The Hedge Fund Mystique: Making Money with an Investment That Goes against the Flow

EXECUTIVE SUMMARY * HEDGE FUNDS ARE SUCCESSFUL ONLY IF THEY MAKE money in both up and down markets. To do this, they employ some creative and risky investment strategies--selling short, using leverage, trading put and call options, trading futures and investing in emerging markets. * SINCE HEDGE FUNDS ARE NOT RIGHT FOR EVERYONE, CPAs should gain some understanding of these complex funds and how they work before recommending clients invest money in them. * CPAs USED TO THE VAST AMOUNTS OF INFORMATION available off mutual funds will see some critical differences. Hedge funds aren't required to report returns, generally don't have to disclose their security holdings and sometimes lock up investors' money for a year or more, Because these funds are private, they have tremendous flexibility in the investments they can make and the strategies they can follow. * HEDGE FUND INVESTORS FACE A VARIETY OF RISKS. These include liquidity risk, both within the fund and with individual investments; human risk, because a hedge fund is only as good as its managers and traders; and size risk, because as a fund grows, trading becomes more difficult and suitable investment opportunities are harder to find. * GIVEN THE COMPLEXITY OF SELECTING AND MONITORING a hedge fund, CPAs should recommend clients commit assets only after doing thorough research. The benefits of this advice are well worth the cost. When many investors look at hedge funds, they see only the allure of these high-risk investments. In reality, hedge funds are the workhorse of the investment industry. They are considered successful only if they make money--in both up and down markets. Achieving success in all kinds of markets isn't easy, so hedge funds use some creative--and risky--strategies. When shooting for absolute performance, a hedge fund might sell short, use leverage, trade put and call options, trade futures and invest in emerging markets. In a bull market, the best way to make money is to be long. In a bear market, the best way is to be short. In an up and down market like the one we have today, the best way to make money is to be both long and short. Despite the contradictions this strategy implies, hedge funds try to do it all. They move constantly, making quick trading decisions based on up-to-the-minute market conditions. This adds to the considerable risks hedge fund investors face. As such, they aren't right for every client. Here is some information about hedge funds and their risks CPAs can use to evaluate the suitability of this investment for their clients. BEWARE WHAT YOU DON'T KNOW CPAs have begun to introduce hedge funds to some of their clients. Broadly speaking, hedge funds are unregulated investment pools. They generally are more nimble and dynamic in their trading strategies than other investment funds. These strategies can be very sophisticated. Before recommending a client invest in a hedge fund, CPAs should understand some basic facts about the funds. Contrary to the old saying, what you don't know can hurt you. Hedge funds are private entities, typically organized as limited partnerships or as limited liability corporations. Because the funds are private, they have tremendous flexibility in the types of investments they can make and the strategies they can follow. This flexibility is what makes it possible for hedge funds to offset risks against each other and perform well under all kinds of market conditions. CPAs used to the vast amounts of information available about mutual funds will find some critical differences. Because hedge funds are private, they aren't required to report returns, don't generally have to disclose their security holdings and sometimes lock up investors' money for a year or more. In contrast, mutual funds post their net asset values daily, disclose their holdings quarterly or semiannually and can easily be bought and sold on a daily basis. …