What is the difference between a hedge fund and a mutual fund? Are hedge funds available to individual investors?

Paul's Answer:

Traditionally, a hedge fund is a private investment pool that compensates management on the basis of performance rather than on a fixed percentage of assets. The term hedge fund arose from the practice of taking aggressive positions, including heavy leverage, to back up a manager's belief about near-term market performance. Some hedge funds use futures contracts and options. Others use margin to buy stocks that managers expect to go up while taking short positions in stocks expected to fall. Often a hedge fund manager has a significant personal stake in the fund and acts as a general partner to the other participants. As you can imagine, this gives the manager a very strong incentive to produce high performance while controlling risks.

Mutual funds are restricted to investing in types of assets outlined by their prospectuses. But hedge funds are free to invest in any asset, anywhere in the world. Typically, hedge funds are more opportunistic than most mutual funds. They may take highly leveraged positions in very short-term situations, hoping to get in and out of markets nimbly.

Under SEC regulations, hedge funds are private investment partnerships, limited to 99 investors. At least 65 of them must be accredited, meaning they have net worth of $1 million or more than $200,000 in annual income. Hedge funds may not advertise, and investors typically find them through informal networking or by hiring consultants. Most hedge funds have high minimum investments, typically ranging from $100,000 to millions.

Needless to say, hedge fund prices aren't listed, and they can't necessarily be sold every business day, as is the case with mutual funds.

Some mutual funds and limited partnerships are run like hedge funds. The Barr Rosenberg Market Neutral Fund is an example. It employs a balance of long and short positions in stocks in order to seek attractive returns and controlled risks. The fund has an expense ratio of 2.5 percent, much greater than average for mutual funds. The fund was down about 12.5 percent for the first nine months of this year. Last year, it lost 1.1 percent.

Recently, hedge fund returns have been very disappointing. Long Term Capital Management, a huge hedge fund that used 100-to-1 leverage, was such a large disaster that for a time it threatened to bring down the world's economies.

Unless you are a sophisticated investor with a lot of money, leave hedge funds to others. Instead, stick with mutual funds that invest in asset classes that over time have proved to be productive.