional or non-traditional betas?


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## RedJoker (20 Jun 2007)

zephyro said:


> Did this study use traditional or non-traditional betas?



Traditional.


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## RedJoker (20 Jun 2007)

Nermal said:


> You showed that a particular hedge fund created alpha at some point in the past, which is not the same thing.





Nermal said:


> From the abstract: 'We analyze the performance of a universe of about 3,500 hedge funds from the TASS database from January 1995 through April 2006'. Particular hedge funds, over a particular period in the past.



That's a bit different then 'a particular' at 'some point in the past', it's a significant percentage of hedge funds over more than a decade.  That's all I was taking issue with.


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## RedJoker (20 Jun 2007)

room305 said:


> I'd go along with CapitalCCC's suggestion that hedge funds could form part of an investment strategy but not all. Depends on the fund though obviously.



I agree with that, I'd never suggest they should make up all of an investment strategy.



Sunny said:


> Hedge Funds are like any asset. They have their advantages and disadvantages and it comes down to individual investment decisions.



Completely agree.


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## zephyro (20 Jun 2007)

RedJoker said:


> Traditional.


 
Do you know of any studies that use multi-factor betas? Any hedge fund that simply used a momentum factor for example in the past could expect to show positive alpha using traditional beta, but I'd hardly use that as evidence of manager skill.


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## Guest126 (20 Jun 2007)

Redjoker that survey you mention (of hedge fund performance) has a major flaw - it excludes the hedge funds...and God there are many...that went belly up during the reporting period and so were not included by the end of the survey, this survivorship bias means that hedge fund surveys always overstate the performance of hedge funds and understate their volatility.


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## RedJoker (20 Jun 2007)

CapitalCCC said:


> Redjoker that survey you mention (of hedge fund performance) has a major flaw - it excludes the hedge funds...and God there are many...that went belly up during the reporting period and so were not included by the end of the survey, this survivorship bias means that hedge fund surveys always overstate the performance of hedge funds and understate their volatility.



From the second sentence of the abstract:

"First, we analyze the potential biases in reported hedge fund returns, in particular survivorship bias and backfill bias, and attempt to create an unbiased return sample."

There was a whole section given to survivorship bias.  They estimated it at 5.68%, which is far higher than any other survey had estimated it before.  Brown, Goetzmann and Ibbotson (1999) estimated 3% from 1989–1995 as did Fung and Hsieh (2000) on the TASS database from 1994–1998. Barry (2003) using the TASS data from 1994 to 2001 estimated 3.8%. Ackermann, McEnally and Ravenscraft (1999) estimated a 0.2% survivorship bias which, according to Liang (2000), may be explained by compositional differences in the databases and different timeframes.

The figures I quoted were adjusted for this survivorship bias along with other potential biases.


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## RedJoker (20 Jun 2007)

zephyro said:


> Do you know of any studies that use multi-factor betas? Any hedge fund that simply used a momentum factor for example in the past could expect to show positive alpha using traditional beta, but I'd hardly use that as evidence of manager skill.



Yes; from page 12:

"Asness (2004a and 2004b) further proposed breaking hedge fund alpha into: 1) beta exposure to other hedge funds, and 2) manager skill alpha. Fund and Hsieh (2002 and 2004) analyzed hedge fund returns with traditional betas and non-traditional betas, which include trend following exposure (or momentum) and several derivative-based factors. They found that adding the non-traditional beta factors can explain up to 80% of the monthly return variation in hedge fund indexes. Although we agree that a portion of the hedge fund returns can be explained by non-traditional betas (or hedge fund betas), these non-traditional beta exposures are not readily available to individual or institutional investors. Since hedge funds are the primary way to gain exposure to these non-traditional betas, these non-traditional betas should be viewed as part of the value-added that hedge funds provide compared to traditional long-only managers."


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## room305 (21 Jun 2007)

Further information of interest summarised here with links to more information.

http://delong.typepad.com/sdj/2007/06/marginal_revolu.html


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## gonk (21 Jun 2007)

RedJoker said:


> From the second sentence of the abstract:
> 
> "First, we analyze the potential biases in reported hedge fund returns, in particular survivorship bias and backfill bias, and attempt to create an unbiased return sample." etc, etc, etc


 
Ah lads, I thought you were going to give us the basic facts . . . .


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## z108 (21 Jun 2007)

Once I figure out what alpha and beta means Ill be sorted


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## Sunny (21 Jun 2007)

sign said:


> Once I figure out what alpha and beta means Ill be sorted


 
Don't forget about the Delta and Gamma either....


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## RedJoker (21 Jun 2007)

gonk said:


> Ah lads, I thought you were going to give us the basic facts . . . .



Survivorship bias is the tendency for poor performers to drop out and close, leaving the stronger performers.  This creates an overestimation of past returns.

Backfill bias is the tendency for funds to only start reporting their returns after a number of good years, once again creating an overestimation of past returns.


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## howdydoo (23 Jun 2007)

Not all hedge funds will return your money after enormous management fees. Even if it does return handsomely, most of the winning funds are already closed from further investments. 

So hedge funds are cool to many but the risks are there. Just the fees will set you back already. If a fund can't even perform 20% year in year out, it's very difficult to get decent returns, if it manages to avoid losses. Not to mention the taxman if you do make back a dime.


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## Askar (23 Jun 2007)

I posted a link to a study on hedge funds on another thread some time ago - the conclusion of the study, as far as I recall, was that since they are unregulated they only report the good news/returns; so results of funds suffer from reporting bias. Also, the proliferation of funds in recent years has meant that even the biased reported funds returns have reduced in the last 5 years.


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## howdydoo (25 Jun 2007)

Hedge funds is now what dotcoms was in 2000, they'll consolidate eventually with so many funds and little money to go around. I have nothing against hedge funds. The traders tend to be very successful in trading and managing large amounts of their own money. Supposedly, managing other people's money is much easier than managing your own. But when you're talking about +1000x the size of your own account, you walk like elephants and no longer as ants, whole different scenarios (and problems).


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## room305 (29 Jun 2007)

Maybe we can all start our own hedge funds?

http://www.newyorker.com/reporting/2007/07/02/070702fa_fact_cassidy


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## howdydoo (30 Jun 2007)

Nice article. Pretty much summed up what everyone here's been saying. If you do decide to start your own, here's some encouragement:


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## room305 (30 Jun 2007)

That article is brilliant although I rightly fear for any kid that idolizes Jim Cramer, I guess he'll grow out of it by the time he hits his mid-teens!


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## howdydoo (30 Jun 2007)

I'm sure he will. I'm not a fan of Jim Cramer myself (he's a walking ego pushing his own investments) but I have to say he's one of the few who's got enough guts to spill out dirt about the industry. I saw a video of him uncovering some schemes and manipulations wall street sometimes do.

http://youtube.com/watch?v=u9njlcsbATo&mode=related&search=

There are 3 parts, this is the first one. Interesting stuff.


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## Sunny (6 Jul 2007)

Here is another good article explaining the current goings on in the Credit World and the role of hege funds

http://goldnews.bullionvault.com/files/Investment_Landfill.pdf


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## tyoung (31 Jul 2007)

Some of them must have forgotten to hedge.


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## RichInSpirit (29 Dec 2011)

I'm after watching a good few youtubes tonight about hedgefunds etc. (prompted by browsing on AAM  ) including a one about a hedged trade between 2 companies which supposedly removes the market volatility risk out of the trade. And depending on the outlook for one company in the trade being  positive and the other one being somewhat negative. I kind of see a logic in it, but am wondering if the gains on one half of the trade would just cancel out the losses on the other half of the trade ?


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